Political parties in the UK are increasing starting to float the idea of a flat rate of taxation.
The notion of flat tax is simple. Everyone has a personal allowance that allows for a portion of tax free income. Beyond this limit, everyone will pay the same incremental rate, regardless of total earnings.
This approach has already been adopted by a small number of countries but its advocates often point to the Baltic states, and Estonia, as the most profound beneficiaries of adoption of this approach.
But the idea of a move away from a graduated approach to taxation is unpopular in some corners, and the UK’s Treasury has indicated that its analysis finds little to commend the approach.
Bulls of the flat rate tax point out the 23% flat rate in Estonia, the collapse in inflation rates towards low levels, and high growth rates that have been achieved in that economy. But investment specialists F&C Asset Management say attributing this undoubted economic success story solely, or largely, to changes in taxation policy is overly simplistic.
However, it adds there are credible reasons for believing that the flat tax idea will continue to gain traction in coming years.
The attractions of a flat rate tax are, importantly, that it is simple and easy to understand. By simplifying the tax rules then the government may find that tax yields rise, as tax evasion declines, with fewer loopholes to exploit. On the issue of whether a flat rate tax is equitable or not, low income earners may find themselves better off, as exemption levels (or personal allowances) for individuals are raised.
F&C say the flat rate tax could also act as an incentive to reduce voluntary unemployment. At present, the graduated system of tax rates may mean that there is insufficient incentive to work at lower income levels.
Furthermore, F&C say it could be argued that simplifying the tax system may lead to a more efficient allocation of resources, because aside from the fact that fewer accountants may be required, fewer distortions may evidence themselves as a function of tax treatment.
Despite these advantages, some policy makers may well take the view that their ability to pursue social or redistributive policy objectives through use of tax incentives will be reduced.
Furthermore, and as is obvious from construction, a flat tax will largely benefit the very well off (who get a lower effective tax rate) and the very low income brackets (who benefit from a bigger exemption). The majority may well be worse off.
While the Baltics apparently show us that flat tax is the way forward, F&C say we should not ignore the fact that arguably, unlike the UK, these areas suffered high incidence of generalised tax evasion, and (helpfully) the policy actually benefited a high proportion on the population.
Furthermore, anyone assessing the benefits of a flat rate tax by looking at the headline 23% rate applied in Estonia ignores the fact that the effective tax rate there is closer to 45%.
F&C say that this doesnt mean a fuller exposition of the case for and against flat rate taxes is not appropriate, but, as with all headlines promising interesting reading, one has to take care.
George Osborne, the UK’s shadow chancellor, is advocating the policy and the recent election in Germany highlighted that the debate is spreading across Europe into core countries.
Lower taxes are something that most would welcome and a simplification of complex tax legislation would be beneficial. Lower taxes and a lower share of government spending should benefit the medium term economic growth outlook. Nonetheless, and away from the economic theories and comparisons with success stories in very different economic environments, the case has still to be made.
F&C expect the theme to gain ground in political circles over the coming months and years. Moving the debate into the mainstream is, it says, going to take time.