Vivid Romania Think Tank June 2004

ROMANIA THINK TANK
Flat tax in Russia and Slovakia:
a lesson for Romania

by Mark Percival
June 2004

In 2003, the Romanian government botched an attempt at tax reform, trying to replace the current progressive system with a single flat tax of 23 per cent. The plan would have involved an increase from the current lowest level of 18 per cent for those earning least. Not surprisingly, the scheme met with considerable opposition from trade unions and had to be abandoned, effectively putting taxation reform on the back burner at least until after the November elections, notwithstanding the strong recommendations of the Romanian Academic Society (SAR) in their August 2003 report which advocated a flat tax.

Yet the Romanian government needs to look no further than Russia and Slovakia to see evidence of the great benefits which a flat tax can bring, if implemented seriously and at the right level. At the beginning of 2001, Russia introduced a flat rate of income tax of 13 per cent, replacing the previous three tier code under which top rates had been raised to 30 per cent under IMF advice. In January 2002, the reform was reinforced by a reduction in corporation tax from 35 per cent to 24 per cent. Russia also considerably simplified the taxation regime for small businesses of up to 20 staff, with annual turnover of less than 10 million roubles (then $320,000) by giving them the option from the beginning of 2003 of paying either 20 per cent profit tax or 8 per cent on revenue from sales. This eliminated the need to pay large numbers of different taxes, saving paper work and so making payment much easier. The government also reduced sales tax, and replaced separate taxes for pensions, social insurance, medical insurance and unemployment with a unified, lower social insurance rate. Russia has also eliminated many ìnuisanceî taxes and privileges as well as reducing some customs duties.

The Russian reforms provoked a dramatic increase in revenue. In 2001, budget credits from income tax rose by an inflation adjusted figure of 28 per cent, and in 2002 by a further 20.7 per cent, then rising again by 31.6 per cent from January to June 2003. Money raised from income tax increased as a proportion of total revenue from 12.1 per cent in 2000 to 12.7 per cent in 2001.

Although this was helped by economic expansion, the additional amount raised from income tax far exceeded the growth rate. Part of the secret of the reform's success was a clever advertising campaign designed to educate the public that the new tax was a bargain and that it was consequently worth paying. A television commercial, for instance, showed two apples, one with a 13 per cent chunk bitten out and the other with 30 per cent (the highest rate under the old system). In spite of considerable income disparities and disdain for the ìnouveaux richesî a survey by Russia's Public Opinion Foundation showed that 43 per cent of Russians supported the flat tax, compared with 36 per cent who opposed it. The flat tax has had a noticeable effect in reducing corruption, through making the system simpler and hence more transparent, as well as making it less worthwhile to bribe officials to avoid paying tax (before its introduction, Russians are estimated to have declared only a quarter of their total income).

Proof of the success of the Russian flat tax has been the budget's move into surplus, in spite of lower growth rates. More than that, the idea is spreading to neighbouring countries, which fear ìtax competitionî from a more investor-friendly Russia. Ukraine introduced a flat tax (also at 13 per cent) at the beginning of 2004, and even Belarus, which has otherwise shunned reform under Alexander Lukashenko's authoritarian rule, is considering following suit. In the Baltics, flat tax regimes are already well established and these provided some impetus to the Russian reform. But while corruption continues to be a serious problem, and red tape remains a grave impediment to growth, there is still a long way to go before the Russian economy can be said to resemble a Western one. Yet the 13 per cent flat tax has clearly been a step in the right direction and most economists are generally positive about the country's progress.

On 1 January this year, Slovakia introduced a 19 per cent flat tax, partly as a result of lobbying by the Friedrich von Hayek Institute, a Bratislava based think tank. Under the old system, there were five rates for personal taxation. Corporation tax was reduced from 25 per cent to 19 per cent, while VAT was also standardised at 19 per cent. Simplification was a key advantage of the new tax regime, not only through the application of the new 19 per cent standard rate, but also because nearly all exemptions and other loopholes were abolished. Equally, most forms of double taxation will come to an end from the beginning of 2005, with the elimination of dividend tax, inheritance tax, gift tax and real estate transfer tax. Social security is being reformed too, with a new option for workers to invest up to 9 per cent of their income in personal retirement accounts, a policy so far only permitted by a very small number of countries, such as Australia (also allowing up to 9 per cent) and Chile (10 per cent)

The Slovak reform is designed to be revenue neutral in 2004 and was introduced on the basis of five independent estimates; from the IMF, the Slovak Ministry of Finance's Institute of Financial Policy, a special high level working committee, Infostat Slovakia and the Slovak Academy of Sciences. It remains too early to tell what effect there has been on the budget, but already there have been positive effects on foreign investment, the most notable being Hyundai's decision to invest $1.5 billion in a major new car plant. The country has made substantial strides since the early 1990s, when the erratic Meciar regime gave it an almost pariah status. Today, it has already begun to develop a reputation as a ìtiger economyî with EU membership being merely the icing on the cake. With flat taxes and simplification being introduced in countries all around, Romania risks losing out to competitors yet again if it does not follow suit. A low flat tax of around 15 per cent, following the Russian model, and a greatly simplified tax code would increase budget revenue (helping the state provide for the genuinely vulnerable) as well as providing encouragement to foreign investors now deterred by high taxes and red tape. Simplification would also reduce opportunities for corruption, further boosting the country's credibility to international business. With foreign direct investment still minuscule compared with the 2004 EU accession countries, Romania simply cannot afford to delay radical reform.

More on Romania Think Tank, including its position paper In Support of a Flat Tax for Romania can be found at its website, www.rtt.ro