Anyone interested in seeing first–hand what a simple and fair tax system can help accomplish should visit Estonia. After gaining independence from the Soviet Union in 1991, the little Baltic country first tried its luck with the kind of progressive tax system so popular in the West. Productive people were punished with higher tax rates, and savings and investments — the lifeblood of future prosperity — were subject to double–taxation. Not surprisingly, Estonia did not prosper. To be fair, the tax system was just one of many problems plaguing the nation. But it was ironic that Estonia hindered its economic recovery from communist enslavement by using a fiscal regime — progressive taxation — advocated by Karl Marx. No less ironic is the fact that most capitalist economies have adopted that counterproductive taxation model as well.
Seeking a new approach to jump–start its economy, Estonia adopted a 26% flat tax in 1994 and never looked back. Combined with other free–market reforms, the flat tax has helped Estonia become one of the world’s fastest–growing economies. Tallinn is now a boom town, filled with expensive cars, elegant shops, trendy restaurants and new construction. Estonia’s system is not a completely pure version of the flat tax model. But it is remarkably free from distortions, exemptions, loopholes and penalties. The flat rate applies to both personal income and business income. And since one of the key principles of a flat tax is that income should be taxed only once, there is no death tax, no wealth tax and no double–taxation of savings or dividends.
Perhaps most impressive, the country has continuously refined the system. The tax rate has already been reduced to 22%, and it is scheduled to fall — one percentage point annually — to 18% by 2011. Estonia’s corporate tax reform, which took effect in 2000, is especially impressive. For all intents and purposes, the country eliminated the corporate income tax. Instead, there is now a simple cash–flow system requiring companies to withhold 22% of dividends sent to shareholders. That means companies do not have to worry about depreciation rules and other complicated provisions that divert so much time and effort of managers in America and Western Europe.
With such a simple and fair tax system, it is hardly surprising that Estonia is now the Baltic Tiger, growing faster than every other post–Soviet economy. In the last six years, growth has averaged nearly 9%. And that’s after adjusting for inflation.
Low tax rates and simplicity have substantially reduced tax evasion and generated a large Laffer Curve effect. Even though (or perhaps because) tax rates have been cut, personal income tax revenues have nearly doubled since 2000 and corporate tax receipts have jumped by more than 300%.
To be sure, Estonia’s system isn’t perfect. The flat tax allows a few deductions, including for mortgage interest payments. But taxpayers can’t deduct more than 50,000 kroons (less than €3,200) annually. And there is a capital gains tax, which violates the principle of taxing income only once.
The rest of the fiscal system also leaves something to be desired. Payroll tax rates are 33% (though four percentage points go into a personal retirement account), which means there are still enough incentives to hide wages from the tax authority. And there is also an 18% value–added tax.
Perhaps most troubling, government spending is too high, consuming about 37% of economic output. “This is the downside of rapid revenue growth,” says Paul Vahur of the Estonian Free Society Institute. “The government is able to spend more money instead of limiting the size of the state.”
Compared to other European nations, however, Estonia is in good shape. The flat tax is a huge success, which is why 12 other Central and East European countries have followed Estonia’s lead and adopted single–rate systems. Perhaps, some day, the U.S. and Western Europe will have simple and fair tax systems as well.
