Flat Tax: Ideas and Interest

MEDIA CLIPPING

Open Republic Institute

Flat Tax: Ideas and Interest

What to the contemporary observer appears as the battle of conflicting interest has indeed often been decided long before in a clash of ideas confined to narrow circles.
--FA Hayek 1949

The rising tide of flat tax adoption throughout Europe is often explained as a form of contagion. In a global economy - where capital and labour can cross borders - the economic interests of competing nations impact directly upon each other.

With regard to tax regimes, a discrepancy between two neighbouring countries provides an incentive for individuals or firms to choose the more liberal rates, thereby causing capital flight away from higher tax nations. According to Wadell "pressure comes from competing economies" , and the shadow finance minister of the Czech Republic -Vlastimil Tlusty - believes that "if a neighbouring country [adopts a flat tax] it's necessary to follow suit"

This interests view of Political Science is a powerful tool to analyze the adoption of policy proposals, however it is not complete. According to Busch and Braun: "public policy is only possible within a cognitive framework that relates the goals to be achieved to the available means and other data relevant for a particular decision". This cognitive framework implies some form of epistemic choice, where ideas can be seen as constraints, or frames of reference for conflicting interest to compete.

It is easy to say that ideas matter, but quite another to discover how. This can be attempted by the concept of operational codes, which are the cognitive map that actors use to define, perceive and act upon reality. Therefore instrumental beliefs of an individual can be used as a visible proxy for their underlying beliefs. Also, epistemic communities are the associations that create, develop and diffuse ideas. Once identified, they can be analysed as an organization.

An epistemic community functions as a network of knowledge-based experts or groups with an authoritative claim to the policy-relevant knowledge within the domain of their expertise. Members hold a common set of causal beliefs - or operational codes - and share notions of validity based on internally defined criteria for evaluation, common policy projects, and shared normative commitments.

Haas (1992) uses the epistemic community approach to chart the emergence of international consensus to ban CFCs. The population of atmospheric scientists had a common causal belief (in the Rowland-Molina hypothesis) and offered a clear policy prescription to preserve the ozone layer.

Since a flat tax is an operational code closely related to other policies that promote free markets, studying the flat tax provides a terrific starting point to create a more general theory of the diffusion of ideas.
Not only does the flat tax act as a common causal belief, but is also the type of joint policy goal that makes an epistemic community easily identifiable. Consequently, if epistemic choice is an important and neglected factor in the formation of policy, then it's analysis would be most potent and powerful in the case of the flat tax.


THE ORIGINS OF THE FLAT TAX IDEA: AMERICA

The flat tax is a tribute to fiscal simplification, a principled value held and espoused by the first great economist, Adam Smith. He advocated certainty, clarity and convenience as to an individual's own burden. These concepts typify a flat tax and demonstrate the general themes of classical liberalism.

Whereas a progressive income tax includes thresholds at which marginal income is taxed at proportionally higher duty, a flat tax replaces sliding scales with a single rate. All flat taxes will offer an exemption so that incomes below a certain amount are not taxable. Deductions are often the result of special interests that inject complexity into the tax code to either encourage or punish specific types of behaviour. These can be known as loopholes - devices that let experts lower taxable income.

Income tax was introduced in Great Britain in 1842, and four years later Karl Marx called for a "heavy progressive or graduated income tax" as a key feature of a communist society. The first country to adopt a flat tax was Jersey, in 1940, and was followed by Guernsey twenty years later. The two Channel Islands that lie off the Northwest coast of France enjoy a special constitutional status, giving them a unique level of autonomy from the British government.

Hong Kong implemented a flat tax in 1947 with a dual system where citizens can choose whether to pay a flat tax (with exemption) or progressive rate (with deductions). The flat tax is seen as a facet of the liberalisation that has produced such extraordinary advances in growth and economic freedom.

In 1963 Alvin Rabushka visited Hong Kong, and remarked that:

Hong Kong was my first introduction to the real world of free-market economics. I was especially attracted to the colony's simple income tax, which imposed an effective flat rate of 12.5 percent on total earnings, later raised to 15 percent in 1966.

