Wednesday, February 28, 2018

“A flat tax is for a flat Earth”


This was my answer to Grzegorz Kolodko, Poland’s Minister of Finance and First Deputy Premier for the Economy (1994-97 and 2002-03), when in the mid-‘90s he asked me – his adviser sponsored by the European Commission – for an opinion on the feasibility and desirability of introducing a flat tax.  I recommended instead a reduction of indirect taxation and the introduction of a tax on capital gains. To his credit Grzegorz listened to me on the flat tax, he reduced the number and level of marginal tax rates but at the same time he raised public expenditure on investment and on re-distribution, introduced an industrial policy that did not seek to pick winners but promoted high value added and export activities, and his package worked well.

The introduction of a flat tax has become a major issue in the policy discussions on the eve of Italian elections, as it is being vigorously propounded by Silvio Berlusconi and the leaders of his right-wing coalition. My views on the flat tax have not changed at all in the the intervening years.

There are two main arguments in favour of a flat tax:
1) the presumed existence of a Laffer curve, whereby government tax revenue is supposed to rise with the increase of the tax rate up to a maximum, beyond which a higher tax rate would actually reduce tax revenue, and
2) lower taxation would encourage the emergence of activities that at present evade taxation, and therefore raise additional government revenue in that way. 

According to established legend (Wanniski 1978) in 1974 Arthur Laffer, then a professor at Chicago University, drew the curve named after him, depicting tax revenue as a function of the tax rate, on a napkin at a dinner in a Washington restaurant to illustrate the effects of President Ford’s tax cuts. Except that he did not draw it on the basis of empirical evidence, but simply noting that for a zero tax rate tax revenue would obviously be zero, and assuming that for a 100% tax rate there would be a zero revenue because nobody would work or invest for a zero after-tax return. He also presumed that there would be a continuous parabolic shaped curve in between those two points and drew a maximum around a 50% tax rate. Thus you could obtain the same tax revenue with a low tax rate on a large tax basis or with a high tax rate on a smaller basis.

Laffer (2004) acknowledged that already in the 14th century the Tunisian philosopher Ibn Khaldun had noticed this possibility, which had also been asserted by many other thinkers including Keynes: “… taxation may be so high … that … a reduction of taxation will run a better chance than an increase of balancing the budget” (quoted by Laffer).
  
The trouble is that actual empirical estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70% (Fullerton 2008, which fits with the “so high rate” stipulated by Keynes), while current tax rates in OECD countries average about half that rate. So much so that the IMF Fiscal Monitor of October 2017 actually recommends raising tax rates in a progressive fashion in order to reduce current excessive inequality of income and wealth, for “There is little evidence that increased progressivity reduces growth”.

More importantly, a 100% flat tax rate is plainly silly, for a progressive tax can reach fairly high marginal rates, historically even 90% and higher, without ever yielding a zero tax revenue. Indeed it has been argued that the Laffer curve might well be increasing monotonically, and in any case even a flat tax of 100% might yield substantial revenue in special circumstances like wartime or even in normal times depending on behavioural assumptions.

As for the second argument in favour of a flat tax, there is absolutely no evidence that a low tax rate – flat or not – encourages the payment of taxes otherwise evaded at higher rates. And why should it, as Schumpeter put it there is no good reason for anybody not reaping a benefit just because it is small.

Critics of a flat tax lament its lack of progressiveness.  Supporters – such as Berlusconi – are quick to point out that in most OECD countries, including Italy, there already is a flat tax on capital incomes, at a constant rate lower than the higher progressive rates on earned incomes, so that a uniform flat tax levied at an intermediate rate would be more progressive than the current system. And anyway the presence of a tax-exempt threshold maintains a degree of progressiveness, as required for instance by the Italian Constitution, art. 53; “The tax system shall be progressive”.

These answers to critics of the flat tax lack of progressiveness are not good enough, because the first comma of art. 53 states also that “Every person shall contribute to public expenditure in accordance with their capability”.  The progressiveness of a flat tax is minimal, depending exclusively on the size of the tax-free initial threshold, and may be regarded rightly as constitutionally inadequate: the average tax rate rises slowly approaching gradually from below the flat fixed rate on taxable income, and significant progressiveness would only be achieved for extremely large tax-free thresholds, counterproductive for tax revenue. The corresponding reduction in the current progressive tax on earned income would not benefit ordinary workers but only overpaid managers, making after-tax distribution of earned incomes more unequal. While the reduction of current excessively high levels of public debt, as well as the reduction of excessive degrees of inequality of income and wealth, are best served by a genuinely more progressive tax system of the kind recommended by the IMF (2017).

