Will flat tax work?

It is a fundamental question governments across Europe and indeed the wider world are asking themselves – should they replace a tiered tax-system with a flat tax?

The economic divide between western Europe and the former Communist countries of the continent may be constantly narrowing, but when it comes to the issue of adopting the flat tax there is still, for the time being at least, a clear split between the two regions.

Although there is active discussion about a flat tax in western European countries, so far it is in the east where it has really caught on. What are the reasons behind this and what has been the impact so far?

Estonia was the first country in Europe to introduce a uniform tax (26%) in 1994, and since then eight countries of the former Communist Bloc have followed suit, with Georgia and Romania becoming the latest members of the flat tax club. “Competitiveness and the spin around such a move becomes the main benefit and, thus, the main reason [for introducing the tax],” says Dorota Dabrowska, executive director of the American Chamber of Commerce in Poland.

The competitive edge is, of course, a key issue in central and eastern Europe, and enthusiasts say that a flat tax makes countries more attractive to foreign investors, and as the former Communist countries compete with each other for jobs and investors, they are doing everything to attract money from abroad. But not all central and eastern European countries have adopted the flat tax, and Slovakia, the Czech Republic and Poland illustrate varying positions towards the tax and highlight the issues it raises.

In Slovakia the Government of now ex-Prime Minister Mikulas Dzurinda introduced a flat tax of 19% on 1 January 2004. MPs voted 85 to 48 to approve the measure, which made the tax system much simpler, abolished five tax brackets and eliminated a whole range of exemptions. “In the autumn of 2002 we got a new Government which had a big appetite to do something,” says Richard Sulik, an adviser to the Slovak Minister of Finance and a leading figure behind the flat tax.

In neighbouring Poland the flat tax “is still somewhere on the agenda, but dormant”, according to Dabrowska, although the issue was discussed before the general election of September 2005. The Civic Platform Party campaigned on a flat tax platform, but its rival, the Law and Justice Party, with whom Civic Platform was expected to go into government, has been against the tax. Some claim that Law and Justice attracted more voters than Civic Platform because of opposition of the former to the flat tax.

Ministry of Finance official Marek Hajbos points out, however, that Poland has a Corporate Income Tax of 19% (reduced from 27%), a change which came into effect in January 2004, as did a law allowing sole proprietors to take advantage of a 19% tax rate, which is basically regarded as a flat tax.

Interestingly, the Law and Justice Party has been proposing personal income tax rates of 18% and 32%, which has been described as essentially a flat tax. This would replace the current 19%, 30% and 40% rates, and the aim was to introduce the new system in 2007. However, in late September, the current government coalition collapsed, with elections or a new coalition predicted. The future of the Government’s proposals is therefore open to question. “Nothing is certain, but it is extremely unlikely that the tax proposal of the Law and Justice Party will be introduced in 2007,” said Krzysztof Lipka, a partner at KPMG in Warsaw.

For the time being at least, the Czech Republic retains a tiered tax system, although the introduction of the tax elsewhere in the former Eastern Bloc is having a clear impact, with plenty of voices calling for it to be introduced. After weeks of uncertainty in the aftermath of the inconclusive June general election, the question of whether a flat tax will be introduced in the Czech Republic looks a little clearer. The outgoing Social Democratic Government was against the tax but the biggest winner of the election, the Civic Democratic Party (ODS), proposed a rate of 15%, which would apply to income tax, corporate tax and VAT. As a staunch pro-business party, the ODS sees the flat tax as being of key importance, and in an interview in September with financial daily Hospodarske noviny Vlastimil Tlusty, the new Finance Minister, stated that he wanted to begin preparations for tax reform.

However, the current minority Government, made up of the ODS and unaffiliated ministers, is not expected to last long, and even if it does continue, the chances of it pushing through its tax reforms remain slim in the short-term. Another election is one possibility and this could strengthen the Civic Democrats’ position, although flat tax proposals would face strong resistance from the Social Democratic Party (CSSD).

As in the Czech Republic and Poland, politics has a key influence on the flat tax in Slovakia, although it looks set to continue, despite past criticisms of it by the newly elected leftist Prime Minister Robert Fico.

And it is Slovakia that those in favour of the tax turn to as an example of what the tax can help to achieve. For a while after its divorce from the Czech Republic in January 1993, the central European country struggled to make the transition to a market economy, but the governments of Mikulas Dzurinda (1998-2006) introduced extensive reforms of liberalisation. Foreign investors moved in large numbers into Slovakia, which was regarded as a “tiger economy”. In recent years the Slovak economy has made significant progress, with annual growth this year predicted at 6.5%, according to analysts. Foreign investment has played a key role in this growth, and analysts say that the flat tax is helping to attract this investment from abroad.

As an example, Slovak officials cite its role in attracting the Korean car manufacturer Hyundai to the city of Zilina, a point echoed by Sulik. “I am sure that there are some investors that decided to come to Slovakia because of our flat tax”, although he adds that he did not think the number was so large.

Benefits

Analysts also point to the benefits to individuals and companies. “The flat tax would definitely reduce taxpayer inequity as well as the incentives for tax evasion,” says Jaroslaw Kozinski, national director of tax at Ernst & Young Poland. “The flat tax would definitely provide incentives to save and invest, which can mean an additional source of funding for investments for firms,” he adds, which “would translate into quicker economic growth”.

Yet analysts have pointed out that in the Baltic States, where the flat tax was pioneered, the impacts of it have not been as wide reaching as were predicted. And while business leaders and investors have welcomed the introduction of the flat tax in Slovakia, Peter Chrenko, head of tax and country managing partner at Ernst & Young Slovakia, points out that it was the simplicity of the new tax system that has lured investors to Slovakia just as much as its low rate compared with that of other countries. He adds that there were other important factors too. “The key reason was, in my view, the economic stability of the country, the quality of the labour force and other factors.”

Chrenko also cites other introduced reforms, such as pension reform, that attracted companies. He adds: “The flat tax system and no dividend taxation was just another benefit coming with all the other attractions of Slovakia.”

This fact is echoed by Jan Prib, an analyst at the Chamber of Commerce of the Czech Republic. He notes that “the right business legislation, a sufficiently qualified labour force and social cohesion” have to be taken into account too.

But whatever the positive or negative impacts of the flat tax, one thing is clear: simplifying income and corporate tax systems are having a clear effect on neighbouring countries which have a tiered tax system in Europe, both east and west. “Western countries are feeling pressure (from lower tax rates) and are trying to push into more harmonisation in the area of corporate taxation, for example, unification of rules,” says Peter Chrenko. The debate about introducing the flat tax and its impact on the EU looks set to continue.

David Creighton is a freelance journalist and regular contributor to Czech Business Weekly.