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Puerto Rico’s tax dilemma: The case for flat taxes and the consumption tax

Commonwealth seeks to reform taxes, Flat taxes and the consumption tax seen as alternatives to current tax woes


May 20, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

The Commonwealth of Puerto Rico’s existing tax system is a complete mess. Complaints abound that the island’s tax system is inefficient, unfair, too complicated, and incomprehensible. It fosters tax avoidance, evasion, and cheating that adds up to possibly $2 billion annually, and costs millions of dollars more than it should to administer. It also costs billions in lost tax revenue from exempted operations. For decades, Puerto Rico’s tax code has generated antagonism, aggravation, and confusion among the island’s taxpaying sector. Earlier this month, after decades of patchwork solutions to Puerto Rico’s tax code by various Commonwealth administrations, the Special Commission for Fiscal Reform (CERF by its Spanish acronym) presented a proposal to completely reform the local tax system.

Luis R. Benítez, co-president of the CERF and president of Puerto Rico’s Economists Association, in an exclusive interview with CARIBBEAN BUSINESS stated the commission’s proposal literally seeks to throw Puerto Rico’s tax code into the garbage can and establish a completely new one. The uniform and integrated 10% flat-tax system proposed by CERF for all tax modes (individual, corporate, consumption, capital gains, and repatriation) seeks to achieve simplicity, economic efficiency, and fairness, Benítez says.

This is precisely why Treasury (Hacienda) Secretary Juan Carlos Méndez has given his support to the reform proposal. "The three critical problems of the present system are the unreasonable burden imposed on the working taxpaying sector, tax evasion, and the complexity of the system. Real tax reform is required to address all these problems, and I believe that is achieved by the CERF proposal. The commission’s proposals are a remarkable advancement in the right direction," Méndez stated.

Just two weeks after taking over the governor’s office on Jan. 18, Aníbal Acevedo Vilá established the commission to analyze and make recommendations for tax reform for Puerto Rico. The commission delivered its report April 30, recommending radical changes to the Commonwealth’s obsolete tax system, considered a big obstacle to Puerto Rico’s economic development.

Taking on Puerto Rico’s outdated tax system

Puerto Rico’s potential gains from the proposed tax reform are projected to be considerable. In a typical year, it is estimated the Commonwealth fails to collect at least $1.6 billion in taxes from the legal but nonpaying informal part of the underground economy. If the reform proposal were implemented as is, Treasury Secretary Méndez estimates net revenue to the general fund could be $10 billion, $2 billion more than the net revenue of approximately $8 billion received by the general fund in 2004.

According to CERF’s final report, various estimates exist regarding the size of Puerto Rico’s informal economy, among them Booz Allen & Hamilton’s 1984 estimate of $2.5 billion; Jorge Benítez’s 1989 estimate of $2.8 billion; the Puerto Rico Planning Board’s 1998 estimate of $4 billion, and the 2002 Estudios Técnicos figure of $10.5 billion. This means the untaxed informal economy could represent almost one-quarter of Puerto Rico’s $50 billion economy.

Although the far-reaching flat-tax proposal presented by the commission isn’t strictly a flat tax, it also could be described as a politically strategic version of a flat tax offering personal exemptions and tax credits. The proposed tax system seeks to broaden the tax base by putting the tens of thousands of people who aren’t paying any taxes at all, or who are substantially underpaying, to pay a fair share and simplify the system.

CERF recommends all income be taxed at a single 10% flat rate. The variations allow the system to be more progressive than the traditional flat tax. "Although it could be interpreted as a flat tax, in reality, it is a one-rate uniform system. This means all rates of the tax instruments on income and consumption are 10%. A flat tax would apply 10% just to one area. This goes one step further," explained Benítez.

A flat tax is a tax having a single rate for all taxpayers regardless of income levels and types. This type of system taxes everyone at the same rate, regardless of his or her income bracket. Supporters of a flat tax argue it gives taxpayers an incentive to earn more because they wouldn’t be penalized by graduating to a higher tax bracket (as they would in a progressive-rate system as Puerto Rico currently has, with five different brackets that progressively taxes more as income increases).

