New Economist

Tories reject flat tax

Britain's Conservative Party has just published the 200-page report of their Tax Reform Commission today. Though presented as an 'independent' report, the Commission was headed by former Cabinet minister Michael Forsyth and was stacked full of Tories.

Tax Matters: Reforming the Tax System (PDF) covers a lot of ground, including cutting the main rate of corporation tax from its current level of 30% to 25%. This would be funded by scrapping a range of reliefs and exemptions for business. But what caught my eye was the report's rejection of proposals for a flat tax. The authors argue that a flat tax "is the right direction but not the right solution for the UK":

While theoretically attractive, moving directly to a “pure” flat tax in the UK would not in practice be viable. Financing current levels of government expenditure would require a flat tax rate which would entail either undue risk with the public finances or major cuts in expenditure or a steep increase in tax rates for those on low incomes or for middle earners. Nevertheless, many of the features of flatter taxes – simplicity, stability, a broader base, higher thresholds, fewer rates – can and should be actively pursued.

Precisely. Let's hope that Britain's flat earth tax advocates read and digest these findings.

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.

London flat tax debate, 26 January

The Economist and Stockholm Network have organised a debate on flat tax in London this Thursday, 26 January at 6 for 6.30pm.

Flat tax systems now dominate much of Eastern Europe, and over here, the Tories are investigating whether Britain can follow suit. The hope is that a flat tax system would galvanise the economy by making it pay for people to work harder; also it would take many people out of the income tax system altogether; and could help to combat the increasing complexity of the tax system. But would it work? Is it a fairer system for all, not just in theory, but in practice? Or is it just a disguised tax cut for the rich which would hurt middle Britain and leave the least wealthy of us even worse off?

Chair - Paul Wallace, British Economy correspondent, The Economist
Speakers - Allister Heath, Deputy Editor of The Business
Prof. Lord Richard Layard, founder of the LSE Centre for Economic Performance, directs LSE Well-Being Programme
Ondrej Socuvka, Advisor to the PM of the Slovak Republic (Macroeconomics and Foreign Investments)

This event is complimentary, however seats are limited, so please RSVP Sacha as soon as possible.

Australia's flat tax that never was

Australia nearly adopted a flat tax this year - until common sense prevailed. David Uren of The Australian today reports on Costello's secret 30pc flat tax:

When Peter Costello left Canberra for his Christmas break last year, he had before him modelling for the most radical reform to income tax in 60 years. The ambitious plan, prepared for this year's budget, would have replaced all the existing tax scales with a single flat rate of tax of 30 per cent.

The current tax-free threshold of $6000 would have been abolished and replaced with a rebate to ensure low-income earners were no worse off. Treasury modelled a number of tax plans, including proposals from the Australian Chamber of Commerce and Industry, accounting body CPA Australia and the Government's backbench tax ginger group.

The most detailed work, however, was completed on the proposal for a flat tax. It included an analysis of winners and losers and an outline of legislation, covering other tax rebates and pensions, that would need to be amended.

The plan was clearly affordable without pushing the budget into deficit, with the cost rising from $7.7 billion in 2005-06 to $10.1 billion in 2008-09. ...Treasury projects that the budget will be in surplus by $8.5 billion in that year, so the pot from which tax cuts could be drawn totalled $15.2 billion.

Flat tax in the UK, part 4: Treasury's views disclosed

HM Treasury recently released documents on a flat tax, under new freedom of information disclosure rules. The problem is that according to a story by George Trefgarnein today's Daily Telegraph, The flat tax secrets that worried Brown did not want us to see (registration required), they have been censored:

The original version of secret work by officials posted on the Treasury website - after freedom of information request - pooh-poohed the claims of flat tax advocates as "misleading". But large parts of the work had been removed. The complete version reveals that most, but not all, of the elements which were blacked out present compelling arguments in favour of the flat tax.

Under the Freedom of Information Act, such excisions have to be approved by ministers or senior officials, so the inevitable conclusions are: first, that Treasury mandarins are privately taken by the flat tax idea; and second, the Chancellor fears that this could hand a powerful weapon to the Tories.

