U.S. ought to emulate Eastern Europe's flat tax

Star-Ledger, The (Newark, NJ) - Friday, December 30, 2005
Author: DANIEL J. MITCHELL
The report issued last month by President Bush's Advisory Panel on Federal Tax Reform landed in no-man's land. The right was disappointed that its proposals were so timid, and the left was critical because the report highlighted the damaging impact of high tax rates on work, saving and investment.

Perhaps the panel could have won more hearts and minds if it had examined the real-world experience with tax reform. The flat- tax revolution in Eastern Europe is particularly compelling. Nine nations from the old Soviet bloc have adopted the flat tax - which taxes income at one rate - and others are poised to. In an ironic twist, these countries are rejecting the class warfare politics of yesteryear and building tax systems specifically designed to attract investment, fuel economic growth and treat all citizens fairly.

Russia, for instance, enjoys the benefits of the 13 percent flat tax it adopted in 2001. The tax quickly yielded positive results. Revenue poured into government coffers as tax evasion and avoidance became much less profitable. Inflation-adjusted personal income tax revenue has more than doubled since the flat tax was implemented.

But Russia was simply learning from its neighbors. Estonia was the first, adopting a 26 percent flat rate in 1994. Latvia and Lithuania followed in the mid-1990s, with 25 percent and 33 percent rates, respectively. Serbia was next; in 2003 it went with a 14 percent rate. Last year, it was Slovakia (19 percent) and Ukraine (13 percent). This year it's been Romania (16 percent) and Georgia, which boasts the lowest rate - 12 percent.

Estonia has been cutting its rate: It's at 24 percent and will drop to 20 percent before the end of the decade. Lithuania also has decided to make its flat tax more competitive; the rate will go from 33 to 24 percent.

The flat tax is not a silver bullet. But combined with other market reforms, it provides a significant economic boost. All three Baltic nations are enjoying strong growth, averaging more than 5 percent a year. No wonder the "Baltic Tigers" became role models for the region. This growth is generating plenty of tax revenue, in part because tax evasion has been dramatically reduced. And the rich are paying the lion's share: In Estonia, for instance, the top 10 percent are paying 41 percent of the tax .

Slovakia's system is not yet two years old, but it's already successful. According to the director of Slovakia's Hayek Institute, income tax revenue is 0.5 percent of gross domestic product larger than predicted by "static" estimates (those that fail to account for inevitable changes in behavior when tax laws are changed). New investment is flooding Slovakia. So many car companies are building factories that the country is being called the Detroit of Europe.

Others have noticed the economic success these nations are enjoying. The newly elected coalition in Poland may implement a flat tax , and the opposition party in the Czech Republic has promised a 15 percent flat- tax regime if it wins the next election. Lawmakers in Croatia, Bulgaria and Hungary are discussing tax reform.

Western European politicians have cast a wary eye on this tax revolution . Bureaucrats in the European Union and the Paris- based Organization for Economic Cooperation and Development object to "harmful" tax competition, and politicians from France and Sweden complain about "fiscal dumping." But such criticism is hard to take seriously coming from leaders who preside over economies saddled with high unemployment and anemic growth.

Indeed, some Western European lawmakers, including those in Spain, Greece, Denmark , Holland, Germany and Britain, have begun discussing the possibility of implementing a flat tax .

That these discussions are even taking place is a testimony to the liberalizing force of tax competition. And if the rumors are true about China's implementing a flat tax sometime next year, the tax reform steamroller may become a juggernaut.

To be sure, Eastern European nations don't have perfect tax systems. Many are still plagued by oppressively high payroll taxes . But tax reform in Eastern Europe is a clear success, and the United States can learn from what other nations have accomplished.

Our economy, under a flat tax , probably wouldn't grow quite as quickly as Estonia's, and it's unlikely that we'd get the same revenue windfall as Russia. But the evidence from Eastern Europe strongly suggests that a flat tax would strengthen our economy, improve tax compliance and reduce political corruption. We also could expect it to boost capital formation; it has been a magnet for new investment in Eastern Europe.

In recent years, President Bush has praised Russia's flat tax . He even said during a visit to Slovakia that it was his dream to have a flat tax in the United States. Let's hope that dream becomes a reality. America and the West may have won the Cold War, but if we continue to be burdened by the internal revenue code, the former Communist nations may get the last laugh.