Advocates say a flat-tax system arguably may have most of the benefits of a progressive tax, depending on whether the flat rate is combined with a significant threshold. Usually, the flat tax is proposed to kick in at a certain income level or to exempt income below an established level, so those who earn a low income pay no income tax. In the case of Puerto Rico, the CERF proposal exempts single taxpayers with annual income up to $15,000 and married working couples with earnings of up to $30,000. This recommendation automatically would exempt 309,000 taxpayers, up from 180,000 exempted under Puerto Rico’s current tax system because of their low income.

Proponents of a flat tax sometimes advocate raising the "no tax" level to include working-class citizens as a way to avoid raising their taxes when the flat tax is introduced. Under CERF’s proposal, Puerto Rico’s salaried class will pay less taxes than they are paying under the current system. The income of the poor wouldn’t be taxed, according to the commission’s proposal. For example, in 2002, 211,103 taxpayers earning less than $10,000 paid over $22 million in taxes to Hacienda. Under the CERF proposal, almost 100,000 additional taxpayers in the $10,001-$20,000 and $20,001-$50,000 gross-income brackets also would be exempted.

By simplifying the tax code and eliminating "loopholes," Puerto Rico would have a fairer system, Benítez argues. The flat-tax proposal actually would be tougher on wealthier taxpayers than the present income-tax system, due to the many loopholes exploited by high-income residents. The proposal for an integrated unified tax also will result in higher revenue for the government.

CERF’s goal: Tax justice

The proposed tax reform is designed to bring fairness in an integrated manner to Puerto Rico’s taxpaying working class. In all respects, this sector would benefit from the proposed reform, explained Andrés Morgado, co-president of the CERF commission and president of the State Society of Certified Public Accountants. Morgado says the tax-reform proposal was simplified as much as possible to benefit individuals as well as Hacienda.

The commission highlighted the need for a tax system that would relieve some of the burden sustained by taxpaying salaried workers by simplifying the system and distributing it over a wider base. The commission’s final report indicates 90% of individuals who pay income tax are salaried employees and service professionals. In this category, 80% of the taxpayers had an income of $30,000 or less. Out of the total 936,000 individual taxpayers in Puerto Rico in 2002, 725,000 or 77.45% reported income of less than $30,000 and only 15,780 or 1.69% of tax filers reported income over $100,000.

The commission on tax reform maintains salaried employees, whose wages are reported to Hacienda through their employers’ W-2 tax forms, carry a large part of the island’s tax burden. Consequently, the present system fails to encourage savings from the majority of the salaried sector and leads taxpayers to seek ways to avoid taxes, both legally and illegally, to escape the high tax impact in Puerto Rico. Thus, the tax levels are higher to the taxpaying sector because there is so much tax evasion. The government ends up extracting more from those who pay taxes because the taxpayer base isn’t large enough to run the government.

Recommendations made by CERF are projected to lower the maximum marginal tax rate on personal income from 33% (under certain conditions it can reach 38%) to a flat rate of 10%. It is expected the low tax rate will be a disincentive for tax avoidance and an incentive for compliance since the cost of compliance will be lower than the potential cost of avoiding taxes.

In addition to the income exemption, to balance the tax burden between different income levels, CERF proposed a number of credits and deductions. Taxpayers will be able to deduct mortgage-interest payments for their principal residence up to 30% of their adjusted gross income. They also will be able to take deductions for retirement accounts and dependents’ education-oriented savings, as well as for charitable donations. For taxpayers with reported income over $150,000, the mortgage-interest deduction is lowered to 20% of income, making the tax more progressive.

The commission also recommends implementing a series of tax credits, among them, a $500 credit per family member for taxpayers with income of $100,000 or less. This credit would apply to the vast majority of taxpayers, considering in 2002 only 15,780 taxpayers reported earning over $100,000. This credit increases to $1,000 for retirees.

These recommendations allow the system to be more progressive than the traditional flat tax, CERF members say. "Although some could interpret it as a flat tax, in reality, it goes beyond that; it is a one-rate uniform system. This means the rates of all tax instruments on income and consumption are 10%. A flat tax would apply 10% just to one area. This [proposal] goes one step further," Benítez explained.

The bottom line is a substantial number of salaried employees get a break under the flat tax, compared to the existing tax system. In addition, it helps reduce the heavy progressiveness of the present income-tax structure, which acts as a motivator for tax avoidance.

