A Fine Mess

by T. R. Reid

  Generally, the advocates of the flat tax focus so tightly on “fairness” and “simplicity” that they fail to mention the most important impact of a flat-rate income tax: it would amount to a major tax break for the richest people in the country and a corresponding tax hike for many average workers. While a progressive income tax tends to reduce the gap between rich and poor, a flat-tax regime would serve to increase economic inequality. Even the self-proclaimed multibillionaire Donald Trump acknowledged this in his 2000 book, The America We Deserve. “Only the wealthy,” Trump conceded, “would reap a windfall, because a flat-rate tax would shift the tax burden from the richest taxpayers to those in the lower brackets.”

  To see how this shift would work, consider the case of a corporate CEO and her spouse with a taxable income, after exemptions, of $500,000 (a fairly conservative figure for corporate chieftains these days). Under the 2016 U.S. tax code, with graduated rates, they would have to pay $145,646* in federal income tax. If the United States shifted to a flat tax at a rate of 19%, the couple would pay $95,000 in tax; that is, the flat tax would cut this CEO’s tax bill by more than $50,000. In contrast, a secretary at the same firm with taxable income of $50,000, after exemptions, would pay $6,611 under the 2016 tax code.* At a flat rate of 19%, however, the secretary would have to pay $9,500; her tax bill would go up by about 50%. In a flat-tax regime, the system would shift the burden to the $50,000 taxpayers; they would have to pay more to make up for the big tax cut given to the $500,000 family.

  For this reason, flat-tax plans have generally been promoted by high-income taxpayers, by the think tanks and political candidates they fund, and by their supporters in Congress. Of all the advocates, the most visible and exuberant has been Steve Forbes, an extremely high-income taxpayer who inherited a family business (Forbes magazine) and a family fortune from his father, Malcolm Forbes. Steve Forbes ran twice, on a flat-tax platform, for the Republican nomination for president. He made the covers of Time and Newsweek—in the same week!—promoting the idea. He wrote a book about his plan, titled Flat Tax Revolution; it came with a blurb on the cover from (who else?) Donald Trump and a gushing preface written by (who else?) Newt Gingrich.

  I know and admire Steve Forbes; he is a kind, friendly guy, a good father, and a successful corporate leader. But I was surprised when he ran for president. Unlike his flamboyant father—Malcolm Forbes flew his own blimps and dated Elizabeth Taylor—Steve is a rather shy and understated gentleman, much happier in an arcane policy debate than in the turmoil of a hand-shaking, baby-kissing political campaign. (For this reason, perhaps, his two campaigns flopped.) When I saw him on the stump, though, I realized why he was running: the presidential campaign was an irresistible opportunity to make his pitch for the flat tax.

  “We’re going to abolish the IRS!” Steve would shout happily to any voters who would come to his speeches. “Your tax return will be the size of a postcard! You’ll file your taxes in five minutes! We’ll tear up thousands of pages of IRS regulations! We’re finally going to have an income tax that is simple and fair to everybody!”

  In his book on the flat tax,2 Forbes called for a flat rate of 17% on all earned income—that is, salaries and wages paid by an employer. He proposed eliminating many of the taxes that plague wealthy investors, like the capital gains tax and the inheritance tax. He also proposed to eliminate almost all deductions and exemptions that reduce taxable income, including the popular deductions for mortgage interest and charitable contributions. Removing all these complicated exemptions and deductions, he said, would reduce an individual’s tax return to seven lines, which would fit on a postcard. As an added benefit, he argued, this simplicity would sharply cut government corruption.

  For all the fervid support of Steve Forbes and other influential flat taxers, the idea never really caught on in the United States or other wealthy countries. That was due to two basic problems with the proposal.

  First, there’s the issue Donald Trump identified: “A flat-rate tax would shift the tax burden from the richest taxpayers to those in the lower brackets.”

