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.