The Adoption of the Flat Tax: Economic Ideas in Eastern Europe

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ABSTRACT

This article examines the introduction of flat tax and key Eastern European markets since mid 1990s. It also examines the economic theory of flat tax and analyzes the performance of these revenue instruments in the context of economic performance in transition economies.

INTRODUCTION

In 1992, Estonian Prime Minister Mart Laar came to power behind a strict policy of liberalization of the economy and an adherence to the principles of neoliberalism. Laar's first order of business was to figure out a way to solve Estonia's miserable tax revenue and collection problems (Smith, 2002). He answered by eliminating Estonia's gradual, or progressive, taxation structure in favor of a 26 percent flat rate on incomes and business. Within 10 years, Estonia gained admission into the European Union and has become a showcase country for why flat tax policies spur economic growth, attract foreign investment, and better collect revenue for governments. With Poland switching from a gradual taxation scheme to a flat tax policy by 2008, 10 countries in Eastern Europe have adopted flat taxes in the last eleven years. The other eight countries to adopt are Georgia, Romania, Russia, Serbia, Slovakia, Ukraine, Latvia, and Lithuania. This development is all the more surprising because only one country in the world--Hong Kong--had a flat tax prior to Estonia. "Ten years ago, everyone thought the Estonian Prime Minister had gone totally crazy in proposing a flat rate of income tax," said Laar. "The idea, which was then considered radical and unrealistic, is now becoming part of mainstream thinking in Central and Eastern Europe." (Laar, 2003).

This essay will analyze the reasons behind the adoption of the flat tax. In short, the adoption of the flat tax can in part be contributed to the role of economic "ideas" in politics and economics. What economic "ideas" are, and bow they shape policy, will be discussed in the first section of this paper. In the latter section I will more closely examine Eastern Europe and the flat tax, with particular attention paid to the cases of Estonia, Slovakia, Poland, and Hungary. This essay is not intended as a defense of the flat tax, nor implies a call for all countries to adopt the flat tax. This essay is also not a completed project, but the beginning of a larger, more detailed study about the relationship between economic ideas and the adoption of particular policies. The cases analyzed represent a 'first cut' with future research left to be done in this area.

PART I. ECONOMIC IDEAS AND THE FLAT TAX

Policy Explanations: Power, Rationality and Ideas

There are three ways the political economy literature might make sense of why states in Eastern Europe adopted flat tax policies. First, power-based explanations would argue that flat tax policies were adopted because certain agents of power coerced states into adopting a policy. A common explanation with Eastern Europe is that external aid agencies like the World Bank and the International Monetary Fund, and Western governments like the United States, forced Eastern European governments to adopt certain policy choices (Vreeland, 2003; Stone, 2001). In this case, political and economic power--or brute coercion--plays a critical role in shaping economic policy. The agency of relevant politicians is given little thought because local and even national elites play almost no role according to these theorists. At the extreme, these scholars are reminiscent of Marxists with respect to economics. Because capitalists are in a constant search for new markets, they will do whatever possible to open up once closed countries. Therefore, if the flat tax is seen as a way to do this they will coerce national politicians to achieve their ends.

A second explanation, and the conventional wisdom about why Eastern Europe adopted flat tax policies, usually has taken on a functional, or rationalist, logic. It is important to note that both power-coercion explanations and functional explanations are both "rational. …