New World Man

The Economist has printed a pair of articles on the subject of flat tax, in theory and practice. This is a great companion piece to NWM’s last post on taxation where we launched off a Ted Rall catastrophe to examine the merits of a whole-scale adoption of a consumption tax.

Flat taxes are a very interesting idea, one that made a fairly decent splash in the American media during the 1992 presidential campaign when Steve Forbes ran a presidential campaign in the Republican primaries with the flat tax as a central tenet. Something not too many people remember is that Jerry Brown had a flat tax proposal in his 1992 Democrat campaign for president as well.

The Economist looks at the traditional arguments against such a tax, that is it impossible to implement, and that it taxes unfairly, or regressively. Noting that you only modestly threaten the simplicity of tax collection by introducing a large basic exemption to correct for excessive “regressivity”, the newspaper notes that in the last decade we have seen flat tax rates implemented successfully in several countries, and the benefits have been not insignificant.

Simplifying tax codes offers a major win right off the bat. In America between 10-20% of revenues are spent on the collection of taxes. Outrageously, this is equal to between 25-50% of the current large fiscal imbalance.

Even larger economic gains may be achieved by the reduction of government imposed inefficiency to the markets.

Though it is impossible to be precise, that direct burden is almost certainly as nothing compared with the broader economic costs caused by the government’s interfering so pervasively in the allocation of resources. A pathological optimist, or somebody nostalgic for Soviet central planning, might argue that the whole point of the myriad breaks, deductions, allowances, concessions, reliefs and assorted other tax expenditures that clog rich countries’ tax systems–requiring total revenues to be gathered from a narrower base of taxpayers at correspondingly higher and more distorting rates–is to improve economic efficiency. The whole idea, you see, is to allocate resources more intelligently. Yes, well. Take a look at the current United States tax code, or just at one session of Congress’s worth of tax-gifts to favourite constituencies, and try to keep a straight face while saying that.

Longtime readers of NWM will know that one thing that makes us cringe and twist more than anything else is government corruption, and the distortion of the markets in favor of court favorites. Not only does this hurt everyone by damaging resource allocation in unpredictable ways, but it is also plainly morally repugnant when the government favors one business over another. Corporate welfare is an obvious and particularly egregious mis-use of public money, but it is the tax code where favoritism is most easily doled out to those least deserving. Why were sales of the Hummer and other large SUVs so inexplicably high last year? Ask the tax man.

These changes to the tax code, which were originally intended to spur capital investments by farmers and small businesses that rely on heavier vehicles, have made the purchase of heavy SUVs extremely lucrative for any small business owner, whether or not the vehicle is necessary in their work. It has raised the deduction cap to $100,000 for small businesses, while retaining all other aspects of the tax cut. This makes the purchase of at least 55 large SUVs, passenger vans, and trucks-all priced under $100,000-completely deductible in the first year.

As a result, Hummer sales, and SUV sales in general, have skyrocketed and this trend has continued with the passage of the Jobs and Growth Act. This has raised a number of important questions about the effect of this provision. For one, this is another tax break that primarily benefits the rich. Skip Barnett, who owns a hummer dealership in Atlanta, said that most of his buyers are small-business owners with incomes of over $200,000. The tax break has encouraged people from all lines of work, including real-estate agents, lawyers, consultants, and many others-for whom this provision was never intended-to purchase a luxury SUV instead of a luxury automobile, which is not eligible for the same deductions.

Yep, just great. Now to correct this problem which was created by the near impossibility of crafting deductions properly, and checking them all against the rest of the 45622 page tax code, we’ll just change the deduction to specify farmers only. Whoops! GM and Ford have spent the last 5 years changing their entire businesses to take advantage of their fastest growing and most profitable product lines, and now they are hemorrhaging cash when they are already under pressure from stiff competition and rising fuel costs. It’s OK, we’ll just fashion a tax credit that saves the automakers money, risk a trade war by instituting duties on foreign automakers, and also keep a few $B aside in case we need to bail them out. No unintended consequences there!

Any system, driven beyond Rube Goldberg complexity, is destined to fall apart and start doing dangerous things that it was not intended to do. The Economist’s article does a good job of noting that complexity begets complexity; it’s a never-ending spiral it seems, that begs for a grand fix such as the 1986 Tax Reform bill.

