The Economic Jerry-built of Optimal Taxation: Progressive vs. Flat Tax


This essay, as shown by the title itself, represents an invitation to the so full of passions and controversies taxation area. The idea is to discover the economic science potential to „prescribe" an optimal taxation, both in taxation system (progressive vs. flat tax) and in taxation burden. I am going to demonstrate the myths of many popular ideas from the economic theory and public opinion: on the one side, that flat tax is the best way against fiscal discrimination and welfare redistribution in society, and on the other side, that flat tax is the modern source of economic prosperity. But, to consider the optimal taxation problem, an historical and scientific analyze of the tax nature is needed. As any other social product, taxation must be considered, first of all, from ethical point of view. Thus, only by subordinating the efficiency criteria (how is better?) to the ethical criteria (how is just?), the scholars are able to get the correct knowledge. So, we recognize that any fiscal arrangement involves, every time, discrimination and wealth redistribution. In Murray Rothbard's terms, „Our conclusions are twofold: (1) that economics cannot assume any principle of just taxation, and that no one has successfully established any such principles; and (2) that the neutral tax, which seems to many a valid ideal, turns out to be conceptually impossible to achieve. Economists must, therefore, abandon their futile quest for the just, or the neutral, tax". The entire public debate is concentrated on demonstrating the superiority of a certain taxation arrangement. In other words, which taxation system is the best, the one based on progressive taxation or the flat tax one? I'm going to demonstrate that choosing between them is, in fact, a false problem. In all these debates over the taxation nature, the so called specialists neglected the essential element: the overall tax burden on the economy. The real problem does not refer to the way of taxation, progressive or flat, but to the fiscal arrangement that socializes less private property, to stimulate the capital accumulation, investments and entrepreneurship. The article's motto is: "The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing". It shows that, in order to obtain economic prosperity, what is really important is how many feathers are plucked - the general tax burden - and not the method the goose is plucked - the taxation nature.

The “tax as exchange” has been forever the favourite discourse of political elites engaged in and advantaged by the consolidation of state. Illegitimately invoking the “efficiency criterion” the government decides that it has to increase a certain tax or to change the fiscal regime, for the “good of the economy”!! But who is in fact “the economy”? Personally, I do not know this person in order to acknowledge whether the governmental policies hurt it or advantage it. In reality, the economy is a system of voluntary interactions between the owners of legitimate property rights. In the architecture of this very system, governmental policies do nothing else than to divide advantages for some and disadvantages for others, and thus the inherently conflicting nature of all the arrangements based on coercion and implicitly lacked of logic and legitimacy.

It is easy to admit that fiscal policies divide the society in two great competing social categories, as John C. Calhoun has proved in his Disquisition on Government. Even if, formally, we all have the quality of “tax payers”, from an economical point of view however some of us are more tax payers than the others. I am talking, on one hand, about those that earn their revenues in the private sector (the net tax payers), who are dependent on the market, on satisfying the needs of the consumer. On the other hand, I am talking about those that receive their revenues from the public budgets (the net consumers of taxes), as well as of those whose revenues come from the “businesses” with the state, that are not subordinated to the market but to the preferences of the state bureaucracy[i].

Actually a lot of economists are attracted by the idea of flat tax. They consider that the system of progressive taxation, through its high margins, taxes in a discriminatory manner, discourages investments, creates unemployment and brakes economic growth. The standard argument for the flat tax belongs to Robert Hall and Alvin Rabushka. They show that the economic advantage of the flat tax stands in the imposition of a lower tax level, aimed at offering incentives for savings, capital formation and entrepreneurial activity, which would in turn bring about an increase in economic performances. This does not mean that flat taxes can eliminate the depressive effect that, in general, any tax rate exerts over production[ii].

In today’s economy which is increasingly characterised by the intensification of the globalization phenomenon, both employment and capital migrate towards the jurisdictions in which the fiscal weight is as small as possible. This fiscal competition is the institutional phenomenon that raises serious barriers against the state’s power of taxing and regulating. Paradoxically, in the end, the market is – as we can see – the one that establishes constraints to the state[iii], not the constitutions, or, equally false, the political persons and the governmental bureaucracy.

In this context, for the object of our analysis two phenomena are significant: (1) the systematic reduction of the taxation level; (2) the extension of proportional taxation that is the adoption in numerous countries, especially in Central and Eastern Europe, of the flat tax system. There are numerous illustrative examples in order to consider that in this respect we are talking about a global tendency.

