It Is Time For A Flat Tax System In Europe

February 27, 2012Taxesby Emanuele Canegrati

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It Is Time For A Flat Tax System In Europe

Over the last two decades, European policy makers have imposed restrictive fiscal policies on member states. They have concentrated on the design of fiscal rules and the structure of budgetary processes but they have never thought of introducing a new tax system able to reduce unemployment and increase investments. Only one tax system could eliminate all the growth-related problems without generating side effects on domestic expenditure: a flat tax system.

In the Euro-drama that we are living today, European politicians still have not demonstrated that the fiscal rules they proposed two decades ago to save the disrupted European public finances – under the Treaty of Maastricht – are effective. In fact, some economists believe that these rules have not been effective at all. Just take a look at the miserable GDP growth rates of the European member states over the last years and you will easily understand how ineffective these rules are.

The lack of vision about a fiscal reform is one of the best demonstrations of this sense of emptiness and it represents a weakness point for the entire European policy. The European Union would need new tax policies to convince investors that investing in Europe’s future is still a winning bet. Unfortunately, until now, not a serious tax reform proposal has been suggested. A tax reform – able to reduce labour supply distortions, increase investments, and free public resources, under current systems of taxation are wasted in the meanders of the bureaucratic rules – still does not exist.

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European policy makers should convince themselves that there is only one tax system that is able to eliminate all the growth-related problems without generating side effects and convince every member state to adopt it: A flat tax system.

Loosely speaking, a flat system, as originally proposed by economists Hall and Rabushka (Hoover Institution, Stanford University), suggests a tax on all businesses (corporate or otherwise), identical to the VAT, except that wages, pension contributions, materials costs, and capital investments are deducted from the tax base. Individuals are subjected to a low flat-rate tax on wages and pension benefits only if their income is above a given exemption threshold. No other income is taxable, and no other deductions are allowed.

The advantages of a flat-rate tax are quite evident. First, it would provide substantial gains for high-income households, both because their marginal tax rate would decrease and because their marginal propensity to consume is lower. As a result, if a flat tax were to raise as much revenue as the current one, the tax burden for the middle class would rise. From the efficiency point of view, gains might arise from five sources: the change of the tax base from income to consumption; a more comprehensive tax base, thanks to the elimination of all the tax expenditures; lower tax rates, which arise the rate of return to working, saving, and investing and reduce incentives to avoid or evade taxes; reduced compliance costs; and the taxation of previously existing assets during the transition to a consumption tax.

But, to introduce the flat system in Europe, a radical cultural change is needed. Unfortunately, for many years, economists have believed that progressive systems were fairer than any other system. This is the reason why, in European countries, tax rates are still strongly progressive. Unfortunately, after many years of trials and errors, we have to admit that actual systems are not fair, not simple and not growth-oriented.

Historically, progressive tax systems were backed by Marx and Engels, who proposed their adoption because they conceived taxes as a powerful weapon against the richest classes. Later, by adopting an effective semantic mimesis, the socialist school, led by economists such as von Schmoller, Frantz and Schäffle was able to make society believe that high incomes were immoral and, as a consequence, that a system able to “make the rich pay more” was equitable and fair. As a result, in the nineteen century, high incomes were simply considered undesirable and unjustifiable and governments decided to abandon the old flat tax idea to tax incomes as much as they could.

Only in the second half of the twentieth century did some economists start to reflect on the weakness points of the progressive taxation. Supply-side economists argued that high marginal tax rates discouraged labour supply, especially for low-income individuals, such as women. They also discovered that progressive systems generate many distortions and are not efficient. Tax expenditures, consistently used in all modern systems of taxation, generate all kinds of distortions on capital supply, interest rates, equilibrium in housing markets, health markets and investment, encouraging tax avoidance. Not to mention the administrative costs ($100 billion alone in the United States), which governments pay to manage the whole process of tax collection, increasing the total amount of useless public spending.

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It is sad to see how many economists spend their time more in the attempt to invent new budget rules than to find solutions to eliminate bureaucracy, ineffective expenditure and harmful taxation. And, paradoxically, it is sad to see that they try to find a new solution when they have already one in their textbooks. The flat tax is as old as the economic science. There would be nothing new to invent. Only to rediscover the spirit of the classics and to give the flat system a chance.

By Dr. Emanuele Canegrati

Dr. Emanuele Canegrati is an economic adviser to the Italian Senate and a senior economist at the Magna Carta foundation, a free-market think tank based in Rome. Dr. Canegrati was also formerly a Visiting Researcher at the STICERD Centre, London School of Economics.

* Professors Kurt Leube and Alvin Rabushka contributed to this article

* The complete Hall and Rabushka flat tax proposal is downloadable here