Flat Tax

Earlier this month, I wrote about how the flat tax has been gaining popularity in Russia and Eastern Europe.  It seems that businesses like the flat tax as well.

The Cato-at-Liberty blog notes (“…Losing Business to Flat Tax Neighbors…“) that many businesses are leaving ‘high tax-Hungary’ for its flat tax neighbors.  According to a Budapest Times  story,”flat tax is now the preferred system among the post-communist economies of Central and Eastern Europe. Is Hungary – already suffering the lowest rate of economic growth of the new EU member states – in danger of being left behind?…Thousands of Hungarian companies have already relocated their headquarters to Hungarian-speaking southern Slovakia – not only are taxes lower, but accounting has been made child’s play.”

Why do people like the flat tax so much?  The reason is that it is simple, fair, and decreases tax evasion.  The  flat tax is “…a simple, low-rate tax which is easy to collect and difficult to evade is likely to raise more money than a high-rate tax system that is full of loopholes and which nobody fully understands.”

Score one for economists Robert Hall and Alvin Rabushka who have consulted extensively in designing the flat tax systems in Eastern Europe.

According to the Wall Street Journal (“Flat Tax Fred“), Presidential-candidate Fred Thompson has recently proposed instituting a flat tax in the United States “…with two tax rates of 10% and 25%.” One country has already beat Thompson to the punch: Russia.

In 2001, Russia enacted a flat tax rate of 13%.  The reform has been popular and has since been adopted by countries such as Serbia, Ukraine, Georgia, Romania, Slovakia and Macedonia.  But is the flat tax a good thing?

This is the question which Gorodnichenko, Martinez-Vazquex and Sabirianova Peter try to answer in their NBER working paper titled “Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia.”  It has generally been found that tax collections drastically increased after the introduction of the flat tax.  This trend, however, may not be due to the flat tax specifically.  Increased GDP from 2001 until the present certainly accounts for much of the increase in collections.  Also, an increase in voluntary tax contributions or stricter enforcement may be the cause of the increase in tax collections.

The authors use data from the Russian Longitudinal Monitoring Survey and measure tax evasion as the difference between  household consumption and reported household income.  Of course, this is not a perfect measure, but as long as the quantity of the measurement error remains constant over time, this methodology will provide researchers with a good understanding of how tax evasion evolved after the institution of the flat tax.

The authors find the tax evasion is more prevalent among younger, unmarried, individuals with fewer years of job tenure.  Individuals working at small companies were more likely to evade taxes, but surprisingly government workers tend to be among those who most frequently evade taxes.  This is likely due to increased non-reported income from accepting bribes.

The authors use a difference in difference technique comparing changes in tax evasion from low and high tax brackets.  The lower tax brackets were not significantly affected by the changing tax laws, but the higher tax brackets did see a substantial change in their marginal tax rates paid.  The authors also employed a regression discontinuity framework.  This methods compares income groups just below and just above discrete changes in marginal tax rates.

The authors found that the flat tax lead to a significant decrease in tax evasion.  This is likely due to the fact that lower marginal tax rates decreases the incentive to avoid reporting income.  Further, if there is a decrease in tax evasion, policy makers can lower the marginal tax rate further while still collecting the same amount of revenue.

Lower marginal tax rates should also lead to an increase in the labor supply.  The authors, however, did not find this to be the case.  The flat tax had minimal or no impact on worker productivity.  This is likely due to the fact that the supply of labor is very inelastic on both the intensive and extensive margins.

It seems that the flat tax is not only attractive according to economic theory, but may also work well in reality–at least in terms of reducing tax evasion.

•  Yuriy Gorodnichenko, Jorge Martinez-Vazquez, Klara Sabirianova Peter (2008) “Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia“, NBER WP #13719.