Case in Flat: The International Success of the Flat Tax Model

IRS 1040 Tax Form Being Filled Out

Although the flat tax in modern times seems to be politically infeasible in the United States, it has not been so internationally. In fact, there was a wave of flat tax enactment that occurred in the 1990s and early 2000s. This was the flat tax revolution.

The first nation to examine is Russia. Before delving into the Russian experiment, one caveat: Russia is by no means being endorses as an economic role model. The nation operates under quasi-capitalist conditions, with heavy intervention and favoritism in the government towards select former security colleagues of Vladimir Putin. The nation ranked 2nd in crony wealth according to The Economist, and this is undoubtedly a result of noncompetitive deals involving the privatization of natural resources and banks.

That aside, in the beginning of his presidency, Putin made some positive policy changes in Russia, one of which was a flat personal income tax. The flat tax of 2001 condensed three bracket rates into a single 13% rate, which is markedly less than many of the proposed plans in the United States, all of which shoot for targets of around 17-18%.  In addition to the flat tax, the Russian government made policy assurances to all Russian businesses and investors, promising to maintain the current tax structure for the foreseeable future. Time assurances are important, because individuals change their behavior based on the perception of time frames. A short horizon for a tax break encourages the cashing of assets immediately.

The results of the flat tax were astonishing. The flat tax reversed two years of declining revenue, and set Russia on a three year surge of increased revenue. The first, second and third year after enactment, revenue rose (in real terms) by 26%, 21%, and 12% respectively. Explanations vary, but there is little debate that a great deal of this was from increased compliance (as measured using consumption compared to taxed income). Some estimates believe that compliance grew by nearly 33%. Compliance raised the most among those who received the greatest tax decreases. The flat tax left leaves less room for tax evasion, both on the government and the people’s part. Russia also saw extremely high GDP growth from 2003 until 2007, and saw small increases in hours worked by men.

There are, however, strong qualifiers to the results stated above. The first, is that Russia also increased tax enforcement at the same time as it implemented the flat tax.  Much of the increased compliance could be due to the increased enforcement. Second, any GDP growth in the 2000s was in the context of strong global price increases in oil and other natural resources that Russia exports. Finally, generalizing Russia’s experience to the United States’ must account for the fact that Russia maintains a larger shadow economy, and had much higher levels of evasion than the United States.

These qualifiers are likely to influence the magnitude of gains from a flat tax, but even a critic would be hard pressed to argue that there would be real compliance gains, not losses, if a flat tax was implemented. The fact still remains that in 2010, tax evasion in the US was $308 billion; not a number to sneeze at.

Beyond compliance, the Russian experience has caused a “comparably small increasing effect on actual net income inequality.” This is to be expected, as any flat tax will cause a decrease in redistribution. But the doomsday increases in inequality often parroted by the left did not materialize. The flat tax also led to some small examples of ultra-rich individuals moving to Russia. Although there have not been large empirical country wide studies done to test whether taxes can cause people to move, the logic present is strong for the affirmative. It makes sense that those with the most money, who can usually afford to leave a country, will consider how much they will have to pay in taxes. And when the choice is between France, which briefly considered a 70% top rate, and Russia, which levies the 13% flat tax, the choice seems clear.

After addressing the case of Russia, the question then becomes: what about the rest of the world? As it turns out, the flat tax has been highly successful across the countries that have chosen to adopt it. In 2007, the average GDP growth for the 13 countries with a flat tax, for which IMF data was available, was a full 10%. (2007 is used because it is the most recent pre-crisis year) This is nearly double the world average in 2007. Of course, correlation does not directly imply causation, but the correlation is strong, and there is reason to believe that the flat tax was a contributor. The ten countries, for which IMF data was available, also experienced remarkable revenue stability during their transitions to a flat tax, averaging only a 0.10% fall in revenue.

The Russia and the world are all testaments to the benefits of a flat tax. They debunk many of the revenue criticisms of the flat tax, and at the very least prove that there is a strong correlation between flat tax adoption and strong growth. The “Case in Flat” is, by now, a case in point.

 

By Jacob Kohlhepp

The Policy Paladin

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New Tax Cronyism Report

I recently was involved with gathering research for a report published by the American Legislative Exchange Council, titled The Unseen Costs of Tax Cronyism: Favoritism and Foregone Growth. The report documents, totals, and analyzes tax credits, deductions, and exemptions across the 50 states. This is unique, as an attempt to quantify the amount of tax carve-outs at the state level has never been attempted before, due to poor reporting. I have a more detailed summary posted on this blog, The American Legislator. However, I have summarized below some key points and extra items I would like to mention.

