The adoption of the flat tax: economic ideas in Eastern Europe.

Author:Ellis, Joseph M.
 
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ABSTRACT

This article examines the introduction of flat tax and key Eastern European markets since mid 1990s. It also examines the economic theory of flat tax and analyzes the performance of these revenue instruments in the context of economic performance in transition economies.

INTRODUCTION

In 1992, Estonian Prime Minister Mart Laar came to power behind a strict policy of liberalization of the economy and an adherence to the principles of neoliberalism. Laar's first order of business was to figure out a way to solve Estonia's miserable tax revenue and collection problems (Smith, 2002). He answered by eliminating Estonia's gradual, or progressive, taxation structure in favor of a 26 percent flat rate on incomes and business. Within 10 years, Estonia gained admission into the European Union and has become a showcase country for why flat tax policies spur economic growth, attract foreign investment, and better collect revenue for governments. With Poland switching from a gradual taxation scheme to a flat tax policy by 2008, 10 countries in Eastern Europe have adopted flat taxes in the last eleven years. The other eight countries to adopt are Georgia, Romania, Russia, Serbia, Slovakia, Ukraine, Latvia, and Lithuania. This development is all the more surprising because only one country in the world--Hong Kong--had a flat tax prior to Estonia. "Ten years ago, everyone thought the Estonian Prime Minister had gone totally crazy in proposing a flat rate of income tax," said Laar. "The idea, which was then considered radical and unrealistic, is now becoming part of mainstream thinking in Central and Eastern Europe." (Laar, 2003).

This essay will analyze the reasons behind the adoption of the flat tax. In short, the adoption of the flat tax can in part be contributed to the role of economic "ideas" in politics and economics. What economic "ideas" are, and bow they shape policy, will be discussed in the first section of this paper. In the latter section I will more closely examine Eastern Europe and the flat tax, with particular attention paid to the cases of Estonia, Slovakia, Poland, and Hungary. This essay is not intended as a defense of the flat tax, nor implies a call for all countries to adopt the flat tax. This essay is also not a completed project, but the beginning of a larger, more detailed study about the relationship between economic ideas and the adoption of particular policies. The cases analyzed represent a 'first cut' with future research left to be done in this area.

PART I. ECONOMIC IDEAS AND THE FLAT TAX

Policy Explanations: Power, Rationality and Ideas

There are three ways the political economy literature might make sense of why states in Eastern Europe adopted flat tax policies. First, power-based explanations would argue that flat tax policies were adopted because certain agents of power coerced states into adopting a policy. A common explanation with Eastern Europe is that external aid agencies like the World Bank and the International Monetary Fund, and Western governments like the United States, forced Eastern European governments to adopt certain policy choices (Vreeland, 2003; Stone, 2001). In this case, political and economic power--or brute coercion--plays a critical role in shaping economic policy. The agency of relevant politicians is given little thought because local and even national elites play almost no role according to these theorists. At the extreme, these scholars are reminiscent of Marxists with respect to economics. Because capitalists are in a constant search for new markets, they will do whatever possible to open up once closed countries. Therefore, if the flat tax is seen as a way to do this they will coerce national politicians to achieve their ends.

A second explanation, and the conventional wisdom about why Eastern Europe adopted flat tax policies, usually has taken on a functional, or rationalist, logic. It is important to note that both power-coercion explanations and functional explanations are both "rational." By rationality we simply mean that policies are instituted as a means to achieve a certain end. In the power-coercion case, flat taxes are installed at the behest of outsiders to foster economic growth or advance their own interests in particular markets. Similarly, functional explanations argue that elites within a political system change policies to achieve their own goals. One, flat tax policies were said to be easier to collect and administer and, therefore, more desirable than gradual income policies. Two, flat taxes were viewed as a way to attract foreign investment into the countries and better develop the domestic economies of each state (Dilanian, 2005). These theories are standard economic explanations for why actors choose certain policies.

Last, a third way to think about why states adopted flat tax policies concerns the extent to which ideas matter in politics. (1) Even though flat taxes might be adopted for functional reasons, and even if external aid agencies like the IMF support flat tax policies, it does not mean that certain economic ideas did not play a role in structuring what policy choices were available and which were not. The functional logic of flat tax policies is not in question in this research. Indeed, Robert Hall and Alvin Rabushka, the architects of (failed) flat tax proposals in the United States, agree that flat taxes are attractive for these very reasons (Hall & Rabushka, 1995: 52). But the flat tax had little real world applicability, by 1994, and to suggest that the flat tax would be the panacea to a state's economic ills would only have been hazarding a guess. The flat tax should not be seen as simply a pragmatic policy choice that remedied the problems of tax collection, but a specific economic idea that trumped other policy choices.

The extent to which ideas matter in politics is a considerable debate in the field of international political economy. International relations theory has generally been characterized as a debate between realism and institutionallsm. Realists and institutionalists are different with respect to how they view international institutions and cooperation in the world. Summarized succinctly, realists maintain that states are primarily concerned with power and security and that institutions are wrought with "false promise" (See Carr, 1942; Morgenthau, 1993; Waltz, 1979; Mearsheimer, 1993). Institutionalists believe that institutions exist to solve collection actions problems in the world, and that cooperation is a result of states pursuing this goal (See Keohane 1984; Stein 1982). On the other hand, both theoretical traditions share a striking resemblance: they are state-centric and rationalist in orientation.

A third debate in IR developed within the last 15 years dubbed "constructivism" or "sociological institutionalism." Constructivism is a big tent with many competing voices, but most constructivist work share two similar features. First, the constructivist literature moved away from state-centrism and looked towards various arenas--domestic politics, society., and transnational actors being three--to argue that important developments occur within and without states that deserve attention (See Wendt, 1999; Onuf, 1993). Second, constructivism took a more critical look at rationalism in world politics. Rationalist explanations suggest that political actors operate according to rationally expressed self-interest--that actor's preferences are consistent and ordered across time, and that this is a "given" of political life (See Downs...

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