  Second, simple mathematics tells us that a flat tax would generate significantly less government revenue than the current progressive rate structure. If the rate were set at 17% to 20%, the range proposed by many flat-tax backers, most Americans would pay less tax, and as we just saw, the richest Americans would pay vastly less than they do now. For some people, of course, this reduction in government revenues would be a feature, not a bug. In the abstract, just about everybody likes lower taxes and less government. In practice, though, the government programs and benefits supported by tax revenues are highly popular, and just about nobody likes killing them.

  Even Steve Forbes and other conservatives who back the flat tax agree that cutting government revenues would be a problem. So they have come up with an argument that says cutting taxes wouldn’t reduce the revenues that fund government programs. “A flat tax which combines stark simplicity with a tax cut would generate more, not less, government revenue,” Forbes maintained in his book. This would occur, the advocates say, because lower taxes would have a dynamic impact on the economy, prompting people to work more, to start new companies, to do more business. With this flat-tax boom, people’s incomes would grow so much that they would end up paying more in taxes, even at sharply lower rates. By the same reasoning, a tax increase would lead people to work less and thus shrink the economy.

  This argument is referred to as dynamic scoring. Another term for it, offered by the first President Bush, is “voodoo economics.” The problem with it is that recent experience doesn’t support the purported dynamic result. Tax increases, under the dynamic scoring theory, should stifle economic growth. But it’s hard to square that theory with actual experience from the 1990s. At the beginning of that decade, two presidents (George H. W. Bush and Bill Clinton) raised taxes on the upper brackets. The American economy then had its strongest decade in half a century. Similarly, tax cuts don’t always have the predicted dynamic effect. At the beginning of the twenty-first century, President George W. Bush pushed through the two biggest tax cuts in American history. This was followed, a few years later, by the nation’s worst recession in seventy-five years.

  Would a flat tax, then, be a boon to the national economy? It’s never been tried in the United States; the federal income tax has had a progressive rate structure since the very beginning. But we do have laboratory experiments on the concept—thanks to those newly minted nations in eastern Europe, where the world turned downside up in the early 1990s.

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  IN THEIR FIRST HEADY DAYS of independence from Communist rule, of democracy and free markets, the formerly Soviet nations to the west of Russia raced to adopt the prominent features of capitalism. Almost overnight, there were stock markets and chambers of commerce, real estate agents, fast-food chains, and TV ads (“Operators are standing by!”). When I toured several of these new democracies a few years after the fall of the wall, the cities were still largely gray, run-down collections of Soviet-era factories and housing blocks. But there were also some stylish boutiques and multistory department stores offering a wide range of Western goods; there were billboards advertising headache remedies and local brands of vodka.

  Independence was a stunning development for all the new nations, but nowhere more so than in the Baltic nation of Estonia. Estonia was one of those European nations that enjoyed its finest hour in the late Middle Ages, when the port city of Tallinn was a bustling center of shipping for a trade union of northern nations known as the Hanseatic League. Over the centuries since then, Estonia had been ruled by Sweden, Poland, Denmark, Russia, Germany, and the U.S.S.R.; one of the tourist attractions today in the capital city is the Museum of Occupations, with a swastika over one door and a red star over the other. For all those conquering powers, the minuscule Baltic state was a minor holding, not worth any attention or expenditure. Being ignored for all those centuries paid off, in a w
ay; with little development in the central city, much of Tallinn survives unscathed from the days of the Hanseatic League. Today the center of Tallinn is one of the world’s great repositories of medieval architecture, with a looming old castle and towering church steeples protected by a massive fortress wall around the city.

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  BUT ESTONIA, LIKE THE other former Soviet republics, faced major obstacles in the effort to build a capitalist economy. The new nation had virtually no private industry and minimal investment capital to build businesses. Estonia desperately needed to attract private capital and promote business development. In these straits, the national legislature turned to a youthful historian, Mart Laar, to head the government. Laar had become active as a student in Estonia’s main center-right political party; the party elders quickly realized that this young volunteer had the intelligence and the personal charm to go far in politics. And he did; he was elected prime minister in 1992, at the age of thirty-two, the youngest head of state in Estonian history. When I met him, two decades later, Laar had ascended to the position of elder statesman; he was the head of Estonia’s central bank. But he still had an abundance of charm and a lively sense of humor.

