Sunday, November 21, 2004
Fool's gold or economic miracle?
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

It is one of those ideas that look so blindingly straightforward and appealing, you wonder why everybody doesn’t adopt it. Why not, at a stroke, sweep away the complexity of the tax system, remove the incentive for the better-off to employ expensive accountants to cut their tax bills, and ensure that nobody could again complain about unfairness?

The magic pill that could achieve this, say its advocates, is the flat tax. The idea of a single flat rate of income tax to replace the current bewildering array of rates, reliefs and allowances is too good not to adopt, they say.

The flat tax boosts government revenues, allowing more to be directed into public services, by improving economic incentives and reducing tax avoidance. It ends the pork barrel politics of special-interest lobbying, in which different groups press for — and get — their own individual tax reliefs.

It can be set up in a way that exempts the low-paid from paying tax altogether. The flat tax would not apply on, say, the first £10,000 of income. It prevents people from being taxed more than once — on their income and savings for example. If Britain adopted a flat tax the effect would be similar, say its advocates, to the Thatcher tax cuts of the 1980s, which acted as a magnet for higher earners, particularly from Europe.

The flat tax has a long history in some parts of the world. Hong Kong, which consistently comes near the top of international rankings for the most enterprising economy on the planet, introduced a system in 1947 where taxpayers can choose between a flat tax of 16% and rates ranging from 2% to 20% adjusted for deductions and allowances. The overwhelming majority choose the flat tax.

Jersey got there before Hong Kong, adopting a flat tax in 1940, just before the German occupation. Guernsey followed in 1960. Both have flat taxes of 20%.

Lately the flat tax has been sweeping through former communist countries that are now either members of the European Union or knocking on its door.

Estonia led the way in 1994, introducing a flat tax of 26% against the advice of the International Monetary Fund, and has prospered from doing so. The former Soviet state has grown rapidly and gained a reputation for dynamism and enterprise. It has decided to cut its rate to 20% by 2007. Lithuania and Latvia quickly followed, with rates of 33% and 25% respectively, making flat tax the norm in the Baltic states.

But perhaps the most impressive — and surprising — example of a flat tax came in Russia. Vladimir Putin, its ex-KGB president, might have been expected to be less sympathetic than most to an idea championed by free-market think tanks in Britain and America. Yet he stunned the world in 2001 by introducing a flat tax of 13%.

Out went the previous system, with income tax rates ranging up to 30%, and in came the flat tax, with a new business-friendly low rate of corporation tax. Russia has enjoyed three years of strong economic growth since, and the idea is spreading. Serbia, Ukraine and Slovakia have introduced flat taxes.

The question is whether flat tax could now happen in America, and even in Britain. Some think so.

“It’s an idea whose time has come and there will be enormous advantages for the party that embraces this,” says Madsen Pirie, president of the Adam Smith Institute, which last week published a paper, Flat Tax: The British Case, suggesting Britain’s multiple tax rates, allowances and reliefs could be replaced with a 20% flat tax.

In America the flat tax lobby has been encouraged by George W Bush’s election pledge to simplify the tax code, and his plan to appoint a panel of experts to make recommendations next year. One radical possibility would be a flat tax; another would be a national sales tax similar to Vat.

Even advocates of the flat tax do not expect President Bush to move to it in a single stroke, and White House officials have been playing down expectations. But Grover Norquist, president of Americans for Tax Reform, believes there will be significant strides towards a flat tax. “In the past four years there were four tax cuts,” he says. “People looked at those and thought they were just catch as catch can. But those tax cuts moved us towards a single-rate tax system that taxes income just one time.”

A flat tax of 19% for America was proposed by Alvin Rabushka and Robert Hall as long ago as 1981. Ronald Reagan’s tax reforms in the 1980s, in which he replaced an array of tax rates ranging up to 70% with a two-rate structure — 15% or 28% — were seen as progress in this direction.

Other US politicians have been more explicit. In 1992 the Democrat presidential hopeful Jerry Brown campaigned on a flat tax ticket. Four years later the millionaire publisher Steve Forbes, owner of the eponymous business magazine, tried to win the Republican nomination by focusing on the same issue.

What are its prospects in Britain? “It is easier to start with a flat tax when you are designing a new tax system than to impose one on an existing and complex system,” says Andrei Grecu, author of the Adam Smith Institute paper.

Experts also say the political case for a flat tax would be hard to make to a public often sympathetic to the claim that Britain’s existing 40% top rate of income tax is not high enough for the real top earners.

Robert Chote, director of the Institute for Fiscal Studies, is one sceptic. “People think that introducing a flat tax simply involves getting rid of the progressive rate system (in which marginal tax rates rise with income),” he says. “But it would involve much more than that. You’re asking the government to give up all the things that it introduced in order to try and change people’s behaviour.”

Some believe these objections ignore the bigger picture. “A flat tax goes against the whole ethos of the Brown Treasury, which has increased the complexity of the system, and this is why the Tories should adopt it,” says Pirie.

“There is an enormous prize here.The monument to the Thatcher years was that she changed the system through privatisation. A flat tax, like privatisation, would be a lasting legacy that would be very difficult for future politicians to turn the clock back on.”

From The Sunday Times, November 21 2004