IMF: Flat taxes have no Laffer curve effect

Flat taxes are associated with a reduction in personal income tax, and "in no case does there ..appear to have been a Laffer effect". That is the most striking conclusion from a new study by IMF economists Michael Keen, Kevin Kim and Ricardo Varsano in The "Flat Tax(es)": Principles and Evidence (Working Paper No 06/218). The authors summarise the paper thus:

Discussion of these quite radical reforms has been marked, however, more by assertion and rhetoric than by analysis and evidence. This paper reviews experience with the flat tax, seeking to redress the balance. It stresses that the flat taxes that have been adopted differ fundamentally, and that empirical evidence on their effects is very limited.

This precludes simple generalization, but several lessons emerge: there is no sign of Laffer-type behavioral responses generating revenue increases from the tax cut elements of these reforms; their impact on compliance is theoretically ambiguous, but there is evidence for Russia that compliance did improve; the distributional effects of the flat taxes are not unambiguously regressive, and in some cases they may have increased progressivity, including through the impact on compliance; adoption of the flat tax has not resolved common challenges in taxing capital income; and it may have strengthened, not weakened, the automatic stabilizers. Looking forward, the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it.

The impact of a flat tax on work incentives "is not clear cut in principle, and there is no evidence that it has been strong in practice." Likewise, the distributional effects of movement towards a flat tax "are potentially complex", especially for reforms that involve an increase in the basic tax-free amount.

Keen, Kim and Varsano argue that although "the question has received little attention in the debate, ..movement to a flat tax may plausibly strengthen the automatic stabilizers, not weaken them." They also find the introduction of a flat tax has been a useful signal of reform:

The flat tax has commonly—almost universally—been adopted by new governments anxious to signal a fundamental regime shift, towards more market-oriented policies. In several cases, the signal appears to have been well-received. Where no such reputation needs to be acquired, the appeal of the flat tax is consequently less.

The authors conclude by questioning the political sustainability of the move towards flat taxes:

What remains unclear is the sustainability of the flat tax. Structurally, the flat taxes that have been adopted do not provide a coherent framework for dealing with the difficulties that almost all countries now perceive in taxing internationally mobile capital income.

...Political economy considerations point towards the adoption of rate schedules that tend to benefit middle income earners: exactly the group that tends to lose most from the adoption of a second wave flat tax. Moreover, the very spread of the flat tax in itself undermines its value as a signal: it may prove too easy to mimic. While there will no doubt be new members of the flat tax community, in some respects the more interesting question is whether there will be any defections.

Most flat tax structures benefit lower and/or upper income earners at the expense of those on middle incomes - a point I have made before. Such tax structures are hard to 'sell' to predominanatly middle class swinging voters in marginal electorates. In the end it is likely to be the median voter that stops the flat tax movement advancing.

Comments

[*uri]

mmm... what about the fact the flat tax is just cheaper to administer for tax administration as well as for taxpayer.
Reporting your annual income tax in Estonia (flat tax) takes approximately 15 minutes: 10 minutes for waiting as the server is busy, 5 minutes for reviewing data (which is automatically filled in by tax administration) and 0 minutes for pressing submit. If you have right to have some of your paid tax returned, it will be done in course of 2 weeks.
In USA, an average person spends 22 hours a year for tax reporting + consulting costs. It is not of course only because of progressive income tax, but because of more "fair" taxing system in general, which is based on various exceptions.

[Gabriel M.]

It's still too early to tell. The Romanian experience has been good... the tax cuts to the flat level have not been self-financing but that was never expected. Overall, I think it makes good policy, rather than optimal taxation, since it's more robust and, on the other hand, fiscal fine-turning has been a disaster many times, in many places and subject to much abuse.

I fail to see how the flat tax is regressive, though, since 16% of a larger income is larger than 16% of a smaller one. This measure introduced some much-delayed justice, from my point of view. Why penalize the rich(er) for being rich(er)? It's perverse. 16% for everyone might also reduce some of the lobby.

I'd also be weary of class-talk... middle-class vs. upper-class... these boundaries are fuzzy and it's a pernicious socialist mindset. In a healthy, capitalism society there's a lot of mobility; and besides, we should aim for lower taxes for everyone, whenever and wherever possible, not to pass the weight a decrepit system onto the next guy.

Unfortunately, the degree to which the idea has really been applied... is questionable. For a long time not everything was at 16% and double taxation still persists in some areas.

[A. PERLA]

Gabriel M. : I fail to see how the flat tax is regressive, though, since 16% of a larger income is larger than 16% of a smaller one.

If so, then you are myopic.

The purpose of a progressive tax is not fiscal but social. The rich pay more because they have more. The money is redistributed further down in order to maintain an essence of social harmony and equity, without which a country simply degrades into a bipolar society of haves and have-nots.

Your comments make it obvious why so many Romanian "refugees" are seen knocking on the doors of other European countries. They are not political refugees but economic - Romania should be taking care of its own, rather than exporting its societal misery.

[A. PERLA]

uri : "... what about the fact the flat tax is just cheaper to administer for tax administration as well as for taxpayer."