For example, for 26 OECD member states, the average of the biggest three profit tax rates has decreased from 41% in 1986 to 32% in 2000. Even if the IMF has systematically pretended that small taxes are “mean” for the budgetary equilibrium and implicitly for the economic performance, it also proves that the economies with lower fiscal rates benefit of more foreign direct investments than those with a higher one. For example in the period 1996 to 2000, four European countries with the most favourable fiscal regimes – Ireland, Netherlands, Luxembourg and Switzerland, which account for only 9% of the European GDP – have attracted 38% of the American investments in Europe. Moreover, Ireland is the state that established the trend towards fiscal relaxation in Europe through reducing the general tax level from 35% in 1989 to 22% in 2001, the net profit tax being actually of just 12.5%. It is notable that through consequently implementing the pro-market policies, Ireland became the country with the second per capita income and with the lowest tax level in the EU.

In the same time the fiscal reforms started to be affected, more and more often, of the “fiscal revolution” of the flat tax. Estonia was the first European country to adopt, in 1994, a flat tax of 26%. Following suite was Latvia, in 1995, and then Russia in 2001 and Ukraine in 2003. Actually, nine countries in Central and Eastern Europe have proportional tax rates, with rates being differentiated or not between the tax on individual income and the profit tax, as follows: Estonia – 24%, respectively 24%; Georgia – 12%, respectively 20%; Latvia – 25%, respectively 15%, Lithuania – 33%, respectively 15%; Romania – 16%, respectively 16%; Russia – 13%, respectively 24%; Serbia – 14%, respectively 14%; Slovakia – 19%, respectively 19%; Ukraine – 13%, respectively 25% (Edwards, 2005). Professor Alvin Rabushka from Stanford University, one of “the parents of the flat tax” appreciates that this is just the beginning. It is still to be seen to what extent these tax rates will resist the European Union pressures to hamper fiscal competitiveness, since the European harmonization looks more and more like a fiscal cartel.

In this context, two comments are relevant.

First of all, in order to increase the business environment’s appeal through reducing taxation and in this way to also decrease the basis of taxation, the flat tax is not the only solution. It is true that almost all the proposals for introducing the flat tax envisaged, at least at declarative level, the decrease of fiscal weight borne by the tax payers. However, it is equally true that the decrease of fiscal weight can take place through the level of progressive taxing too. How can we imagine that today’s American politicians, and a lot of others, would be eager to return to the fiscal model existent at the beginning of the 20th century? In the United States, the introduction of the federal income tax, in 1913, had marginal rates ranging between 1 and 7%[iv].

Secondly, we have to say that the beginnings of taxation can be traced back, from a historical point of view, in the form of “flat tax”. For centuries, until the social-democratic invention named the “welfare state”, the redistributive state, taxation took place as a flat tax. For example, in the feudal Europe in which the feudal pact defined the social reports between landlords and peasants, the taxation was the confiscation of a specific proportion of the agricultural production from the peasants. This process seems to represent the fiscal ancestor, much milder, is true, of today’s flat tax. More than this, the “revival” of the flat tax in our days does not change the coercive nature of taxation.

Let’s remind the fierce controversies that took place in the last years in Romania regarding the “fiscal revolution” of the flat tax. Progressive taxation versus flat tax, this was the new dilemma that challenge the imagination of both economic analysts and mass-media commentators. Moreover, the majority of the political class and of state representatives, that learned relatively easy how democracy works, promised that this change would bring about the economic boom and the prosperity to which Romanians were dreaming about.

The entire public debate thus becomes focused on the concerns to show the superiority of a specific fiscal arrangement. In other words, what fiscal system is better, the one which is progressive, or the flat tax? In this sense I will show that the “choice” between progressive and proportional taxation is in fact a false problem. Let’s first of all see which the mainstream opinion is regarding the flat tax and the main arguments invoked in favour of this.

In concordance with the popular conception, when answering the question “What is the flat tax?”, Daniel Mitchell (2005) describes this fiscal regime as being a “simple, honest one […] that treats all tax payers equally”. However, recognizing a plus of administrative simplicity does not justify the economic and ethical sharing of the other attributes of the flat tax.

As we have already seen, economic theory and political philosophy teach us that, from a scientific point of view, we can argue that any tax, whatever its level or nature, is a fair one. What, and for whom, can something be honest in an action which is not based on the free agreement, but on violence and coercion? Thus it would implicitly result that it is fair, that it is ethical that the one that is opposed to any requirements of the state over the outcome of his work to be imprisoned on these grounds. This would mean that any decision (to be read “dictatorship”) of the majority is an ethical, correct one. In reality we find ourselves in the impossibility to scientifically validate state’s actions, both through the illusory argument of efficiency and through that of ethics (Marinescu, 2005). Thus, no fiscal regime can treat “all tax payers equally”[v], so no fiscal regime can pass the neutrality test.

