Flat Taxes Are Big in the Former USSR: Have They Worked?

By Braden Goyette, ProPublica

GOP presidential candidates Herman Cain, Rick Perry and Newt Gingrich have all introduced proposals for flat taxes, which aim to tax everyone at the same rate. The idea is to simplify the tax code, getting rid of loopholes and reducing entitlements and deductions. Gingrich and Perry have both promised that Americans would be able to file their taxes on a postcard.

The former Soviet Union is the axis of flat taxes.

Flat income taxes have been criticized for putting a greater burden on middle-income people while cutting taxes for the rich. Critics say a flat tax would bring in less revenue for the government to fund social programs (though, as Rachel Weiner of The Washington Post puts it], “of course, for many conservatives, a drastically smaller government is a feature, not a bug”).

The United States briefly tried a flat 3% income tax between 1861 and 1872; a flat income tax was reintroduced in 1894 but was struck down by the Supreme Court. Instead, the U.S. has had a graduated income tax since World War I. We haven’t really gotten to see how a flat tax would play out here, and it’s a good time to take a look at other countries that have adopted flat taxes, and how it worked out for them.

Flat-tax success stories?

Most of the countries that have adopted flat taxes in recent years are from the former Soviet bloc.

Throughout the 1990s and early 2000s, six former Soviet republics and three other Eastern European countries flattened their income-tax rates. Some, like Russia, adopted a flat personal income tax but kept a different rate for corporate income. Others, like Estonia and Slovakia, instituted a flat tax on personal and corporate income. Many of these countries also have a value-added tax, which taxes the difference between the final cost of a product and the cost of the materials used to make it.

Estonia adopted a 26% tax on personal and corporate income in 1994. The country had gross domestic product growth of 11.7% in 1997, and continuously grew between 7 and 10% throughout the early 2000s, although many factors, of course, contributed to that. (U.S. GDP growth was 2 to 4% over that period.)

In 2001, Russia switched from a system of 12, 20 and 30% tax rates to a 13% flat income tax. Adjusted for inflation, revenue from Russia’s personal income tax increased by 26% [PDF] in the year after a flat tax was implemented, and by nearly one-fifth as a percentage of GDP. Russia also saw strong GDP growth throughout the 2000s, ranging from 6 to 8% from 2003-07.

Apparent success stories like these had American supporters of a flat tax crowing. A 2005 Wall Street Journal editorial declared that “the world is flat;” the Cato Institute, a libertarian think tank, proclaimed a “global flat tax revolution.”

But economists caution that you can’t necessarily translate these experiences into an American context.

Why flat taxes gained traction in the former Soviet Union

For one thing, those reforms came at a time of massive economic change as former Soviet republics transitioned from command economies to the free market, and Eastern European countries made other systemic changes. Estonia, which introduced a flat tax in 1994, had just started transitioning to a capitalist system three years earlier.

“One of the fastest-growing countries in Eastern Europe has been Slovakia. They introduced flat taxes in 2004, but they also then liberalized the labor market,” said Anders Åslund, a senior fellow at the Peterson Institute for International Economics. “Countries with flat income taxes have had high growth, but you can’t isolate the causality.”

For one thing, adopting flat taxes was also a way for politicians to mark a new era and separate themselves from the former regime.

“It was a way of signaling a commitment to the free market,” said Michael Keen, an International Monetary Fund senior researcher who contributed to a 2005 study of Russia’s flat-tax reform.

Flat-tax reforms also caught on because a simpler tax helped to improve collection rates in countries that had large shadow economies and entrenched corruption. Indeed, among industrialized countries, Russia still ranks among the most corrupt.

For those at the top of the income spectrum — whose tax rate had dropped from 30 to 13% — there was less of an incentive to evade taxes. The simplified system also left less room to lie on tax forms.

“The more complex the tax system, the more avenues there are for discretion both by people on the revenue side of the collection system and the people paying the taxes,” said Gary Hufbauer, also a senior fellow at the Peterson Institute for International Economics, who formerly worked on tax policy at the Treasury Department.

More than just tax reform

While the 2005 IMF study found that overall tax compliance had improved in Russia — more people were reporting their incomes and paying taxes appropriately — the study also found that this didn’t account for the entire increase in revenue.

“The general view among those who have looked closely at the data was that what happened to revenue was a reflection of broader developments to the Russian economy at the time,” Keen said.

An overall increase in wages contributed greatly to increased tax revenue.

“Our analysis suggests that the strength of [personal income tax] revenues in Russia over this period was largely driven by an increase in real wage rates unrelated to the reform,” the IMF study said [PDF; see p. 40].

Though proponents of a flat income tax speculate that a lower consistent tax rate would motivate people to work harder, the 2005 IMF study also found that that wasn’t the case in Russia.

“Based on what we found and what others have found since, there has been very little effect on actual work effort,” Keen said.

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