Taxes: linear or not?

The “linear” or “flat” tax was often referred to as a theoretical concept, but seems to be an appealing notion in some of the emerging markets of CEE. There, pioneered in the mid 1990s by Estonia and subsequently the rest of the Balitcs, it has been (in various mutations) accepted by 9 countries and sparks discussion in several others.
So what is it that is so appealing about the idea of taxing income at a single rate instead of the most common progressive rates?

Benefits of linear taxes:
- simplicity – if compliance with taxes is easy, effortless and cheap(see Box) – the incentive to pay is higher – as tax evasion is costly and it becomes even more costly when easy to monitor. This is especially important in countries with traditionally complex tax systems, where filling in a declaration is time consuming; and high tax evasion both legal (deductions, loopholes) and illegal (grey economy).
- transparency – related to the previous one: when the rules of the game are clear (no deductions, no income brackets) tax payment becomes easy to monitor.
- efficiency – a quite disputable motivation – goes as follows: the effort put into evading taxes, the time spent on filling in tax forms, the income spent on tax advisories can be spent in a more productive way. Similarily with the effort (and money) spent on tax collection.

Costs
- not progressive - (ill?) perceived motives: as the argument goes, because linear tax is not progressive, poorer people tend to pay a higher proportion of their income than the richer ones, who obtain income from capital gains, savings etc. However if we look more closely, the system of deductions in existing progressive tax regimes, similarly with low taxes on capital gains allow much of the wealthies’ income to be taxed less– therefore it is not obvious that the progressive systems do have a redistribution effect, and which way this effect actually works. A linear tax with no deductions together with appropriate taxes on capital gains and interest should actually increase the tax base of the wealthy. But as it can happen the idea of introducing linear taxes is often perceived as an idea of lowering taxes for the rich.
- no deduction - the government looses a policy instrument of deductions for instance for expenditures in areas it considers “justified” – but because of the inefficiency of this sort of incentives, this argument is also often used as a benefit. Moreover, part of the instrument can be recuperated by changing VAT rates for certain goods and services.

Box 1. Theoretically a pure flat tax (say of x%) would result in extreme simplification of tax collection, as de facto would result in obliging the companies to pay x% of the wage bill together with the CIT and VAT, similarly if we want a capital gain, dividend or interest tax, x% can be withheld by the broker or bank and sent to the tax authority directly. As everyone obliged to pay taxes would be working in some sort of company (be it private companies, public-sector or self-employed) this would be in fact the only method of direct tax collection – allowing payroll workers to fully forget about filling in tax declarations. The simplicity of this solution is appealing, though one may argue the abolishment of the minimum taxable income threshold and tax exemptions for the poorest would be a problem. However, there are at least straightforward solutions: (a) taking care of the poor on the expenditure side, (b) low VAT on basic foods, products and services which constitute large shares of the low income budgets, or, (c) tax refunds – at some point the government would refund part of the tax, by shifting the money into tax-payers bank accounts. Think of this in comparison to a linear tax of x% but with minimum taxable income threshold of A – the equivalent of a progressive tax with two rates 0% up to A and x% above. In this case an individual earning B>A pays (B-A)*x taxes – which is equivalent to paying and getting a refund of Ax%.

Two things must be kept in mind – first of all this discussion is about the potential introduction of a linear tax, and not, what is often discussed together about lowering taxes. Second, such a reform must be accompanied with appropriate changes in the whole tax collecting system. Without the determination of the government to increase compliance, improve monitoring and simplify the taxation process the linear tax will not provide the expected benefits – in a corrupt system any tax, linear or progressive, is worth thinking of avoiding.

Coming back to the examples of CEECs it is worth noticing that none (aside perhaps Georgia) of the countries in fact have a pure flat tax, thus cannot enjoy the full the benefits of a purely simplified tax system (see Table). Even the lowest level of the income exempt from taxes causes the “company paying an share of its payroll directly to tax office” story to become invalid.

