Why nations settle for flat tax rates

EXPERT EYE

It is usually a politician's delight to satisfy some social groups or the other by granting exemptions or lowering rates of duty for goods usually bought by them.

It is their favourite misconception that lower duty rate for goods usually bought by the poor would bring progressivity to the tax structure.

Politicians tend to think that the public will acquiesce to a value-added tax (VAT) more easily, if products consumed by the lower-income households attract lower rates than products consumed by the better off.

It is not so commonly realised that introducing more tariff rates is complicated, the administrative cost increases and even the welfare effect is compromised. The fact is that a departure from uniform rate of VAT does engender complications and costs for the tax administration and the taxpayers alike.

Historically, therefore, the trend has been for countries to more often have multiple rates than single rate. In 1997, multiple rates were prevalent in 11 out of 12 countries in Europe, six out of nine in Latin America and one (Israel) in West Asia.

From 1985 to now, the European Countries (EU has 25 countries) have not moved towards single rate. Only Denmark and Slovak Republic have a single rate, while 24 others have two, three or four rates.

Now the trend has changed and in some large countries and many small countries (economies) the trend has been towards a single rate. In 2001, out of 125 countries, 68 countries had a single rate.

And in 2005, out of 141 countries there are 76 countries having single rate. Zero rate, that is exemption, is, however, not a rate since some exemptions are there in all countries. So about 54 per cent countries are having single rate taxation from 2001 to now.

This is what is known as the flat tax revolution. It started as a single rate of income tax in Estonia and is now followed by nine countries in EU and Russia. This, apart from Hong Kong and Singapore, which are usually not counted as examples being island countries.

Amongst the single rate, or flat-rate, VAT countries, most are small economies of Asia, Africa and islands but the well known and big economics include Denmark, Canada, New Zealand, Japan and Australia.

The flat tax revolution has become such a success due to the overwhelming reasons in favour of a single rate (with few exemptions). The reasons are the following:

Multiple rate structure and exemptions distort both consumer and producer choices.

Traders may mark up low-taxed items to cross-subsidise higher taxed goods.

Some countries already subsidise essential goods such as food, electricity, fuel, health care and public transportation. It does not make sense to lower the standard rate thereafter.

A lower rate of tax reduces the tax base and, thereby, makes the total collection less. This may end in the government increasing the standard rate.

Once a lower rate is given to some, others will clamour for the same saying that they also deserve it.

For traders, simplicity of tax and, consequently less documentation, is a great virtue.

Multiple rates lead to interpretation problems so far as applicability of rates to similar items are concerned.

The tax base is eroded.

It is an inefficient way to protect the poor as it also benefits the rich.

The conclusion is that the welfare gain of an equalised tax rate is compromised rather than increased by rate differentiation. The arguments are overwhelming in favour of a single rate of VAT with zero rates for export and very few exemptions.

smukher2000@yahoo.com