However not all the excisions were of text favouring a flat tax. For example:

"Proponents of a flat tax have to face up to the reality that such a system is tough on the low paid unless you spend a lot of money on generous personal allowances or a very low rate of tax, or both."

Treasury pointed out that not only would tax credits have to go under such a scheme, but also "important tax reliefs" such as "age related allowances" would be scrapped, leaving many pensioners facing a tax increase. It's a pity the full documents were not released, so we could have been given a more nuanced and balanced perspective.

(For my previous entries on the UK flat tax debate please see here, here and here).

UPDATE: Until I saw this morning's print edition, I did not realise that the Daily Telegraph also made this its front page lead story, Treasury blocks move to flat rate, by George Jones and George Trefgarne:

The uncensored paper seen by The Daily Telegraph presents a more balanced picture, acknowledging that a flat tax could increase economic activity and tax revenue, making Britain more attractive to foreign investors. It could create a "mini-economic boom" and would "eliminate distortions", the paper says.

Ah, the joys of internet news searches.

UPDATE 2: Dr Madsen Pirie at the Adam Smith Institute, Tim Worstall and Gavin Kennedy have also blogged about the story. Pirie writes:

Conservative shadow chancellor George Osborne accused the Treasury of "seeking to mislead the public." It is difficult to see it as anything else.

And Chris Dillow at Stumbling and Mumbling thinks it might encourage small government:

I suspect one motive for wanting a flat tax is that it would increase the political pressure for smaller government by making the cost of the state more transparent, especially to lower earners. Personally, I have no problem with this. As I've said ..big government is an obstacle to income equality.

On motive he is probably right. But the issue is perhaps more complex. Chris also asks: "Should egalitarians therefore really be opposed to a flat tax?" Yes, I think they probably should. It would be quite difficult to design a revenue-neutral flat tax that didn't reduce the income tax paid by high-income earners. If the tax scales also ensured low-income earners were no worse off, then middle-income taxpayers would be the losers. That would be a hard sell politically, and quite inegalitarian.

The onus is on the proponents of a flat tax is to show how it could be introduced into the UK without further enriching the already wealthy, or making the poor worse off. If that can be demonstrated, and it was revenue neutral, then I'd support it. 

Can Germany reform?

Germany looks like it could have a new Chancellor, Angela Merkel, on 18 September. But will she have the courage to undertake far-reaching reforms needed? Maybe she does, if her preferred finance minister is any guide. The Daily Telegraph story, headlined Economic radicals join German contender's policy team, reports today:

Germany's Christian Democrats yesterday picked a tax revolutionary and high-brow eurosceptic to head their economic team in the lead-up to the elections next month, signalling a shift in strategy from gentle reform to more radical thinking.

Dr Paul Kirchhof, who takes charge of public finances, is a Heidelberg law professor, former judge and taxd reformer. He is no centrist:

Dr Kirchhof wrote the landmark 1993 ruling on the Maastricht Treaty stating that Germany reserved the right to strike down any European Union directive that breached its own constitutional law. ...But he is best known as a critic of Germany's arcane tax system. In 2001 he drew up proposals to slash the top rate of income tax from 39pc to 25pc, while abolishing a dizzying range of 163 tax exemptions to offset the loss in revenue.

That's almost a flat tax. Not surprisingly, Germany's BDI industry federation said it was a "magnificent appointment" that would help kick off a new era of economic growth. Others were more sceptical. According to Bertrand Benoit in today's Financial Times:

“Kirchhof’s concept is good,” said one private sector economist who declined to be named. “But a flat tax is not politically doable. People here feel very strongly about having a progressive system.” One US economist said Mr Kirchhof’s blueprint “was legally attractive and fairer than the current system, but not competitive internationally. Capital, which is more mobile than labour, must be taxed less heavily than wages if you want it to stay in the country.”

