The Greek tax system is particularly complex, suffers from lack of transparency, is conducive to noncompliance and—since the tax burden predominantly falls on those who cannot evade or (legally) avoid—it is also unfair. Christos Kotsogiannis discusses a reform for personal income taxation in Greece and advocates ‘flattening’ the personal income tax. He argues that a flat tax system can reduce the existing distortions, increase tax compliance, and therefore, tax revenues. The distributional effects of flat taxes are not necessarily regressive (as political rhetoric might argue). Allowing for the impact of those taxes on compliance they can even increase progressivity.
The full article of C. Kotsogiannis:
As Greece looks to address its fiscal deficit through the tax system, and boost growth, getting the tax system right (levels of tax rates, structure, and compliance) should be high on the structural-reforms agenda. The reason for this is simple: The Greek tax system is particularly complex, suffers from lack of transparency, and is conducive to noncompliance. Since the tax burden predominantly falls on those who cannot evade or (legally) avoid, it is also unfair. In short, it has all the characteristics that a tax system should not have!
It is tempting for one to ask the question ‘what is the best tax system for Greece?’, but for the purpose of the present discussion such a (challenging) issue will not be addressed here. Instead, I will focus on one particular aspect of the tax system, that of personal income taxes, and advocate that income taxes should move towards the ‘flat tax’, in the sense of moving taxes towards a single strictly positive marginal tax rate on income, over and above the tax free threshold. It is worth stating from the outset that I will not discuss the need to intensify and rationalise the tax enforcement efforts. This is taken as given!
Why a flat tax? The optimal tax literature offer some advice on how to design a tax system that minimizes economic inefficiencies, taking into account redistributive considerations, but, unfortunately, does not allow for sweeping generalizations as there are inherent limitations in all theoretical frameworks. Nevertheless, several economic arguments emerge from the literature which are supportive of a flat income tax structure. It is argued that a flat tax:
- Substantially reduces the cost of administration: The direct cost of administering a complex tax system is enormous. By simplifying the tax code there are significant savings in administration to be made. It also decreases the direct cost to consumers by making tax filing less complicated.
- Lowers the tax burden and so improves allocative efficiency: Empirical evidence suggests that personal income is very sensitive to taxation–particularly so in economies plagued with tax evasion—and, therefore, high income taxes result in significant deadweight losses. In addition, lower taxes in the upper part of the income distribution will improve labour force participation of the high skill individuals.
- Increases reporting of income and, therefore, is conducive to tax compliance: The elimination of loopholes through a simplified tax structure reduces the marginal benefit from evading taxes. Simplicity of the tax system reduces also the possibilities of collusive behaviour between tax payers/tax professionals and the tax authorities. It also reduces extortion practices in tax collection between the tax authorities and tax payers.
- It reduces government corruption[i]: If the government is in pursuit of self-interest, acting as revenue-maximizes, the tax system is designed overly complex with a complicated pattern of marginal tax rates, exceptions and loopholes. Restricting the tax system into one marginal tax rate limits the amount of revenue that is being wasted.
A flat(ter) tax structure, therefore, can potentially increase tax revenues. While lower tax rates tend to reduce revenues, an increase in compliance responses, a reduction in corruption, and an improvement in allocative efficiency, can have a significant impact on the tax revenues. A flat income tax requires not only flattening of the tax schedule but a reduction in rates (both average and marginal) in the upper part of the income distribution. Because of this, it appears to be widely presumed—and quite often this is, unfortunately, part of the political rhetoric—that flat taxes are less progressive than taxes ought to be and so they are less ‘fair’. This is misleading: A flat tax is not necessarily less progressive than the one it replaces. The key to achieving progressivity is not only in the tax rates but also in tax exceptions (for the wealthy) and so in the overall design of the tax system. Progressivity can be achieved (and within wide limits) with a flat tax by simply adjusting the rate and the basic tax allowance (and, of course, closing the loopholes that now (mostly) the wealthy take advantage of). Indeed, the distributional effects of the flat taxes are not necessarily regressive. Allowing for the impact of those taxes on compliance they can even increase progressivity.
What does the recent experience of other countries teach us? It is difficult to draw on the experience of other countries as there are distinctive differences across them. There is, however, some evidence from Russia (a state where tax administration has been particularly weak), which adopted a flat tax—replacing a graduated tax schedule—in 2001. The new tax rate, at 13 percent, was close to the lowest rate in the pre-reform schedule, and the basic allowance was only marginally higher than the previous one. Personal income tax revenues grew by 26 percent in 2001, 21 percent in 2002 and 12 percent in 2003. A similar pattern was also observed for income tax revenues as a share of gross domestic product, implying that tax revenues increased faster than gross domestic product. The substantial increase in revenues came predominantly (though there was an improvement in tax enforcement too) by behavioural responses to the reduction in taxes. The magnitude of the tax-induced change in compliance was significant enough to offset the revenue loss that resulted from the lower tax rates on personal income.
What about Greece? It is difficult to advocate for a particular rate without an explicit consideration of the income distribution (and an understanding of how Greek taxpayers respond to taxes and benefits). But with the Greek income tax rates being in the range of 18-45%, a tax close to the lowest tax rate, with an increase in the basic tax allowance, could be a feasible proposition.
Looking forward it is, I think, time that Greece simplifies the income tax structure considerably and considers the flattening of the rate structure of the income tax schedule, adjusting appropriately the tax free income level. It will be, however, wrong to see the flattening of the tax rate structure as ‘the’ solution to the problem. This, however, together with the development (and, more importantly, implementation) of a credible set of tools of tax enforcement (as, for example, better information-reporting requirements and more effective audits (which may vary in probability and intensity) is a step in the right direction.
 For recent evidence on tax evasion, see the article posted on this blog (August 20, 2012) entitled ‘[t]ax evasion across industries: Some soft evidence from Greece’.
[i] This, of course, presupposes that either there are no explicit constitutional devices (or fiscal rules) that limit the behaviour of policymakers to engage in rent-seeking activities or, if they exist, they are not implemented.