  As the nation’s new prime minister, Laar turned his attention to the dismal local economy. Having studied capitalist economies in the West, Laar quickly eliminated government price controls and Soviet-style regulation of business. He created legal protections for private property so that landowners would be willing to fund development. He set two important national goals: Estonia would join the European Union and adopt the euro as its currency; both goals were met, early in the twenty-first century. And he changed the nation’s complicated tax structure to a single-rate income tax—the flat tax.

  As Mart Laar told the story years later, he knew nothing about economics or taxation.

  “I had read only one book on economics,” he said. “It was Milton Friedman’s Free to Choose.” (This assertion probably wouldn’t stand up to close examination, because Laar had recently earned a Ph.D. in history from the University of Tartu, Estonia’s version of Harvard.) In that 1980 volume, a seminal text for a whole generation of free-market economists, Friedman argues for a flat-rate tax on everybody, with minimal exemptions and deductions. Friedman suggests that an income tax at a flat rate of 23.5% would bring in enough revenue to fund all legitimate government operations. But then, Milton Friedman had a rather strict view of what government could legitimately do; he opposed national parks, Social Security, the Food and Drug Administration, public housing, mortgage subsidies, agriculture supports, and so on.3

  When Laar started talking about a single-rate tax system, internal and external advisers forcefully urged him to drop the idea, he recalled later. “Experts advised against it and said it was a very stupid idea. My finance minister said, ‘Don’t do it.’ The IMF said, ‘Don’t do it.’ But it’s not very easy to convince a young person that he is wrong. And I was that kind of young person. So I did it.”4

  In 1994, the Laar government dropped Estonia’s three-bracket progressive income tax structure and replaced it with a single 26% tax rate that applied to both personal income and corporate profits. This “radical change,” as Laar described it, was electrifying news for proponents of the flat tax in the West; it immediately made an obscure place called Estonia stand out from all the other former Soviet states. “At the stroke of a pen,” the Economist reported, “this tiny Baltic nation transformed itself from backwater to bellwether, emulated by its neighbors and envied by conservatives in America who long to flatten their own country’s taxes.”5

  “The flat tax came to be sort of our national trademark,” Professor Viktor Forsberg, an economist at the University of Tartu, told me one frigid January afternoon as we toured the four-hundred-year-old campus. “And it made some economic sense in a country where almost nobody was rich. We all had roughly equal incomes, so we didn’t need the equalizing effect you’d get with a progressive tax structure. So why not get some attention with a flat-rate tax?

  “For a small, little-noticed country,” the professor continued, “it was useful to have a trademark. The problem is that now we’re stuck with it. The flat tax eventually outlived its benefit, but it’s our trademark, so we can’t fix it.”

  In the first years of Mart Laar’s flat tax, the Estonian economy soared. By 1997, the country’s GDP growth rate was 11%, making it one of the fastest-growing economies on earth. Growth rates above 7% continued into the first years of the twenty-first century. (Of course, growth rates tend to look large when a country starts from a minuscule base, as Estonia did.) And government revenues went up. “After decrease of the level of taxation, budget revenues did not fall but increased significantly,” Mart Laar wrote some years later in his English-language blog. “Introduction of flat-rate proportional income tax helped to boost economic activity and create new working places.”6

  But nobody can measure how much of the post-independence boom in Estonia was due to the experiment with the flat tax. There were a lot of other things going on. In the 1990s, all the eastern European nations saw significant economic growth with the development of free markets and private property rights. They benefited from the so-called enlargement effect; that is, they all got major financial support from the European Union, which wanted to enlarge its membership by taking in the former Soviet states. They all offered much lower labor costs than the western European nations.