However Merkel also appointed Peter Müller, the popular state premier of Saarland, to cover the economy and labour. He has the rare distinction (for a conservative) of being a long-standing trade union member. Labour reform is critical if Germany is to reduce its double-digit unemployment rate. German business leaders are seeking labour reforms after the election, according to Richard Milne in today's FT (subscription required):

German business leaders want next month's election to result in labour reforms that would extend working hours, increase flexibility and facilitate the hiring and firing of workers. In interviews with the Financial Times, chief executives of Germany's biggest companies expressed hopes for change after the poll. German business has not backed a specific candidate.

They will not be pleased with Müller's appointment. He belongs to the CDU’s left wing, and according to today's International Herald Tribune is no enemy of labour:

Merkel also gave a nod Wednesday toward the wing of her party that still cultivates close relationships with Germany's labor unions. ...Müller, who last year won a landslide victory over Schröder's Social Democrats, has rejected any abolition of rules against quick job dismissals, and has supported the party's more moderate stand on tax policy.

So, if Merkel wins next month, economic policy may come down to a struggle between a conservative academic and judge considered to have radical but impractical ideas, versus a popular centrist politician (and trade unionist) who last year won a landslide victory. That should be an interesting battle!

The flat-tax revolution

The 15 April edition of The Economist has two special features on what it calls The flat-tax revolution. The first piece starts by lamenting the "tax-code sclerosis" prevailing in most rich countries:

Revenue must be raised, of course. But is there no realistic alternative to tax codes which, as they discharge that sad but necessary function, squander resources on an epic scale and grind the spirit of the helpless taxpayer as well?

They argue a flat tax is a serious and practical alternative to current tax codes. The piece briefly addresses the two main objections. First, in response to the argument that a flat tax is 'Fine in theory, just not practical in the real world,' they respond that in Estonia and eight other countries it "seems to be working as well in practice as it does on the blackboard." The second objection is that a flat tax would undermine the progressive nature of income tax:

Enlightened countries, it is argued, have “progressive” tax systems, requiring the rich to forfeit a bigger share of their incomes in tax than the poor are called upon to pay. A flat tax seems to rule this out in principle. Not so. A flat tax on personal incomes combines a threshold (that is, an exempt amount) with a single rate of tax on all income above it. The progressivity of such a system can be varied within wide limits using just these two variables.

And in any event, the current tax system is not as progressive as claimed:

Flat tax in the UK, part 3

I did not think I'd be writing about this issue so soon after my last post, but Roger Bootle's piece on flat taxes in today's Sunday Telegraph, Is a flat tax a fairer way to raise revenue? (registration may be required) has re-opened the debate. He nails the fundamental flaw with the  flat tax proposal - it is not revenue neutral:

A recent paper by Richard Teather for the Adam Smith Institute has tried to provide a way out. It argues for the introduction of a flat tax at 22 per cent, combined with a tax-free personal allowance of £12,000. The result, Teather says, is that top earners would see an increase in their post-tax earnings of 0.5 per cent, while below-average earners would see their post-tax earnings increase by more than 12 per cent. Sounds too good to be true? It is. The problem is that this produces a massive loss of tax revenue - some £38bn in the first year.

The article is a good basic introduction to the issue. Interesting to note that Dr Eammon Butler from the Adam Smith institute is not concerned about a mere trifle like £38 billion:

But of course the merely administrative savings proposed in the James Review, plus the expanded tax base and the economic growth unleashed by the new low tax rates, would easily take care of that. And as he says, the potential gains are worth striving for.

Ah yes, if only it were that easy. I have serious doubts about just how easily the somewhat glib assumptions contained in the Tory's James Review could be implemented. Also checkout Tim Worstall's critique. Worstall lambasts Bootle for committing "something of a howler" by addding in the employee component of National Insurance (NI), but not the employer component:

When you add the NI and income tax systems together the UK already has something pretty close to a flat tax system (horribly riddled with examptions etc but...). For there is not one NI tax, but two, so called Employer’s and Employee’s. Together these amount to some 22% of wages from anything just over spit to just below the 40% income tax band. Add the 22% income tax that applies to most of that income (personal allowances for income tax are very low in the UK and the 10% income tax band is very thin) and you have for anyone earning the minimum wage full time a marginal tax rate of 44%.