On 24 January last the Washington Post reported that Mike Hughes, a 61-year limo driver from California and a flat-Earth strong believer, has been planning to launch a self-built rocket to propel himself 52 miles into space in order to be able to see for himself that the Earth is flat, for “in many months of research I’ve not been able to prove otherwise” – he said. The trouble is that the project would cost 2 million dollars to finance the building and fuelling of the rocket, a space-suit and a hot-air balloon (Mike Hughes is a bit vague about his logistics), and he was only able to raise $8,000 from GoFundMe. As he now has a fellow flat-Earther in billionaire Silvio Berlusconi, it would be best for Silvio to fund the project in exchange for a lift in the same rocket, and all will end well both in California and in Italy, in the best of all possible worlds. 

Addendum 1
Trabandt and Uhlig (2019) estimate the Laffer curves for labour taxation and capital income taxation for the US, the EU-14 and individual European countries for 1995-2007. They find that the US can increase tax revenues by 30% by raising labour taxes and 6% by raising capital income taxes. For the EU-14 they obtain 8% and 1% respectively. Germany could raise 10% more tax revenues by raising labour taxes but only 2% by raising capital taxes. The same numbers for France are 5% and 0%, for Italy 4% and 0% and for Spain 13% and 2%. Only Denmark and Sweden are on the “wrong” side of the Laffer curve for capital income taxation.

Addendum 2 
In the latest Italian elections the Lega proposed a Flat Tax at 15% over the €7,000 tax-free threshold (plus minor further exemptions on households), while Berlusconi proposed its introduction at 23%. According to the Lega their flat tax would create an initial shortfall of €63bn (i.e. €103bn tax revenue from households and €18bn from companies instead of the combined current tax revenue of €184bn from IRPEF-IRES). 

They propose to cover this shortfall first of all from 25 expenditure cuts and additional taxes (including €5bn savings on centralised public procurement, €2,5bn on military expenditure, €5bn tax increase on gas prospection, €900mn from abolition of interest charges deduction by banks and insurance companies, €800mn for official cars abolition for hospitals, €700mn cuts in "golden pensions" (of dubious constitutionality). The bulk of the coverage would come, however, from the emergence of the black economy, reduced tax evasion, additional VAT and income tax on additional transactions and incomes expected from the tax reduction. Pie in the sky.

REFERENCES
Fullerton Don (2008). "Laffer curve", In Durlauf Steven N., Lawrence E. Blume, The New Palgrave Dictionary of Economics (2nd ed.), https://doi.org/10.1057%2F9780230226203.0922

International Monetary Fund IMF (2017), Fiscal Monitor: Tackling Inequality, October.

Laffer Arthur B. (2004), “The Laffer Curve: Past, Present, and Future”, 1 June, Backgrounder #1765, The Heritage Foundation, https://web.archive.org/web/20071201225944/http://www.heritage.org/Research/Taxes/bg1765.cfm  

Selk Avi and Amy B. Wang (2018), “Can this flat-Earther’s long-delayed rocket launch be saved? We may soon find out.” The Washington Post, 24 January, https://www.washingtonpost.com/news/speaking-of-science/wp/2018/01/24/can-this-flat-earthers-long-delayed-rocket-launch-be-saved-we-may-soon-find-out/?utm_term=.5a9d7e82d352

Trabandt Mathias and Harald Uhlig (2010), “How far are we from the slippery slope? The laffer curve re-visited”, ECB Working Paper Series No. 1174, April, Frankfurt, https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1174.pdf?344d6e77a58718332bd900b10e4d85b2

10 comments:

Tom said...

So, Laffer drew his curve on a napkin in a Restaurant, just like Toulouse Lautrec at the Moulin Rouge? Amazing!

Stefania Jaconis said...

I fully agree with you on the undesirability of a flat tax system for Italy, which is a country that of late has exhibited income and social inequality growing at increasing rates. I may just add that the often cited example of former socialist economies - many of which have hastened to apply the Rabushka-sponsored reform - is devoid of any validity in terms of its purported advantages, be it only for the totally different institutional context in which the introduction of a flat tax rate took place (transition to the market from a virtually 'taxless' system), and also for the fact that the measure in those countries was accompanied by major changes in the tax base, in social contributions, indirect taxation and tax administration.
This is an issue on which experiments are de facto impossible (which is the control group in a nation-wide policy measure?), and all the more so when system changes occur at the same time as policy implementation.

Robocop said...

Raising progressive taxation is simply not feasible in today's world of fiscal competition within the European Union and global competition by fiscal paradises.

D. Mario Nuti said...

Tom: Laffer says that he does not remember the details of the Washington meeting, except that the restaurant had cloth napkins and his mother had taught him "not to desecrate such things", but confirms that he used his curve in classes and with anyone else who would listen,

D. Mario Nuti said...

And yes, Stefania, you are absolutely right. In Transition Economies the effects of the flat tax, though not always brilliant (Ukraine) cannot be separated from the impact of the restoration of markets and re-integration into the global economy (also not always brilliant). The main argument in favour of a flat tax in Transition Economies was the inadequacy of admninistrative capacity to manage anything more complex than that.

D. Mario Nuti said...

More Robocops like you is what we need to cope with the problems you raise: indeed fiscal competition within the EU countries and from global fiscal paradises make the adoption of independent fiscal policies much harder, and especially progressiveness.

