All Eyes on Slovakia's Flat Tax

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Alfaro: Overall, other countries can look to Slovakia as a model of what might happen when a flat tax is adopted, as this example illustrates several aspects. The overall economic performance has improved: Real output growth in Slovakia was 8.2 percent in 2006-a record high. However, it is difficult to disentangle the effects of the flat tax from that of the other reforms. Clearly, a lesson to be learned from Slovakia is that such a drastic change to fundamental tax habits needs to be thoroughly explained to all individuals and groups affected by it.

It has to be taken into consideration, however, that flat taxes in these countries were often made possible by the fact that tax collection had been limited under the communist regime, so in any case tax revenues were likely to increase. Recently, the government elected in June 2006 introduced some changes to the original reforms, even through these changes were, in the eyes of many, quite minor. But again, the case of Slovakia highlights that beliefs and views of a country on what is fair matter for the long-term sustainability of reforms.

Q: What do you think it would take for the idea of a flat tax to gain ground in the U.S. or Western Europe?

Dessain: Economists and business leaders alike are talking about flat taxes in many countries. As Western European countries lose ground vis-à-vis countries in Eastern Europe endowed with low tax rates, low salaries, and skilled labor, governments will increasingly look for ways to reform their tax and labor systems in order to attract business-or simply stop businesses from delocalizing. The direct effect of the Slovak flat tax can be seen in Europe, where neighboring Austria has lowered its corporate tax rate from 34 percent to 25 percent. This has been perceived by many as a clear sign that the Slovak reforms have been attractive to foreign investors. In response to broader initiatives, Germany has recently decided to reduce its corporate tax rate from 39 percent to below 30 percent in an effort to make the country attractive for investors.

Jensen: Similarly, voters in Finland decided to oust the ruling Social Democrats in favor of parties promoting tax cuts in response to the attraction of neighboring Estonia's flat tax. Most recently, the United Kingdom reduced its corporate tax rate from 30 percent to 28 percent and its income tax rate from 22 percent to 20 percent in an attempt to simplify the tax system. Still, the British government decided to reduce social security contributions and industry allowances, as the initiative was supposed to be revenue neutral.

Alfaro: In spite of these examples of tax reduction, there is a long way to go from lowering tax rates to introducing a flat tax in the U.S. or in Western Europe. This would require a change of attitude in countries marked by a substantial history with progressive taxation. To many, the concept of applying the same rate of tax to everyone regardless of income is simply not possible. Most certainly, the elimination of deductions and exemptions-such as mortgages, etc.-is a battle many politicians will not want to take on in the near future.

Also, the argument that a flat tax is likely to be paid by the middle classes is probably one reason why the concept has yet to gain ground in the U.S. or in Western Europe; the middle class simply doesn't want it. As economist Joseph Schumpeter said, 'The spirit of a people, its cultural level, its social structure, the deeds its policy may prepare-all this and more is written in its fiscal history.'

Contact the HBS Europe Research Center.