Do Flat Taxes Encourage Compliance Dr. Konstantin Pashev Hilton Sofia, October 28, 2005 Session 1: The Informal Economy

The Flat Tax in Eastern Europe CountryYearPIT rate (%)CIT rate (%) Estonia (dividends) 24 (05) 22 (06) 20 (07) Lithuania (wages)15 Latvia Russia dividends 30 Serbia Ukraine Slovakia Georgia Romania200516

The Concept  Taxing all income at uniform rate regardless of the income levels or sources. It is a broad concept for a simple taxation which applies the same rate on all kinds and levels of income, and avoids double taxation  The vertical dimension: uniformity across levels of income  The horizontal dimension: uniformity across sources of income: wages and business income  Tax exemptions, deductions and credit are reduced to personal allowances only

The Hall-Rabushka Tax  19% flat rate on all wage an business income (corporate and personal)  Corporate income tax base is a mixture between CIT and VAT: Similar to CIT, H-R tax leaves labor expenses out of the corporate income tax base and taxes them as income from wages and salaries at the same rate. Similar to VAT however it does not tax capital expenditures: they are written off at the time of purchase rather than depreciated.

The Hall-Rabushka Tax  It encourages saving and investment: It deducts the full cost of the new equipment (the so called expensing) It does not tax interest income but does not deduct it from business income either It does not tax income from dividends. Savings in pension and other insurance instruments are taxed at the time of withdrawal.  It eliminates all tax preferences except for a more generous family allowance

Disadvantages 1. It affects the middle-income groups Graduated 10% % % % H-R 19%

Disadvantages 1. It does not cover social taxes Bulgaria: Taxation of sole proprietors and wage earners (PIT+SIC)

Why is the flat tax more successful in Eastern Europe  Politically weaker middle class  Less pervasive system of exemptions and deductions, but even then this issue is not adequately addressed In most countries businesses rely much more on tax evasion or political protection rather than legal tax avoidance. This is one of the reasons for the larger share of the shadow economy as well. With the strengthening of business lobbies and interest groups and tax administration, breaking the rules of the game will tend to give way to changing them.  Lower share of income taxes in revenues Anti-avoidance capacity of the flat tax is limited. Therefore the fiscal effect of the tax and hence its feasibility depends on its evasion-curbing potential.

Do lower tax rates mean lower evasion rates?  Neither the theory, nor empirical tests support the common intuition  In terms of the classic models of tax evasion it is determined by the tax rate, the penalty structure, the probability of detection and attitudes to risk  Under an assumption of risk aversion the rate has ambiguous effect on evasion because it integrates two effects: substitution effect and income effect. Of course, evasion is hardly a result of gambler-type weighting of benefits and costs.  But empirical tests yield mixed results as well.

Flat rate and the small business The informal economy is very much the domain of the so called “hard- to-tax”: small entrepreneurs, and self employed in the sectors of services, retail trade, family hotels and catering, First the rates should really be lower. A flat rate of the Baltic type can hardly be expected to produce positive compliance response. As already shown, the flat tax may confront them with steeper schedule than the graduated scale. Moreover, if progressivity at the lower income brackets for business income is eliminated like in the case of Lithuania, proportional tax is not an easy stepping stone into formality, but on the contrary a high barrier.

The single rate and high-income taxpayers  The positive effect should be expected mainly in regard to high income taxpayers, who benefit most from lower rates. Due to limited opportunities for tax avoidance, the magnitude of evasion may be quite large in the new market economies.  A study on Russia’s flat tax effect (Ivanova A., M. Keen and A. Klemm 2005)finds that compliance rates increased in the top two brackets, where the MTR were cut by 7 and 17 percentage points, but still it is not clear how much of this effect was due to Putin’s stringent enforcement measures

Bulgaria’s tax cuts did not raise compliance rates CorporatecentrallocalcombinedPersonal rate bracket rate bracket rate bracket rate bracket rate bracket rate bracket rate bracket

The reason: High social insurance contributions  By keeping compulsory social insurance contributions high and trying to raise compliance by cutting income taxes tax designers have been pushing the wrong button.  SIC evasion erodes the PIT base because of large scale underreporting of wages by employers  Excessive SIC burden leads to hiding of corporate income as well, so that employers can pay wages without registering them. The base of CIT is also eroded

Does the single rate reduce compliance and enforcement costs?  Simplicity can curb shadow economy in two ways: Reduced compliance costs: costs to understand taxpayers obligations, to keep records, to interact with tax authorities, Regulatory and administrative deficiencies make these costs very high. Makes detection easier - deterrent to tax evasion  But excessive compliance and enforcement costs are primarily problems of the tax base, not of the tax rate.  Compliance costs are regressive: they are not such a strong driver of evasion for the large companies

The capacity of the flat rate to improve compliance rates remains to be confirmed. Policies oriented towards better taxpayer services and risk management techniques may prove more effective and efficient.