Reflections on flat-tax

The flat-tax, paired with the low redistribution rate is considered to be the key of economic success, so-called miracles in many ECE countries. The Baltic states, Slovakia, Bulgaria, Romania used to be mentioned as obviuous examples. In Hungary, where a one-sided dabete on the problem ensues (economists and "economists", "experts" strongly argues in favor if its introduction, while the socialist party obstructs it, although without the necessary intellectual capacity) these countries are often used as textbook examples of fast growth that substituted the budget revenues lost with the abandonment of differentiated taxation and it is often percived as well, that these countries have, due to their tight fiscal policy, room for manoeuver in this crisis. To put it simply: they have the necessary reserves to loosen their budgets and stimulate consumption either with financial transfers or with invesments.

The present crisis offeres proofs for a very different interpretation as well. According to the latest news I would dare to say, that at least in ECE this mixture of tax-system and fiscal policy led to an ironically pro-cyclical model instead of the perceived anti-cyclical one. Let's collect some data and facts:

a, the Romanian budget collapsed in the last two months of 2009 due to the loss in VAT (the figure of budget deficit as ratio of the GDP dubbled in this period)and the revenues were well under the expectations in the first two months of 2009 as well

b, Latvia is struggling to controll its budget, the 5% deficit agreed with the IMF in last year seems at the moment highly impossible, even a reduction to 7% would need drastic cuts, for example 20% of wages in the public sector

c, Estonia - a country that run budget surplus for years and having large reserves - needs cuts (!) of budget expenses in order to achieve its goal, a 3% deficit in this year, not really allowing the governemnt to take stimulating measures

d, the most striking of all: Slovakia's budget revenues are lagging behind last years figures with 15% (the figure is even worse compared to this year's budget, as that was calculated with a 2,9% GDP growth) and the revenues from VAT are almost 50% lower than in the previous year.

Obviously, there is no room for fiscal easing and stimulus, these countries rather needs harsh budget cuts (or tax hikes) in order to control their state houshold, what is quite the contrary to the proposals of an anti-cyclical policy, even if the flat-tax system was treated as an important factor of the impregnability of these economies.

Once again I have to admit that I'm not an economist, therefore my forthcoming observations are rather hypotetical, a kind of brainstorming, but I hope that not completely without substance. The main question is what caused this unexpected turn of events?

The above mentioned tax systems were made attractive with a relatively low flat-rate, between 10% (Bulgaria) and 24% (Estonia), mainly around 20%. Usually it was achieved with the abandonement of a progressive tax system with high rates for higher income. The restructuring also meant transfer of the focus of taxation to the consumption, especially as the effective lowering of taxes for individuals were meant as means to drive it. As the budget revenues reached their former level usually soon after the introduction of the new systems it was considered as a success. (Fiscal reserves were built by cutting expenses.)

Therefore it is not surprising that with the decline of personal consumption budget revenues are declining as well. But I would dare to say that situation is worsened by two factors, a general one and a specifically East-Central European. We can presume that wages are - at least in Europe - less flexible than consumption even in times of crisis, therefore taxation on income is more predisposed to withstand sudden changes and yield relatively more revenues than based on consumption. (Well on the long run changes are maybe the same, but we are struggling for months of survival until our export markets can restore their demand.) That could mean that taxation systems based on income has more reserves on a shorter horizon, giving a chance for stimulation. (Well, of course only in case of a relaxed state household.)

More interesting is the specifically Eastern-European phenomenon, the possible importance of the credit bubble for the states themselves. Although it sounds very nice that net wages were raised by 10-20-30% due to the new tax systems, as a source of consumption in an area of free trade like the EU it meant less than one would have expected. Avarage gross wages were between 500-800 EUR (630-100 USD) two or three years ago, now they are somewhere between the 600-1000 EUR range. With a very basic calculation we can assume that lowering the tax rate with 10% meant 50-80 EUR in a month, not a very substantial sum, I would dare to say, especially if someone was eager to buy more expensive goods and not only extend food consumption. This sum in itself was not really able to incite a consumption frenzy, but if it was multiplied by credit ... 100 EUR is the monthly payment for a decent sum. Add the effects of the housing bubble to it (mortgage based consumption credit meant in Hungary only a two thirds monthly payment compared to normal consumption credit, inflating the bubble considerably) and it is a very dire picture. I would conclude that the credit boom were necessary to stimulate consumption and through consumption raise budget revenues. It is possible that without this source of income states would have been forced to cut further public services and that way incite public discontent...

Anyhow, if my hypothesis has some basis, the collapse of budget income is more comprehendible. Consumers are saving money, as it is common in times of crisis, banks are not lending money as it is one of the main factors behind the crisis and even if workers are not laid off, the wages are taxed so moderately, that it won't bring too much for the state. Governments suddenly has to cut budget expenses instead of an expansion.

(There could be a counter-argument, that the effective tax-rate in Hungary, calculated as a ratio of the sum of the officially paid wages, is not higher than in these countries - at about20%. But there is at least one significant difference, as the minimal wage is taxed with a very low rate (2-3%) that means a significantly higher rate even in case of average wages. Those, who have higher salaries, and therefore arguably have a better position in their companies, not to be laid off so easily, pay the bulk of personal income taxes, while those with minimal wages are paying minimal taxes, therfore if they lose their jobs - and one can assume that they are laid off in the first phases as they are easily replacable - it is not a loss for the state houshold, even though a burden in the form of unemployment benefits. This tax system is not making individuals cheerful, but it could have suprising - well, relative - advantages.)