A single tax bracket is not required to do a lot of good of course. One can close all loopholes and still maintain 3 tax brackets without too much difficulty. It’s also easy to argue that taxes should be maintained in cases where “externalities” are not properly captured by the market, taxing pollution, greenhouse gas generation, and unhealthy products such as tobacco are clear examples where costs are not efficiently captured by the market at the time of production. These taxes can actually make a market more efficient But the criteria for introducing such taxes must be open, clear, and strong. NWM posits that distorting taxation is like pornography, difficult to define, but you know it when you see it.

But what of the charge that progressive measures are still a very necessary aspect of a tax system? Do the highest income earners really pay less tax under lower rates. Incredibly historical antecedents suggest that increases in compliance under a simpler system with less opportunities to evade taxation, and less motivation to do so actually increases a government’s take from the most productive and highest paid citizens.

While proponents of a flat-tax system argue that lifted from the disincentive of high marginal rates, individuals will work harder and productivity will increase faster, it is in compliance that perhaps the biggest wins are to be made by both the government and it’s citizens. The federal government of the US lost between $312B and $353B in 2001 due to non-compliance, 19-20 cents on the dollar.

The extremities of the Russian example illustrate how quickly noncompliance can be attacked by making compliance easier and cheaper, making noncompliance more obvious, and freeing up resources to force compliance. Again from The Economist.

The most remarkable turnaround in government revenues was recorded in Russia. Prior to its 2001 tax overhaul, the federal government’s tax-raising powers were rapidly deserting it. Clifford Gaddy and William Gale of the Brookings Institution report that tax arrears amounted to 34% of collections in 1997. By 1998, federal revenues had fallen to just 12.4% of GDP, leaving the government unable to pay its creditors. Investigators appointed by the president revealed that Russia’s biggest enterprises ignored 29% of their taxes and paid another 63% in kind, with goods and services the government might or might not want. In lieu of $80,000 in taxes, one company reportedly offered the government ten tonnes of toxic chemicals.

On January 1st 2001, Russia flattened and broadened its personal income taxes, collapsing 12%, 20% and 30% bands into a single, uniform 13% rate. The state also withheld taxes at source, identified taxpayers by number, and audited suspected tax-dodgers. Messrs Gaddy and Gale note that no tax system could hope to bring in much revenue without these rudimentary instruments of tax enforcement.

How did revenues respond? A year after the reform, the personal income tax was raising almost 26% more revenue in real terms. Some of this was due to the rebound in the economy: real wages grew by 12% that year, and the take from all taxes, flat or otherwise, consequently improved. But the surge of rubles encouraged by the flat tax was more sustained.

A careful study by two IMF economists, Anna Ivanova and Michael Keen, together with Alexander Klemm, of the Institute of Fiscal Studies in London, tries to unearth the causes of this pleasant fiscal surprise. They find little evidence that Russians, freed from the yoke of progressive taxation, suddenly started working much harder. This is perhaps not surprising, as Russia’s reform actually raised personal income taxes for the many households that previously fell into the 12% bracket.

They did discover a conspicuous increase in compliance with the tax authorities, however. In the year before the flat tax, Russians in the two higher tax brackets reported only 52% of their income to the taxman. In 2001, after falling into the new, all-encompassing 13% bracket, these same households reported 68%.

The most remarkable turnaround in government revenues was recorded in Russia. Prior to its 2001 tax overhaul, the federal government’s tax-raising powers were rapidly deserting it. Clifford Gaddy and William Gale of the Brookings Institution report that tax arrears amounted to 34% of collections in 1997. By 1998, federal revenues had fallen to just 12.4% of GDP, leaving the government unable to pay its creditors. Investigators appointed by the president revealed that Russia’s biggest enterprises ignored 29% of their taxes and paid another 63% in kind, with goods and services the government might or might not want. In lieu of $80,000 in taxes, one company reportedly offered the government ten tonnes of toxic chemicals.

Governance, and the development of a society that respects rule of law, has no easy solution, but it might just have a simple one. Make the basic operations of government simple, and transparent, and people will be compelled, both through the design of the system, a basic understanding of how it works, and a recognition of fairness. The example of Russia’s devastating default in the late nineties, which occurred when the level of public spending required to keep the country functioning, outstripped the amount of revenue it was able to collect.

In light of the anecdotal evidence the NWM has heard of low tax compliance in China in relation to the rapidly expanding infrastructure costs of the nation should give you an idea of why NWM is cautious about the world economy over the next 5 years. But that’s another post.

This entry was posted on Thursday, April 14th, 2005 at 23:59 and is filed under economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.