  Beyond that, Estonia was the closest of the new nations to Scandinavia, and thus cashed in on investment and tourism—Tallinn opened several lavish Vegas-style casinos—from wealthy countries like Finland and Sweden. Estonia cleverly set its liquor taxes far below Scandinavian rates; as a result, the fast ferries crossing the Baltic a dozen times per day were—and still are today—jammed with Finns, Swedes, and Danes who brought movers’ dollies and kids’ wagons on the ship to cart home massive quantities of cheap Estonian vodka. With an excellent higher education system, the nation also had a talent for high-tech advances. There wasn’t a word in the language for innovation, so the Estonians created one: innovatsiooni. They might not have had a word for it, but they knew how to do it. Estonia built up a mini Silicon Valley in the suburbs of Tallinn; among other successes, the Internet phone service called Skype is a product of Estonian innovatsiooni. The former dusty backwater is today a global leader in computerizing government functions. You can renew your driver’s license, cast a vote, close on a real estate transaction, borrow from the library, or renew a prescription from a computer screen at home. Of course, Estonia has an e-tax system for paperless filing of tax returns; the national tax office says the average time it takes to file a tax return is seven minutes. (When I tried it, with help from a kind Estonian accountant, Jüri Kalda, my fictional return took just under ten minutes, start to finish.)

  “It’s hard to say, as an economist, that our boom in the ’90s was due to any single factor,” Professor Forsberg said. “Yes, the flat tax may have helped. But we might have had the same economic result with a more traditional graduated income tax.”

  To other eastern European nations—Estonia’s economic competitors—the flat-tax idea looked to be a winner. Fearful of losing out on a wave of investment, Estonia’s closest neighbors, Lithuania and Latvia, moved quickly to flat-rate systems—33% in Lithuania and 25% in Latvia. Russia adopted a flat-rate income tax in 2001, at the bargain-basement rate of 13%. But then Russia, where tax avoidance was a national pastime and government revenues drew much more from energy exports, had never relied heavily on the income tax in any case. Gradually, the idea spread south to Romania, Bulgaria, and Serbia. And at the dawn of the twenty-first century, the flat tax found an ardent champion in the person of Ivan Mikloš, a young economist in Slovakia, the eastern half of what had been Czechoslovakia.

  The nation of Czechoslovakia, created after World War I, was always something of a shotgun marriage; the Czechs and Slovaks spoke roughly similar languages b
ut were never really comfortable about sharing a country. After the Soviet Empire collapsed, the two halves were free to part company; in 1993, they did, under an arrangement known as the Velvet Divorce. At the beginning, the Czechs were significantly more prosperous than their Slovakian cousins to the east. For most of the 1990s, per capita income in the Czech Republic was 40% higher than in Slovakia. Prague, the Czech capital, is one of Europe’s greatest cities, and it did a booming business drawing tourists from Germany and other western European countries; Slovakia’s capital, Bratislava, a smaller, dustier town, attracted few foreign visitors. In its first decade of independence, Slovakia tried—in vain—to generate economic activity with infrastructure projects and Soviet-style central planning.

  Looking back on those dark days, a Slovakian banker, Vladimir Vano, told me that the country “made a nice case study in how government spending does not create growth. We built dams and highways and public buildings, but we did not try to build a corporate sector. And we were just not keeping up economically with our neighbors in central and eastern Europe.” The U.S. secretary of state at the time, Madeleine Albright, called Slovakia “the black hole of Europe.” She said that in 1997, and it clearly stung. Some seventeen years later, just about everybody I met in Slovakia reminded me of that insult.

  After a severe economic downturn at the end of the 1990s—unemployment reached 20%—Slovakian voters threw out their left-leaning government and installed a center-right party. The new government hired Ivan Mikloš, a smart, no-nonsense economist, to be finance minister, with a mission to revamp the nation’s tax system. By the time I met him, Mikloš’s party had lost an election, and the former finance minister had been relegated to a minute closet of an office in an annex building of the parliament. Still, he glowed with pride as he described the taxing revolution he brought about in 2004.