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29 November 2006 Flatter Taxes Still the International Trend There has been a dramatic move to lower and flatter statutory rates of personal income tax in the OECD. Sweden and the United Kingdom had top rates of 87 and 83 percent respectively in 1975. An extra dollar of income increased the after-tax income of their top taxpayers by just 13 or 17 cents. The comparable rates in Ireland, Japan and the United States were 77, 75 and 70 percent respectively. At its peak New Zealand's top rate reached 66 percent. Only Canada and Denmark of 18 OECD countries had a top tax rate below 50 percent in 1975. By 2005 15 of those countries had a top rate of less than 50 percent. The Netherlands had the highest rate of 52 percent. No country had a higher top rate in 2005 than in 1975. Much lower top rates and less than proportionate reductions in other rates of tax have produced lower and flatter personal income tax scales. The trend is continuing, with Australia being another country to cut its top tax rates this year. New Zealand requires attractive tax rates to help offset natural disadvantages that it cannot change. It risks falling behind comparable countries unless well-designed tax cuts are implemented and growth in government spending is contained. The reintroduction of tax concessions for businesses, as foreshadowed in the review of business tax, are not a substitute for such tax cuts. They cost revenue and reduce the scope for cutting marginal rates. Economic distortions occur when preferential tax treatment is applied to a handful of selected activities or industries. The move toward lower and flatter tax scales in many countries has been driven by a growing body of research, starting in the 1960s, which shows that high marginal rates of tax are economically costly. They discourage investment, saving, employment and other productive activities, and thus impede economic growth. Some taxpayers may decide that it is not worth working overtime, taking a promotion or investing in further education and training. Beneficiaries may stay on welfare rather than seek paid employment. Others may simply avoid or evade taxes, for instance by doing 'cash jobs'. Wealthy individuals may emigrate to more welcoming tax climates and potential immigrants who could strengthen links to offshore markets may choose not to come to New Zealand. International studies estimate the loss of output arising from a small increase in marginal tax rates to range from around 10 percent to well over 100 percent of the revenue raised. A flat or flatter income tax would reduce such losses. With a pure flat or proportional income tax a single rate of tax is applied to all income. However, in practice the structure of flat taxes usually consists of an initial level of income which is exempt from tax or subject to a low rate of tax, and a single rate of tax on additional income. Undistributed company income, trustee income and the earnings of superannuation funds are currently subject to flat rates of tax. The two-rate tax scale (18 percent on income up to $29,500 and 33 percent on any additional income) proposed by the McLeod Tax Review in 2001 would be a step toward a flat tax. A flat tax would foster productive activities by reducing the rates of tax that inflict the most harm on the economy. It would also help to reduce the complexity of the tax system. For instance, income earned through companies and superannuation funds could be taxed at the appropriate rate in the hands of those entities. There would be no need to tax individuals on dividends paid by companies resident in New Zealand. There are also strong arguments on grounds of fairness for a broadly proportional tax scale rather than a steeply graduated one. A person who earns $100,000, five times as much as a person who earns $20,000, would pay five times as much tax. The Labour Party has adopted essentially a flat tax formula – a 5 percent levy – on its members of parliament to pay for the pledge card. Its decision should not be a surprise. Proportionality is applied in many voluntary situations, for example in dividing profits among partners in proportion to the capital contributed. Most people see that as fair. Why should tax be any different? A reduction in the top tax rate benefits people on high incomes initially, and may even widen after-tax income disparities in a static sense. But it does not only benefit well-off people. Lower marginal tax rates boost overall economic growth, people move from lower to higher incomes as they gain skills and experience, and strong growth does more for the poor over time than even the most aggressive income redistribution policy. A flat tax does not prevent the government from engaging in income redistribution. As the McLeod Review observed, most redistribution occurs through government spending. The International Monetary Fund recently published a paper which was quite critical of certain countries that adopted flat taxes contrary to its advice. It reviewed the experience of the 8 Eastern European countries that implemented a flat tax between 1994 and 2005. Half of the tax reforms examined had been in place for just two years. It is impossible to draw firm conclusions based on such limited experience, as the paper notes. Nevertheless the authors highlight the gap between the claims apparently made by some advocates of flat taxes and experience to date. They rightly point out that some claims were extreme, noting that "there is no sign of Laffer-type behavioral responses generating revenue increases" from tax cuts. Most respected economists accept that income tax reductions are not usually self-financing over the medium term, let alone the source of higher revenue. But neither is it true that the revenue costs are as large as the effects measured on a static basis. US research suggests that perhaps 40 percent of the initial reduction in revenue might be recouped over the medium term as people and firms respond to the incentives flowing from well-designed tax cuts. Flat taxes are not new, and are not confined to the former Soviet Union countries. New Zealand's initial income tax – at 6 pence in the pound (2.5 percent) up to £1000 and a shilling on additional income – was close to a flat rate. Hong Kong has had more or less a flat tax for over 50 years. The IMF may be right to question whether some of the adopters of flat taxes will stick with them. But any departures are likely to be for political, not economic, reasons. So-called progressive taxation – more than proportional taxation on those on higher incomes – is an idea embraced by Karl Marx that has held powerful sway. But just as other Marxist economic ideas have faded, the trend in tax rates in the last 30 years has been in the opposite direction. A flat income tax rate – like a flat GST – is an idea whose time may yet come.
Roger Kerr is the executive director of the New Zealand Business Roundtable. |