Friday, September 07, 2007


In Central and Eastern Europe, the flat tax revolution took place in early and middle 1990s when simple flat-rated tax on individual and corporate income replaced previous progressive tax rates on productive behavior such as labor supply.

According to Eurostat, Eastern European economies generate high periodic growth rates and outstanding output performance despite some recent inflationary pressures which are, in turn, a natural consequence of high growth that normalizes when annual and period (quarterly) GDP growth rates resile the output gap (case study: Latvia):

Latvia - 11,9%
Estonia - 11,4%
Slovakia - 8,3%
Romania - 7,7%
Czech Republic - 6,5%
Bulgaria - 6,1%
Poland - 6,1%
Slovenia - 5,2%
Hungary - 3,9%

Source: Real GDP growth rate in 2006, Eurostat (link)
See also: Frederick Mishkin: Inflation Targeting in Transition Countries: Experience and Prospects, NBER Working Paper 9667 (link)

There is innumerable practical and empirical support for less aggregate tax burden. In effective terms, the reduction in marginal tax rates could significantly stimulate the propensity of productivity since each additional unit produced and hour spent in the market, would not be penalized by additional taxation. On supply-side, the fundamental rax reform applied to corporate entities, such as the elimination of double taxation of income that is saved and invested and the abolishment of capital gains and divdend taxes, could stimulate the economic performance as well as encourage the business competitiveness. The real evidence has shown that countries with lower aggregate tax burden and flat-rated taxes generate higher output growth rates respectively. In addition, high aggregate tax burden empirically leads to the tax evasion and the groundbreaking path towards hidden economy, since it is typically cost-beneficial to avoid paying the tax through complex set of deductions, exemptions and loopholes or to boost the economic performance away from government control.

The impact of progressive tax code
is multi-layered. As first, punitive tax regime on labor income, produces a cost distortion as well as a negative impact on human capital creation which is essential to dynamic growth conditions. Hence, progressively-rated tax on labor supply results in a high wedge between gross cost of the employee beared by employer and the real wage. This particular variety of taxation negatively affects the productive ability of the employees to spend more hours on market since each additional earned income unit is deducted by a punitive tax rate. And second, labor supply is highly sensitive to tax rates. Higher tax rates on labor supply mean higher taxes on human capital. Thus, firms such as service sector are discouraged to hire employees that could generate high productivity and contribute its portion to firm's output. And third, in sum, high progressive tax rates on productive behavior alienate investors and contribute to the loss of net direct investment. Adding the aims for tax harmonization, the effect multiplies downward.

The latest indice of tax reform proposal has come from Poland. The effect of international tax competition between jurisdictions is that labor supply and capital easily shift from high-tax jurisdictions into locations with growth-friendly and less complex and costly tax system. Since investment and capital creation boost economic growth, Poland would suffer a loss in net direct investment in case of maintaining a progressive and complex tax code with rudimentary compliance burden, despite the advantages of Polish business environment such as low comparative cost of labor and outward/inward international flows. In fact, punitive tax regime with high effective tax rates on labor and capital and weak structural e-competitiveness, could backstage Poland's transformation to full-fledged free and competitive market economy.

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