Nuggets of Wisdom

Tuesday, March 24, 2015

Libertarian Tax Policy: Estonia

An artful taxman, according to Jean-Baptiste Colbert, treasurer to Louis XIV, so plucks the goose as to obtain the most feathers for the least hissing. Such arts are lost in America. As the April 15th deadline for filing tax returns falls due, the hissing is as audible as ever. But Americans are not alone. New Zealand's tax code instils “anger, frustration, confusion and alienation” in the islands' businessmen, according to a 2001 report to ministers. Adam Smith spoke for many when he bemoaned the “unnecessary trouble, vexation, and oppression” the people suffer at the hands of the tax-gatherers.

The White House claims to be listening. Shortly after his election victory, President George Bush set up a panel to advise him on how to reform the tax system. A report is expected this summer. Judging by the remit he has given them, Mr Bush wants to iron out some of the kinks in the tax code that distort saving and deter work, while retaining tax breaks for charity and home-ownership. But he also wants to simplify the tax code for simplicity's sake.

The Americans are talking about it. Meanwhile in Europe, east of Vienna and as far afield as Russia and Georgia, they are actually doing it. In 1994, Estonia became the first country in Europe to introduce a so-called “flat tax”, replacing three tax rates on personal income, and another on corporate profits, with one uniform rate of 26%. Simplicity itself. At the stroke of a pen, this tiny Baltic nation transformed itself from backwater to bellwether, emulated by its neighbours and envied by conservatives in America who long to flatten their own country's taxes...

...At the time of its reform, Estonia also taxed labour and capital at the same rate. After 2000, however, it chose not to tax profits at all until they are distributed to shareholders as dividends. This gives companies an incentive to retain their earnings and reinvest them. Indeed, very little of the burden of taxation in Estonia falls on corporations directly: corporate taxes accounted for only 3.6% of total tax revenues in 2003.

Estonia's economy has grown impressively since its 1994 reform. Growth reached double digits in 1997, and has since settled at around 6% annually, after a slump at the turn of the century. Repealing its high tax rate on the rich did not erode the country's tax base as some might have feared. In 1993, general government revenues were 39.4% of GDP; in 2002, they were 39.6%. Estonia now plans to cut its flat tax from 26% to 20% by 2007.

But how much do Estonia's robust revenues owe to its flat income tax? Perhaps less than is frequently advertised. In 1993, the year before its reform, Estonia's multiple personal income taxes raised revenues amounting to 8.2% of GDP. In 2002, its flat income tax raised revenues worth just 7.2%. Indeed, the flat income tax that generated so much excitement abroad seems to be carrying less weight than Estonia's old-fashioned VAT, which raised 9.4% of GDP in revenues in 2002.

VAT is, of course, the flattest tax of all. It levies a uniform rate on the goods you buy, taking a constant cut of your money when it is spent as opposed to when it is earned. Estonia's VAT is also quite broad, leaving relatively few things out (hydropower and windpower were two curious exceptions). The same point could be made about Slovakia. At 19%, it has a relatively low rate of income and corporate taxes, but one of the highest rates of VAT in Europe. It may be this high rate of VAT, not the flattening of its other taxes, that sustains the government's revenues in the future.

- "Flat Tax Revolution: The Case For Flat Taxes", The Economist.