Table 1: Tax rates in countries with linear PIT as of begining 2006

Country (date of introduction of linear PIT)	CIT	VAT(1)	PIT	Minimum taxable income (monthly, approx EUR)
Estonia(1994)	0(a)	18	23	128
Lithuania(1994)	15	18	33(b)	75
Latvia(1995)	15	18	25	37
Russia(2001)	24	18	13	12(d)
Serbia(2003) **	10	20	14	93
Slovakia(2004)	19	19	19	195
Ukraine(2004)	25	20	13(c)	21(d)(e)
Georgia(2005)	20	18	12	-(f)
Romania(2005)	16	19	16	71(d)

Notes: (a) on retained profits, distributed profits taxed at 23%; (b) 27% from July 2006; (c) 15% from January 2007; (d) if income below certain threshold;(e) 3 EUR if above threshold; (f) some exemptions for specific groups; (1) standard rate; (**) the additional threshold tax levied on the total income which actually makes it closer to a standard progressive tax rate.
Sources: Ministries’ of Finance websites, PWC Doing Business in Serbia, Baker Tilly Doing Business in Romania, Georgia Enterprise Growth Initiative.


Obviously, the rates cannot be compared as tax bases are different, but give a broad picture. Moreover the actual effect of the linear taxes is difficult to quantify – most countries in the table have been growing rapidly in the past years, but there are hardly any appropriate counterfactuals, while many introduced reforms both of the economy and of the tax system itself. This, together with a general lowering of income and corporate taxes seem to make the effect hard to single out, however the question remains interesting.

EMU enlargement: Lithuania - looking forward to a no-no ?

George Parker and Ralph Atkins in FT (13/06/2006, “Lithuania set to become victim of tough EU single currency stance”) confirm the determination of the Baltic State to join the single currency – its central bank is expected to apply for euro membership amid warnings that its application will be rejected. Joaquim Alumnia the EU monetary affairs commissioner warned against the “unpleasantness” of getting a negative answer.

Lithuania aims at joining the Euro together with Slovenia on the 1st of May, but higher inflation expected at the end of the year would breach the benchmark MC levels.

The authors justly underline the fact that the sharp contrast of the scrutiny the Baltic States are subject to with the politically fueled rush that at the wake of the formation of the common currency at the beginning of the 1990s.
They also quote Bruegel, a Brussels think-tank that claims the undervaluation of the adverse side of “premature” EMU entry, allegedly the case of Italy and Portugal, and the loss of the possibility to devalue currency as a response to shocks may be problematic in the case of rapidly growing Baltics. Needless to say, the currency board experience of Lithuania shows it does not tend to rely on the devaluation tool. Moreover, there is not much evidence that the Lithuanian currency is undervalued at the moment - the CA is in deficit, mainly due to rising imports of services.
If due to rapid growth the real exchange rate (RER) appreciated and was to adjust because of mounting pressures we must compare the effects of a sudden devaluation of the currency with nominal price and wage adjustments, be it inside or outside the euro. On the other hand, as the Baltics claim, their CA deficits are in large part due to FDI inflows, and once the effect of such investments kick in, exports should rise and close this gap. Moreover, as visible in Charts 7 and 8 of the report by Alan Ahearne and Jean Pisani-Ferry (The Euro: only for the agile ) the cumulative RER appreciation is lower in the Baltics than in most NMS – being a source of the recent inflation.
Whether Lithuania is trying to signal its commitment, hoping for luck, be it in lower-than-expected inflation or in putting some pressure on loosening of the EC stance, that is a different question, though betting against an explicit rejection may turn out costly – unless one is willing to go as far as to adopt the euro unilaterally.

Divided Europe? Labor market restrictions and NMS…

The enlargement of the EU entailed serious obstacles to the access to labor markets of the western EU states for workers from CEECs. On the date of entry, only three “old” EU states (U.K., Ireland and Sweden) decided to open-up their labor markets to citizens from new EU members. Other countries, Germany and Austria among the ones with a toughest stance, proposed different “transition” periods during which they restrict the access of east Europeans to their job markets. These restrictions can last up to seven years. The Netherlands and Denmark despite previous declarations also introduced these types of arrangements.
Currently, as official declarations have it, on the 1st of May 2006 Spain, Portugal and perhaps Finland and Greece are to open up their labor markets to workers from the NMS. Italy withdrew on its previous statements and decided to prolong the “transition” till 2009.
Before we try to analyze some arguments in favor of this protectionist stance, it may be useful to have a look at the experience of countries that opened up.