For example, in 2002, the effective tax rate for taxpayers with income below $10,000 was 2%. It doubles to 4.1% in the $10,001-$20,000 income bracket, increases to 7.1% in the $20,001-$50,000 income bracket, 14% for the $50,001-$100,000, and peaks at 23.3% for those making more than $100,001. The average effective tax rate for all personal income was 9.9%.

With a 10% flat-tax rate, the average effective personal tax rate will be much lower since individuals will take their deductions and credits, with few taxpayers getting close to the 10% tax rate. Documents obtained by CARIBBEAN BUSINESS show the government’s expected net revenue from personal income tax under the commission’s proposals is estimated to be about $1.25 billion, more than $1 billion below the $2.3 billion personal income taxpayers paid in 2002 and over $1.5 billion below the $2.8 billion paid in personal income tax in 2004. If this holds, the average effective personal income tax rate could be less than 5%. Preliminary estimates indicate personal income tax collections under the proposed system would represent 12% of the Treasury’s total revenue, down from 36% today.

Tax evasion more costly than paying

Tax evasion was cited as one of the biggest problems faced by the Commonwealth’s existing tax system. To resolve this problem, a number of measures were deemed essential. The first measure, which already has begun, is the implementation and expansion of the Tax Equity Program (PEC by its Spanish acronym). This measure included the immediate setup of necessary technology to assist Hacienda in identifying tax evaders, by crossreferencing internal Treasury data and consumption and investment patterns with information reported to other government agencies.

Beyond identifying tax evaders, the commission highlights the importance of processing them according to the law, making sure they pay their due. CERF further suggests requiring certification to specify no outstanding debt with the Treasury and having filed tax returns to be eligible for government benefits.

Andrés Morgado, who co-presides over the tax-reform commission, emphasized the necessity of a massive educational program that will inform the public about the changes and the importance of paying taxes. Without a massive education program, Morgado believes the tax-reform program won’t succeed. "Those who will be most affected under the reform will be tax evaders. It no longer will make sense to evade taxes. As it stands today, it is more cost-effective to evade tax payment. Under the reform, it will be more cost-effective to pay them instead of getting caught," he noted.

In addition to tax evasion by individuals and evasion of the 6.6% general excise tax at ports of entry, tax avoidance by corporations also has been targeted under the commission’s proposal. While revenue from personal income taxes grew 15.7% between 2000 and 2004, tax revenue from corporations only grew 2.77%. Of the 140,000 registered corporations, only about 35,000 file taxes.

An end to needless tax exemptions

Although the number of corporate tax returns is significantly lower than the estimated 950,000 individual returns, the processing system for corporate returns is outdated. The CERF report points out that the multimillion-dollar information-management systems Hacienda acquired haven’t yielded the expected positive results.

Puerto Rico-based corporations proportionally carry most of the corporate income-tax burden since the Commonwealth’s outdated economic development model historically has provided substantial tax benefits to corporations operating under the Puerto Rico Industrial Incentive Act (PRIIA). In fiscal 2004, Hacienda collected $2.5 billion from corporations.

The commission reports that in 2001, 40,526 businesses reported $417 million in profits, but only 437 reported profits of more than $100,000.

When deciding to extend the 10% tax rate to corporations, Benítez explained the commission closely studied the corporate taxes being paid in countries like Ireland (12%) and Singapore (18%). He explained that nonexempt local companies are subject to a 39% tax rate, while companies operating under the PRIIA pay 0% to 7% in taxes, although on average they only pay 2.5% to 3%. These tax-exempt companies transfer out of Puerto Rico’s economy upward of $25 billion yearly in mostly tax-exempt income.

Puerto Rico’s economic growth has come to a near standstill over the past three decades. Surely, one reason is the confiscatory taxation of successful local endeavors and the tax subsidy to local and nonlocal mainly manufacturing operations.

According to Benítez, one of the reasons behind the 10% tax was to redefine the strategy of the PRIIA, scheduled to expire in 2007, so incentives would be based on tax credits rather than tax exemptions. The proposed system would provide eligible companies with tax credits for employment creation, infrastructure improvement, productivity, providing ongoing employee education, environmental protection measures, and efficient energy use, among others.

The so-called tollgate tax that companies would have to pay to repatriate profits also would be 10%. Benítez clarified that this doesn’t mean corporations are being penalized since they can claim the tollgate tax as federal deductions.

