Europe Circles The Flat Tax

The success of a single tax rate in the East is spurring Western Europe to take a closer look

The flat tax. In the eyes of many fiscal conservatives, it's the Holy Grail of public policy: One low income tax rate paid by all but the poorest wage-earners, who are exempt. No loopholes for the rich to exploit. No graduated rates that take a higher percentage of income from people who work hard to earn more. No need for a huge bureaucracy to police fiendishly complex tax laws. U.S. conservatives have been pushing the idea for decades. But it has gotten its first real road test in the former Soviet bloc, where at least eight countries, from minuscule Estonia to giant Russia, have enacted flat taxes since the mid-1990s.

Most of these countries' economies are growing at a far-healthier clip than those of their neighbors to the west. So it's no surprise that calls for a flat tax are now being heard in Western Europe, the most heavily taxed zone on the planet. Angela Merkel, the Christian Democratic Union's candidate for Chancellor in Germany's Sept. 18 elections, chose a leading flat-tax advocate as one of her main economic advisers. In Britain, the opposition Conservatives on Sept. 7 announced they would set up a commission to study a flat-tax proposal.

Günther Fehlinger, president of Europeans for Tax Reform, a Vienna-based flat-tax advocacy group, says interest has picked up noticeably since last year, when a flat tax took effect in Slovakia: That country's booming automotive industry is luring billions in highly desirable investment away from Western Europe. "That changed everything," Fehlinger says.


The issue is so politically explosive that no Western European government is likely to impose a flat-tax regime anytime soon. German Chancellor Gerhard Schröder's center-left Social Democratic Party has scored points in the current election campaign by branding Merkel's pro-flat tax adviser, Paul Kirchhof, a radical who would cut taxes for the rich. Kirchhof, a professor of tax law at the University of Heidelberg, has in the past advocated placing a 25% tax on all income, both corporate and personal, above $22,000 a year and eliminating virtually all loopholes and deductions.

But tax simplification is clearly in the air. The platform of Germany's CDU, which Kirchhof now says he supports, calls for cutting the top personal income tax rate from 42% to 39% and eliminating tax shelters. France's center-right government says that it plans to reduce the number of tax brackets from seven to five, lower the top marginal rate from 48.1% to 40%, and limit individual deductions, starting in 2007. By yearend, Spanish Finance Minister Pedro Solbes is expected to propose cutting the top personal income tax rate, now 45%, and reducing the number of tax brackets, now five. Greece, after cutting the country's corporate tax rate, now is looking at reducing and simplifying personal income taxes as well.

What's driving this interest all of a sudden? It's a competitiveness issue, says Paul Mylonas, chief economist at the National Bank of Greece. "Our neighboring countries are reducing taxes, which provides them with a more attractive business climate."

Slovakia is a case in point. The country has been intent on building an investor-friendly climate. So in 2004 it swept away 21 categories of personal income taxes, five tax brackets, and scores of exemptions and deductions, replacing them with a flat 19% rate. Slovak officials say that their flat-tax reform was crucial in securing a $1.3 billion investment last year by Korean auto maker Hyundai Corp., which is building a factory for its Kia brand cars in the city of Zilina. Total foreign direct investment in Slovakia last year was $13.6 billion, a sixfold increase since 1998. Slovakia's attractively low 19% corporate tax rate is a big draw, too. But, says Martin Bruncko, chief economic adviser to Slovak Finance Minister Ivan Miklos, "the flat [personal income] tax has made Slovakia more attractive for highly paid expatriate employees. That's important for companies looking at an offshore operation."

Even without pressure from the East, many Western European governments face growing complaints about the complexity of their tax regimes. France, for example, offers a bewildering 560 tax breaks -- ranging from a special exemption for journalists to a deduction for taxpayers who happen to employ household help -- that cost the government more than $60 billion a year. The French government says that starting in 2007 it will cap such breaks at $9,400 per taxpayer per year.

In the free-market regime of Britain, the tax code has become pretty gnarly as well. Under the ruling Labour Party's guidance, the government handbook of tax regulations has roughly doubled in volume since 1997. In early September, a parliamentary committee blasted the system of tax credits for the nation's poor households, calling it a complicated "nightmare." That prompted George Osborne, the Conservative shadow Chancellor of the Exchequer and a longtime flat-tax enthusiast, to appoint a commission to study the introduction of a single rate for all British taxpayers.

There's no guarantee, of course, that flat taxes would work as well in Western Europe as they have in the countries to the east. In the former Soviet bloc, most of the countries that enacted flat taxes gained revenue as people who had worked in the shadow economy began reporting their income and paying taxes. The former tax dodgers figured that with rates so low, it was no longer worth running the risk of breaking the law. Moscow, which introduced a flat tax in 2001, saw its income tax revenues more than double in real terms from 2000 to 2004.

Compared to citizens of the countries behind the old Iron Curtain, relatively few Western Europeans work in the shadow economy. But a flat or streamlined tax code could still go a long way toward restoring public trust in the tax system by wiping away loopholes and cutting out mounds of red tape. Lower top rates also could stanch the flow of "tax expatriates" -- for example, wealthy French people who move to Britain or Belgium to avoid high French income taxes. Flat-tax Europe? It won't happen overnight. But the conversation is getting under way.

By Carol Matlack in Paris, with Jack Ewing in Frankfurt, Jason Bush in Moscow, Alkman Granitsas in Athens, Carlta Vitzhum in Madrid, and bureau reports

Before it's here, it's on the Bloomberg Terminal.