Who Needs a Flat Tax?

A careful study of these countries – mainly post-communist countries in Eastern Europe and a smattering of tiny micro-states worldwide – suggests that there are three main reasons. First, some countries are so relatively poor and lacking in domestic capital that they opt to drop rates in order to attract foreign investors. Other countries are so small and ineffective at collecting revenue that they cannot afford a progressive tax system. Finally, some countries are so corrupt that they have to offer the wealthy a huge rate cut to get them to pay any taxes at all.

The United States, like other developed countries, does not suffer from any of these conditions (yet), so it is not clear why it needs a flat tax.

The formerly communist countries of Eastern Europe that have adopted a flat tax – including Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania, Macedonia, Romania, Slovakia, and Ukraine, among others – sorely lack investment capital. Whether on the European Union’s doorstep or just inside, they compete for the attention of foreign direct investors, for whom a flat tax provides an important signal: You are welcome, we will not steal your money, and you can keep what you earn.

For developed countries that already have capital and a track record of inward investment, “the appeal of the flat tax is consequently less,” as a report by the International Monetary Fund concludes. Thus, the flat tax has not been adopted in any developed countries, or in China.

The other countries that have embraced a flat tax are small or micro-states: Jamaica, Tuvalu, Grenada, Mauritius, Timor-Leste, Belize, and Seychelles. The only (partial) exception to this rule is Paraguay, which adopted a flat tax in 2010. Here, flat-tax advocates’ administrative-simplicity arguments have some traction. If a country is so small that it cannot develop a tax administration effective enough to manage a fair system of progressive taxation, then a flat tax may make sense.

Moreover, some small countries have other sources of revenue, so the benefit of implementing a progressive tax system does not justify the cost. Tuvalu’s government, for example, derives nearly 10% of its revenues from the sale of rights to its “.tv” Internet domain name, which brings in about $2 million annually. Countries that are just slightly larger can afford to collect income taxes in a fairer way.

Finally, if a country’s public institutions are in the thrall of oligarchs who are accustomed to stealing with impunity from the public till, a flat tax may be the only way to induce the wealthy to pay any tax at all. Thus, in 2001 Russia became the first large state to adopt a flat tax, reducing the top marginal rate from 30% to 13%. In 2003, Ukraine dropped its top rate from 40% to 13%.

In nearly all countries that have introduced a flat tax, government revenues from income tax have declined. That is why its adoption is often associated with an increase in value-added tax rates (as has occurred throughout Eastern Europe). In the US, the Republican presidential candidate Herman Cain’s “9-9-9” plan calls for a 9% rate for personal and corporate taxes, together with a new 9% national sales tax.

A country’s tax system reflects its institutional capacity, economic circumstances, and distribution of political power. If the US were to become the first developed country to experiment with a flat tax, that shift would tend to confirm what many suspect but hope is not true: that America is broke, desperate for inward investment, incompetently governed, and increasingly ruled by a self-regarding oligarchic elite.