In the midst of these debates over the nature of the fiscal regime, “specialists” neglected the essential element: the general fiscal weight. The true problem does not regard the taxation method, being it progressive or proportional, but the fiscal arrangement which “socializes” the least private property. In other words, in the context of the fable used as a motto, we have to be interested more in the number of feathers that are taken away (the general level of taxation) not in the manner of taking them away (the nature of taxation). It is thus a thing that is related not only to ethics, but complementary, to efficiency.

Numerous famous economists, among which Friedrich Hayek and Milton Friedman, as an example, argue that the flat taxation rate has important advantages resulting from the lack of discrimination between individuals, discrimination that is inevitably made by the progressive taxation rate. It is like you would pretend that the uniform expropriation would be more ethical than the discriminatory one; in the last instance, for a healthy flight of the goose, for favouring its prosperity, it is important for it to be left with as many feathers as possible.

In which regards the source of economic prosperity, arguments cannot be reduced only to the common numeral of the “flat tax”: the real source of prosperity does not lie in itself in the flat rate, but in reducing the level of taxation. The fact that in general the flat tax is associated with a lower level of taxation does not mean that, necessary, the proportional taxation attracts a decrease in the fiscal weight. The establishment of a flat tax, for example less than 20% does not have any value in itself. We can imagine flat taxes established at 50% or even above this level – this is what is taken from the tax payers in the present welfare state from Occidental Europe.

This is the reason for which a progressive taxation with tax rates ranging in between 1% and 7%, as in the beginning of the 20th century United States, is preferable to a flat rate of 16%. Thus, depending on the general taxation level, the progressive fiscal regime can be more favourable to capital saving and to investments than the proportional one. It is the same thing with saying that the budgetary deficit can be more advantageous for the economic progress than the budgetary equilibrium. Certainly, it depends on what is level of the budget at which the deficit is realised, respectively the level at which the budgetary equilibrium is realised: for example a deficit of 1% of GDP – when the budget represents, let’s say, 20% of national production – is a situation preferable to a budgetary equilibrium which would manifest at a level of 60% of the same national production.

To conclude, the decision of government officials to tax progressively or proportionally is irrelevant from a scientific point of view. The problem is in fact one of non-scientific nature, being about an exclusively political decision. However, through the complicity of “scientists” the political problems – regarding the maintenance or the gain of political power – fraudulently gain scientific pretences. What can be scientific in building up policies that offer institutional incentives for some at the expense of others?

The economic calculus argument shows the relativist, arbitrary character of whatever fiscal policy. What is the reasoning on whose basis the government proposes a flat tax rate of 16%? Why not 16.5% or 20% or 10%? Which are the calculations that are generally used in establishing the tax rate? Is it about that optimum tax rate that makes the economy “work” best?

The fiscal options of governments that adopted the flat rate show us the great diversity of the tax rates used. Fuelled by electoral problems, everywhere we assist at successive reforms of national fiscal systems through which politicians seek to give value to the economic conjecture in which they find themselves. Thus, the choice of fiscal regime cannot be subordinated to an objective scientific reasoning based on the universal laws of economic science. This option is a political one, as professor Alvin Rabushka recognizes in an interview given after Romania announced the adoption of the flat tax rate starting with the 1st of January 2005[vi].

In the end the option for a certain fiscal regime is not and cannot be an objective, scientific one. It is not about ensuring the “good functioning” of the economy or about reducing the costs of collecting the taxes, as the fiscal authorities often advocate. Only in the sphere of private property there may be an interest for saving costs because only under market conditions the irrationality is penalized through losses and eventually through bankruptcy. Unfortunately, we cannot image how a government can go bankrupt due to… high tax collection costs!!

Some economists consider that as long as the reasoning of taxation is that of providing the means for financing public goods, then the fiscal regime should be subordinated to the necessity of providing these goods. For example, Richard Epstein shows that taxation has to be rather proportional than progressive due to the fact that people do not benefit of public goods other than progressively.

However, if the “public goods” logic of reasoning is continued until the end then the solution should be another one. Its deduction is based on the very economic nature of public goods: their utilisation of a person does not reduce the availability of these goods for other persons belonging to a community. Thus, we can pretend by using the attributes of non-exclusivity and non-rivalry of public goods that no one benefits to a higher extent than others of national security and defence, public lightning, radio waves spectre, etc.

In this situation, a “more correct” financing of public goods couldn’t be a unique tax as a lump-sum tax? The answer is yes since the usage of public goods is not made progressively or proportionally with the income of each person[vii] but identically by everybody. How can we thus compute under these conditions the taxes that the government should extract from everybody? Nothing simpler than this: by dividing the production costs of the public goods to the number of persons that belong to that community.