It seems they do not regret their decision. U.K. Prime Minister Tony Blair summarizes : “I have not been alone in pointing out that those countries which opened their labour markets to people from the EU’s new member countries have benefited economically.”. Indeed, in the countries that decided to open up, thus, arguably in the line of fire - at risk of taking a bigger blow of immigrants, than if other countries did the same, the idea of revising their decision is not subject to much discussion.

So what is the rationale for keeping job-markets closed to new EU members?

Alas, it seems hardly economic reasons that keep countries from lifting restrictions on their job market. A textbook model of growth (Obstfeld and Rogoff, Foundations of International Macroeconomics, pp.448-453) based on the Ramsey-Cass-Koopmans shows that opening up labor markets, both to skilled and un-skilled workers, can have a positive effect increasing per capita income in the short run, and having no negative effect on the steady state. Although very simple and easy to contest, it serves to argue that economic theory does see the citizens of incumbent countries benefiting from the inflow of both un-skilled and skilled labor. Of course, the effect is aggregate, and through distributional effects specific groups may be negatively affected, however it is quite clear the interests of the protectionist groups are not that of the entire countries.

As for the arguments of enormous inflows of cheap labor bringing deterioration of living standards in the West by importing higher unemployment and lowering wages and working standards, they are based on some assumptions that do not look quite right when given a closer look.

First, unemployment rates, in countries like Poland do not entirely reflect the actual job market situation – many of the people registered as unemployed, are not active job seekers, main reason for being registered is that monthly health insurance is costly – and a person officially registered as unemployed receives it for free, without a time limit.

Minimum wage requirements and labor contracts will guarantee the wage pressures to be limited – in fact legal immigrants are a lesser threat to incumbents wages than grey-zone workers, who do not pay taxes, social security, are not subject to minimum wages or practically any labor standards. And as it seems, many industries, both low skilled (agriculture etc) and high skilled (engineering, computer software etc) do seem to feel the lack of suitable labor force. Furthermore, with capital (or simply companies) being relatively mobile, the single market for goods relatively well established, the flow of immigrant workers should not be viewed against the alternative of a sheltered labor market, but perhaps against the alternative of jobs being relocated to the NMS themselves.

The flood of workers from Eastern Europe is more a populist argument, than an economic menace. Especially if we remember that Italy, which was previously discussing the possibility of opening-up on the 1st of May 2006, but recently declared to postpone it, faces elections upcoming in April this year.
To stay with Italy, the Ministry of Foreign Affairs named problems with the large presence of illegal workers from NMS as one of the prime arguments against opening its job market. Easy to see that this populist argument is completely flawed – opening the job market would not only increase tax income, accountability to labor regulation, decrease in financing of criminal organizations but would also decrease the pressure of immigrant workers on wages and facilitate monitoring of their status.
I did not find convincing estimates of the number of NMS workers illegally employed in the EU, but “guesstimates” suggest the problem is significant, moreover, UK experience suggests that legal access to the job market creates a significant “coming out”.

Moreover, it is rarely recognized that quite a substantial amount of NMS citizens can already legally work in the EU. Studies quoted by J.H. Brinks estimate the number of Polish citizens with a German passport as somewhere between 400’000 to 1 mln mostly registered in Silesia. These are not subject to the obstacles to job-market access in and in fact many of them do work (be it seasonal or permanently) in the “old EU”. Exact numbers are difficult to obtain, but one can expect that “double-nationality” citizens from Poland, Czech Republic and other NMS who can already legally work in the whole EU constitute a substantial amount of the ‘labor emigrants’.

Additionally, each year many “old” EU states issue work-permits allowing external workers to work legally (Italy – 90 ths. increasing to 170 ths. next year, majorly for NMS and Accession countries; Germany issued 500 thousand work permits, Austria 70 thousand to various types of NMS workers according to a European Commision report ) allegedly in order to better control the structure of labor inflow but in fact not only going against the idea of “united” Europe, but also creating an additional source of costs, instability, lack of transparency and potentially corruption.

