All Eyes on Slovakia's Flat Tax

BSE | NSE 21/02/12

Martha Lagace

As interest in the flat tax grows, the world seems transfixed on an unlikely country, Slovakia, whose 3-year-old tax reform program is paying early dividends.

               

Laura Alfaro is an associate professor in the Business, Government, and the International Economy unit at Harvard Business School.

Essentially applying a uniform tax rate on citizens (and sometimes companies) regardless of income, countries that have adopted a flat tax are presently clustered in Eastern and Central Europe. But it is Slovakia-with its 19 percent flat rate-that has captured the world's attention of late, says HBS professor Laura Alfaro. Why?

What are the goals and complexities of introducing a flat tax? Is a flat tax a good basis for attracting foreign direct investment and for sustainable economic growth?

These questions and more are explored in a forthcoming business case coauthored by Alfaro along with HBS professor Rafael M. Di Tella, Executive Director of the HBS Europe Research Center Vincent Dessain (HBS MBA 1987), and Research Assistant Ane Damgaard Jensen.

The case, "Rovn� da�: The Flat Tax in Slovakia," describes how the flat tax was introduced there in 2004 as well as the surprising influence of Slovakia ever since. But the concept of a flat tax is not new: Jersey began one in 1940 and Hong Kong followed in 1947. It was post-communist Estonia that launched the Eastern European wave in 1994. Though Slovakia was not the first country to adopt a flat tax nor is it the biggest economy, Slovakia has raised some important issues regarding tax harmonization within Europe and the integration process.

"The case of Slovakia highlights the fact that the beliefs and views of a country on what is fair [do] matter for the long-term sustainability of reforms," says Alfaro.

Alfaro, Dessain, and Jensen joined forces for an e-mail interview with HBS Working Knowledge.

Martha Lagace: What is a flat tax, what does it aim to do, and why can it be controversial?

Vincent Dessain: A flat tax is as an income tax; it basically applies the same rate of tax to everyone and to each component of income. As opposed to a progressive tax system, which has the average tax rate increasing with the level of income, a flat tax doesn't distinguish between different levels of income. Wealthy, middle class, or poor, you pay the same rate. Also, a flat tax system is often completely free of deductions, exemptions, and exceptions. These efforts aim to make the tax system more transparent and easier to administer, while it should also reduce the incentive and possibility to commit tax evasion. Overall, taxes do have a real impact on the business environment, and in most cases business is in favor of the simple and often low flat tax.

Laura Alfaro: Naturally, the controversial part of the concept lies in the fact that it can be difficult, from a fairness perspective, to argue that the poor should pay the same rate of tax on their income as the rich. Most societies don't believe that the poor should pay the same rate as the rich. For this reason, many economists advocate including a tax exemption at the bottom in order to protect the groups earning the least. Nevertheless, opponents claim that a flat tax is likely to redistribute more of the tax burden from the rich to the middle classes. The fairness issue is very important in this case. It is not easy to say what "fair" is, but a "fair tax" is one that guarantees a socially desirable distribution of the tax burden, which is of course shaped by the views and beliefs of a country.

Ane Damgaard Jensen: Overall, people have different views of what a flat tax is and what it should allow. For example, in the case we highlight Steve Forbes' view of the flat tax, which is very different from Pat Buchanan's. But in fact, the flat tax proposals of these two individuals, together with the Slovak example, cannot be deemed true flat taxes because of the tax exemptions that have been added at the bottom. Technically, most countries haven't implemented theoretical flat taxes.

Q: Slovakia introduced a flat tax in 2004 with a 19 percent rate on personal income, corporate income, and value added tax. What are some of the complexities of the Slovak situation that made you decide to highlight it as a case?

Alfaro: I initially wanted to explore some of the many interesting developments going on in Eastern and Central Europe for my course Institutions, Macroeconomics and the Global Economy, so I contacted Vincent at the Europe Research Center to find out if they could help me with some ideas. After a period of transformation during the early 1990s, many countries in the former Eastern Bloc went through breakthrough reforms, remarkable economic growth, and increasing macroeconomic stability. Further, many of the countries joined the European Union and hence took part of one of the strongest economic regions of the world, benefiting businesses.

Dessain: We pitched this idea to Laura because a case on the flat tax, which has been widely implemented in Eastern Europe (in Estonia, Lithuania, Latvia, Russia, Serbia, Ukraine, Slovakia, Georgia and Romania), would be able to illustrate many of these issues. We discussed the idea with an HBS alumnus in Vienna, Georg Kasperkovitz (HBS MBA 1999), and decided to highlight Slovakia's experience when we realized that the flat tax was one of the hot topics. Meanwhile, we were witnessing "reform fatigue" within the populations of some of the Eastern and Central European countries; seemingly successful governments that had managed to reform economies were defeated by newcomers that promised more emphasis on the welfare state. This clash was interesting to us.

Many economists advocate including a tax exemption at the bottom in order to protect the groups earning the least. -Laura Alfaro

Jensen: Slovakia previously had a tax system that wasn't particularly supportive of the business environment: It was complicated and distortive, consisted of several rates, and included numerous exemptions and deductions. Former Finance Minister Ivan Miklo� wanted a simple, neutral, and non-distortive system. The system that was created had no special rates, no exemptions, no exceptions, and almost no deductions.

The Finance Minister told us that Slovakia had implemented one of the most simple, neutral, and effective systems in the world that improved the business environment, reduced tax evasion and, in connection with other reforms, brought about high and sustainable economic growth. And the situation kept evolving throughout the course of writing the case; in 2006, the Slovaks elected a new government. In March 2007, the case was taught twice in the elective course Institutions, Macroeconomics and the Global Economy, to a total of 250 MBA students at HBS.