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Last Updated: Friday, 15 April, 2005, 00:23 GMT 01:23 UK
The ups and downs of flat taxes
By James Arnold
BBC News business reporter

Tallinn, Estonia
Rapid reform has helped Estonia wax rich
For more than a decade, Eastern Europe has subscribed to Western advice on how to run its economies.

But the flow of ideas is no longer, it seems, exclusively one-way.

Take the curious case of the flat tax: the notion of everyone paying the same proportion of income, rather than the sliding scale used across Western Europe.

Popular among libertarians, and with a persistent minority following in the US, the flat tax has recently mushroomed throughout ex-communist Europe.

Now, there are signs of it taking hold in the West. The Netherlands, Spain and Germany have taken a look; Britain's right-wing Veritas party has included it in its election manifesto, and many Conservatives favour the idea.

Does it make sense?

Flat and flatter

Contrary to expectations, perhaps, flat-tax regimes come in all shapes and sizes.

On a limited scale, they are everywhere: in Britain, for example, VAT is a form of flat tax; so is the BBC licence fee.

Hong Kong: Adopted 1948
Estonia: 1994
Latvia: 1995
Lithuania: 1995
Russia: 2001
Serbia: 2003
Slovakia: 2003
Ukraine: 2003
Georgia: 2004
Romania: 2005

But the idea of applying the same principle to income tax - personal, corporate or both - is a much bolder, and rarer, step.

So far, a dozen or so countries - almost all East European - have this purer flat tax. Estonia is the purest, charging a no-quibbles 24% on all forms of income; Hong Kong, the pioneer, has a more complex system, hedged about with deductions.

Existing flat-taxers are lowering their rates: Estonia is aiming for 20%, while more recent adherents are even lower.

And the club is growing: Poland has said it is aiming for a flat tax, while momentum is gathering in the Czech Republic. Even Iraq is supposed to adopt the tax, according to US proposals.

Many happy returns

Fans of a flat tax make much of its simplicity. In the US, campaigners insist it would shrink the tax return - currently a dreaded annual chore - to the size of a postcard.

A pure flat-tax regime would operate without the current mass of deductions - expenses offset against tax obligations - bringing an extraordinary measure of transparency to the system.

Since deductions are the main means of massaging one's figures, proponents say the system would vastly reduce evasion.

Opponents question this. Cheats, they say, would simply divert their attention from fabricating their expenses to hiding their income.

And there are a mass of complications. What type of a flat-tax system is best? And where should the level be set to avoid either harming taxpayers or emptying government coffers? Calls for a 10% flat tax in the US, for example, have been projected to cost the Treasury some two-thirds of its revenue.

Out of the net

Fans don't entirely mind such upheavals. A major part of the creed is to rethink the whole way society relates to taxation.

Proposed flat-tax form
Are postcard-sized tax returns a libertarian pipe-dream?

Flat taxes go hand-in-hand with a sharp increase in personal allowances: in the UK, the free-market Adam Smith Institute proposes a 22% flat tax kicking in after 12,000, rather than the 4,745 currently in force.

This reduces the burden on the poor, and would even take some 10 million people out of the tax net entirely, the Institute says.

Some libertarians welcome the prospect that a flat tax would cut government revenue; leave the money in people's wallets, they say. Others argue that a low-tax environment would stimulate business, leading to above-par growth and an eventual increase in tax payments.

Left out

This last argument has never found favour on the left, and is scarcely universal on the right.

And the idea that reducing government revenue could be a force for good also arouses vehement opposition - not least because many fear the consequences of creating a very large class of non-taxpaying - and hence non-participating - members of society.

Most of all, though, it is the political consequences that scare politicians. The majority of people in the West support the idea that the rich should not just pay more tax, but a greater proportion of their income. A poll last week in the US showed 57% of voters in that camp.

In Britain, Chancellor Gordon Brown has refused to countenance even the most tentative discussion, and has repeatedly taunted the Conservatives for their flirtations with the idea.

East is east

Nor is it entirely encouraging that the notion has caught on so quickly in the ex-communist East.

True, the Baltic States are models of free-market reform, and have reaped the benefits in rapid growth in recent years (it is debatable, however, how much of that growth can be attributed to the flat tax).

But Ukraine, Russia, Serbia and Georgia are scarcely enviable; in many cases, the flat tax was introduced in a desperate attempt to stem runaway evasion.

Most East European economies have radically different tax structures from the West.

Although their headline income tax levels look low - commonly about 15-25% - they tend to charge far higher rates of social security, leaving their overall "tax wedges" among the highest in the world. Western economies, far more reliant on income taxes, cannot afford such generosity.

Flat-tax boosters say investment money will start to flood from West to East, forcing the complacent French, British and Germans to take flat taxes seriously. Until that happens (if it does), expect resistance to be fierce.

Corporate tax rates

Tax wedges

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