The flat tax

In many countries, the tax system has become so complicated that the need to simplify has become urgent. Between 2000 and 2003, seven OECD (Organisation of Economic Cooperation and Development) countries cut the number of tax brackets. A radical idea which is being hotly discussed today is flat tax, a system that taxes all entities in a class at the same rate (as a proportion of income). In contrast, in a graduated, or progressive scheme, people with higher incomes pay tax at a higher rate than those with lower income.

In 1994, Estonia became the first country in Europe to introduce a “flat tax” on personal and corporate income, with a single uniform rate of 26%. Latvia (25%), Lithuania, Russia (with a rate of 13% on personal income) Slovakia (19% on personal and corporate income), Ukraine (13%), Serbia (14%), Georgia (12%), Romania (16%) have followed subsequently.

The flat-tax movement has taken off in a big way in these former communist countries as they were starting from scratch, or nearly so, in choosing a tax code. So opting for the simplest, most efficient system available was the natural thing to do.

According to conventional wisdom, “progressive” tax systems are better as they tax the rich more heavily, compared to the poor. But progressive tax systems have not been all that successful in introducing an element of fairness. In New Zealand, for example, only the richest tenth of households pay more under the country’s progressive income tax system than they would under a 25% flat tax. And whatever fairness gained may not be worth all the extra complexity resulting from many tax brackets and exemptions. In the United States, the costs of compliance, administration and enforcement have been estimated between 10% and 20% of revenue collected or 25-50% of the government’s budget deficit.

In contrast, the administrative elegance of a pure flat tax is phenomenal. Because every rupee is taxed at the same rate, the tax collector need not know who is earning how much. The tax authorities can simply withhold, say, 20% of a company’s payroll.

The flat tax can come in different versions. Russia has imposed a single 13% tax rate on all personal income. But it has a different rate for corporate profits. Slovakia’s flat tax, by contrast, covers both personal income and corporate income, as well as VAT,  a move aimed at discouraging tax arbitrage. For example, it was earlier quite common for people in  Slovakia to declare themselves self-employed, even when they were salaried employees. Their lunch would be counted as a business expense while their wages would be taxed as profits!

There is increasing evidence that a flat tax can yield good results. In Estonia, just before the  introduction of flat tax, 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.

The most impressive achievement has been recorded in Russia, whose tax arrears amounted to 34% of collections in 1997. Russia’s bigger enterprises evaded an estimated 29% of their taxes and paid another 63% in kind, with goods and services often of little value to the government. In lieu of $80,000 in taxes, one company reportedly offered the government 10 tonnes of toxic chemicals!

On January 1, 2001, Russia combined its 12%, 20% and 30% personal income tax bands into a single, uniform 13% rate. A year after the reform, the personal income tax was raising almost 26% more revenue in real terms. In the year before the flat tax, Russians in the two higher tax brackets reported only 52% of their income to the tax authorities. In 2001, these same households reported 68%.

In our country too, we need radical tax reforms. Our Income Tax Act despite some reforms in the past 20 years remains as complicated as ever. Measures like the fringe benefits tax introduced in the recent budget are clearly a retrograde step. A flat tax may be the need of the hour. The leftists and socialists who have a significant say in policy formulation today may describe it as anti-people! But the sheer convenience and ease of administration of a flat tax system hold out the promise of a clean and transparent tax system, which our country badly needs.

The author is dean, Institute of Chartered Financial Analysts of India (ICFAI), Hyderabad. email: ved@icfai.org