I commented on Tim's blog that:

Ultimately of course the public pays for all taxes one way or another, but simply adding income tax, employee NI and employer NI together is simplistic. Employer NI matters principally because of the tax wedge it creates, which raises the cost of hiring workers.

The distributional issues of who would lose and who benefit from a flat tax, and of how progressive the current income tax system really is anyway, are complex. But from both an equity and public policy perspective, well worth investigating. This is something the IFS might usefully get their teeth into. 

Flat tax in the UK, part 2: Throwing down the gauntlet?

Just over a fortnight ago I mentioned the new Adam Smith Institute report calling for a flat tax in the UK. The Institute gave it another plug on their weblog last week, and Gary Duncan has discussed it in The Times of March 29 in a piece called Shallow populism stifles taxation debate. He summarises the potential advantages thus: "Distortions are removed, disincentives eradicated, complexity swept away, double taxation of savings eliminated and compliance costs cut." Duncan makes three important points about a flat tax. First, tax and investment competition:

The move to flat tax in Eastern Europe has thrown down the gauntlet to Western European governments, which confront the risk that jobs and investment will gravitate to more attractive, low-tax competitors.

Second, he reminds us that it's a lot easier to introduce a flat income and company tax in "smaller economies in a state of transition .. in Eastern Europe" than in "a big, developed economy such as the UK [which] would be immensely challenging".

Third, even if governments consider a flat tax "too scary to offer to a skittish electorate, there are plenty of less daunting alternatives. As Mr Martin argues in his pamphlet, the tax regime could be drastically simplified even within the bounds of the existing, progressive framework of bands and allowances."

I also favour simplification of the income and company tax systems. But I'm sceptical about whether there really would be significant net gains from moving to a flat tax in the UK. Tim Worstall, in commenting on my previous blog on this topic, made the point that cutting taxes for low income earners could boost happiness:

I don’t think those on less than about 10k should be paying income tax or NI. There’s even a leftish justification for that in Richard Layard’s numbers on happiness. Up to about $20 k dollars a year happiness increases with rising income. It’s as good a justification as anything else for a moral basis for taxation.

It would be nice to tax low income earners less. But that raises the perennial problem with any major tax refirm - who would pay? If a flat tax was introduced into the UK with a high zero tax threshold, low earners would pay less tax. So too would the rich, benefiting from lower marginal rates. Assuming the change is designed to be revenue neutral, then middle income earners would have to pay more tax. Hard to see how that would be acceptable to politicians or voters...

Of course the not-so-hidden agenda of many flat tax advocates is not principally a simpler tax system. It is lower taxes and a smaller state. But if that's their core agenda, they should say so - and identify what public services they would cut.

There is little evidence of such a taxpayer revolt in the UK. Indeed, the remarkable thing about the current political era is the degree to which the public - and the Conservative Party - have accepted Labour's agenda of higher public spending. As Gary Duncan notes in his article:

Labour’s bold second-term gamble on trying to shift the terms of electoral debate decisively in favour of a tax-and-spend strategy seems to continue to pay off. Despite ministers’ substitution of well-intentioned rhetoric for reforms in the state sector, the public seems content to wait to see whether Mr Brown’s billions deliver meaningful improvements in services.

Until that public mood shifts, advocates of a flat tax in the UK will continue to receive short shrift.

Flat tax alert!

It was only a matter of time before the simple-minded advocates of flat taxes reached British shores. Who better than the Adam Smith Institute to spread the word? Their new report, A Flat Tax for the UK - a Practical Reality (PDF), calls for income tax to be simplified into a flat rate tax of 22%. Under the proposal, there would be a tax-free personal allowance of £12,000.

Meanwhile Tim Worstall reports on news that Poland is following the Eastern European trend towards flat taxation systems. 

I agree with Tim (and the Conservatives, and it seems, even the Adam Smith Institute) that those receiving the minimum wage should not have to pay tax. But aside from being simpler, I doubt a flat tax would be much improvement to the current UK tax system. When coupled with a 17.5% VAT, the obvious risk is of a highly regressive tax impost.