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After Eastern Europe, the Flat Tax Is Flat-Lining

Over the last decade, Eastern European countries became darlings of the far right by instituting free-market economic policies designed to break convincingly from their Communist past. The so-called Baltic Tigers—Latvia, Lithuania, and Estonia—garnered worldwide plaudits for a number of free-market reforms, led by the imposition of a flat-rate income tax, especially from the American right. "The flat tax is making a comeback," trumpeted the conservative National Review. The three nations are "leading a global tax reform revolution," said the right-leaning Heritage Foundation.

Income Tax
Income Tax

The idea behind a flat tax is deliciously simple: Charge one uniform rate of income tax for all payers, regardless of their relative wealth. That, say its advocates, will end tax cheating and bring in higher revenues than the usual graduated tax system used in the United States and most other countries. Before the Eastern European "revolution," the loudest proponent of the flat tax was Steve Forbes, a former Republican presidential candidate and the editor-in-chief of Forbes. Of course, thus far American policymakers have not shown much more appetite for the flat tax than American voters did for Steve Forbes' candidacy, which is why the right was so excited that the idea took hold abroad.

Too bad for them that it hasn't worked out. Latvia, which has a flat tax of 25 percent, and Lithuania and Estonia, which have 21 percent tax rates, are all in deep economic trouble. They all have huge government budget deficits, a sign that they took in too little in tax revenue to cover their costs, primarily state expenditures to provide a generous welfare state. Conservatives might argue that they didn't slash welfare benefits enough, but there is no dispute that the flat tax didn't provide the expected revenue.

To be sure, they all had other problems as well: a sharp decline in exports to Western Europe because of the worldwide recession and huge borrowing in foreign currency to pay for a major real estate bubble that has now popped. "It turns out that Eastern Europe has now become the subprime borrower of Western Europe," said Bodgan C. Enache on the Web site Mises Daily. The Baltic countries are the most indebted in the region: Estonia's foreign debt represents 131 percent of GDP, Latvia's debt is 116 percent of GDP, and it's 72 percent for Lithuania.

That's partly why no one calls them tigers anymore. The crisis has hit Latvia the hardest. The Latvian economy fell by 10.5 percent in the final quarter of 2008 and its GDP is expected to decline by 12 percent in 2009. Riots broke out in Riga in January when demonstrators marched to protest the falling economy. The government was forced to resign in February. "The Latvian economy is staring into the abyss," said Neil Shearing, the emerging market economist at Capital Economics.

Latvia received a $10.5 billion bailout from the International Monetary Fund, the European Union, and Scandinavian countries last year, requiring the government to hold the budget deficit below 5 percent. But the newly installed prime minister, Valdis Dombrovskis, now says the government cannot meet the 5 percent hurdle and may be forced to ask for more financial assistance. "Given the pretty harsh economic situation there could be a possibility that Latvia would need more international loans and certainly one cannot exclude this," Dombrovskis said. The alternative would be more budget cuts, he said.

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Riots also spread to Lithuania in January, when about 7,000 demonstrators threw eggs and stones at windows of government buildings to protest economic austerity measures. Economists are predicting a 5 percent decline in GDP this year, and parliament has imposed pay cuts on public-sector workers and lowered state pensions. On March 23, Prime Minister Andrius Kubilius said he was cutting $1.2 billion from the 2009 budget, including axing 4,000 civil-service jobs. He said other budget cuts would follow in June.

Estonia, which was the first Eastern European country to adopt a flat tax in 1991, fell into recession in the second quarter of 2008 and is still struggling. The government is constrained by the fact that it wants to keep the budget deficit below 3 percent in order to qualify for membership in the euro common currency. Finance Minister Ivari Padar says the budget will be slashed by between $424 million and $508 million and the economy is predicted to shrink 9 percent this year, lowering likely tax revenues.

And it turns out that one of the alleged benefits of the flat-tax system, a sharp decline in unemployment, didn't really hold up to scrutiny. In fact, as is made clear in this article from Latvia, where unemployment has risen from 8 percent to 9 percent this year, the unemployment rate was kept relatively low because hundreds of thousands of workers migrated to Western Europe, attracted by relatively high wages. If they had stayed home, the unemployment rate would have been much higher.

Of course, no one can be sure that Eastern European countries would be any better off if they'd enacted a progressive tax. But the evident failure of the experiment certainly vindicates the longstanding criticisms of the flat tax. There are two main criticisms of the flat tax: It reduces the relative tax burden on the rich while increasing it on the middle class, and it requires big cuts in social spending to reduce the budget burden.

No appeal for elected officials

The fact remains that no matter how frustrated people are with the current complexity and arbitrariness of their tax codes, the flat tax has little appeal for those who, in most countries, would need to put it into place: elected officials. Asked in 2005 about a flat tax by his Tory opponents, Gordon Brown (then chancellor of the exchequer in 2005) ridiculed it as an unfair idea in which the "millionaire (pays) exactly the same tax rate as the young nurse, the home help, the worker on the minimum wage." Unless there is a better real-world example than Eastern Europe, that argument will be hard to refute.