Summary and Key Takeaways:

The biggest takeaway is that tax favoritism is a form of central planning. If many deductions, exemptions, and credits were removed, codes could be simplified and rates could be reduced for everyone evenly. It is hardly fair for some to pay the full brunt of the tax burden while other, select organizations do not. This is done constantly, through the service exemption to the sales tax, the food exemption, credits for buying green energy, deductions for doing business in certain areas, etc. In some of the most egregious examples, states even go as far as striking individual deals with companies to provide breaks.

Companies should not be demonized for the utilization of tax breaks, or for attempting to negotiate individual tax credits. This type of action is the rational, profit maximizing response, and one cannot blame a company for acting in its own rational self-interest. It is the fault of the code and the government for providing such an environment that encourages rent seeking.

Please check out the report, as it covers an issue that truly spans the partisan divide, at least on the surface.

By Jacob Kohlhepp

The Policy Paladin

 

Note: This post is the expression of the author’s opinion and does not represent the opinion of the American Legislative Exchange Council. 

Flattened Rates, Fewer Headaches: In Support of a Flat Tax

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The flat tax is a simple idea: condense the current progressive graduated marginal personal income tax system of the United States into a single percentage rate that is applied to all individuals and all levels of income. It is also, in my opinion, the best option for tax reform within the United States, as long as it includes a single exemption of the first $50,000 in income, sets a rate that is close to the current average effective federal personal income tax rate and a complete removal of all current exemptions, credits and deductions. Such a new code would have notable benefits vis-à-vis the current system, and in a later post I will describe several case studies of flat tax success.

The bipartisan consensus is that our tax system is broken, and one reason for this brokenness is overall complexity. By reading the average 1040 form, it is easy to tell that the American tax code is complex, but the average person has little experience with the incredible magnitude. As it stood in 2013, the US Tax code spanned 73,954 pages, with an average growth of nearly 3,076 pages every year post World War II.

Code complexity produces many negative externalities, the first being wasted tax payer time. In 2012, the IRS Tax Payer Advocate estimated that 6.1 billion hours a year are spent filling out taxes, while the total cost of compliance, which includes accounting costs, petitioning costs, and others, can mount to as much as $1 trillion annually. This revenue is completely lost: it goes solely towards complying with federal law and achieving the lowest legal tax burden. It is money that not only is taken out of citizen’s hands, but also not even given back through some ostensibly productive public service. Tax compliance costs like this are direct impediments to growth and direct perversions of what could otherwise have been useful capital and time.

One of the beauties of the flat tax is the removal of the entire progressive system of marginal rates. Removing these rates would accomplish three main things: a simplification of the code by definition, an increase in transparency, and the removal of a system that punishes higher earnings. The simplification benefit is easy to understand—one flat rate requires less explanation. The transparency externality is a little more nuanced. One of the reasons why the current American system is ineffective is precisely because the average person’s effective tax burden is hard to calculate. Under a flat tax, it is clear what a person pays in taxes, and it is clear when someone is under or over paying. A removal of all exemptions, credits and deductions would also allow for a fairer system of taxation. Less loop holes, simpler economic structure, and a straightforward rate prevents the legal circumvention of taxes by resourceful individuals who have the money to afford tax lawyers. It levels the playing field for small business, and removes an incentive to waste profit on tax code compliance and savings maximization.

As an additional political benefit, a full rewriting of the personal income tax code, and the reduction of simplicity implied by a flat tax, would make any attempts to carve out specific crony tax expenditures (credits, exemptions, etc) very visible, and thus unlikely. It is easy to shine a light on tax inequity when everyone is ostensibly supposed to be paying the same rate. A flatter, simpler code also further removes the current efforts by the government to influence consumption, investment, and even social choices through the tax code. A flat tax, put simply, is an excellent way to make government smaller.

Finally, the condensing of marginal rates also restructures a system that punishes the drive to achieve higher earnings. The current system operates under the flawed premise that the more you earn, the greater the government’s right to each marginal dollar. If we believe that higher profit or earnings generally means a person is providing the public with a product or service they want more of, then why does it make sense for the government to take a larger and larger percentage as one moves up the income brackets? Some supporters of progressive taxation say that business owners and the rich benefit more from the public services the government provides, and thus this justifies the rate brackets. But evidence suggests otherwise.

