“Flat tax” a hot issue in German elections

Eleven Eastern European economies have shown the way. The former Estonian Prime Minister Mart Laar was the first to introduce in 1994 a flat tax rate on personal income that will gradually be lowered to 20% by 2007. Russia followed in 2001 by implementing a flat tax of 13% for individual incomes and 15% for most business income. In January 2004, Slovakia introduced a flat tax rate of 19% on personal as well as corporate income.

Flat tax systems have proven to be more equitable than systems of progressive taxation, because they do away with complicated systems of tax holidays and special tax regimes. In Slovakia, for example, former tax policies favoured certain businesses and industries. They provided tax incentives for job creation, foreign direct investment and investment in certain assets. As a consequence, Slovakia experienced a high tax-rate environment with overly complicated rules for taxes and allowances. Moreover, the system was riddled with poor targeting of the tax relief measures, moral hazard and many unintended consequences that caused an ailing economy.

In 2004, Slovakia introduced tax policies based on simplicity, neutrality and transparency. The new priorities were tax reductions and the introduction of a flat tax as well as the elimination of tax holidays, tax relief and special tax regimes. Today, public tax revenues remain at about the same level as before the reforms. The OECD, however, recently acknowledged that the expansion of domestic demand that began in the first half of 2004 has gathered pace, and the GDP growth is expected to remain in the 4¾ to 6% range until 2006. Meanwhile, employment growth has disappointed, and the unemployment rate is not expected to fall below 17% until late 2006.

Slovakia has attracted the investment of sizable foreign companies, like Sony, Volkswagen and Peugeot-Citroen. Other Eastern European countries are also experiencing higher growth rates than the old European member states and challenge them with their more competitive systems of taxation. This caused much concern in Western Europe. Germany’s Chancellor Schroeder and the French Finance Minister Nicolas Sarkozy criticized Eastern Europe in 2004 for attracting investment through their lower taxes and called for sanctions that reduce EU transfer payments to these countries. Their effort to pressure the new EU members back into higher and ineffective tax regimes and to also stifle tax competition within the EU was finally rejected by the European Commission.

Meanwhile, the British opposition has engaged the government in a discussion about the flat tax. The British Chancellor of the Exchequer Gordon Brown recently rejected the idea together with a research paper by the Treasury, which suggested there could be an “economic mini-boom”, if a flat tax were introduced. The paper, which was first censored by the government but then leaked to the Daily Telegraph, noted that under flat tax systems in other European countries the rich end up paying a larger share of total tax revenues. Moreover, in flat tax countries, taxpayers in the highest brackets move from consumption or tax-sheltered investments to more productive, taxable investments, which ultimately benefits growth and development.

The upcoming elections in Germany have now triggered a heated debate whether lowered or even flat tax rates should be introduced in Germany. In the last decade, Germany’s economy has grown only 14.6%, while the rest of Europe saw an average growth of 24%, the US grew by 39.9% and the world economy by 45.6%. Germany’s government expenditures and the over-regulated labour market are the main reasons why the country has not been able to tackle external shocks, like re-unification, globalisation, EU-enlargement etc.

Prof. Paul Kirchhof, former judge of the German Constitutional Court and the fiscal expert in the oppositional CDU “team of competence”, a sort of shadow cabinet, calls for tax reforms as a remedy for the German malady. He suggests a simple and transparent tax system with a flat corporate and personal income tax of 25% as an instrument to trigger corporate investment and increase employment in Germany. In addition, he calls for the abolishment of 418 tax exemptions.

The current German system levies a minimum tax of 15% on annual incomes beyond 7,664 Euro. Above that, levies progressively rise to a maximum of 42% on incomes higher than 52,151 Euro. Within these margins there are several tax exemptions and tax relief measures for certain businesses and for social reasons promoted by the government. At first glance, it seems fair and just to put a higher burden on those who earn more and to put those investors at an advantage, who put their money into either small or future-oriented businesses or who invest with a social cause, e.g. raising employment of disadvantaged people.

So why do away with this system? Well, first of all there are hardly any Germans who actually pay the maximum tax rate. They can afford highly paid tax advisors who help them think of strategies to circumvent taxation, precisely by consumption or tax-sheltered investments as stated in the mentioned report of the British Treasury. The influential political magazine DER SPIEGEL, usually in support of social democratic visions of society, has positively covered the Kirchhof model and actually calculated that the lower income groups would benefit most, while those with higher incomes would face the extra financial burden under the flat tax system.

With a flat tax system in place, the employment of handicapped people as well as other social objectives would in future not anymore be achieved through tax preferences. In fact, fiscal policies are in principle not supposed to aim at non-fiscal objectives, because this usually causes distortions and inefficiencies. There are many other ways to create favourable conditions for the socially disadvantaged than by creating fiscal incentives for investors. These ways need to be identified and corresponding policies need to be formulated. The CDU has announced in its campaign agenda it will keep the progressive taxation system, but lower the margins to 12% and 39%. According to leading party members, like the Chief Minister of the State of Saxony, a flat tax could anyway not be implemented in the expected first term of a CDU government.

Nevertheless, Kirchhof’s suggestions caused a heated debate in the German media. Over night, the flat tax has been made part of the political discourse in Germany. Those who are generally supporting the agenda of a lean state celebrate Kirchhof as the courageous visionary the republic has long been waiting for. Meanwhile, the Social Democratic government has found the long awaited issue to hammer the opposition for supposedly unjust policies in favour of the rich. Days before elections, a poll showed the “election battle over Kirchhof” (SPIEGEL) caused the CDU to fall 1.5 points to 40.5% while the Social Democratic SPD leapt 3.5 points to 34%.

The Slovakian father of the flat tax, Deputy Prime Minister Ivan Mikloš, has much experience with introducing unpopular reforms. In his view, introducing reforms provide the government a chance to trigger the required change, and this may ultimately cause the popularity of the government. In Germany, government and opposition are far from being popular and even further from introducing unpopular reforms. Nevertheless, the flat tax has now been the talk of the town. Some look to its successful implementation in Eastern European countries like Slovakia. They think it could be the cure for the German malady. Others are afraid it will sacrifice Germany’s “cautious, consensual welfare capitalism” (The Economist). After all, it is going to be the German voter who will decide on 18 September.