Corporate tax reform, however, requires further work and analysis. The commission acknowledges most of the analysis conducted concentrated on the production sector. The particularities of individual subsectors still must be addressed and polished. The proposed reform provides room to negotiate the specific details that arise regarding different industries, Benítez adds.

Félix Norman Román, a CPA in private practice at Román, Torres & Co. PSC and a member of José Aponte’s transition committee in the House of Representatives, informed CARIBBEAN BUSINESS that the tax-reform model seems to have been created with the manufacturing sector in mind, without considering deductions particular to the service industry.

CARIBBEAN BUSINESS also learned there is concern regarding future treatment for research & development expenses or investments because the report doesn’t address this area. Treasury Secretary Méndez, however, seems ready and willing to negotiate. "In some areas, the reform wasn’t that precise, but that was done to grant greater flexibility and room to negotiate," he explained.

Taxes paid by corporations under the proposed reform eventually are projected to increase by over 100%, from $2.4 billion in 2004 to $5.7 billion. Under the new system, the share of corporate taxes to total tax revenue will represent 41%, compared to the current 24%. A source familiar with the committee’s work told CARIBBEAN BUSINESS that if the expected revenue materializes, tax credits to corporations for eligible activities could surpass $1.5 billion.

An end to excise taxes

The 6.6% general excise tax imposed by the Commonwealth will be repealed under the proposed tax reform, ending decades of an inefficient tax system with an incremental effect as the product passes from the importer, who paid the tax, to the wholesaler, and finally the retailer, leading to higher prices for island consumers. Tax collections from the general excise tax have been extremely inefficient in the past, and its rate of growth hasn’t kept pace with imports to the island. For example, between 1995 and 2004, imports increased 104.8%, while revenue from the general excise tax increased 45.65%. The excise tax-collection system has been very inefficient and has led to massive evasion, in many cases just to avoid the big delays by the available collectors to process the tax and thus holding up the merchandise needed by the market.

The commission suggested the excise tax be replaced with a 9% consumption tax, which would start out at 10% during the plan’s first five years. The hundreds of specific exclusions to the excise tax will be eliminated. Prescription drugs and raw and intermediate materials for manufacturing and educational products would be exempted from the consumption tax.

Real-estate transactions also will be excluded but services will be taxed. Special excise taxes, such as those for gasoline, alcoholic beverages, cars, and jewelry, would remain the same and be exempted from the 10% tax.

In addition, CERF introduced an inventive form of the consumption tax, one they describe as a hybrid between a sales tax and a value-added tax (VAT). Economist Benítez, who personally designed the model, affirms the hybrid model takes the best from both systems and would take only six to 12 months to implement. A pure VAT would take at least 18 months to implement.

According to the plan, at the point of entry, importers (most of them bonded) would pay $1 per every $100 of cargo. The importer would keep tax payments separate from sales invoices to the distributor and would charge them separately for taxes. The same would happen when the product passes from distributor to retailer. The tax wouldn’t be part of the cost or price of the product. At the end of the chain, the retailer would then charge the consumer the 10% tax, keep the 1% paid to the distributor, and pay the Treasury the difference. Benítez explains that keeping the tax independent from the product price would prevent the multiplier effect of the present system.

Excise-tax revenue as a percentage of total revenue has decreased from 51% in 1960 to less than 24% in 2004. Under the proposed reform, the sales tax could result in collections of about $3 billion which, added to approximately $1.2 billion in specific excise taxes, would represent $4.2 billion in revenue to the government.

Compensating the poor

From the increased revenue the Treasury would receive from the consumption tax, the committee suggested creating a "Social Fairness Fund" to compensate individuals and families, according to their income and spending capabilities, as a way to minimize the regressiveness of the tax.

For example, working married couples with income of less than $50,000, singles with income of less than $25,000, retirees and beneficiaries of the federal Nutritional Assistance Program (PAN by its Spanish acronym) would receive compensation from the Social Fairness Fund. The federal government (U.S. mainland taxpayers) pours $1.4 billion a year into this program to assist needy families on the island.

In addition, PAN beneficiaries wouldn’t have to pay the sales tax on any of the food products allowed under the program since their cost will be reimbursed by direct deposits into their PAN accounts. It is expected $1 billion will be redistributed to Puerto Rico’s poorer sectors through the "Social Fairness Fund," sources close to the committee estimate.

