D Murali

Flat tax that economists may fault

D. MURALI | Updated on November 06, 2011

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Alberto Vega García's recent paper in http://papers.ssrn.com, titled ‘ Simplification and Tax Justice,' reviews the proposal to reform the German tax system presented by Paul Kirchhof. The main characteristic of the proposal is the search for simplicity in order to make legislation easier to understand, increase tax compliance, and treat all taxpayers more homogeneously, the abstract introduces. “Thus, the number of taxes is reduced and the rules governing them are simplified by limiting tax incentives and applying a flat tax rate. In our opinion, tax simplification is a praiseworthy objective, but it should not be used to justify limiting the progressivity of the tax system.”

Since the downloadable paper is in Spanish, you may benefit from general Google search to know more about Kirchhof. Such as, how flat tax is ‘hot in Germany,' as www.brusselsjournal.com reported in September 2005. “The 62-year old Kirchhof is one of Germany's most outspoken proponents of the flat tax, a fiscal system with only one tax rate for all personal income and corporate profits. This system was first introduced in Estonia in 1994 and has since been adopted in 11 countries, mostly in Eastern Europe, with booming economies as a result,” one learns.

The article by Paul Belien informs that Kirchhof's proposal speaks of introducing a flat tax rate of 25 per cent while abolishing the 418 loopholes in the German tax system. “It is often quipped that German families need a fiscal adviser as much as a medical doctor because the German tax system is so complicated with its 90,000 tax rules. It takes ‘twelve Saturdays to fill in one's tax forms,' says Kirchhof. He wants to reduce this ‘to ten minutes.'”

A related article by Belien is ‘Walking on Water: How to Do It,' an interview with former Estonian Prime Minister Mart Laar, the pioneer of Europe's flat tax revolution. When Laar became Prime Minister, inflation in Estonia was over 1,000 per cent, the economy was falling at a rate of 30 per cent, unemployment was over 30 per cent, 95 per cent of the economy was State-owned and 92 per cent of Estonian trade was dependent on Russia, traces Belien. “It is very fortunate that I was not an economist,” Laar tells the author. “I had read only one book on economics – Milton Friedman's ‘Free to Choose.' I was so ignorant at the time that I thought that what Friedman wrote about the benefits of privatisation, the flat tax and the abolition of all customs rights, was the result of economic reforms that had been put into practice in the West.”

It seemed common sense to Laar and, as he thought it had already been done everywhere, he simply introduced it in Estonia, despite warnings from Estonian economists that it could not be done. “They said it was as impossible as walking on water. We did it: we just walked on the water because we did not know that it was impossible.”

A proposal our taxman may flatly decry?

Letter from taxman

At a time when fuel price hikes are stirring up continual debates, you can read ‘ Tax Credits Response to Tax Enforcement: Evidence from a Quasi-Experiment in Chile,' by Claudio A. Agostini and A. Claudia Martínez. More importantly, it can be reassuring for our tax officials to learn from the paper how a letter from the Chilean IRS could bring forth noteworthy results in terms of reduction in the tax credits claimed.

The not-so-uncommon story in the experiment is about the differential diesel tax treatment in Chile, which creates incentives for firms to use “tax exempted” diesel in activities requiring “non tax exempted” diesel. This might be particularly easy to do for multi-products firms using diesel for several activities, allowing them to evade diesel taxes by claiming a larger tax credit than the legally allowed, the authors inform. In an attempt to reduce potential evasion of diesel taxes and improve tax enforcement, the Chilean IRS sent a letter to some firms asking to voluntarily report more details of every diesel transaction during the last year, the paper recounts. The impact of the letter was a significant reduction in the amount of tax credits claimed by firms; “on average, treated firms reduce their tax credits claims by around 16 per cent after receiving the letter.”

The authors find that the results are consistent with other results in the literature (Fellner et al.) showing that just receiving a letter from the IRS has an impact on tax compliance because it causes a substantial increase in the perceived detection risk. The results show that the IRS in Chile can successfully reduce diesel tax evasion by affecting firms' perceived cost on non-compliance, the authors emphasise. “It would be important to consider in future research what happens in the long run. It could be possible that future letters would not have the same effect or even that the effect of the letter fades out in time and firms go back to the over-reporting practice.”

Instructive study about taxpayer behaviour.

Know your tax

Very simple forms of taxation are in danger of causing tax perception bias, caution Martin Fochmann and Joachim Weimann of the University of Magdeburg, in a paper titled ‘ The Effects of Tax Salience and Tax Experience on Individual Work Efforts in a Framed Field Experiment.' The authors narrate that in an assortment of studies, the salience of a tax – the degree of tax visibility – is identified as the main determinant of tax perception. For instance, in a laboratory experiment, Rupert and Wright (1998) used four different presentation forms of a tax scale that differed in the visibility of the marginal tax rates, and found that the quality of investment decisions increases with the visibility. “Sausgruber and Tyran (2005) find that subjects are much more aware of taxes if they have to pay the tax bill than if the other market side has to pay. Chetty et al. (2009) observe in their field experiment that an explicit tax posting on price tags induces consumers to pay more attention to taxes. In the same manner, Finkelstein (2009) finds that the awareness of tolls is much lower when individuals pay the toll automatically by using an electronic toll collection system than when paying in cash.”

In the authors' view, all of these studies reveal that the higher the salience of a tax, the higher the tax perception; and that the degree of tax consideration in individuals' decisions is affected by tax salience. The paper explores the question what the necessary conditions for a correct perception of tax are, because answering this question is not only important for governments trying to create tax systems that produce correctly perceived taxes, but also for the economic analysis of taxes. “For example, if taxes are misperceived, this affects the welfare analysis of taxation because the excess burden of taxes becomes smaller or greater due to the perception bias.” A promising way to overcome the misperception of taxes, particularly for simple taxes, is their transparent presentation, the authors suggest. “Progressive tax scales with more than one marginal tax rate have a higher salience, simply because they are more complex. Nevertheless, a graphical illustration also improves the correctness of tax perception for these tax scales.”

Would it not help, therefore, improve tax perception if pay-covers and invoices had a pie chart that showed ‘tax suffered' in the ‘exploded' style?

Published on November 06, 2011

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