Flat taxes are the order of the day among the business communities in the new member states these days, and calls for tax cuts and simplification are also coming from a number of commentators in Malta following the call for discussions on the pre-budget document.
Simply put, flat tax means that everyone is taxed at just one rate. In such a system, in place of a complex set of income tax brackets, the state declares a threshold above which all parties pay a fixed rate on all their income. This threshold is normally low enough to provide an “incentive” for the taxpayers to prefer paying rather than evading their taxes.
As typically conceived, the flat tax is equivalent to a consumption-based national sales or value-added tax that is rebated to those whose income places them below a tax-paying threshold. Such a system taxes all income once and only once, on its inception. As regards corporate taxes, the idea is similar: one bracket should fit all. While flat-tax proposals vary, all share three key elements which include a single marginal tax rate considerably below the top marginal rates of today’s income tax. Furthermore there will be no loopholes such as interpretations on deductions and exclusions from the tax base. As you would expect there will be a high exemption threshold, below which individuals would not be subject to the tax. The erstwhile Mr John Dalli, the former minister of finance, had toyed briefly with the idea about a flat tax on overtime earnings and on bank interest at 15 per cent but no further reforms were considered to apply a flat tax on personal income. Relative to the present income tax, a broad-based flat tax would distort economic decisions far less and would be much simpler to file and administer. However, most of its benefits could be achieved through reforms of the current system, without the adoption of a single marginal tax rate or the switch to a consumption tax base. Many lament that the reform of our personal taxation is now overdue and rumours are rife that the first attempt to their introduction may be initiated in the 2007 budget. Politically this would be perfect timing and would alleviate the pangs of the increased load of taxation following the introduction of eco taxes, a fuel/utilities surcharge and the 20% VAT hike in 2004.
By contrast campaigners for fairer taxation have criticised the implementation of a flat rate income tax and claimed that it would be set at a high rate to match current tax takings. So are we are late to start noticing the advantages of such a new regime?
The answer is that we have streamlined our personal taxes but the surgery was not deep enough. Invariably we meet a modern-day renaissance of the flat-rate income tax by a number of the accession countries. To begin with we find that the system was initiated by Estonia in 1991, followed by Latvia (1994), Lithuania (1994), Russia (2001), Serbia (2003), Ukraine (2003), Slovakia (2003), Georgia (2004) and Romania (2005). Hungary has for now declined to jump on the flat tax bandwagon. Experts also call attention to the fact that a country’s competitiveness is determined by a number of other factors besides its tax system or the type of support the country gives to new investments. While it is generally true that lower taxes leave more money to circulate – and thus to be invested – in an economy, and that flat rates generally increase the citizens’ willingness to pay their taxes, lower taxes may also mean lower tax revenues, which in turn may be detrimental to the given state’s budgetary status. According to reliable sources Malta as a late entrant to the EU club will have “no option” but to evaluate the merits of the “flat tax bandwagon” in order to improve the country’s competitiveness and attract a fair share of foreign investments. But one may ask how equitable is the system that wants us to squeeze into a one size fits all?
Flat tax has a number of critics and the main one is that it is not progressive. Again, it made headway in countries where the black economy was rampant. This is obviously true since by lowering the threshold more undeclared income will start coming forward. This is not a fait accompli and of course any inducement to declare more depends on the interplay of indirect taxes and the state of the economy. While certain models of flat taxes can provide tax progressivism at the low end of the income distribution, they cannot do so at the high end. This is because a taxpayer’s average tax rate can rise no higher than the single marginal rate, virtually any flat tax would reduce the tax burden on very high-income individuals.
Unions will protest that the heavy burden of taxation is not shared according to the Marxist’s ideology of each according to his means. They criticise that if the working classes also benefit relative to the current system, through the high exemption threshold, and tax revenues remain the same, then even in today’s mystical world of budget analysis this means that the middle class will face a tax increase.
In the end it is always the middle classes that are penalised as they seem to be hit by the wrong end of the stick. It is the rich who will pay proportionately less, the working classes will pay nothing while the middle classes will carry the can (unless total tax revenue drops). Already it was revealed that more than one third of the taxpayers are tax exempt. Perhaps the easiest way to lessen this problem is to introduce one or more additional tax rates under the individual component of the flat tax and raise the top individual rate and the rate on business cash flow.
While this revised tax system could no longer officially be called a “flat” tax, it would preserve most of the simplicity of the flat tax.
What constitutes a flat tax system that can replace the existing income tax and tax management act? In a nutshell, one may redefine this tax model as a consumption tax. Naturally, advocates of flat taxes claim that it encourages private saving and investment by exempting capital income from tax. Within our personal tax rules we can visualise a transition from a graduated FSS system to a flat scheme.
All this has to be studied in order to minimise shocks to the Treasury coffers and guarantee a safe proof mechanism with minimum leakages. It goes without saying that the full effect of the flat tax on national saving depends on several factors, including the magnitude of windfalls during the transition from Malta Lira to the Euro as the mountain of currency in circulation will have to find a permanent shelter next year. Of importance is the extent to which government revenues change as a result of the Euro adoption.
Some contend that once the flat tax is in place savings will increase while others contend that the increased spending power will lead to a mini boom in consumer spending which will create more jobs in the short term. The minister of finance is pressed hard to make the arithmetic work and balance the tax intake without fuelling inflation. The option in cutting taxes has to be matched by an equal reduction in public spending which means less social services unless the cost of employing overmanned departments is minimised. In the short term, we probably need to install progressive rates at low income levels by instituting a high tax-paying threshold as otherwise the restriction to a single marginal tax rate would limit their progressivism at higher income levels.This problem may be addressed while preserving the basic flat-tax structure by conceding to business and individual taxpayer’s income components of the tax base to face different tax rates and by introducing one or more additional tax brackets at the individual level. Lobbyists for flat taxes wax lyrical on their purity. Gone are the tax loopholes and the need for them, given the low rate.
Instead of paying tax some may want to shelter income and invest it offshore in property schemes in Croatia. Voters may ostensibly find it cheaper just to pay the tax. In its simplicity and diversity a low rate makes it more worthwhile to earn more, which brings economic expansion.