On his trip to Slovakia last week, President Bush praised Prime Minister Dzurinda for the flat-tax system he instituted last year. Bush noted that the new tax regime simplified tax collection, attracted foreign capital, and created economic vitality and growth.
Three years ago, Bush made a point of congratulating Russian President Putin for his country’s flat tax, which took effect on Jan. 1, 2001. On that occasion, Bush particularly noted the fairness of the Russian system, which treats taxpayers equally, rather than punishing the successful merely for being successful.
Hoover Institution political scientist Alvin Rabushka points to eight different countries in the former Soviet bloc that have adopted some form of flat tax in recent years. In addition to Russia and Slovakia, they are Romania, Georgia, Estonia, Latvia, Serbia, and Ukraine. He predicts that Poland and the Czech Republic will soon joint them.
Why so much interest in the flat tax? A key reason is that it is far more effective at raising revenue than progressive rates. With progressive rates it looks as if extra revenue is being extracted from the wealthy. But it is also giving the wealthy a powerful incentive to arrange their affairs so as to minimize their tax liability and also evade taxes altogether.
With a flat tax, there is much less incentive to engage in tax avoidance or tax evasion. Also, the knowledge that everyone is being treated equally helps eliminate the culture of evasion that often becomes pervasive in high-tax countries, and often drives even the law-abiding into the underground economy.
Consequently, it comes as no surprise that a new study by the International Monetary Fund found that Russia’s flat tax led to a substantial rise in government revenue. This was due almost entirely to a sharp increase in compliance, which significantly raised the share of income declared on tax returns.
While compliance in the U.S. is not as bad as it was in Russia before its tax reform, it is a growing problem. In his new book, Many Unhappy Returns (Harvard Business School Press), former Internal Revenue Service commissioner Charles Rossotti warns that we are approaching a crisis in tax administration. He estimates that in 1999 the IRS was only able to collect about 17 percent of the $277 billion that corporations and individuals failed to pay that year, leaving $230 billion uncollected.
Recent data from the Department of Commerce suggests that tax evasion has risen since 1999. Annually, it publishes data comparing adjusted gross income paid by governments and businesses (wages, pensions, interest, dividends, etc.) with the amount reported by individuals on their tax returns. The gap between these two figures is the best measure we have of tax evasion.
In 2002, the latest year for which there is data, there was almost $1 trillion paid out that was not reported by individuals. If all this income were taxed at that year’s average individual income-tax rate of 14 percent, the federal government would have collected an additional $135 billion. And this is a low estimate, since much of the income not reported was undoubtedly earned by people in brackets well above 14 percent.
More worrisome is the rise in the tax gap to 13.7 percent in 2002. (The tax gap is the difference between the IRS and Department of Commerce income measures as a share of the Commerce figure.) This is the largest figure recorded since data was first kept in 1959. The gap averaged 11.9 percent in the 1980s, 11.4 percent in the 1990s, and was only 10.7 percent in 2000.
The flat tax is not a cure-all for tax evasion, but as the Russian example shows, it can help a lot. When people perceive that the tax system is fundamentally unfair, because everyone appears to be paying different tax rates despite having similar incomes, it diminishes any guilt taxpayers may feel about underpaying their taxes.
Too often in Washington, tax fairness is defined solely in terms of what economists call vertical equity — whether the rich pay more than the poor. But horizontal equity — treating equals equally — is much more important for tax compliance. When there is a single tax rate people are more confident that their neighbors are paying the same tax they are. This boosts compliance.
It also improves compliance because the IRS doesn’t need to know as much about the nature and timing of taxpayers’ income. Since all income is taxed the same, earners have, for example, no incentive to convert wages into capital income or shift income from one year to another.
It should also not be forgotten that a flat tax is the revenue-raising system that is most compatible with human freedom. As University of Chicago law professor Richard Epstein recently put it, “It is no accident that every strong defender of limited government has gravitated toward the flat tax.”