IMF's shoddy flat tax study

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The International Monetary Fund is supposed to help nations grow faster, but the international bureaucracy is frequently criticized because its officials often tell poor countries to raise taxes and devalue their currencies. This characterization may be a bit unfair, since the IMF has more sensible views on issues such as trade, regulation and privatization, but it's also true that the organization generally is seen as an obstacle to market-based fiscal policy.

A good example is a recent IMF study attacking the flat tax. With many nations in Central and Eastern Europe having adopted low-rate flat taxes, tax reform has become a global issue. Countries as diverse as Slovakia, Romania, Russia, Estonia and Georgia are experiencing faster growth, better tax compliance, lower unemployment and increased foreign investment thanks to tax systems that impose low penalties on productive activity and wealth creation.

But when the IMF looked at European flat taxes, it concluded that "that empirical evidence on their effects is very limited" and that "there is no sign of Laffer-type behavioral responses." The study also asserted that, "their impact on [tax] compliance is theoretically ambiguous." A close examination of the IMF study reveals two serious shortcomings, either one of which would have yielded a failing grade in an introductory economics class.

First, the study ignores the impact of tax reform on economic performance. At no point do the authors compare economic growth in flat-tax countries to growth in nations with high-rate tax regimes. Another obvious comparison would be to see whether countries with flat taxes enjoyed more growth after tax reform. Yet this simple calculation isn't part of the IMF study.

The failure to examine economic growth is just the tip of the iceberg. The authors ignore job creation, unemployment rates, investment or any other measure of prosperity and competitiveness. It isn't clear why these important variables were neglected, but one possible reason is that they all contradict the premise of the paper. Indeed, they indicate that the flat tax has been very successful.

Second, the study asserts that a Laffer-Curve effect exists only if new revenues from faster growth and better compliance completely offset the revenues lost because of the low-tax rate. This is a grossly misleading characterization of the Laffer Curve, a classic "straw man" argument.

The Laffer Curve is nothing more than a graphic representation of the centuries-old principle that tax rates impact incentives and that this can affect taxable income (either because people change the amount of income they earn or they change the amount of income they report to the tax authority). The change in taxable income, needless to say, directly affects the amount of tax money the government collects. So if a tax-rate reduction causes even modest increases in growth and tax compliance, revenues will be higher than projected by simplistic calculations -- and the effect will grow with each passing year.

But only in very rare cases will the increase in taxable income be sufficient to fully compensate for the lower tax rate. This probably happened when Ronald Reagan reduced the top tax rate in the 1980s. More recently, it appears that the 1997 reduction in the capital gains tax rate "paid for itself."

The IMF study actually reveals strong evidence that flat tax reforms have yielded Laffer Curve effects. But the authors attempt to mislead readers by claiming that tax reform is successful only if the revenue feedback is at least 100 percent. Even more astonishing, they assume that this revenue feedback effect should happen within one year of reform. So even though taxable income climbed significantly in most flat-tax nations and income-tax revenue generally has exceeded expectations, readers are supposed to conclude that the flat tax is a failure.

It's unclear why the IMF is hostile to pro-growth policy. Cynics point out that the international bureaucracy has an incentive to perpetuate poverty since that creates more pressure for a bigger IMF budget, but hopefully ignorance is the real reason.

If nothing else, the IMF is a poor judge of global trends. The authors wrote that "the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it." This is a rather bizarre claim since Romania and Georgia adopted a flat tax last year, while Macedonia and Kyrgyzstan joined the flat tax club this year. Moreover, no nation with a flat tax has chosen to go back to a discriminatory tax regime. Even the new government in Slovakia, comprised of socialists and nationalists, decided to preserve the flat tax rather than risk killing the goose that is laying golden eggs.

It's unfortunate that socialist governments have a better understanding of tax reform than bureaucrats at the IMF.

Daniel Mitchell is the former McKenna senior fellow in political economy at The Heritage Foundation (heritage.org).