Rabushka would go on to write The Flat Tax in 1985, a critical catalyst in presenting the flat tax as a real policy proposal in the United States. To do so, however, he had to meet Milton Friedman: "Milton urged me to undertake studies of Hong Kong's economy" . Friedman was a pioneer of liberty in the c20th, as an academic economist and also as popular writer. According to another Nobel Prize winning economist, Gary Becker:

In the same book [Capitalism & Freedom], Friedman showed that without any change in the tax base, a flat income tax rate of 23% could bring in the same revenue as the system of rates that ranged in the 1960s from 20% to an incredible 91%. A few years later, he went further by demonstrating that the flat rate could be reduced to 16% without any diminution in tax revenue if all special deductions for mortgage interest, charitable contributions, and the like were eliminated.

Perhaps the only other c20th scholar to rival Friedman's input into the science of liberty was FA Hayek, who advocated a flat tax in his own treatise on government, The Constitution of Liberty:

Unlike proportionality, progression provides no principle which tells us what the relative burden of different persons ought to be. It is no more than a rejection of proportionality in favour of discrimination against the wealthy without any criterion for limiting the extent of this discrimination.

These dual founding members of the flat tax epistemic community had laid the foundations for studying the issue in greater detail. Their forceful and passionate establishment of principled values called for an empirical agenda that could provide causal beliefs to solidify the legitimacy of the flat tax as a policy goal. Via the think tanks and institutions that funded Hayek and Friedman - such as the Hoover Institution and the Volker Fund - this work was started. The National Bureau of Economic Research published a report on Chile that showed the flat tax reduced income inequality and increased expenditure sustainability . James Heckman and Gary Becker (who's influence from Friedman was highlighted earlier) found similar conclusions for the US and Canada .

Rabushka cemented his position within the boundaries of the community by becoming a National Fellow of the Hoover Institution in 1971, and a senior fellow in 1976. The Hoover Institution acted as a forum for him to publish books on Hong Kong, and taxation generally, leading to a film that was made by the Liberty Fund of Indianapolis, Indiana and was then shown at the 1980 Mont Pelerin Society (hosted, incidentally, by the Hoover Institution).

A critical factor in the ability to impose policy, is the access to both policymakers and the media. Rabushka was invited to serve on a tax policy task force by Ronald Reagan's chief economic advisor in 1980, and contributed to the recommendations that led to the Economic Recovery Act of 1981. Rabushka also had an article on the editorial page of the Wall Street Journal on March 25 1981 called The Attractions of a Flat-Rate Tax System, and a further article in the same publication on December 10th.

A policy maker, however, is needed to act upon a ground swelling of public opinion and that happened when Dennis DeConcini proposed a bill in congress on March 1st 1982, introducing the idea to congress. It didn't pass, but the flat tax was back on the agenda in 1994 with a bill by Richard Armey. Armey demonstrates his ideological commitment to the flat tax idea in his own book The Flat Tax published in 1996, by quoting the vision and principles of Alexander Hamilton, reminiscent of Smith:

The genius of liberty…reprobates everything arbitrary or discretionary in taxation. It exacts that every man by a definite and general rule should know what proportion of his property the state demands.
-- Armey p.7

Aside from having the same underlying principled values to Adam Smith, Armey's utilization of Rabushka's proposal shares Friedman's causal beliefs.

When taxes are lower, there's more money available for investment and savings. When there's more investment, more things are produced and created. When that happens, wages go up and the general standard of living rises. The by-product of it all is higher tax revenue.
-- Armey p.64

As it transpired, the proposal did not have enough weight to pass, and might be considered as a failure. However a crucial aspect of the epistemic community approach to the diffusion of ideas is the policy stream, rather than policy outcome. When we look at streams, the ripples generated by ideas can have far reaching and unexpected success. An epistemic community is not confined to any geographical area and therefore is not a network constrained to locality, especially in the internet era. Indeed the flat tax implemented by Estonia in 1994 (which paved the way for the European wave) is a very similar incarnation to that devised by Rabushka and Hall.

