- The Washington Times - Tuesday, March 1, 2005

On his trip to Slovakia last week, President Bush praised Prime Minister Mikulas Dzurinda for the flat tax system he instituted last year. Mr. Bush noted that the new tax regime simplified tax collection, attracted foreign capital and created economic vitality and growth.

Three years ago, Mr. Bush made a point of congratulating Russian President Putin for his country’s flat tax, which took effect on Jan. 1, 2001. Then, Mr. Bush particularly noted the fairness of the Russian system, which treats taxpayers equally, rather than punishing the successful.

Hoover Institution political scientist Alvin Rabushka cites eight different countries in the former Soviet bloc that have adopted a flat tax in recent years. In addition to Russia and Slovakia, they are Romania, Georgia, Estonia, Latvia, Serbia, and Ukraine. He predicts Poland and the Czech Republic soon will join them.

Why so much interest in the flat tax? One key reason: It is far more effective at raising revenue than progressive rates. With progressive rates, it seems that extra revenue is extracted from the wealthy. But it creates a powerful incentive for the wealthy to so arrange their affairs that their tax liability is minimized — and also to evade taxes altogether.

A flat tax offers much less incentive for tax avoidance or tax evasion. Knowing everyone is treated equally helps eliminate the evasion often pervasive in high-tax countries and that frequently drives even otherwise law-abiding citizens into the underground economy.

As a result, it is no surprise a new study by the International Monetary Fund found Russia’s flat tax substantially boosted government revenue. This was due almost entirely to sharply increased compliance, which significantly raised the share of income declared on tax returns.

Though compliance here is not as bad as it in Russia before its tax reform, it is a growing problem. In his new book, “Many Unhappy Returns” (Harvard Business School Press), former Internal Revenue Service Commissioner Charles Rossotti warns we are approaching a tax administration crisis. He estimates that in 1999, the IRS was only able to collect about 17 percent of the $277 billion that corporations and individuals failed to pay that year, leaving $230 billion uncollected.

Recent data from the Commerce Department suggest tax evasion has risen since 1999. Commerce annually publishes data comparing adjusted gross income paid by governments and businesses (wages, pensions, interest, dividends, etc.) with the amount reported by individuals on their tax returns. The gap between the two is the best measure of tax evasion.

In 2002, the latest year for which there is data, there was almost $1 trillion paid out that was not reported by individuals. Were all this income taxed at the average individual income tax rate of 14 percent that year, the federal government would have collected an additional $135 billion. And this is a low estimate, since much of the income not reported was undoubtedly by people in brackets well above 14 percent.

More worrisome is the rise in the tax gap to 13.7 percent in 2002 — the difference between the IRS and Commerce income measures as a share of the Commerce figure. This is the largest figure recorded since the beginning of data collection in 1959. It was only 10.7 percent in 2000. The AGI gap averaged 11.4 percent in the 1990s and 11.9 percent in the 1980s.

The flat tax is not a cure-all for tax evasion. But the Russian example shows it can help a lot. When people perceive the tax system as fundamentally unfair, because everyone seems to pay different tax rates on similar incomes, it diminishes any guilt taxpayers may feel about underpaying taxes.

Too often in Washington, tax fairness is defined solely in terms of what economists call vertical equity — whether the rich pay more than the poor. But horizontal equity — treating equals equally — is much more important for tax compliance. When there is a single tax rate, people are more confident their neighbors pay the same tax they do. This boosts compliance.

It also improves compliance when the IRS doesn’t need to know as much about the nature and timing of taxpayers’ income. Since all income is taxed the same, there is no incentive to convert wages into capital income or shift income from one year to another, for example.

Lastly, it should not be forgotten a flat tax is the revenue-raising system most compatible with human freedom. As University of Chicago law professor Richard Epstein recently put it, “It is no accident that every strong defender of limited government has gravitated toward the flat tax.”

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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