Fiscal competition within the EU is rife, with countries like Ireland, the Netherlands and Luxembourg unashamedly favouring foreign companies with ad hoc deals. In his earlier capacity as Luxembourg premier for almost twenty years Jean-Claude Junker presided over sweetheart tax deals with foreign companies in order to attract FDI and fiscal revenue, literally robbing the countries that he later sought to discipline for their excess debt in his capacity as President of the European Commission and of the Eurogroup.

Recently the European Council produced a black list of 17 fiscal paradises. Howevewr this did not include any EU country – such as Malta, Cyprus, Luxembourg and the UK including the Channel Islands - because they are supposed to comply with EU rules, not because they do. Other countries such as Morocco and Capo Verde were excluded at the last minute on the strength of secret undertakings (and strong backing respectively by France and Portugal); Qatar was excluded for no good reason. A grey list of governments were given time to reform on the strength of secret promises, some Caribbean countries have also been given extra time to comply because they had suffered from hurricanes.

Harder does not mean impossible, though. It is more a question of national governments fearing the impopularity of progressive taxation with their electorates.

Gaby said...

This is extremely interesting, Thanks!
I am all in favour of progressive taxation, but only up to 35% and even 40% for the higher earners, not higher especially in view of tax avoidance by the rich, who can always migrate to lower taxed countries (and return home only if and when tax rates are reduced) or simply conceal their wealth and income in fiscal paradises.

Michael Ellman said...

Naturally I agree that a flat income tax is normally undesirable and a progressive income tax is better. However, I believe that in the FSU countries in the initial transition period a flat tax was reasonable, simply because the tax administration was very weak and the population not used to paying income tax.

I was surprised to read that in Italy income from capital is taxed at a lower rate than income from work. In the UK all kinds of income are currently taxed equally (except that there is a small exemption for dividends and interest). In the UK, for many years after WWII, capital income (unearned income as it was officially described) was taxed at higher rates than labour income (this was abolished by Margaret Thatcher). In the Netherlands, in place of a tax on capital income there is currently a wealth tax on the value of real estate, securities and bank deposits.

Capital gains should also be taxed progressively, but there are many details that have to be worked out for it to work equitably and efficiently. They include, the treatment of capital losses, unrealised capital gains, owner-occupied houses, etc. I also support the taxation of inheritances, although here too there are many details to work out, such as inheritance by spouses, family businesses, etc.

I am against very high marginal tax rates since they mainly generate a lot of work for accountants and lawyers and lots of avoidance and evasion. Winston Churchill only wrote his war memoirs (at a time when the top marginal rate of income tax was 98%) after his lawyers arranged with the tax authorities that his income from them would be treated as a (at that time tax-free) capital gain rather than as income (he sold the text to the publishers rather than receiving a royalty income). He was probably sailing close to the wind: if it had been anybody else it is doubtful if the tax authorities would have agreed with his lawyers.

[Incidentally, there is a fascinating book about Churchill’s finances (he was perpetually short of money) which, amongst other things, shows how he used his positions as Chancellor of the Exchequer and as former Prime Minister to get favourable deals from the tax authorities. It is: David Lough, No more champagne: Churchill and his money (London: Head of Zeus, 2015). Possibly the reason it was published by this obscure publisher was because it was too sensitive for big publishers to touch. However, Churchill, despite his excesses, was far exceeded in financial shenanigans by Berlusconi].

I myself was irritated when one year I fell victim (in the Netherlands) to a marginal income tax rate of 63%. I felt that to be unfair. As a result I took avoiding action in the next tax year by buying a tax-advantaged life insurance policy which reduced my top income tax rate to 52% which I thought reasonable (my gross income was about three times the average). These policies were tax-deductible as part of a government policy to encourage people to save for their old age: so I was not engaged in disreputable tax avoidance but doing what the government was encouraging.Tax systems always have to take account of the behavioural response of the taxpayers. On that Laffer was right, although his prescription was wrong.

Nanni said...

Another billionaire entrepreneur, Elon Musk, has been funding a commercial space agency, SpaceX, for interplanetary space travel. Musk claims that a cargo mission to Mars will be possible by 2022, with a manned mission following in 2024. He envisages the creation of an inhabited city on the planet, with up to 100 people able to travel to the base per trip. Clearly an excellent prospect both for Berlusconi or for unwanted immigrants.

Nanni said...

Hughes was supposed to launch himself a mile across the Mojave desert last November, in a steam-powered (sic) rocket with “Research Flat Earth” painted on the side, Phase 1 of his one-man space programme – as a fundraising stunt. The rocket was launched on schedule but strong doubts have been expressed whether Hughes was actually on board.

Certainly Berlusconi will be very much safer in Elon Musk’s spaceship, and will be able to return to Italy in time for the 2031 elections (he says he will live until he is 120 anyway, i.e. until around 2057).