Friday 7 October 2005

Flat Progress

The Malta Independent - Friday Wisdom

The debate about the appropriateness of flat direct tax systems for energising our economy and attracting investments seems to be gradually washing our shores.

In international circles the debate has long been going on and is gathering momentum. Only recently in the German election campaign, the fact that Angela Merkel’s economic adviser was known to favour the adoption of a flat tax model , was enough to cause substantial political damage to the CDU’s chances of a more substantial victory.

Even though the CDU did not have a flat direct tax model in their manifesto, the SPD could credibly argue that a CDU in power will favour its adoption. In a social democracy like Germany where the state channels tax money to give support for the lower ranks of society, it is easy to prospect that flat tax models can only co-exist with substantial dilution of the state’s ability to sustain such social support.

The argument against flat direct taxation is that it is regressive and socially unjust in comparison with progressive direct taxation where the rate of marginal tax increases as the taxable income skips from the lower to the higher bands. In a society like
Germany with substantial fiscal adherence and a strong sense of fiscal morality the argument against switching from progressive direct taxation to a regressive flat direct tax system is very forceful.

In our particular circumstances where fiscal adherence is still sub-standard, though improving, and fiscal morality is still a pipedream, the argument against flat direct taxation due to its regressive properties is much less valid. On the contrary some would argue that a flat tax model would be socially just as it would remove the incentive to evade taxation by reducing the marginal tax rate and it would help to render tax enforcement much more effective through the very simplification of the tax system.

Imagine as a hypothesis the introduction of 18 per cent flat tax rate. To simplify the tax system we would have a uniform 18 per cent tax rate for direct taxation, for VAT (retaining the current exemptions and lower tax at 5 per cent of particular sectors to avoid a double dose of regressive taxation) and a withholding tax rate of 18 per cent (up from 15 per cent) for income subject to final withholding tax systems. This would in a way eliminate one of the social injustices in our tax systems where earned income is taxed at a high marginal rate of 35 per cent while unearned income (bank interest, investment income) is subject to a final withholding tax of 15 per cent. Why should the fruit of labour be taxed at more than twice the fruit of capital?

Obviously before one can take a firm decision on such dramatic strategic shifts in taxation one has to study models to ensure that government income is not impaired. Our fiscal position is hardly in a position to take risks regarding sustainability of government revenue, even in the short term, notwithstanding any prospect of economic growth and resultant enhanced flows of taxation in the long term.

This underlines the need to achieve fiscal manoeuvrability in order to have access to some real levers to manage the economy. As long as we remain with unacceptable deficits in our public finances, it is impossible to consider creative shifts in tax systems. Fiscal deficits are a stranglehold drawing blood out of our economy, constraining it to no or slow growth which will constrain us to fall back on the EU average GDP as new entrants race forward with growth and investment.

In fact the flat tax direct tax model has worked wonderfully well in the economies of the previous communist states. The example was set by
Estonia. Inheriting a no tax system from the previous communist regime, and not having the obligation to carry legacy cost of a working social economy, it was easy for such states to adopt a flat tax model. They had no tax revenue to prejudice as in the case of a switch from progressive direct taxation to flat direct taxation. Their objective was to keep taxes low to encourage investment and simple to permit easy enforcement in an economy void of any tax culture.

This system has worked wonders and was quickly copied by most former communist states including Russia as its mainstream direct tax system (with different arrangements for particular sectors like the oil industry as Khodokovsky of Yukos found out in his jail cell for tax fraud). This success has led to economists in developed countries to press for the adoption of such a flat tax model in order to remain competitive against such new countries that were learning to run very quickly.

Large developed economies with ingrained social models are finding it impossible to consider the adoption of such a model, irrespective of their economic effectiveness, as the legacy costs of their social models act as a democratic barrier to leaders who need to promote economic growth as well as preserve power.

In our case we have the worst of both worlds. We have the legacy barrier of a social economy that makes it difficult to switch from progressive taxation to flat taxation. We have a fiscal deficit that permits little room for manoeuvrability and we have a system that rewards inefficiency through protected employment in the public sector, easy early retirement adding to the cost of our social model, and a government that cannot even admit we have serious economic problems. Frank acceptance of such problems should force us to think the unthinkable and to open a debate on certain shift changes, including direct tax models

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