The new ‘new idea’ in politics is, increasingly, linked to taxation policy. Taxation is typically a subject which turns people off or instils negative feelings, such as the monthly grumbles which accompany each payslip and the annual completion of the tax return. Now, however, taxation policy, and discussion thereof, may be about to become interesting! (Well, perhaps interesting is too strong – but discussions over taxation could become more widespread in the mainstream).
The big idea which some, including the Conservative Party in the UK, have started to float is the idea of a flat rate of taxation. The notion of flat tax is mercifully simple. Everyone has a personal allowance which allows for a portion of tax-free income. Beyond this limit, everyone will pay the same incremental rate, regardless of total earnings.
This approach has already been adopted by a small number of countries but its advocates often point to the Baltic states, and Estonia, as the most profound beneficiaries of adoption of this simple approach. Clearly, the idea of a move away from a graduated approach to taxation is unpopular in some corners and the UK’s Treasury has indicated that its analysis finds little to commend the approach. Could this, however, have more than a little to do with Left-of-centre ideals rather than economic analysis? The two are not mutually exclusive.
Bulls of the flat rate tax point out the 23% flat rate in Estonia, the collapse in inflation rates towards low levels, and high growth rates which have been achieved in that economy. Unfortunately, however, attributing this undoubted economic success story solely, or largely, to changes in taxation policy is overly simplistic.
Despite caution in reading too much into inappropriate comparisons and statistics which are touted on the issue, there are credible reasons for believing that the flat tax idea will continue to gain traction in coming years.
The attractions of a flat rate tax are, importantly, that it is simple and easy to understand. By simplifying the tax rules then the government may find that tax yields rise, as tax evasion declines, with fewer loopholes to exploit. On the issue of whether a flat rate tax is equitable or not, low income earners may find themselves better off, as exemption levels (or personal allowances) for individuals are raised.
The flat rate tax could also act as an incentive to reduce voluntary unemployment. At present, the graduated system of tax rates may mean that there is insufficient incentive to work at lower income levels. Furthermore, one can argue that simplifying the tax system may lead to a more efficient allocation of resources. Aside from the fact that fewer accountants may be required, fewer distortions may evidence themselves as a function of tax treatment.
Despite these (apparently) clear advantages, some policy makers may well take the view that their ability to pursue social or redistributive policy objectives through use of tax incentives will be reduced.
Furthermore, and as is obvious from construction, a flat tax will largely benefit the very well off (who get a lower effective tax rate) and the very low income brackets (who benefit from a bigger exemption). The majority may well be worse off.
While the Baltics apparently show us that flat tax is the way forward, we should not ignore the fact that arguably, unlike the UK, these areas suffered high incidence of generalised tax evasion, and (helpfully) the policy actually benefited a high proportion on the population. Furthermore, anyone assessing the benefits of a flat rate tax by looking at the headline 23% rate applied in Estonia ignores the fact that the effective tax rate there is closer to 45%.
This is not to say that a fuller exposition of the case for and against flat rate taxes is not appropriate but, as with all headlines promising interesting reading, one has to take care. George Osborne, the UK’s Shadow Chancellor, is advocating the policy and the recent election in Germany highlighted that the debate is spreading across Europe into core countries.
Lower taxes are something that most would welcome and a simplification of overly complex tax legislation would be beneficial. Lower taxes and a lower share of government spending should benefit the medium term economic growth outlook. Nonetheless, and away from the economic theories and comparisons with success stories in very different economic environments, the case has still to be made. Over coming months and years, however, the theme is likely to gain ground in political circles. Moving the debate into the mainstream is, however, going to take time.
Dismissal of the flat tax idea as a political gimmick is foolhardy, however. One of the clearest legacies which Gordon Brown will leave us, aside from self-proclaimed economic stability and an independent central bank, will be a hideously complex and distorted tax system. Regardless of whether it is implemented, simplification of existing tax rules is the tonic to the current fiscal frivolity. Little wonder that the tinkering chancellor does not appear to be a fan.
By Paul Niven, Head of Strategy at F&C Asset Managemen