Morgado emphasized that although people may have to spend more money, they will have more disposable income because of the lower tax base. "One of the things most appealing about the reform, from the standpoint of a financial planner, is the current system penalizes income. However, under the reform, people will have more control over their money because of the low tax rate. They always have the option of controlling their spending," Morgado pointed out.

The consumption tax also will be an effective tool to collect taxes from Puerto Rico’s huge informal economy, which is comparable in size to economies in transition to market economies, such as those of former communist countries.

Local tax avoidance industry has flourished

The terminology of tax avoidance is extensive. Terms such as loopholes, tax shelters, tax credits, exemptions, deductions, allowances, and the like are all familiar. The Puerto Rico Tax Code is full of them.

As a result, a massive industry has emerged thanks to the Puerto Rico Tax Code: tax experts, tax scholars, tax lawyers, tax planners, tax filers, tax accountants, and even tax collectors. Sheltering income has become a major industry and tax planning a worthy profession.

Tax avoidance is a costly business for Puerto Rico’s economy. Some of the best minds in the legal and accounting professions, not just on the island but also in the mainland U.S., invest time searching for loopholes in Commonwealth tax regulations. Investment vehicles are created to exploit these loopholes, and time and money are spent to market tax-advantaged investment opportunities to potential investors and stay on guard to fend off Hacienda and the IRS.

None of this is a productive activity in the sense of creating anything of value to society. Its sole objective is to help some taxpayers pay less in taxes.

The Commonwealth’s current income-tax system imposes two huge costs on Puerto Rico. The first is in direct compliance costs (record keeping; learning about tax requirements; preparing, copying, and sending forms; commercial tax-preparation fees; audits and correspondence; penalties; errors in processing; litigation; tax-court cases; enforcement; and collection). The second is in indirect economic losses from disincentives–economists call these "deadweight losses" or "excess burdens"–because of the reduction in output incurred by the complicated, high-rate local income tax (reductions in labor supply, capital formation, and new corporate & business formations, failure to expand existing businesses, investments designed to reduce taxes rather than produce income, commonly known as tax avoidance, and tax evasion).

Hacienda prints millions of pages in the form of tax returns and instructions that are sent to more than one million taxpayers every year. A postcard-size flat-tax form with one page of instructions could go a long way in saving the government in printing costs.

There is another, often overlooked, cost of the current system. Corporate and individual taxpayers spend money and effort to influence the Legislature in their favor when it comes to taxes. The system of high rates coupled with hundreds of loopholes encourages factions to lobby for preferential treatment while persuading the Legislature and executive branches to force other groups to pay more in taxes. Overall, the economy loses as more and more economic activities come under the sway of the tax system, either by receiving special benefits or bearing disproportionate costs. The proposed tax reform seeks to eliminate this political game.

Far-reaching proposals

The commission’s proposed tax reforms don’t end with the commonwealth central government. A proposal to eliminate the property tax on inventory that goes to municipalities also is recommended. Recognizing the rampant tax evasion that occurs in this area, Benítez explained companies simply would attempt to keep inventories as low as possible or not report them correctly to avoid paying taxes.

This will have a direct effect on the price of products since retailers no longer will be obliged to pass on their inventory’s tax burden to consumers through higher product prices, Morgado added. "Before, businesses didn’t keep inventory [in stock] so they wouldn’t have to pay taxes. As a result, they would have to order products through express mail services. Under the reform, they can be more effective," he explained.

To compensate municipalities for lost revenue, the commission suggested that as much as 3.5% of the Commonwealth government’s net tax revenue be channeled to municipal governments.

Real-estate property will be reappraised because the commission recognizes property values in Puerto Rico are based on 1957 estimates, resulting in expensive residences in high-end communities often paying less property tax than residences in lower-income areas. The commission suggested reducing the maximum tax rate to less than 1% and establishing a tax-exemption base of $150,000 to $200,000. According to the reform proposal, municipalities would be allowed to keep all property-tax revenue from this source rather than contributing 1.03% to the central government, as presently stipulated.

To help municipalities implement the suggested changes, CERF proposes granting them 10% of the revenue collected from the sales tax for no longer than five years. At the end of that period, the consumption tax would be reduced to 9% and municipalities no longer would be eligible to receive the proposed allocation. In other words, Benítez says they have five years to get things in order and to remedy the fiscal problems plaguing the overwhelming majority of Puerto Rico’s municipalities.