And, so? The European VAT costs VERY much less to collect than income tax and produces more state revenues. (In France, for instance, one family out of two pays income tax.)

Taxes are not a matter of just state revenue or taxpayer declaration grief. It is first and foremost a social necessity. Without social harmony, the rich have far more to lose than the poor. So, why shouldn't they proportionately pay more? Who should, if not the rich? The middle-class?

[happyjuggler0]

Gabriel is correct, the flat rate tax is highly progressive. A 16% tax on an income of $20,000 results in paying $3,200 to the government. A 16% tax on $2,000,000 results in paying $320,000. Any tax system in which someone is paying 100 times as much as someone else can't reasonably be described as anything but progressive.

In my opinion the biggest asset of a flat rate tax is that there is a built in political disincentive to increase government spending (and with it the eventual tax increases on everyone), and therefore the economy can grow faster than it would with a huge deadweight loss.

[Lafayette]

happyjuggler0: "A 16% tax on $2,000,000 results in paying $320,000. Any tax system in which someone is paying 100 times as much as someone else can't reasonably be described as anything but progressive."

You're misconstruing the word "progressive", as if to say it means "goodness". If a flat tax is "progressive" then it is so only mathematically. It is otherwise reactionary.

The accumulation of riches by a minority class of the wealthy is NOT the nirvana that you think. In fact, it is ultimately dangerous, depending upon the country and the times. It is also bereft of any humanitarian value.

Just how many BMWs can your garage contain?

[Sandy]

A. PERLA: "The money is redistributed further down in order to maintain an essence of social harmony and equity, without which a country simply degrades into a bipolar society of haves and have-nots."

From the parent post: '"Likewise, the distributional effects of movement towards a flat tax "are potentially complex", especially for reforms that involve an increase in the basic tax-free amount.'

Do you have any data with which to enlighten the IMF on how "simple" the inverse-bell-curve distribution of income after the introduction of a flat tax is?

[New Economist]

Sorry Gabriel M., Lafayette and happyjuggler0 - the flat tax you describe is not progressive. A progressive tax system is one where those with a greater capacity to pay (higher income earners and/or those without dependents) pay a higher rate (not amount) of tax.

A flat personal income tax without a tax free threshold is, by itself, neither progressive or regressive - it is tax neutral. With a tax free threshold, it can be progressive for the lower part of the income scale.

But in conjunction with indirect sales taxes, a flat income tax is usually regressive. This is because those on lower incomes (1) spend a higher proportion of their income than the rich; (2) their consumption bundle tends to have less services and more goods - which are often taxed more heavily; and (3) they spend a higher proportion of their income on cigarettes and alcohol.

As a result, the overall rate of tax paid will in many cases be higher for low income households than those on middle incomes. In other words, the tax system is 'regressive' for most taxpayers.

[Arthur Eckart]

The Laffer Curve Effect may work through a threshold effect. In the IMF examples, the tax rates didn't change significantly to influence taxpayer behavior. If the income tax rates were lowered to 10% or raised to 90%, for example, then significant behavior effects may be noted. However, small changes in tax rates may significantly influence capital creation or destruction, since everyone attempts to maintain autonomous consumption. Also, tax revenues are dependent on the business cycle.

High-income workers tend to save more than low-income workers. Consequently, if taxes are raised too much on high-income workers, their marginal propensity to save may decrease. Also, when there's an economic contraction, people will use saving and then borrow to maintain consumption. When an economic expansion is underway, people will pay-down debt and then save.

When Kennedy, Reagan, and Bush (Jr) came into office, they cut income taxes. In those three periods, economic booms soon followed. However, it could be argued that taxes were cut due to economic conditions, and the tax cuts turned out to be procyclical. However, Clinton raised taxes at the beginning of an expansion and the U.S. almost fell into recession (the Fed achieved a rare soft-landing).

In 1999 and 2000, the U.S. had budget surpluses, because of the stock market boom and high employment, causing higher tax revenues. However, when the market crashed and the country fell into recession, tax revenues fell sharply. Also, people had to pay capital gains and alternative minimum taxes for gains the prior year, while the market was crashing, which may have facilitated the crash. So, it would seem, an optimal tax rate in one year, if found, is not optimal in another.

[happyjuggler0]

New Economist,

First of all thanks for the blog. I keep finding great new links here in your posts.

As far as progressive is concerned, you are technically correct in the sense that the way the term progressive income tax is clinically defined is a graduated income tax.

However, if you ask the average "man on the street" why we ought to have progressive taxes (assuming we ought to have them), and they'll all tell you that people who can afford to pay more for government ought to pay more. Therefore, while the Left has successfully framed a flat tax rate as not being progressive, in practice it very much is as I pointed out in my 100x example.

It is simply absurd to say that someone paying 100 times as someone else for anything is somehow not pulling their fair weight, or whatever euphemism you want to use.

