Tax Break

Who said tax is boring?

Czech mate

I have just sold Czechoslovakia and this is the receipt

Slovakia spent most of the twentieth century as the hapless side-kick in a Vaudeville double act that was incessantly down on its luck thanks to British and French betrayal, German invasion, Soviet domination and Soviet invasion. When Czechoslovakia finally broke up peacefully in 1993 the junior partner had an uphill battle to establish itself. But establish itself, it did.

The masterstroke came in 2004 when the center-right government announced that henceforth the country would be subject to a Flat Tax – a 19% rate for corporate profits (but not dividends), business income, employment income  and VAT. Slovakia was not the first former Eastern Bloc country to adopt a Flat Tax – that distinction belonged to Estonia as far back as 1994 – but it was considered to be a model of success and did wonders for the reputation of Arthur Laffer and his Curve that showed the relationship between the tax rate and government revenue. The election of a centre-left government earlier this month is slated to spell the end of the Flat Tax.

The concept of a Flat Tax is a simple one – adopt a relatively low rate of taxation with a very broad tax base. The tax is defined as a Proportional Tax – you pay a fixed proportion of your income –  as opposed to the more common Progressive Tax – where marginal tax rates increase with income.

The big advantages of Flat Taxes are that they encourage foreign direct investment and sustainable economic growth while, at the same time, being more transparent, easier to administer and providing less incentive for tax evasion. The absolute opposite of this is probably the US Tax Code of which President Richard Nixon’s Treasury Secretary William Simon once commented that he wished for a system that “looked like someone had designed it on purpose”.

Marx getting a firm grip on western civilization

The biggest objection to Flat Taxes is that they do not meet the common or garden definition of “Social Justice”. Karl Marx (still venerated in North Korea and Cuba) popularized “from each according to his ability to each according to his need” and that epithet has managed to stick to the tax systems of countries whose attitudes to socialism range  from passionate love to passionate hate. But the old windbag of Highgate Cemetery did not have a monopoly on the meaning of “Social Justice” –  I believe, like Irving Berlin, that the world would not be in such a  snarl, had Marx been Groucho instead of Karl –  and there are good, if less popular, arguments for the social justice of proportional taxes.

In any event, the Occupy Movement and its various offshoots, have ensured that vote-hungry governments hammer the rich and the banks without reference to the effect on GDP and the ultimate welfare of those they seek to avenge. In the   1960’s a British Labour politician was embarrassingly caught traveling First Class on a train; he explained ingeniously- if ironically – that his party’s ambition was for everyone to travel First Class.

It looks like Slovakia is suffering from a political reality which could do very nasty things to its economy. Unlike the profligate Eurozone countries of Southern Europe, Slovakia did not get itself in a total mess over the last few years (at least not Euro -wise).  Along with everybody else, however, it has agreed to limit its budget deficit ( 3% of GDP this year, down from 4.6% in 2011). In order to achieve that it needs to either decrease government spending or increase taxation – economic growth will not close the gap in the immediate future. GDP is amongst the lowest in the Eurozone and government spending is still relatively modest –  so it is down to taxation.

But the question is – what taxation?  The  Flat Rate system in Slovakia is not a pure system – although the individual tax rate is 19% there are personal allowances a personal income deduction for non-working spouses and pensions and charitable contributions. On the other hand there are punitive social security taxes. Overall this is referred to as a marginal flat tax (or sometimes a progressive average tax rate). What seems to be clear is that whatever the reason – and some commentators have stressed the relative importance of factors other than the tax rate – the system has worked and as one top international tax expert once told me “If it ain’t broke don’t fix it”.

Will Fico take the fizz out of the Flat Tax?

The plan of Robert Fico and his center-left Smer party, just returned to power after a brief stint in opposition, is reported to be to introduce a 25% higher rate for high earners and jack up the corporate tax rate to 22% for companies with significant profits. This all fits in nicely with populist social justice arguments but risks destabilising the very system on which impressive foreign investment has been based. A former finance minister has urged him to look to taxes that do not directly affect competition – singling out excise, environmental and property taxes.

The pity really is that countries like Slovakia have to fall in with Europe’s austerity package at all. The previous government fell over its support for the European Financial Stability Fund designed to address the European Sovereign Debt Crisis of which Slovakia was not guilty. It is lucky for Europe that Mr Fico and his predecessor did not take a leaf out of  British Prime Minister Neville Chamberlain’s book. Explaining his sell-out of Czechoslovakia to the House of Commons in 1938 he said:  “How horrible, fantastic, incredible it is that we should be digging trenches and trying on gas masks here because of a quarrel in a far-away country between people of whom we know nothing”. Anybody know the way from Bratislava to Athens?

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