A Euro-Exit for the Flat Tax

As Europe's economic troubles continue, some eastern European countries are reconsidering their flat taxes -- for good reason

Bloomberg Businessweek's Carol Matlack reports that several central and eastern European countries that adopted flat-rate income taxes over the last two decades are now abandoning them or considering doing so. The Czech Republic and Slovakia switched last year to progressive systems, where rates get higher as incomes rise. Now, Bulgaria is considering a similar move.

This makes sense, because flat taxes were never what they were cracked up to be. The flat tax is usually sold as a simplification tool, but multiple tax rates aren't what make tax systems complex. Rather, it's rules about what goes in the tax base that complicate things. And most "flat-tax" systems aren't really single rate anyway; they generally include personal exemptions that create a bracket of income taxed at a rate of zero.

What really sets flat taxes apart is not simplicity but the effect on distribution: High earners can't be made to pay a much higher share of their income in tax than moderate earners. This puts a political constraint on revenue, because tax increases on the rich are possible only to the extent the same rate can be imposed on the middle class.

While this inability to redistribute income limits the government's power to reduce inequality, it may help the economy. Because the economic cost of a tax is a function of the tax rate squared (or, roughly, a 20-percent tax causes four times as much economic loss as a 10 percent tax), political rules that limit marginal tax rates may help spur investment and economic growth.

On the other hand, a flat tax can hurt the economy by limiting the government's ability to react to changing economic conditions. An asymmetrical recession like the one we just had (and much of Europe is still having) hurts the poor more than the rich, and calls for an increase in the progressivity of fiscal policy to alleviate poverty and stimulate consumer demand. That's harder to do with a flat tax. A flat tax may also hold the size of government below its economically ideal level, reducing the provision of valuable public goods.

Even the poster child for flat-tax fans, Estonia, isn't looking so hot. Since the 2008 crash, Estonia has resolutely kept its flat tax and signed up for severe fiscal and monetary austerity, even joining the Euro area. Its economy has strongly rebounded since 2010, but only after an extremely hard crash that has left its gross domestic product still below its 2007 peak.

Of course, a lot of European countries with graduated taxes are doing badly, too. But that's the point: You can have good or bad economic performance with a flat tax or a graduated one. Since the economic impact of flat taxes is ambiguous, and they limit the government's ability to alleviate the negative effects of recession, it's no surprise Europe's ongoing troubles would lead countries to abandon them.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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    Josh Barro

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