The Hindu Business Line : Progressing towards a flat tax?

The main argument against flat tax is that it is socially unjust. The solution to this problem, however, is not high tax rates because the rich pay less taxes despite that. The correct strategy is to impose heavier excise and import duties on consumption goods, says Bharat Jhunjhunwala.

THE reduction of personal income-tax and corporate tax rates in the Budget is welcome, but there is a need to move faster. Russia moved from a progressive tax system to a flat tax in 2001, Estonia (1991), Latvia (1994), Lithuania (1994), Serbia (2003), Ukraine (2003), Slovakia (2003), Georgia (2004) and Romania (2005).

Hungary is reportedly considering introducing a version of the flat tax regime soon. The argument in favour of a progressive tax rests on social justice. But evidence is that progressive tax is not so progressive, after all.

In his article "Why the case for a flat-tax is irresistible," Dr Madsen Pirie of The Adam Smith Institute says:"A low rate of flat tax (with low earners exempted altogether) can rapidly lead to the rich paying not only more tax, but a higher proportion of the total. Something of this effect was seen following the UK's tax cuts of the 1980s.

The top 10 per cent of earners, who had contributed 32 per cent of income-tax before the cuts, were contributing 45 per cent afterwards. US tax cuts have produced similar results."

The reason is that the rich find many ways of escaping the tax net. Kirby R. Cundiff, Associate Professor of Finance at Northeastern State University in Tulsa, complains: "I have the income of an average American taxpayer.

On a marginal basis, I (am) in about the 40 per cent marginal tax bracket. Bill Gates' tax bracket is well below 15 per cent. Bill Gates and most wealthy Americans make most of their money off capital gains, not earned income. The maximum long-term capital gains tax rate is 15 per cent and this is only paid when stocks are sold. The net effect is Bill Gates, and other billionaires' wealth grows largely tax-free while people whose primary source of income is labour pay 40 per cent or more of their income to the government in taxes. The effect of this tax system is to make the rich richer relative to the middle-class."

It is difficult to recover taxes from the rich. They engage the best of lawyers and manipulate the legal system. They bribe the officers. The incentive for the rich to evade increases in proportion to the rate of tax.

This was explained by economist Arthur Laffer: When you tax at zero per cent, you get no revenues, and if you tax at 100 per cent, you get very nearly zero revenues, and there is a big peak of high revenues somewhere in the middle. Experience shows that lower rates of tax yield higher revenues.

To be fair, some reservations have been expressed on the efficacy of the flat tax. William D. Shingleton of the US National Defence Council Foundation challenges the notion that Russia's economic growth is due to its adoption of a flat tax.

He points out that the growth of revenue in Russia may be due to oil prices rather than the flat tax. The Russian economy has been growing since 1999, even though the flat tax was only implemented in 2001. Russia's economy depends heavily on its energy sector, which accounts for two-fifths of exports. While Russia's total energy production is falling, the value of its energy exports is rising as global energy prices surge.

Also, he says, "the economic spur is the low exchange rate. Russia's currency is still undervalued as a result of the rouble's 1998 collapse. As a result, imports into Russia are expensive while exports are artificially cheap. This led to an explosion in Russia's manufacturing exports. As the rouble rises again, however, Russia's failure to restructure manufacturing firms will resurface."

The Economist Intelligence Unit disputes the benefits of flat tax for Poland and Slovakia: "In Poland, total inflows of foreign direct investment (FDI) in the first eight months of 2004 were marginally lower than the inflow recorded in the same period of 2003. The fall in FDI, moreover, came despite a significant improvement in the general economic situation. "In Slovakia, it is also difficult to assess whether fixed investment has responded to the cut in corporate taxation. Year-on-year growth in real fixed investment was just 0.9 per cent in the first quarter and 3.5 per cent in the second quarter, though this followed four quarters of falls (year-on-year) in 2003. On the other hand, Slovakia has enjoyed a sharp rise in FDI inflows. To what extent this rise is linked to the fall in the corporate tax rate is not clear."

The apparent failure of tax simplification and rate cuts to stimulate FDI in Poland, and uncertainties over whether and to what extent it has played a role in boosting FDI in Slovakia, underlines that tax is only one element of a country's business environment that investment decisions are made. It has proved difficult to identify a strong, separate effect of tax changes from the effects of differences in wage levels, productivity and all the other variables. Indeed, survey evidence suggests that tax regimes appear to rank in importance well below other factors — in particular, the expected growth of demand. While there may be some truth in these assessments, it has to be admitted that there is little negative impact of the flat tax.

It is good to earn more as long as it is used for investment or charity. The problem arises when it is used for consumption. High income-tax does not differentiate between one who invests and one who consumes. As a result, high rates of income-tax lead to lower investment.

The correct strategy should be to put higher burden on he who consumes more. This can be attained by imposing high rates of excise and import duties on luxury consumer goods such as air-conditioners, chocolates and branded garments.

It is unfortunate that the Finance Minister, Mr P. Chidambaram, has reduced the excise duty on air-conditioners from 24 per cent to 16 per cent. He has lamented that he has not been able to reduce the excise duty on bottled soft-drinks. Indeed, the indirect tax system will become somewhat complicated in this approach but social justice cannot be jettisoned for that reason. The reduction in income-tax rates in the Budget is welcome but not in excise duties on luxury consumption goods.

(The author is a New Delhi-based freelance writer. He can be contacted at bharatj@nda.vsnl.net.in)

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