Within the dusty tomes of academia, the seeds of the flat tax had been sowed. The fresh breeze of post-Communist Eastern European would carry the fertile germ across the Atlantic and into the heart of a new wave of liberalisation.


THE IMPLEMENTATION OF THE FLAT TAX IDEA: EUROPE

When Estonia became the first country to adopt a flat tax as a deliberate economic policy it should be no surprise that in substance and rhetoric it reflected the vision of Rabushka, for both conceptions were bound by the same epistemic community. The Estonian Prime Minister Mart Laar shared the principled values and normative beliefs of the flat tax epistemic community we've defined - a belief in free markets, personal responsibility, risk-taking, competition and trade as a stimulus for development.

In an interview with City Paper Laar explains the guiding principles which framed policy decision, The fact is, your Friedmans and Hayeks only give you the basic theory. You can't look through Friedman's books and expect to find answers to specific economic problems. But Laar was willing to take this 'basic theory' some distance. Indeed he spoke of a 'faith' in the free market principles that he'd learnt from Hayek and Friedman:

City Paper : Intellectually, you could not have fully understood everything you were doing. You must have made a lot of your decisions based on raw faith - on the faith that the things Milton Friedman was saying were fundamentally true?

ML: Yes. Like the idea that, okay, if you cut taxes, you will raise more revenue. That was only written in text books.

The legacy of Friedman and Hayek - and the effective transmission of the flat tax policy by the free market epistemic community - was also felt in Russia. In the early 1990s Yegor Gaidar worked on economic policy for Boris Yeltsin. In a PBS series called Commanding Heights he said:

Yes, I read Friedman's books with interest, and also Hayek. They were very authoritative for us, but all the same far away from our domestic realities.

The above quotation demonstrates that a crucial prerequisite for policy change is an openness to hear the practical implementation of a good idea. In other words the idea entrepreneurs create a demand for policy entrepreneurs - and sympathetic policy makers provide a window through which they can jump. In the Russian case the policy entrepreneur - or baggage handler - was Andrei Illarionov, brought to Moscow by Gaidar. He founded a free market think tank called The Institute for Economist Analysis in 1994, and in 1999 worked for the Center for Strategic Planning under Putin. The Center produced a document called The Strategy of Development for the Russian Federation for the Year 2010 that acted as a key proposal and secured Illarionov's position within Putin's Kremlin in 2000. He is known for his ability to pressure other ministers, and is also known as being a member of the free market epistemic community. In the Moscow Times and the Wall Street Journal he has endorsed the Objectivist and Capitalist writer Ayn Rand (and has even given Putin a copy of Atlas Shrugged), and spoke at a conference that launched a Russian translation of her work. His underlying principled values regarding taxation are clear with the following: Every tariff and every limit on foreign-exchange transactions is a blow to our consciousness. Every tax acts against our freedom.


THE FUTURE OF THE FLAT TAX IDEA

The European nations that adopt a flat tax tend to be reforming, and thus benefit from the increase in compliance associated with a straightforward code. Increasing the tax base is therefore a major factor in favour of a flat rate, but by contrast a major obstruction is the vested interests of those enjoying loopholes. It is for this reason that Milton Friedman had little hope that his prescriptions would be implemented within America - think of all the interests (bureaucrats, accountants, lawyers, administrators etc) that would suffer from the change.

A smaller society with fewer entrenched interests provides a constitutional moment where ideas have a level playing field upon which to compete.

It is no coincidence that liberal economic ideas - of which flat tax is an example - have more chance of adoption after regime change, because vested interests have less time to become entrenched.

This historical and reflective survey has shown how several key players, acting within an epistemic community that helped to diffuse and implement the policy goal, drove the flat tax idea. There is common appreciation that think tanks lead policy, but a lack of substance to explain how. By wrapping ideas within the concept of operational codes - such as a flat tax, and by developing the function of epistemic communities, it is hoped that the power of good ideas can become a recognised determinant of policy adoption.

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