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There have been a number of articles lately praising Baltic countries in the old "iron curtain"--like Estonia, Latvia, Slovakia and Lithuania--for adopting some version of a "flat" tax. See, for example, this one by Mark Landler in the San Francisco Chronicle. It seems clear that the flat tax is currently working well in countries like Estonia, but that success should not be taken as an indicator that countries with highly developed economies should follow the Baltic lead or indeed that the Baltic states can be expected to retain their current tax systems.
After the fall of the Soviet regime, Estonia began its income tax system in 1990 with a fairly sophisticated progressive tax structure, but with very unsophisticated tax administrators and taxpayers. See this description of the tax system. The complexity and lack of administrative expertise created unsurmountable problems, leading Estonia to switch to the current "flat" system in 1994.
Estonia's "flat" system is actually a progressive rate income tax, but with relatively low rates (currently the top rate is 24% and it is scheduled to drop to 20% by 2009) and a broad base (without differentiation between ordinary income and capital gains, and with limited deductions and exemptions permitted). Id. There is a standard exemption amount (i.e., a zero rate bracket), but families receive additional exemptions for children. Certain pensions are excluded. Various personal expenses--such as mortgage interest--are deductible, but deductions cannot amount to more than 50% of taxable income. In other words, the Estonian tax system is an income tax with a broad base and flattened (but not flat) rate structure. There is also an 18% VAT.
An enforced and collected tax creates steady revenue streams that permit government to do the things that must be done to support a stable economy and jumpstart economic growth. No government can effectively provide public services, including a stable environment for economic growth, without a steady stream of tax revenues. So getting a tax system off the ground and working would be very important to economic growth in a country that did not have a working tax system. A simpler and more transparent tax would be especially important in that case, and clearly the system Estonia developed, permitting internet filing of income tax returns (much like the 1040EZ used by many ordinary Americans in the lower four quintiles) has worked to spur Estonia's growth. It might well be that higher rates and additional rate brackets would work as well (or better), if the country avoided the constant adjustment that was apparently tried in the first few years of Estonia's income tax system and could rely on experienced tax administrators. Consistency and transparency, in other words, may have been much more important for Estonia than reducing to two (three) rates from four rates.
Once revenues are coming in, they can permit governments to create the kind of infrastructure that will drive more growth. The government of Estonia is clearly paying attention to this issue at this point, by devoting government resources to providing internet access and supporting research on ways to make the internet a productive organ of economic growth. Many of Estonia's cities have done what Philadelphia is doing (see here)--providing universal wireless access so that citizens can all leap into the information universe. There are 700 public internet access points and 600 free wireless zones in the country, every public school has internet and computer systems, and a majority of the population are internet users. See this story on Estonia's economy. Estonia is the home of Skype, the "free-to-use internet telephony system" as described here.
(In the USA, by the way, communications companies have worked to make it illegal for cities to do what Estonia has done--use tax revenues and partnerships with private companies to create public or quasi-public utilities that provide great wireless access cheaply and universally for all citizens. Verizon spent $3 million lobbying for a Pennsylvania law to prevent cities from offering muni-wireless unless a telecommunications company refuses to do so, and other states are considering such a bill. See here.)
Having consistent tax collections and an active government that supports markets, as Estonia's government is doing by encouraging internet research and development, is a wonderful driver. It is especially important when there has been a dearth of such activities. Growth in that context should be meteoric--there is a long way up to go from how far down Estonia was.
There are a number of issues, though, for these new "flat" tax countries, and those issues may become paramount as the heady days of rapid growth wane and the divide between rich and poor becomes more apparent. For one thing, flattened income tax at lower rates may not generate enough income, even with the critically important equal taxation of capital and labor income. Funding for the many activities of modern governments--from security to the arts, education to health care--is expensive. Estonia has so far mimicked the US instead of its European neighbors in providing a very thin social safety net. Lesser revenues because of the flattened rate structure, however, will make it hard to provide important public goods like education, health care, assistance for the elderly and other state support that most developed countries think necessary. As it becomes a more integrated member of the European Union, Estonia's citizens may demand government support for a standard of living similar to their more established Nordic neighbors.
Furthermore, the lower-tax states in Europe are in many cases making gains by undercutting their more established neighbors. German and French leaders claim that the Baltic states are just grabbing foreign investment from neighboring states by selling their lower tax rates. See the San Francisco Chronicle story, above. At the same time, the European Union is still providing financing to its newest members, and that financing supplements the lower tax revenues from the flat tax, providing necessary funds for the countries to continue their modernization drive. Whether Estonia adopts the Euro or not, tensions between European Union countries over tax policies and financing will need to be resolved, perhaps ultimately through some kind of European tax harmonization beyond the general directives currently in force.
The article on economic indicators for Estonia, cited above, shows that for 2004 Estonia had a growth rate of 7.8% of GDP, mostly through improved productivity. Job increases were relatively small. That is what might be expected of an economy that is coming out of a long slump under the Soviet occupation. Over the long haul, the economy needs to create significant jobs and reduce the unemployment rate below its current level (around 9.5%).
Most problematic for the Baltic states is the impact of the flat tax on already existing inequalities. Those who came out of the Soviet era with the most assets will carry a relatively light tax burden, while those at the bottom may find the 24% tax rate unbearably steep. In the United States, for comparison, generally only taxpayers in the top quintile of the income distribution pay an effective tax rate above 25%. Even assuming continuing economic growth, the higher tax burden on lower-income Estonians may make it hard for them to move forward with the economy.
Where will the Baltic states be in a decade? I don't have a crystal ball, but I expect that developed countries will ultimately decide that governments will increasingly emphasize support for quality of life expenditures from education to environment to health care. Health care and care for the elderly is especially significant as we become more capable of treating disease and prolonging lives. Education will continue to be the doorway to a better standard of living, and governments will be expected to provide strong educational foundations for all citizens. As use of carbon products explodes with countries like China and India rapidly adopting Western lifestyles, environmental expenditures will also need to mushroom. Those needs may well require countries like Estonia to move towards a more highly progressive rate structure than the one currently in place.
As Edgar Savisaar, leader of a center-left party in Estonia states (in the San Francisco Chronicle article cited above), "The best societies in the world to live in are the Nordic societies. [Estonia has] to move in that direction."