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The Flat Tax Revolution in Europe

David Storobin, Esq. - 8/5/2006

In 1994, Estonia became the first country to institute the flat tax, charging 26% on all personal and corporate income with no deductions allowed. “The economy flourished” as a result, declared The Economist. The Estonian example was followed by the other two Baltic states, Latvia and Lithuania, but remained largely irrelevant and unknown to the world at large, as few people were aware of what was taking place in the region. But on January 1, 2001, Russia joined the Baltic states with an even lower tax rate of only 13% (the country’s corporate tax is still very high). This led the world to notice. In what was arguably President Vladimir Putin’s most successful act, tax reform jumpstarted Russia’s economy and tax revenue skyrocketed, doubling within three years.

In 2003, Serbia passed flat tax reform with a new rate of 14%. The next year, Ukraine and Slovakia imposed a flat tax of 13% and 19%, respectively, and Romania’s flat tax - instituted in January 2005 - is 16%. The lowest tax of all, at only 12%, is in Georgia, which was passed by an overwhelming vote of 107 to 11 parliamentarians on December 22, 2004.

Several other countries may join the above 9 nations if the next elections lead the opposition to take power. Poland, the most powerful East European country in the EU, is likely to be one. The main opposition, Polish Civic Platform Party, wants a 15% flat tax on personal and corporate income, as well as VAT.

Likewise, the Civic Democratic Party, the primary opposition in the Czech Republic, is proposing a 15% flat tax, and even the governing Social Democrats are likely to simplify the tax system (without making it flat).

Former Hungarian Prime Minister Viktor Orban, the leader of the main opposition party FIDESZ-MPP, said Budapest will have “no choice” but to jump on the “flat tax bandwagon” to retain the country’s share of foreign investments that will otherwise flow to flat tax nations. The statement was echoed by Hungary's finance minister, Tibor Draskovics, a member of the Socialist Party, who is now prepared to examine the possibility of a flat-rate income tax. The governing coalition’s junior partner, the Free Democrats, had already issued which proposed a 30% optional flat tax on income in place of the current system, which has a top marginal rate of 38%.

Croatia, Slovenia and even Belorus, which otherwise is very resistant to economic reform, are strongly considering the flat tax, and are likely to adopt it in the coming years. Bulgaria is an especially likely candidate and will probably be the next to adopt the single-rate tax system.

Flat tax proposals have recently spread beyond Eastern Europe, although none of these countries have adopted it.

China is known to be examining a tax reform featuring a uniform, single tax rate for all. In Barbados, the President of the Barbados International Business Association, George Gleadall, called for a 12.5% flat rate on both personal and corporate income, indicating that it may even be as low as 7.5%.

In past years, the Canadian Alliance, then the largest opposition party in Canada, called for a flat tax (CA merged with the Progressive Conservative Party, and is now known as the Conservative Party).

In the United States, of course, progress has been very slow and nothing is likely to happen in the coming years. In 1992, Jerry Brown, who lost to Bill Clinton in Democratic primaries, introduced a flat tax proposal as part of his run for US Presidency. Four years later, Steve Forbes’s campaign, which also went nowhere, was based primarily on the idea of a flat tax.

During my last visit to Congress in April of 2005, I questioned Sen. Rick Santorum (R-PA), the third highest ranking Republican in the Senate, about the idea of a flat tax, which he quickly shut down, calling for a lower tax instead. Whether he supports it or believes it cannot be passed in the US, he certainly did not seem very excited about the idea.

But if the federal tax may not become flat, states may certainly be the ones to lead with this system. Utah's Tax Reform Task Force appointed by Gov. Jon Huntsman Jr. to study tax reform has come out in favor of a flat tax. Huntsman has taken their advice under advisement. Other states may soon follow in at least studying this system.


The challenge to Western Europe

Tax reforms in Eastern Europe are having a tremendous effect on Western European economies, as companies are bound to move to neighboring states to avoid paying the near-confiscatory taxation (especially when you combine the income tax with corporate, capital gains and dividend taxes) levied in the “Old Europe” to support the Welfare State system. Furthermore, whereas hiring an employee in the Old Europe resembles a Catholic wedding, where no divorce is possible except in the most extreme cases (and even then, companies face union strikes and negative media attention), in the formerly Communist states, one can hire an employee without the fear of being stuck with someone who’s incompetent, lazy, unqualified (e.g., lied about qualifications) or simply obsolete. Western Europe shutters at the thought of a person being obsolete (and, naturally, nobody in the Old Europe is lazy or incompetent), but if a business can replace a person with a computer that can produce more in less time and with less expense, it becomes a necessity in order to keep up with the competition (imagine a horse-and-buggy mail delivery business competing with a business providing emailing and faxing services). Likewise, if your competitor can save costs by operating in a country with lower taxation, they will be able to price their goods cheaper, thus forcing you to either lose your profit margin, go out of business or move to a place that will allow you to compete on a level playing field.

However, lowering taxes is very difficult in Old Europe because much of the population is so dependent on the Welfare State that they can no longer imagine any alternative and see the lowering of government spending as a sure way to increase poverty and cause other ills in every imaginable field, from education to health care.

Faced with a stark choice of fighting their electorate to force through unpopular reforms or stagnating economy with a constantly outflow of job-creating companies, Western Europe hopes it has found the third way – attacking Eastern Europe and threatening it into raising taxes in line with Old Europe.

After the Flat Tax was introduced in Slovakia, German Chancellor Gerhard Schroeder reacted by accusing it of unfair competition for "dumping" tax rates to stimulate domestic economic growth and attract foreign investment. This charge has also been leveled against other East European nations that are moving towards a free market.

Responding to German Chancellor's attacks, Slovakian Finance Minister Ivan Miklos asserted, "I understand he's under pressure from German investors and entrepreneurs who are criticising the high taxation and not optimal business environment in Germany."

At other times, Western Europe threatened newly admitted EU nations to end subsidies if taxes will be lowered or flattened, arguing that any country that can afford to lower taxes doesn’t need subsidies. New Europe’s response has been to assert that they aren’t lowering taxes due to some independent wealth, but rather to stimulate their economies, and more revenue will be collected from lower rates. The argument rings true, as it is precisely the East’s “theft” of business through low taxation that is causing worries in Western Europe, adding to their already long-troubled economies.

At the same time, many think-tanks and members of the media in Western Europe have come out in favor of the proposal, realizing that there is little that can be done to stem the spread of low, flat taxes in Eastern Europe. ‘If you can’t beat them, join them,’ agree many in Old Europe.

Few took seriously a UK Conservative Party study on the Flat Tax, but within months, several governments joined the Tories in considering it. Prime Minister of Spain Prime Minister José Luis Rodríguez Zapatero, elected on the Socialist Party ticket, is now considering this system and his director of the Economic Office, Miguel Sebastián, open favors a flat tax system. In the past, he co-authored a paper with Manuel Díaz-Mendoza, currently serving as an adviser for the tax system in the Prime Minister's Economic Bureau, entitled "A Proposed Reform of Tax System in Spain", proposing a flat 30% tax.

Likewise, the recently departed socialist government of German Chancellor Gerhard Schroder studied the flat tax system. On July 27, 2004, a Finance Ministry twenty-nine member panel proposed a 30% flat tax on all personal and corporate income.

Even the ultra-liberal Sweden is considering the flat tax, with the country's largest newspaper, Dagens Nyheter, calling for the government to scrap the progressive tax in favor of a single rate for all tax payers.

Greece is also set to adopt the flat tax system and it remains only a matter of time before other nations of the Old Europe join the Flat Tax Revolution.