The flat-tax revolution
George Osborne on the lessons we can learn from Eastern Europe Ducking into the mediaeval Church of the Holy Ghost in Tallinn last week to escape the Baltic rain, I stumbled across a remarkable memorial. It is to the British servicemen, mainly sailors and submariners, who died fighting in the Estonian war of independence. Forgotten in Britain, they are heroes in Estonia. They had been sent there in 1919 to help the Estonians defeat the imperial ambitions of Lenin’s Red Army. Next to the war memorial is a plaque commemorating the holders of Estonia’s Star of Liberty, and it reads like a roll call of early 20th-century British politics: David Lloyd George, Arthur Balfour, William Bridgeman, Joseph Chamberlain and Winston Churchill.
More than 70 years later Estonians fought another war of independence from communism. This time no shots were fired. Mercifully, the Red Army departed peacefully; but they left behind them an economy stultified by decades of socialism and Soviet control. Estonians have been fighting ever since to build a modern, dynamic market economy and their principal weapon this time is not the Royal Navy but instead a British idea: the flat tax.
What is a flat tax? In its purest form, a flat tax charges the same rate of tax on all income. All exemptions and allowances are scrapped. Simplicity reigns. The idea of a flat tax is not new to Britain. The Channel Islands and Hong Kong have had one for decades. But in recent years there has been a flat-tax revolution in Central and Eastern Europe. Estonia began the revolution by introducing a flat tax in 1994. As I saw for myself, it has played a key role in a liberal, free-market economic policy that has achieved high growth rates and attracted substantial foreign investment. Since Estonia took the lead, Lithuania, Latvia, Russia and Slovakia have followed suit, and Poland is set to join them. In fact, the competition from these neighbours means that Estonia is now cutting its flat-tax rate to 20 per cent.
Flat tax scores highly on the age-old principles of good taxation, famously laid down by Adam Smith, who said that taxes should be efficient, transparent, simple and fair. They are easy to collect. The amounts charged are predictable. The burden on companies and individuals is low. The economic benefits follow: the deadweight cost of the tax system falls, competitiveness improves, and incentives to work increase as you keep more of your earnings. The result is that tax revenues can remain surprisingly buoyant even as tax rates fall.
There is now a growing body of opinion that would like to see Britain adopt a flat tax. Once the preserve of right-wing think-tanks, the idea is starting to catch the wider public’s imagination. Gordon Brown should take the credit for this vogue. For as Chancellor he has introduced a mass of complexity to our tax system that was not there before. Tolley’s, the accountant’s guide to tax law that is published annually, has grown in size by more than 30 per cent since he took office — and the whole book now has to be produced in a smaller print size to fit in all the complex changes to the tax system. So no wonder people are crying out for something that will cut through the thickets of our tax law. ‘If countries like Estonia and Poland can do it with a flat tax, why can’t we?’ they ask.
Of course, we are not comparing apples with apples. What the Central and Eastern European countries all have in common is that they have introduced the flat tax into economies that did not have a long-established income tax system. They started with a fairly clean slate, while in Britain we have a direct tax system that has developed since Pitt the Younger had to finance war with France. There are established exemptions, such as tax-free savings for pensions or taxfree donations to charity. This makes life a lot more complicated. Conservatives should not balk at looking for the right solution just because it is difficult. We must be clear, however, that introducing a pure flat tax into the UK would mean having to overcome some major obstacles.
That does not mean that we cannot learn from the flat-tax experience. Indeed, we must. For in an age when companies can move across the globe to take advantage of lower tax regimes, Britain cannot afford to remain on the path of higher and more complex taxes that Gordon Brown has set us on.
The lessons of the flat-tax revolution are clear. The first is that tax codes do not have to be complex. Brown’s explosion of tax legislation increases the cost of compliance, which everyone else has to bear. His latest overcomplicated fiasco — the tax credits scheme has brought misery to millions of families as his elaborate bureaucracy fell into chaos. Instead of micro-managing and failing to deliver, we should simplify, reduce complexity, and make taxes fair again.
We can learn from all flat-tax countries that when we do away with countless exemptions and deductions, we discourage attempts to avoid tax through complex wheezes. That sort of activity is just as wasteful to the economy as a pointless quango or an overmanned Civil Service. At present the Inland Revenue is stuck in a vicious circle of its own making. Each year hundreds of pages of new tax legislation are introduced to try to stop tax avoidance. This week another lengthy door-stopper of a Finance Bill is being passed though Parliament. But tax avoiders find refuge in complex tax systems; the dodgers and the taxmen are locked in a war of attrition. Simplify the tax system and at a stroke you remove the loopholes the dodgers are trying to jump through, and remove the incentive to try.
The second flat-tax lesson is that lower taxes help encourage investment and enterprise. As Nigel Lawson proved in the 1980s, and the Estonians are demonstrating today, reductions in tax rates do not necessarily lead to corresponding reductions in tax revenues. Lower taxes help create an environment in which business and wealth-creation flourish, generating additional revenues for the government. It is a win-win situation. Of course, the Treasury cannot bank on these additional revenues and must proceed in a way that does not jeopardise the public finances. But equally we should bear in mind that there is a major risk to our economy if we do not find ways to reduce taxes. For it is difficult to see how we are going to compete with flat-tax regimes and other low-tax economies unless we do. In 2000, 20 out of the 30 major countries of the OECD had a higher corporation tax rate than Britain. Today, just five years later, only 10 do. No wonder we have fallen in the world competitiveness league table. No wonder foreign direct investment into the UK has almost halved since 1997. Creating a lower tax environment is a crucial part of meeting the competitive challenge that globalisation is bringing.
Britain was once the home of exciting new economic ideas. In the 1980s our free-market revolution inspired a generation of young people in Central and Eastern Europe fighting for their economic and political freedom. Today, thanks to their courage, they enjoy both. Now those young people are running their countries, and it is their dynamic flat taxes that should be an inspiration to us.
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