Finally, relocation is costly – even within a country, where regional labor markets have a lot in common: language, laws, taxes, skill recognition, health insurance and often proximity. Thus the apocalyptic vision of Poles from northern regions, with registered unemployment rates in excess of 40% ( National Statistics ) flooding labor markets of western EU, pushing Germans and Italians into unemployment, seems quite improbable. Flawed as they may be, the statistics show that although Warsaw and other regions with ca. 5-6% unemployment rates, are within a couple hours drive and regional wage differentials (which seem quite big –Warsaw having industrial wages 50-60% higher relative to high unemployment regions – National Statistics ) – the equalization doesn’t take place – people are less willing to relocate than populists tend to claim. Of course the wage differential is higher when we compare to “old” EU (though the statistics as crude and troubled by similar flaws), but so is the cost of moving, living and traveling.
Add to this language problems, imperfect skill/qualification recognition and the fact that U.K., historically one of the most desired labor markets for East Europeans is already open to them (~350ths. workers from NMS working in the UK, on various types of contracts usually well above minimum wage – Accession Monitoring Report, Homeoffice UK, February 2006, 107 thousand in Ireland Commission report ), and I would claim most of the people that would potentially seek employment abroad – are already there.

Probably, EU accession of Romanian and Bulgarian workers will spark an even fiercer discussion, but generally most arguments appearing in everyday press seem to both highly overvalue the potential threats to the old members and the potential benefits to the new members. Most discussions forget that the sheer fact of NMS workers being treated as an inferior category of EU citizens, is also subject to hot debate in these countries, increasing discontent with the EU and feeding the local populist parties. Hence for inter-EU relations, the direct effect on the labor market may turnout smaller than the effect of the signal given.

Thus, summarizing the previous argument - opening-up may fuel an increase in registered workers, but in fact I would not expect an actual substantial increase of workers inflow into these countries. Moreover, the threats associated with giving access seem relatively low, while the benefits, be it from inflow of needed labor or decriminalization of the worker underground, are substantial. It seems Italy, and many others may be shooting themselves in the foot.

Re: Re: Entering the EMU - not such an easy task? - promised article comment

Well, I finally found the mentioned article (FT 30/01/06 p.15 “Monetary union is not for the poor”). The author, W. Munchau, contributes to the discussion on whether Estonia and Lithuania should join the euro, raising the point that the inflation criteria, which the two countries recently do not fulfill, may be used as a neat tool to prohibit (or actually post-pone, though indefinitely) their entry. Further, the author claims that there is not much reasons, on economic and technical grounds, to keep the two Baltic States outside the EMU. However, also ads, that entry may be very harmful for them – because they are “still too poor”.
As with the first case I tend to be in line, with the second, I must disagree. The main argument, repeated after a Bundesbank report, that “the biggest risk lies in the choice of a potentially wrong conversion rate when entering the euro. As we have seen in the case of Germany, which entered the euro with only a moderately overvalued exchange rate, it can take many years to correct such a mistake” , is in my opinion the least important one:
1. The two Baltics have relatively long experience with currency boards (Estonia since 1992, first to DEM then EUR; Lithuania since 1994, first to USD then EUR) and have actually gained quite substantial experience in managing a fixed exchange rate. Having fixed exchange rates for the past years, despite rapid growth, the countries did not see much of the problem of misaligned currencies and this was not even undermined by the Russian crisis. Up till now ‘overvaluation’ has not been a problem.
2. A comparison with Germany and Italy is problematic on the grounds that the Baltic economies appear relatively flexible, and hence I would suppose the adjustment of a potentially overvalued rate would be much quicker.
3. Fiscal policy, which in the (practical) absence of maneuver monetary policy would serve to adjust to shocks, is also relatively sound compared to the “old” members – it has actually served for this purpose during the c.b. and should be well prepared to continue. Estonia has actually maintained a surplus or balance since 1997 (when Eurostat data starts) excluding the 1999 when it responded to the Russian crisis, while Lithuania’s deficit is within reasonable bounds (below 2% 2001-2004), though perhaps should be curbed slightly.
4. Rapid growth is not impossible within the emu ( look at Ireland ;) ) - also, the BS effect can take place, without causing any harm to the economies.
5. current account imbalances, if dangerous at all, seem much more dangerous if the countries stay out maintaining a c.b. than if they adopt the euro.
6. And related to the previous, what that the author omits is the issue of credibility that these countries derive from fixing there currency – which can only be full when they actually adopt it. If they are not allowed to join, then this credibility may be undermined, actually triggering a crisis, even if there is a lack of other fundamental reasons. And if diverse imbalances were to put pressure on the exchange rate, a nominal adjustment within the euro would quite probably be less painful than scrapping the c.b.