As for those who argue that society will collapse if people are allowed to become very rich, all I can say is "oh please"! The only way the average person will rebel is if they lack opportunity to succeed due to the way the "game is rigged". Since it is much harder to start your own business if you don't have money, then a high tax rate on one's income acts as a barrier to progress for those wanting to make it to the top. Therefore high tax rates are if anything more likely to lead to social chaos, not less likely.

I can see the point of view that inheriting money is somehow unfair, but the notion that it is unfair if people who create wealth are graciously allowed to keep the lion's share of their creations is absurd.

[happyjuggler0]

As an example, there was serious rioting in France a year ago where disenfranchised youth burned a copious amount of cars. They weren't upset that others could own cars, they were upset because they lacked the opportunity to get to that stage by working hard, indeed, by working at all.

Highly "progressive" France is in much more danger than the US is of social chaos and blood in the streets. Although if the US doesn't get its act together in K-12 educucation in the cities it may have some recurring ugly problems with sporadic "frustration violence" like it did in LA in 1992.

To reiterate, the problem social issue is not individual phenomenal wealth, the problem social issue is lack of opportunity. Progressive taxation doesn't do anything to create opportunity, indeed to the extent that it hinders new business formation (and its resultant hiring) it can actually hurt the cause of opportunity for the poorest.

[Suvi]

"Progressive taxation doesn't do anything to create opportunity"

Progressive taxation is about creating opportunity, or ought to be. If the revenues are used to provide things like "free" higher education, as they are in many countries, they must increase opportunity, especially at the bottom end of the food chain.

[Arthur Eckart]

Suvi, I think, Happyjugglar is saying that a flat tax means higher income people will pay more taxes (e.g. 20% of $1 million versus 20% of $10,000). So, one person will pay 100 times more in income taxes than another for the same public services. Also, I believe, he's pointing out that progressive taxes mean fewer employment opportunties or less available capital.

[Suvi]

Yes Arthur. But 20% of of $1 million versus 20% of $10,000 is not progressive, as New Economist explains.

"Also, I believe, he's pointing out that progressive taxes mean fewer employment opportunties or less available capital"

Ok. Now let's have some empirical studies that prove it.

[spencer]

The difficulty and time consuming nature of reporting your income for taxes has nothing to do with the rate. It is no more time consuming or difficult to calcualte a 39% tax rate rather than a 27% rate.

the difficulty and time consuming nature of filing taxes comes from determining ones income. There is no reason to think this would be any easier under a flat tax then under a graduated income tax. Yes, in theory you can eliminate all deductions and exceptions under a flat tax. But in theory you can also do that under a graduated tax.

[Arthur Eckart]

Suvi, I'm sure there are lots of empirical studies, e.g. in Public Finance, and many economic laws or theories that can be applied. Also, a mathematical model can be used.

[Lafayette]

Suvi : "Ok. Now let's have some empirical studies that prove it."

Prove what? That existing taxation schemes, which have been around for a donkey's age, are progressive and the flat-tax regressive?

Yah, right. Any other bit of socio-economic policy you want proved, whilst we are at it? Just wondering ...

Why is it that "only the rich" in developed countries propose a flat-tax? Why is it that only the countries that never had any tax system (worth shaking a stick at) are adopting a flat-tax (because it is easier to collect from people who have never paid a tax and have little will to do so)?

[Arthur Eckart]

Lafayette, I'm sure most people, whether they're rich or poor, don't like paying taxes, and obviously rich people pay more. However, a benefit of a flat tax is its simplicity. High-income people tend to spend more to lower taxes, e.g. paying up to $1 to lower taxes by $1, and a flat tax may save money and time when filing income taxes.

[Lafayette]

Eckart: "and obviously rich people pay more. However, a benefit of a flat tax is its simplicity."

Simplicity in collecting taxes is NOT a national priority. Social equity is, or should be.

When 80% of the wealth goes to 20% of the population, and that 20% moans about "tax fairness", something is drastically wrong in the country.

[Mike]

Ignoring for a moment the larger "fairness" debate, it's worthwhile to remember that the US implementation of progressive taxes is actually "flat" within each marginal bracket, i.e. someone making $1,000,000 / year is taxed at the same rate on their first $10,000 of income as someone who makes $50,000 / year.

It should also be clear, to anyone who gives it 2 seconds of thought, that the progressive nature of the US system is NOT what creates complexity, it's all of the other ancillary items (deductions, EITC calcs, capital gains/losses, AMT, etc) that cause confusion. A progressive system, in and of itself, shouldn't add any measurable degree of complexity to the preparation of tax returns, administration, or enforcement.

[Arthur Eckart]

Mike, right, the example Happyjuggler was using (of 100 times more) is a universal flat tax, which would save money and time compared to the current tax system, and not progressive. I agree, using only a progressive flat tax will simplify filing, perhaps to completing on a postcard.

[Lafayette]

Eckart: "... using only a progressive flat tax will simplify filing, perhaps to completing on a postcard."

Yes, Bill Gates could dedicate even more of his time to philanthropic endeavours. Think of the savings (in time spent) for dear Bill just filling out a postcard and sending it to Uncle Sam's IRS from, say, Malawi.

What planet do you guys live on ... ?

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