The flat-tax revolution

Saturday, 9th July 2005

George Osborne on the lessons we can learn from Eastern Europe

What is a flat tax? In its purest form, a flat tax charges the same rate of tax on all income. All exemptions and allowances are scrapped. Simplicity reigns. The idea of a flat tax is not new to Britain. The Channel Islands and Hong Kong have had one for decades. But in recent years there has been a flat-tax revolution in Central and Eastern Europe. Estonia began the revolution by introducing a flat tax in 1994. As I saw for myself, it has played a key role in a liberal, free-market economic policy that has achieved high growth rates and attracted substantial foreign investment. Since Estonia took the lead, Lithuania, Latvia, Russia and Slovakia have followed suit, and Poland is set to join them. In fact, the competition from these neighbours means that Estonia is now cutting its flat-tax rate to 20 per cent.

Flat tax scores highly on the age-old principles of good taxation, famously laid down by Adam Smith, who said that taxes should be efficient, transparent, simple and fair. They are easy to collect. The amounts charged are predictable. The burden on companies and individuals is low. The economic benefits follow: the deadweight cost of the tax system falls, competitiveness improves, and incentives to work increase as you keep more of your earnings. The result is that tax revenues can remain surprisingly buoyant even as tax rates fall.

There is now a growing body of opinion that would like to see Britain adopt a flat tax. Once the preserve of right-wing think-tanks, the idea is starting to catch the wider public’s imagination. Gordon Brown should take the credit for this vogue. For as Chancellor he has introduced a mass of complexity to our tax system that was not there before. Tolley’s, the accountant’s guide to tax law that is published annually, has grown in size by more than 30 per cent since he took office — and the whole book now has to be produced in a smaller print size to fit in all the complex changes to the tax system. So no wonder people are crying out for something that will cut through the thickets of our tax law. ‘If countries like Estonia and Poland can do it with a flat tax, why can’t we?’ they ask.

Of course, we are not comparing apples with apples. What the Central and Eastern European countries all have in common is that they have introduced the flat tax into economies that did not have a long-established income tax system. They started with a fairly clean slate, while in Britain we have a direct tax system that has developed since Pitt the Younger had to finance war with France. There are established exemptions, such as tax-free savings for pensions or tax-free donations to charity. This makes life a lot more complicated. Conservatives should not balk at looking for the right solution just because it is difficult. We must be clear, however, that introducing a pure flat tax into the UK would mean having to overcome some major obstacles.