Flatland

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In the tax reform debate, those who favor the flat tax have a decisive advantage: many countries now actually have flat tax systems, and we can therefore ask what observation shows us about what the likely consequences would be of adopting such a system here. Unless you are a devout Kantian with a “damn the consequences, full speed ahead!” attitude, consequences are of interest.

In this regard, the prestigious National Bureau of Economic Research (NBER) published last year a detailed study of the effects that the adoption (in 2001) of a flat tax had on the Russian economy. The study, entitled “Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia,” is by Yuriy Gorodnichenko, Jorge Martinez-Vazquez, and Klara Sabirianova Peter, and is available on the NBER website.

As the authors note, Russia’s adoption of the flat tax was noteworthy. The tax was quite low – only one bracket, set at 13% – and it was the first really large economy to change from a graduated to a flat income tax. (There are now 23 countries with the flat tax, and four more close to adopting it.) The following year saw Russia achieve a 5% real growth in GDP and a whopping 25% real growth in tax revenues collected. So Gorodnichenko et al., tried to get a precise fix on what portion of these favorable effects can rightly be attributed specifically to the new tax policy.

Measuring the level of tax evasion in any country is inherently tricky. But the authors devised a clever way of doing so, by measuring the gap between reported earnings and actual household spending as an indicator of tax evasion. They compared these data immediately before and after the institution of the flat tax.

The study found that the flat tax resulted in a significant drop in tax evasion, and not surprisingly, that the greater the drop in tax rates, the greater the drop in tax evasion. Moreover, they found that this increased compliance with the law could not be attributed to any changes in Russia’s tax enforcement policies.

The authors also found that the adoption of the flat tax resulted in a real gain in economic productivity, although that gain was small, compared to the gain in revenue from decreased tax evasion. As you know, the specter always evoked by opponents of an equitable flat tax is that it would not produce the same revenue as our current, hideously complicated system.

With incomes in the upper tax brackets, the authors estimate (by looking at the rise in consumption as a proxy for increased productivity, including people’s working more hours) that the increased productivity was from 2.7% to 5.5%. But adding in the lower income brackets, where people did not see their tax rates fall under the flat tax, the estimate ranges from 0 to 4%. As the authors put it, “In summary, the response of after-tax income [after the flat tax was introduced] can be decomposed into windfall gains (4-5%), productivity effect (0-4%), and tax evasion effect (10-11%). Although the reform provided more resources to households and could have increased labor supply, the main effect was improved tax compliance. The government lost some revenue due to lower tax rates, but it gained substantially more revenue from enhanced reporting of income.”

The upshot is that we now have solid observational support or the view that a flat tax will produce major revenue gains through decreased evasion, and lead to some, though lesser, productivity gains as well.

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