Could the World be Flat? Simulating Flat Tax Reforms in Western Europe

Abstract

The flat tax idea has given rise to an ongoing debate both in academics and politics. Further on, it has recently been very successful, especially in transition countries in Eastern Europe. Although flat taxes are high on the political agenda in various Western European countries, they have not been implemented in these grown-up welfare states. The introduction of a flat tax with a basic tax allowance, a low uniform marginal tax rate, and a broad tax base as a reform of existing tax systems is supposed to have several advantages. Most importantly, positive effects on employment and GDP as well as reduced tax distortions are expected. In addition, flat tax reforms are thought to reduce administration and compliance costs as well as incentives for tax avoidance or evasion. However, the distributional effects seem to prevent a flat tax adoption in democracies with a well-established middle class. The motivation of this book is to identify hereby the driving forces behind the economic effects of a flat tax reform. There are two dimensions to be considered that are mutually interdependent: the details of the reform and the environment of its implementation. First, the flat tax design (e.g. parameters such as marginal rate and allowance, tax base simplification or cash flow corporate taxation) plays an important role for the results. Second, the results crucially depend on the country under observation. The underlying income distribution and demographic structure as well as the institutional background (i.e. the tax benefit system, welfare state) are decisive for the outcome of such a reform. The present book contributes to the existing literature in various ways. First, we provide a comprehensive survey of the state-of-the-art in simulation modelling for the ex-ante analysis of tax reform proposals. Second, we analyse and compare different types of welfare states and tax benefit systems especially with respect to the distribution and redistribution of income to explain differing results across countries. Third, we conduct an extensive analysis of the key sources of the economic outcomes of flat tax reforms. For this purpose, the extended methodology of simulation analysis is applied to analyse different hypothetical flat tax scenarios and the impact of their key elements (tax base simplification, marginal tax rate and basic allowance) on equity and efficiency for Germany and the other EU-15 countries in a common microeconometric framework. The analysis differs from the existing literature mainly by analysing the distributional effects as well as the effects on welfare and employment in a uniform simulation model and by applying a systematic approach for choosing the flat tax parameters. As stated above, the aim of this book is to identify the conditions which mainly influence the economic effects of a flat tax reform. The setup of this analysis is as follows. Chapter 2 introduces the methodology. Chapter 3 analyses the relevance of the flat tax design. In chapter 4, the European countries are compared regarding their institutional background and the underlying income distribution. In chapter 5, the role of these country specific aspects and their impact for possible flat tax reforms is investigated. Chapter 6 draws conclusions. At last, what can be learnt from our analysis is that the flatness of the tax schedule itself is not a key feature of the economic success of a tax reform. Other elements (simplification, increased compliance, corporate taxation) play a more important role. However, a flat tax reform can indeed overcome the fundamental equity efficiency trade-off. This is only true in two specific cases: first, for Mediterranean countries with highly polarised income distributions, and second, for Germany in the long-run if accounting for general equilibrium effects. Therefore, due to its adverse short-term distributional effects, the chances that the flat tax idea will invade the grown-up democracies of Western Europe are rather low. However, a further movement towards lower (marginal) tax rates with broader and simpler tax bases shall be observed. This, however, could eventually lead to tax benefit systems moving closer to linearity, albeit without an actual flat tax schedule.