The main criticisms levied against a flat tax come from both sides of the political spectrum. From the left come outcries that a flat tax is both unfair and revenue negative, but this depends on the rate chosen, the minimum exemption for basic cost of living, the existence of any revenue benefits from restructuring the tax code, and the number of exemptions, credits and deductions that are removed. To put that into perspective, the total of major federal tax expenditures was somewhere upwards of $800 billion in 2012 according to the CBO, which is 5.3% of GDP. Additionally, tax evasion (which was estimated to cost $305 billion in 2010) and tax avoidance could be discouraged and better prosecuted under a simpler code. Finally, a simpler code that does not punish higher earnings, that does not implement distortions in the economy, and that implements lower rates overall, could have positive growth effects.  The effect of lower taxes benefitting creativity and growth in industry is supported by a majority of peer-reviewed evidence, especially OECD working papers that examine tax data across countries.

The other main criticisms come from some on the right who believe consumption based taxes are superior because they encourage saving and investment to a greater degree. Although I recognize this point as valid, I believe there are some drawbacks to the initiation of a national sales tax. The first is that sales taxes in my experience appear to be more vulnerable to special interests. It would seem to me that it is simpler to argue that a product or a good should be sales tax free, than to argue that an individual or firm should be income tax free. Although I do not possess numerical evidence, there are prime examples in state tax laws, including the exemption of services and food from sales taxation. Secondly, the need to exempt business to business transactions to avoid tax pyramiding also opens the door to complications that I feel could be disastrous when trying for tax simplicity. Finally, a sales tax similar to those used in the states is inherently regressive, and I feel that the taxation of retail items disproportionately hurts the poor, who use the bulk of their meager income to buy necessary goods.

It is for these reasons that a flat tax truly stands as the best option for American tax reform. In the next post, I will examine several foreign examples of flat tax success, and hopefully provide some tangible evidence to back up my arguments here.

 

For now,

The Policy Paladin

On Taxes: The History, the Issues, and the Battlefield

 

This will be my first post on the Policy Paladin, and to celebrate that I want to start things off with one of my favorite fiscal policy issues: taxes. Today, taxation is probably the most fundamental of all policy issues facing the United States and the world at large, and this should not be surprising. Taxes touch social issues, by allowing the government to manipulate the incentives to raise a family, get married, and make donations; taxes touch foreign policy, by providing the money necessary to fund military operations around the globe; and they affect the economy, most obviously, by changing the things people wish to buy, the businesses people are willing to start, and the money people are willing to invest.

So far, I have strayed away from being a partisan hack, because in this first post I want to set the stage for a series of posts about tax policy, which will make strong claims and present strong opinions. Most people can accept that to some degree, taxes affect incentives. If you have taken any type of economics class, you have heard the catch phrase that “people react to incentives.” I think this is one of the most true and underrated statements in economics, and surprisingly, it is ignored in politics because often times the incentives that a policy causes are not immediately or overtly visible. In later posts, I will discuss this in the context of the minimum wage, right to work, licensing, and other subjects.

In the United States, the debate over the correct level of taxation has been burning since the Revolutionary War, which was in fact fought over taxes. What most people do know about the war is the “taxation without representation” slogan. What many do not know, is that the Revolutionary War involved many other complicated tax debates, including privileging some companies, like the East India Trading Company, above others within British tax law. In fact, the Boston Tea Party was likely more a result of a tax cut given to only one company than anything else. I will return to this topic later on.

Today, the debate being waged on taxes is largely through three dimensions: the overall size of the tax burden, the complicated nature of the tax code, and the choice of who should bear the brunt of the tax burden.

In my next series of posts, I would like to address themes related to the three dimensions I mentioned. In the course of this blog, I will also discuss government regulation, international political economy, and other topics within the umbrella of fiscal policy. I hope that with each post, I earn your readership. Please contact me if you have a suggestion, a criticism, or a general comment.

Defending Freedom,

Jacob Kohlhepp

 

 

Welcome to My Blog!

Hello world!

 

This is a blog written by me, Jacob Kohlhepp. The main topics I intend to discuss are politics, public policy, and philosophy! I hope my words capture your imagination, cause you to question, inspire you to debate, and justify you coming back for more!

To humble beginnings, fresh thoughts, and the first chapter,

 

Jacob Kohlhepp