Eastern Europe Goes Flat

While most of the oldest members of the European Union remain mired in weak economic growth and high unemployment, desperately trying to preserve their heavily regulated economies and overburden welfare states, the formerly communist nations of Eastern Europe are percolating with new distinctly capitalist economic ideas. To the great satisfaction of American magazine mogul and erstwhile presidential candidate Steve Forbes, one of the most popular ideas currently sweeping through Eastern Europe is the "flat tax" under which all taxpayers pay the exact same tax rate, regardless of income.

The European commissioner for taxation, Laszlo Kovacs, described flat taxes, - one rate for all income and corporate taxation - as "absolutely legitimate" and said Western European nations may be tempted to adopt them. His comments will fuel debate that low-tax, low-cost economies of the East are undercutting Europe's industrial heartland.

In place in Slovakia and the three Baltic states, which joined the EU last year, flat taxes are credited with helping them grow fast and creating thousands of jobs. French politicians have led complaints about "social dumping" and the risk to their employment and social standards. Others argue that such a regressive system, under which a millionaire and a road-sweeper pay the same rate, can never be fair.

Mr Kovacs, a former Hungarian foreign minister, said: "As far as the position of the EU is concerned, we consider it as absolutely legitimate because the EU does not tackle the issue of income and corporate tax rates.

"Four countries have introduced it and are satisfied, and they claim that it works properly. Some six or seven are considering flat taxes - that makes 10 or 11 member states that could introduce flat tax.

Still, the older economies of Western European countries, increasingly strangled by heavy regulation and the high taxes necessary to maintain their bloated welfare states, adamantly resist the notion of the flat tax and the economic dynamism it might represent. In France, opinion polls indicate the a majority of French voters may reject the proposed European Union constitution next month exactly because they fear that the EU may push for free market reforms that would liberalize their economy and sweep away much of the French welfare state. Germany's economy has become so weakened, with unemployment surging past eleven percent, that economists are increasingly worried that "Europe's largest economy could eventually end up as its economic backwater."

Ironically, the reason for Eastern Europe's relative economic flexibility and willingness to adopt new tax programs is the very inefficiency of the former communist regimes, which left little functioning economic programs or tax collection measures in place when they fell. The Eastern Europeans have had to build their economies from the ground up, unencumbered by the quasi-socialist thinking that plagues so much of Western Europe.

Former Communist countries were open to the experiment because they did not inherit sophisticated tax collection machinery. In 1994, Estonia pioneered the move when its prime minister, Mart Laar, took the plunge, to be followed by Latvia and Lithuania. Others jumped on to the bandwagon including Russia, Serbia, Ukraine and Georgia. Slovakia, which joined the EU last May, introduced a flat tax of 19 per cent on income, corporate tax and VAT, in 2003. Romania - to become a member of the bloc in two years - has followed suit.

In Slovakia, the experiment has gone hand in hand with a boom in foreign direct investment worth €2.29bn (£1.5bn)this year.

The central tenet of the flat tax is simplification. Wipe away the labyrintine maze of tax laws, loopholes and tax shelters, and you make it easier for people to comply with tax law, as well as making it easier for businesses to structure and plan their operations. The cost of tax collection and enforcement for the respective governments is also greatly reduced.

Dispensing with the need for exemptions and allowances, flat taxes rely on simplicity: all those whose earnings exceed a threshold pay the same rate.

Sometimes, revenues have increased because fewer people take the risk of evading lower thresholds and there are fewer exemptions for accountants to exploit. Applying a basic - if regressive -system also saves time for citizens completing tax returns and for civil servants.

Mr Kovacs argued: "The advantage is that it limits tax avoidance but also it is more simple, so it reduces the administrative burden and reduces the compliance cost. The disadvantage is the lack of progressivity in the case of personal income." The commissioner did not name the nations considering flat taxes, though Hungary, the Czech Republic and Poland are known to be among them, and the issue has been raised in Cyprus and Malta.

Sadly, despite Steve Forbes' quixotic campaign, don't expect to see the flat tax come to the US any time soon. The allegedly "small government" Republicans who swept to power in Washington during the 1990s no longer care about reducing the size or scope of government, nor demonstrate even a feigned interest in fiscal responsibility. The GOP has become the party of "big government," massive pork spending, and fiscal lunacy. Meanwhile the entrenched quasi-socialists of France and Germany will stifle any market reforms in those countries, preventing the EU from becoming a great economic power.