The proposals were endorsed by the island’s mayors through their representatives on the commission, José Aponte de la Torre, Carolina mayor and president of the Mayors Association, and Aníbal Meléndez, Fajardo mayor and president of the Mayors Federation.

Simplicity of flat taxes

The virtues of the flat tax are numerous. It is simple. Tax returns potentially could be completed on a postcard, considerably reducing the time and cost to complete tax forms. Filing tax forms will be much simpler and efficient and taxpayers will save money currently spent on tax professionals. The proposed flat tax is fair, removing thousands of low-income people from tax rolls and enabling people to move ahead by retaining more of their earnings.

Puerto Rico’s proposed flat tax also promotes homeownership, inspires charitable giving, eliminates the marriage-tax penalty, and avoids delivering pork to politicians’ favored constituencies. The most important change is we would spend time thinking about producing goods and services and improving productivity instead of remaining obsessed about exploitive tax-advantaged opportunities or filling out tax forms.

With top marginal rates of nearly 40%, many high-income people feel they must hide any significant income from Hacienda, putting major effort into reducing taxable income and diverting income into tax-free mechanisms. At 40 cents on the dollar, dishonesty is lucrative. At 10%, most people would relax. Evasion and avoidance are far less profitable at 10% than at 40%. Keeping more than 90 cents of every additional dollar of income is also a stimulus to produce as much as possible. With taxes taking no more than 10 cents from each additional dollar at every income level, most people would pursue those economic activities that bring the highest return, rather than ones that minimize taxable income.

Perhaps most important for the ordinary working Puerto Rican, the 10% rate would abolish the annual nightmare of tax-return preparation in April. In addition, the government would spend less revenue to monitor and audit a simpler fiscal system.

The flat-tax reform would have a huge impact on the whole economy, modifying the government’s role and influencing Puerto Rico’s position in the international and national business arenas. The flat tax increases government revenue. As a result of a more dynamic economy and less tax evasion, the government would collect more revenue.

As shown by Arthur Laffer’s analysis and the history of tax cuts in the mainland U.S. and in Puerto Rico, lower tax rates stimulate additional tax revenue.

The flat tax seeks to make Puerto Rico’s fiscal system more attractive to foreign investment. In a global economy, where investors move freely across country borders, a simple fiscal system attracts increased global business. In turn, foreign investments further boost an economy with a simple, efficient fiscal system.

Economists and politicians worldwide, from the U.S. to China, are supporting the idea of a flat tax. Even more convincingly, the flat tax actually has worked remarkably well in all countries where it has been implemented.

On the negative side, the Puerto Rico version of the flat tax continues to double-tax a substantial part of individuals’ salaries and wages and corporations’ income. Individuals pay a percentage of their income for Social Security and unemployment taxes, and the same total income is taxed by the flat tax.

For corporations, the shareholders of a successful business are taxed 10% when the profits flow in and another 10% when the returns make their way via dividends to the entrepreneur and the other owners. Nevertheless, it still will be much better than what it is right now.

However, for Puerto Rico, the problems with the tax system appear to be more influenced by culture than political or theological endorsements. "People need to feel proud about paying taxes. In Puerto Rico, people don’t see the fruits of their tax investments," pointed out CPA Román. "Perhaps when the people of Puerto Rico begin to the see their tax money invested in quality schools and health services, into repairing roads and developing infrastructure, fixing recreational areas, and other necessary improvements, they will be able to learn how to feel that pride."

If properly imposed, the tax reform could generate more than $12.5 billion in tax revenue for the Commonwealth. Deduct the $2.5 billion scheduled to be returned to the economy in the form of corporate tax credits and compensation to low-income and poor residents through the Social Fairness Fund, and the Commonwealth is left with $10 billion or about $2 billion more than it collected in 2004.

How this additional revenue generated for the Commonwealth is spent must be closely monitored. Part of this amount should be designated to a Puerto Rico Permanent Fund or used to pay existing government debt, not on creating bigger and more government bureaucracy.

