Flat-tax movement stirs Europe

A few years ago, Martin Bruncko studied the flat tax at Harvard University. Today, the 28-year-old is flying to European cities to promote the idea, which he made a reality in his native Slovakia.

"In theory it was interesting, but we never thought we could do it in practice," says Mr. Bruncko, recalling class discussions at the Kennedy School of Government. "So it was fun to see that you actually can do it."

What flat-tax advocates like Steve Forbes and the Hoover Institution's Alvin Rabushka have been pushing in the United States for decades, Bruncko and a team of Western-educated wunderkinds in this country of 5 million achieved in one year.

Last January, Slovakia became the sixth Eastern European country to adopt a flat tax, which means all income-earners pay the same rate. Since then, Romania and Georgia have followed suit, creating a global proving ground for the concept. In the process, flat-taxers have moved Eastern Europe from a Communist backwater to an investment spring - pressuring its higher-taxed Western neighbors to adapt to the new environment.

US conservatives, meanwhile, hope the experience of flat-tax countries like Slovakia - which the World Bank named top economic reformer last year - will persuade President Bush to implement a flat-tax of his own.

Mr. Bush praised Slovakia's tax-reform efforts during a trip there last month. "I really congratulate ... your government for making wise decisions," he said.

Western Europe feels differently. To support large governments and sizable welfare payouts, many Western European countries impose a triple-tiered tax regime of Value-Added Taxes (VAT), akin to a sales tax, high taxes on corporate revenue, and personal tax rates that can exceed 50 percent. Eastern Europe's cheaper labor market and growing reliance on flat taxes leave Western European economies struggling to compete.

"I believe it is putting some pressure on some of these countries and I think ultimately that pressure comes through competing economies," says Kevin Waddell, vice president and director of the Boston Consulting Group in Poland.

Leaders such as Chancellor Gerhard Schröder say that the Eastern European countries steal business with their low tax rates while at the same time benefiting from European Union (EU) aid.

Last year, former French Finance Minister Nicolas Sarkozy said that if the new states were "rich enough" to introduce a flat tax they wouldn't need EU funds. France and Germany want to harmonize tax rates within the EU, and bring flat-tax rebels under a unified code.

With such heavy budget obligations, countries such as France and Germany reject flat taxes because they wouldn't be able to afford a cut in their tax revenues, says Wolfgang Wiegard, chairman of the German Council of Economic Experts.

Last summer, Mr. Wiegard's council, dubbed the "wise ones" in Germany, recommended that the government introduce a flat tax of 30 percent to replace the country's average rate of 38 percent. Such a system would make Germany "internationally competitive," he said.

The government ignored the advice, preferring Wiegard's alternate recommendation of a system that would tax capital income and labor income differently.

Much of Western Europe has likewise spurned flat-tax proposals, but some nations have chosen to follow, rather than beat, their flat-tax rivals.

Austria, whose neighbors include Slovakia, Hungary, and the Czech Republic, lowered its rates from 50 percent on corporate and personal income to 34 percent this year. Britain, mindful of Ireland, another low-tax haven for companies, and Spain are reportedly mulling over the same. But the prospect that more countries will follow suit is less likely.

"The challenge that Western Europe has is that you have a lot of entrenched interest groups," says Waddell. "When you try and put in place a flat tax, you take something away from somebody else."

Like most Eastern European countries, Slovakia looked west when developing its tax system after the fall of the Iron Curtain. The resulting five-bracket system featured deductions for everything from home ownership to computer purchases.

"It was not a stable system, and super complicated for small and medium-sized companies," says Bruncko.

Flat taxes used to be the norm in Western countries. But in the 19th century, Communism founder Karl Marx listed a "heavy progressive" tax as a top priority. Soon, higher income-earners were being taxed at higher rates around the world. The irony today is that every flat-tax country (except Hong Kong) is a former Communist nation.

Since the flat-tax took effect last year in Slovakia, rich and poor alike pay a 19 percent tax on their income. A corporate tax and VAT of 19 percent is also levied. A percentage of the tax is deducted from paychecks every month, and there are only two exemptions: one for pensions and one for contributions to Slovakian NGOs.

Flat-tax advocates - and there are many here - say the reform has encouraged tax compliance and added to the flow of foreign investors. But a small chorus of critics here worries that the uniform rate will mean less money for social services and make it difficult on the working class.

"I'm not sure it's fair to those people," says Pavol Pasca, an opposition member of parliament from the eastern Slovakian city of Kosice, where he says wages are 40 percent of the EU average. "Maybe it's fair in a more-developed country with a bigger middle class."

But Mr. Pesca, like the rest of Slovakia's opposition politicians, has few concrete arguments against the flat tax. In fact, he agrees with the government's argument that the simplicity of the new code has led to more transparency and less tax evasion. It has become one of Slovakia's best selling points.

"We did heavy marketing of it, and explained it to business people," says Bruncko, who became the finance minister's chief economic adviser shortly after graduating from Harvard in 2003.

"We have a much cleaner system," says Ivan Kocis, cochairman of the Euro Valley Industrial Park, which lies on the highway to Prague, a half hour out of Bratislava.

The park, situated in the valley that separates the Alps from the Carpathian mountain range, is a symbol for the future that Slovakia would like to see. Italian tire-maker Pirelli and multinational steel concern Arcelor are building facilities here. And last month, a joint venture between a German transmissionmaker and Ford Motor Company announced a $395 million investment in eastern Slovakia.

The flat tax is "a very important factor," for these new companies, says Kocis.

Trade experts say foreign investment has been flowing into Slovakia at a higher rate since the tax reform.

In 2003, the government's trade development agency, SARIO, brought in 22 investment projects that created 7,500 new jobs. In 2004, it brought in 47 projects worth more than 12,700 jobs.

Bruncko is gratified by Europe's shift toward lower rates, but says the flat tax is not a panacea. "It's a good and necessary basis for fast growth," he says. "But you lose the advantage in the long term."

For now, it appears to be helping Slovakia. After months of talking to business leaders across Europe, Bruncko had to cancel trips to Lisbon and Madrid last month. Word on his country's tax reform, it seems, had already spread.