The public choice theory shows that the rules of the democratic game give incentives to the government officials to maximize the advantages resulting from increased public spending, sometimes at the expense of economic development, as economic history shows. This is the reason for which governments spend the maximum of resources they are capable to cash and even more, through systematically creating deficits and public debts. Anew the fiscal regime is inevitably subordinated to the discretionary budgetary needs and to the political interests, in a world in which the majority of economists continues to illusory talk about “optimum”.

There is no such thing as an “optimum” regarding the relative dimension of the public sector. The admirable argument of Ludwig von Mises regarding the impossibility of economic calculus in socialism represents the basis of this explanation, since the public sector is indeed an “island of socialism”. In the absence of markets and prices, the allocation of “socialized” property through state budgets is a political one, decision whose viability with respect to people’s needs is impossible to verify. The size of the public sector cannot be given dimensions by using “productivity calculations” (economic ones), but it can be manipulated depending on the interests and the political programs that are thought to be winning (electoral calculations).

[i] Through an exemplary logical exercise, M. Rothbard (1970, pp. 141-62) proves the impossibility of any fiscal regime to be neutral. He shows that governmental bureaucracy falls into the category of net consumers of taxes, because it cannot pay taxes. It is an inherently impossible fact for a minister, for example, to pay a tax on its wage as a minister as anybody else does. If the minister has a gross salary of, lets say, 4000 Ron a month and gives back to the government 16% from the gross amount, this does not mean that he is paying taxes “as anybody else does”. It is in fact a simple accounting regulation between the government bureaucrats and the state budget, having the value of 640 RON/month. This has no economic importance: what really matters is that the respective minister obtains 3.360 Ron/month from the fiscal collections of the state budget, taken from the net tax payers.

[ii] Talking about the taxation problem, the representatives of supply economics argue for the introduction of a fair tax rate!!! Without showing which tax rate can be fair, they appreciate that such a tax rate would contribute to (1) stimulating production and (2) providing some maximal fiscal revenues for the government. However, these two aims of fiscal policies are virtually incompatible. The increase in tax collections cannot do anything else but to attract the extension of the role of the state in an economy, which would contradict the „liberal” program of development to which the supply economists adhere. This approach did not bypass Romania; together with the introduction of the flat tax rate, the finance minister showed that a decrease in taxes is the best way for increasing the state budget. What a liberal politics!

[iii] Even the nature of the market is the one that imposes these constraints. The market means private property rights and, implicitly, freedom. Thus, the market appears as the natural institutional arrangement of social order, of civilization and prosperity.

[iv] As James Gwartney and James Long show („Is the Flat Tax a Radical Idea?”, Cato Journal, vol. 5, no. 2, 1985, p. 407-32), at least one senator voted against the introduction of the tax, because he was afraid that one day the marginal rates will reach a level of 14%, that is a level considered to be restrictive. In the same context, as I have shown in „Institutions and prosperity”, the French economist Paul Leroy-Beaulieu argued in 1888 that taxing national production with 12% is too much and susceptible to hamper economic growth and liberty. Four decades later, even Keynes pretended that a fiscal rate of 25% represents the maximum degree of tolerance. However, they have not seen anything that was to follow in the second half of the 20th century.

[v] The equal treatment of all individuals in a society would exist only if all individuals in the society would gain their revenues through “economic means”, that is through their affirmation in the division of labour, through production and exchange of legitimate private property rights. However, this condition is incompatible with the very existence of the state: in the virtue of the later, as John Calhoun shows, society is divided in the category of the governed (the net tax payers, those that form the private sector) and the governors (the net consumers of taxes, those that account for the public sector). The political governance is nothing more than the existence of the social division of labour that is a social relation between equals. The existence of persons that live on the basis of the taxes that others’ pay shows that taxation is incompatible with the equal treatment of everybody. Obviously we can imagine an equal treatment of tax payers, but not of all of then, but of the net taxpayers that are bound to pay a flat rate.

[vi] “Professor Rabushka shows that certainly, if 16% is too low and thus it does not manage to generate the required income it is more a problem of controlling public expenses than a problem regarding the option for a certain level of taxation”. It seems that, in this conception, the actual fiscal trend is to adapt the level of taxation at the pre-established level of public spending, designed to “satisfy” the majority of the electorate. The Romanian government confirms that the fiscal reform that starts with reducing public spending in order to further on healthily reduce taxation levels has presently become outdated (or non-electoral?)

[vii] Through their nature public goods cannot be „consumed” progressively or proportinally with the income of individuals. Individuals cannot choose, for example, to fall into the scope of armed forces or public lightning in a manner that is progressive or proportional to their incomes, such that to justify progressive or proportional taxation for financing these kinds of services.






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