Flat taxes around the globe: Evidence from countries confirms flat tax is viable fiscal alternative

Hong Kong’s adoption of the flat-tax system through the Inland Revenue Ordinance of 1947 was essential for the expansion of one of the fastest-growing economies in the world, reported The Economist. The Baltic countries of Estonia and Latvia have had a flat tax of 24% and 25%, respectively, with a tax-exempt amount, since the mid-1990s. Estonia presently enjoys a 5.6% gross domestic product (GDP) growth rate and the Estonian Ministry of Finance forecasts growth to stay around the 6% level over the next four years. In Latvia, real GDP growth over the past three years averaged 5.6% as well.

On Jan. 1, 2001, a 13% flat tax on personal income took effect in Russia. In 2004, Russia’s economy grew 7.3%, and revenue from the country’s personal income tax has increased 150% since 2001. Ukraine followed with a 13% flat tax in 2003. Between 2001 and 2003, the average GDP growth rate was 5.5%. Slovakia introduced a 19% flat tax in 2004; the government was then able to collect 10% more income tax than it had expected and the number of new firms registering in the country jumped by 12%. The Channel Islands offer an even more convincing example of flat-tax efficiency: a uniform rate of 20% has led their economy to clearly outpace that of England and Wales.

The flat tax has had remarkable results in countries and other political jurisdictions around the world, such as the Channel Islands, Lithuania, and Serbia. Endorsed by economists and politicians in the U.S., the flat tax considerably simplifies the tax system, thus saving taxpayers billions in direct and indirect compliance costs. It would give a boost to the economy by considerably improving incentives to work, save, invest, and take entrepreneurial risks. The flat tax also would shift billions from investments that help people avoid taxes, to those that produce goods and services.

The recent successful implementation of the flat tax in Eastern European countries has led a number of Western European countries, including Germany and Spain, to discuss the flat-tax alternative in their parliaments this year. Proponents of the idea in both countries suggest implementing a 30% flat tax. Canada, Hungary, and China also are considering the idea.

During his recent trip to Europe, President George W. Bush praised the countries that have done away with their complicated tax codes and adopted a flat tax, especially Slovakia, which recently became a member of the European Union. Bush has appointed a bipartisan tax-reform commission to carefully look at the global spread of the flat tax. In the mainland U.S., although the national income tax is progressive, the flat tax is sometimes found in income taxes for smaller jurisdictions. Five U.S. states–Illinois, Indiana, Massachusetts, Michigan, and Pennsylvania–have a flat state tax on personal income with rates ranging from 3% in Illinois to 5.3% in Massachusetts (Pennsylvania’s is a pure flat tax with no zero-bracket amount). Proposals for a flat tax for the federal government have emerged repeatedly in recent decades during various political debates.

Jerry Brown, former Democratic governor of California, made the adoption of a flat tax part of his platform when running for president in 1992. Four years later, Republican candidate Malcolm S. Forbes, Jr. proposed a flat tax as part of his core platform. Although neither captured their party’s nomination, in both cases, their proposals prompted widespread debate about the current U.S. income-tax system. Sen. John McCain, a potential presidential candidate in the 2008 election, also has endorsed the flat-tax idea.

The proof is in the curve

Economist Arthur B. Laffer, who has been credited with revolutionizing U.S. economic thought, also is credited with offering the most convincing explanation of the relationship between the tax rate the government imposes and the revenue it collects. The "Laffer Curve" portrays the trade-off between tax rates and tax revenue and can be used to understand how a nonprogressive flat tax need not decrease, and may even increase, overall tax revenue.

The Laffer Curve suggests tax revenue increases more steeply at low levels of taxation. As the tax rate increases further, revenue increases at a decreasing rate until the government collects the maximum amount of tax revenue. Any increase in the tax rate prompts people to work less, or to do more to avoid the tax, thereby reducing total revenue. At a hypothetical 100% tax rate, nobody would have any incentive to work at all, since the government collects everything people earn.

The Laffer analysis also explains how the government can obtain the same revenue in two different ways: by collecting a high tax from a small fraction of the population (a high tax on a narrow tax base), or by imposing a lower tax on a wider segment of the taxable populace (a low tax on a wide tax base).

Proponents of the flat tax are convinced the existing progressive tax system raises a barrier against working more, reinvesting, or saving. They believe taxes are higher than the optimal tax rate described by the Laffer analysis, and a moderately low flat rate would increase tax revenue. They argue that if tax rates were lowered, people would have a greater incentive to work and invest, which would boost the entire economy.

This Caribbean Business article appears courtesy of Casiano Communications.
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