Evidence on Flat Taxes

This is from London’s New Economist blog:

IMF: Flat taxes have no Laffer curve effect

Flat taxes are associated with a reduction in personal income tax, and “in no case does there ..appear to have been a Laffer effect”. That is the most striking conclusion from a new study by IMF economists Michael Keen, Kevin Kim and Ricardo Varsano in The “Flat Tax(es)”: Principles and Evidence (Working Paper No 06/218). The authors summarise the paper thus:

Discussion of these quite radical reforms has been marked, however, more by assertion and rhetoric than by analysis and evidence. This paper reviews experience with the flat tax, seeking to redress the balance. It stresses that the flat taxes that have been adopted differ fundamentally, and that empirical evidence on their effects is very limited.

This precludes simple generalization, but several lessons emerge: there is no sign of Laffer-type behavioral responses generating revenue increases from the tax cut elements of these reforms; their impact on compliance is theoretically ambiguous, but there is evidence for Russia that compliance did improve; the distributional effects of the flat taxes are not unambiguously regressive, and in some cases they may have increased progressivity, including through the impact on compliance; adoption of the flat tax has not resolved common challenges in taxing capital income; and it may have strengthened, not weakened, the automatic stabilizers. Looking forward, the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it.

The impact of a flat tax on work incentives “is not clear cut in principle, and there is no evidence that it has been strong in practice.” Likewise, the distributional effects of movement towards a flat tax “are potentially complex”, especially for reforms that involve an increase in the basic tax-free amount.

Keen, Kim and Varsano argue that although “the question has received little attention in the debate, ..movement to a flat tax may plausibly strengthen the automatic stabilizers, not weaken them.” They also find the introduction of a flat tax has been a useful signal of reform:

The flat tax has commonly—almost universally—been adopted by new governments anxious to signal a fundamental regime shift, towards more market-oriented policies. In several cases, the signal appears to have been well-received. Where no such reputation needs to be acquired, the appeal of the flat tax is consequently less.

The authors conclude by questioning the political sustainability of the move towards flat taxes:

What remains unclear is the sustainability of the flat tax. Structurally, the flat taxes that have been adopted do not provide a coherent framework for dealing with the difficulties that almost all countries now perceive in taxing internationally mobile capital income.

…Political economy considerations point towards the adoption of rate schedules that tend to benefit middle income earners: exactly the group that tends to lose most from the adoption of a second wave flat tax. Moreover, the very spread of the flat tax in itself undermines its value as a signal: it may prove too easy to mimic. While there will no doubt be new members of the flat tax community, in some respects the more interesting question is whether there will be any defections.

Most flat tax structures benefit lower and/or upper income earners at the expense of those on middle incomes – a point I have made before. Such tax structures are hard to ‘sell’ to predominanatly middle class swinging voters in marginal electorates. In the end it is likely to be the median voter that stops the flat tax movement advancing.