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Business Insight Comment: Flat-Taxers Show the Way

16 05 2007  

Southeast Europe is learning what star reformers already know – that lower, simpler taxes boost competitiveness.

By Natasha Srdoc-Samy in Zagreb

It started in Estonia. In 1994, the government of Mart Laar, already proven as one of central and eastern Europe's most daring reformers, instituted a flat tax. The idea was simple: no matter how much people earned, they paid the same income tax, and it was relatively low at 26 per cent.

The idea was not new in theory; the flat tax concept was first proposed 25 years ago by the American economists Alvin Rabushka and Robert Hall. But it was brand new in practice, and it worked. Simple taxes, easy to pay and difficult to evade, boosted Estonia's competitiveness, lured foreign investment and helped make the Baltic republic Europe's fastest growing economy.

There is much for the economic reformers of southeast Europe to learn from eastern Europe's great success stories, and this is among the greatest.

So it is surprise to hear Ivan Suker, Croatia's finance minister, describing his country's tax system as "perfect". Take a look. Croatia hits its taxpayers with heavy rates such as a 45 per cent marginal income tax and 20 per cent corporate tax and, in the process, entangles them in one of the region's most complicated tax codes.

Meanwhile elsewhere in eastern Europe a flat tax revolution is afoot. It is no longer enough to harmonise tax codes with European Union expectations. Even longtime EU member states themselves are being forced to scale down against more competitive tax regimes to the east, or risk losing business. In an increasingly borderless Europe, this struggle to attract investment and yield growth is constant and real.

On tax, Croatia is a slow learner. Serbia (14 per cent flat tax on personal income and 10 per cent corporate income tax), Montenegro (9 per cent flat tax on corporate income) and Romania (16 per cent flat tax on personal and corporate income) have bought in to the flat tax idea, and the list of converts is growing rapidly.

On January 1 of this year, Macedonia adopted a 12 per cent flat tax on personal and corporate income and plans to cut this to 10 per cent in 2008. On July 1, Montenegro is due to institute a flat tax of 15 per cent on personal income, lowering it to 12 per cent in 2009 and 9 per cent in 2009. In Albania, members of parliament are weighing the possibility of a 10 per cent flat tax on personal and corporate income.

Bulgaria, too, may join the fray. Flat tax proponents there are preparing to hold a major conference, citing concerns that Bulgaria may lose out on investments unless it drops its 24 per cent marginal income tax rate and 15 per cent corporate tax rate – already well below Croatian levels.

Foreign investment is not the only consideration. Flat taxes also carry a promise to free up economies for growth, by forcing gray economic activity into the legitimate market and simplifying collection. Economic activity increases, and so does honest reporting of income, while tax evasion drops. The result has been, in all countries that have implemented flat taxes so far, steady or increased tax revenue within the first year.

In a region like southeast Europe, such a change should be welcome. Countries of the region are challenged by corruption, inconsistent implementation of laws, high volumes of unregistered trade and low protection of property rights. Flat taxes help counteract such problems by closing loopholes and unmasking evasion techniques.

Under such circumstances, conservatism is the enemy of prosperity. It is in this way that Croatia's robust ties with "old Europe" are proving to be a disadvantage. Yes, investment from EU countries such as Austria continues to play a crucial part in Croatian economic recovery. No, we should not import the excessive economic, regulatory and tax conditions that EU-based companies are so evidently keen to flee.

Yet a characteristically conservative verdict on Croatia's tax system came at a conference on tax policy held last month in Zagreb, as reported in Austria's Der Standard. Participants concluded that Croatia's tax administration is "almost" on par with Austria's. But they failed to note is that Austria's heavyweight tax system is nothing to emulate. Indeed, it is currently in retreat, having recently reduced its corporate tax rate from 35 to 26 per cent, under pressure from neighbouring Slovakia's 19 per cent rate.

At the conference, Nadan Vidosevic, chairman of Croatia's conservative Chamber of Commerce made a passionate case for stability instead of reform, valuing stability and predictability above all. Suker agreed. But stability is only helpful once a system is made competitive, and Croatia is not there yet. How else to explain the under supply of greenfield investments and the accordingly high rate of unemployment, 18 per cent?

Suker blames this on the war, whose influence distinguishes former Yugoslav economies from other transition economies in eastern Europe. But his explanation falls short.

Even western Germany, with its cities and industries utterly devastated after the Second World War, rose from ashes within a decade to become one of Europe's strongest economies. Economic freedom plus foreign investment did the trick. Croatia has already had longer than a decade to rebuild. It has achieved much, but as time drags on, references to yesterdays' suffering increasingly sound like throw-away excuses for today's unimaginative governance.

Some southeast European countries are learning to look forward more daringly, as Estonia once did. The race is on. Let Croatia and other reform laggards take note.

Natasha Srdoc-Samy is president of the Adriatic Institute for Public Policy, a free-market think tank in Rijeka, Croatia. Balkan Insight is BIRN’s online publication.