Silvio Berlusconi has proposed introducing a flat tax as part of his electoral campaigning. (Credit: EPP/Flickr)
Silvio Berlusconi has proposed introducing a flat tax as part of his electoral campaigning. (Credit: EPP/Flickr)

This was my answer to Grzegorz Kolodko, Poland’s minister of finance and first deputy premier for the economy (1994-97 and 2002-03), when in the mid-1990s he asked me – his adviser, sponsored by the European Commission – for an opinion on the feasibility and desirability of introducing a flat tax.

Instead, I recommended a reduction of indirect taxation and the introduction of a tax on capital gains. To his credit, Grzegorz listened to me on the flat tax. He reduced the number and level of marginal tax rates but at the same time he raised public expenditure on investment and on re-distribution, introduced an industrial policy that did not seek to pick winners but promoted high value-added and export activities, and his package worked well.

The introduction of a flat tax has become a major issue in policy discussions on the eve of the Italian elections, as it is being vigorously propounded by Silvio Berlusconi and the leaders of his right-wing coalition. My views on the flat tax have not changed at all since the mid-1990s.

There are two main arguments in favour of a flat tax:

1) The presumed existence of a Laffer curve, whereby government tax revenue is supposed to rise with the increase of the tax rate up to a maximum, beyond which a higher tax rate would actually reduce tax revenue;

2) Lower taxation would encourage the emergence of activities that at present evade taxation, and therefore raise additional government revenue in that way.

According to legend (Wanniski 1978), in 1974, Arthur Laffer, then a professor at Chicago University, drew the curve named after him, depicting tax revenue as a function of the tax rate, on a napkin at a dinner in a Washington restaurant to illustrate the effects of President Ford’s tax cuts. He did not draw it on the basis of empirical evidence, but simply noted that for a zero tax rate, tax revenue would obviously be zero, and he assumed that for a 100% tax rate there would be zero revenue because nobody would work or invest for zero after-tax return. He also presumed that there would be a continuous parabolic shaped curve in between those two points and drew a maximum of around a 50% tax rate. Thus the same tax revenue could be obtained with a low tax rate on a large tax basis or with a high tax rate on a smaller basis.

Laffer (2004) acknowledged that as far back as the 14th Century the Tunisian philosopher Ibn Khaldun had noticed this possibility, which had also been asserted by many other thinkers, including Keynes: “… taxation may be so high … that … a reduction of taxation will run a better chance than an increase of balancing the budget” (quoted by Laffer)[1].

The trouble is that actual empirical estimates of revenue-maximising tax rates have varied widely, with a mid-range of around 70% (Fullerton 2008, which fits with the ‘so high rate’ stipulated by Keynes), while current tax rates in OECD countries average about half that rate. The IMF Fiscal Monitor of October 2017 actually recommends raising tax rates in a progressive fashion in order to reduce current excessive inequality of income and wealth, for “There is little evidence that increased progressivity reduces growth”.

More importantly, a 100% flat tax rate is plainly silly, for a progressive tax can reach fairly high marginal rates, historically even 90% and higher, without ever yielding a zero tax revenue. Indeed, it has been argued that the Laffer curve might well be increasing monotonically, and in any case, even a flat tax of 100% might yield substantial revenue in special circumstances, like wartime, or even at normal times, depending on behavioural assumptions.

As for the second argument in favour of a flat tax, there is absolutely no evidence that a low tax rate – flat or not – encourages the payment of taxes otherwise evaded at higher rates. And why should it; as Schumpeter put it, there is no good reason for anybody not reaping a benefit just because it is small.

Critics of a flat tax lament its lack of progressiveness. Supporters – such as Berlusconi – are quick to point out that in most OECD countries, including Italy, there already is a flat tax on capital incomes, at a constant rate lower than the higher progressive rates on earned incomes, so that a uniform flat tax levied at an intermediate rate would be more progressive than the current system. Anyway, the presence of a tax-exempt threshold maintains a degree of progressiveness, as required for instance by the Italian Constitution, article 53: “The tax system shall be progressive”.

These answers to critics of the flat tax’s lack of progressiveness are not good enough, because the first clause of article 53 states also that “Every person shall contribute to public expenditure in accordance with their capability.” The progressiveness of a flat tax is minimal, depending exclusively on the size of the initial tax-free threshold, and may be regarded rightly as constitutionally inadequate: The average tax rate rises slowly and gradually from below the flat fixed rate on taxable income, and significant progressiveness would only be achieved for extremely large tax-free thresholds, counterproductive for tax revenue.

The corresponding reduction in the current progressive tax on earned income would not benefit ordinary workers but only overpaid managers, making after-tax distribution of earned incomes more unequal. The reduction of currently excessive high levels of public debt, as well as the reduction of excessive degrees of income and wealth inequality, are best served by a genuinely more progressive tax system of the kind recommended by the IMF (2017).

On 24 January the Washington Post reported that Mike Hughes, a 61-year limo driver from California and a strong believer in a flat earth, had been planning to launch a self-built rocket to propel himself 52 miles into space in order to be able to see for himself that the Earth is flat, for “in many months of research I’ve not been able to prove otherwise”, he said.

The trouble is that the project would cost $2 million to finance the building and fueling of the rocket, a space-suit and a hot-air balloon (Mike Hughes is a bit vague about his logistics), and he was only able to raise $8,000 from GoFundMe. As he now has a fellow flat-earther in billionaire Silvio Berlusconi, it would be best for Silvio to fund the project in exchange for a lift in the same rocket, and all will end well both in California and in Italy, in the best of all possible worlds.

 

This article originally appeared on Domenico Mario Nuti’s personal blog and is republished here with permission.

References

Fullerton, Don (2008). Laffer curve. In Steven N. Durlauf and Lawrence E. Blume, The New Palgrave Dictionary of Economics (2nd ed.)

International Monetary Fund (2017). Fiscal Monitor: Tackling Inequality. October

Laffer, Arthur B. (2004). The Laffer Curve: Past, Present, and Future. The Heritage Foundation Backgrounder, 1765.

Selk, Avi and Wang, Amy B. (2018, January 24). Can this flat-earther’s long-delayed rocket launch be saved? We may soon find out.” The Washington Post

Trabandt, Mathias and Uhlig, Harald (2010). How far are we from the slippery slope? The laffer curve re-visited. ECB Working Paper Series, 1174. Frankfurt.

[1] Trabandt and Uhlig (2019) estimate the Laffer curves for labour taxation and capital income taxation for the US, the EU-14 and individual European countries for 1995-2007. They find that the US can increase tax revenues by 30% by raising labour taxes and 6% by raising capital income taxes. The EU-14 would obtain 8% and 1% respectively. Germany could raise 10% more in tax revenues by raising labour taxes but only 2% by raising capital taxes. The same numbers for France are 5% and 0%; for Italy, 4% and 0%; and for Spain, 13% and 2%. Only Denmark and Sweden are on the ‘wrong’ side of the Laffer curve for capital income taxation.

 

 

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