What does make me wonder (though on a purely hypothetical basis ;), is the idea raised by J.Rostowski. If these countries are so determined to adopt the common currency, perhaps they could consider doing it unilaterally? And could they actually be stopped from doing so, or would the new status quo have to be eventually acknowledged….

EU: Tax harmonization or tax base harmonization?

The front page of today’s FT (3/03/06), reports that the tax commissioner of the EU is to press ahead with the plans of tax base harmonization in Europe. Additionally, there are plans of introducing a tax to fund the EU budget.

As for the first case, the discussion about harmonizing the corporate tax base and tax rates has a fairly long history, possibly almost as long as the EU itself. Once in a while, though frequently and loudly since the preparations for the most recent phase of enlargement, officials in one of the states considered to have a high tax burden (like Germany or France) raise the issue, which is usually met with fierce opposition of Ireland, and many of the CEECs. Why is this such a hot topic?

First of all, Ireland and many CEECs, especially the Baltic States and Slovakia with their lower tax rates are causing officials from many other EU countries to claim they unfairly compete through taxes, while not bearing the full cost of providing business infrastructure. Arguably, this is one of the reasons why these countries have recently been so successful in attracting businesses, and it is also claimed that they “destroy” jobs in the high tax countries. Thus the “low tax” countries are threatened with EU infrastructure subsidies cuts as a measure of retaliation.
But as the commissioner justly mentions, the current corporate tax rates are not really comparable, as they do not reflect the actual tax burden. One cannot say much about the meaning of an X % rate in one country, Y% rate in another, if the tax bases are different.
Thus in fact, tax base harmonization should be in the interest of the countries that have lower taxes, or that want to compete on tax rates, as the information costs of the actual taxation regime would be reduced. The gain in transparency would allow the corporate sector to see clearly where it can pay less tax. It would also be easier to weigh this advantage against all other advantages like closeness to market, language, infrastructure, business environment etc. Yet it is the “low tax” countries that seem to oppose any talk of harmonization most fiercely, while it is mostly the countries that have allegedly higher taxes that seem to push hardest.

The main reason is that it is not just tax base harmonization at play, but there is also the issue of tax rate harmonization lurking around. While the first, through transparency and thus efficiency should be beneficial for everybody, the second seems a scarecrow for the “low tax” countries. And what they fear most is that relaxing their stance on the discussion of any harmonization in the tax regimes will end in a harmonization of tax rates. This, they argue will be the scrapping of the comparative advantage they have, which is not only lower labor costs, but also lower taxes, which compensate for poorer infrastructure and other inferior business conditions. Moreover they reflect lower burdens on the state budget, thus allowing the countries to compete on taxes.

While the sheer issue of increasing transparency by tax base harmonization seems the right way to go, I find the fears of the countries opposing it somewhat justified. Imposing common, or similar tax rates in the EU would cause more harm then benefits. Moreover, I would not fear, as some of the officials, a race to the bottom as a result in tax rate competition as we can expect that as the countries with lower tax rates grow, their infrastructure improves and thus the subsidies they receive should phase out. The sheer fact of some tax competition may prompt spending reforms in the countries with higher taxes.
Finally, as the world becomes smaller and smaller in business terms, profits tend to be de-linked from the home countries of the companies HQ forcing countries to “harmonize-up” may simply result with the shifts of profits outside the EU.



As for the second point raised, there is the issue of funding the EU budget with a special tax. This seems a simple but appealing idea. I support the view that this could shift the energy to the discussion on how the money is spent and not how big the contributions ought to be, though I think this may be politically even harder to push through than tax base harmonization. Yet, it could yield an additional benefit – a tax intended to fund the EU, whether corporate, or even better some VAT or PIT would cause the nationals in the EU to “feel” the cost of the EU - perhaps it would encourage them to express more interest on how the money is spent, and possibly increase participation in the EU, for instance in parliamentary elections.
However it should not be an additional tax – the burden on most EU activities is already high enough, and therefore it should be designed to substitute for part of the national tax.