March
1 , 2005
Higher Compliance One Benefit of Flat Tax
By Bruce
Bartlett
On his
trip to Slovakia last week, President Bush praised Prime Minister
Dzurinda for the flat tax system he instituted last year. Bush
noted that the new tax regime simplified tax collection, attracted
foreign capital, and created economic vitality and growth.
Three years
ago, Bush made a point of congratulating Russian President Putin
for his country's flat tax, which took effect on Jan. 1, 2001.
On that occasion, Bush particularly noted the fairness of the
Russian system, which treats taxpayers equally, rather than punishing
the successful merely for being successful.
Hoover Institution
political scientist Alvin Rabushka points to eight different countries
in the former Soviet bloc that have adopted some form of flat
tax in recent years. In addition to Russia and Slovakia, they
are Romania, Georgia, Estonia, Latvia, Serbia and Ukraine. He
predicts that Poland and the Czech Republic will soon joint them.
Why so much
interest in the flat tax? A key reason is that it is far more
effective at raising revenue than progressive rates. With progressive
rates, it looks as if extra revenue is being extracted from the
wealthy. But it is also giving them a powerful incentive to arrange
their affairs so as to minimize their tax liability or to evade
taxes altogether.
With a flat
tax, there is much less incentive to engage in tax avoidance or
tax evasion. Also, the knowledge that everyone is being treated
equally helps eliminate the culture of evasion that often becomes
pervasive in high-tax countries, which often drives even the law-abiding
into the underground economy.
Consequently,
it comes as no surprise that a new study by the International
Monetary Fund found that Russia's flat tax led to a substantial
rise in government revenue. This was due almost entirely to a
sharp increase in compliance, which significantly raised the share
of income declared on tax returns.
While compliance
here is not as bad as it was in Russia before its tax reform,
it is a growing problem. In his new book, "Many Unhappy Returns"
(Harvard Business School Press), former Internal Revenue Service
Commissioner Charles Rossotti warns that we are approaching a
crisis in tax administration. He estimates that in 1999, the IRS
was only able to collect about 17 percent of the $277 billion
that corporations and individuals failed to pay that year, leaving
$230 billion uncollected.
Recent data
from the Department of Commerce suggests that tax evasion has
risen since 1999. Annually, it publishes data comparing adjusted
gross income paid by governments and businesses (wages, pensions,
interest, dividends, etc.) with the amount reported by individuals
on their tax returns. The gap between these two figures is the
best measure we have of tax evasion.
In 2002,
the latest year for which there is data, there was almost $1 trillion
paid out that was not reported by individuals. If all this income
were taxed at the average individual income tax rate of 14 percent
that year, the federal government would have collected an additional
$135 billion. And this is a low estimate, since much of the income
not reported was undoubtedly by people in brackets well above
14 percent.
More worrisome
is the rise in the tax gap to 13.7 percent in 2002 -- the difference
between the IRS and Commerce income measures as a share of the
Commerce figure. This is the largest figure recorded since data
began being kept in 1959. It was only 10.7 percent in 2000. The
AGI gap averaged 11.4 percent in the 1990s and 11.9 percent in
the 1980s.
The flat
tax is not a cure-all for tax evasion, but as the Russian example
shows, it can help a lot. When people perceive that the tax system
is fundamentally unfair, because everyone appears to be paying
different tax rates despite having similar incomes, it diminishes
any guilt taxpayers may feel about underpaying their taxes.
Too often
in Washington, tax fairness is defined solely in terms of what
economists call vertical equity -- whether the rich pay more than
the poor. But horizontal equity -- treating equals equally --
is much more important for tax compliance. When there is a single
tax rate, people are more confident that their neighbors are paying
the same tax they are, which boosts compliance.
It also improves
compliance because the IRS doesn't need to know as much about
the nature and timing of taxpayers' income. Since all income is
taxed the same, they have no incentive to convert wages into capital
income or shift income from one year to another, for example.
Lastly, it
should not be forgotten that a flat tax is the revenue-raising
system most compatible with human freedom. As University of Chicago
law professor Richard Epstein recently put it, "It is no
accident that every strong defender of limited government has
gravitated toward the flat tax."
Copyright
2005 Creators Syndicate
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