Flat Tax: What Is Important And What Is Not

European territories that have flat tax systems. Photo: Wikimedia Commons.

The “Flat Tax Era” in Slovakia came to a definite end on 1st January 2013. Corporate tax rate of 23% (highest in the whole Central and East European Countries region by the way) became valid instead of the 19% rate. This was considered to be the last nail in the flat tax coffin. The flat rate used to apply to all personal income, corporate income and VAT until 2011, when 20% VAT (described as a “temporary crisis measure”) and 2013, when 25% personal income tax rate for high earners were introduced. 

The second government of Mr. Fico, who won election in 2012 after the brief period of rule of Mrs. Radičová, fulfilled its promises to tax business more. On 1st January 2014 the corporate tax rate was cut to 22%, but only in exchange for newly introduced annual fixed business levy. This levy is imposed on every business no matter if in profit or loss and siphons double the amount of money the 1pp cut saved. Paradoxically, the end of the flat tax caught more attention abroad than in Slovakia.

After the brief cheer after the disintegration of the Eastern block and peaceful separation of Czechoslovakia a darker period began in Slovakia. The years of 1993-1998 were stamped by the rule of semi-authoritarian Prime Minister Vladimír Mečiar. Besides stagnation of civic society, when opposition and media were indirectly and sometimes directly oppressed, also economy stagnated.

European territories that have flat tax systems. Photo: Wikimedia Commons.

It was not obvious immediately; average growth reached solid 5.4 % of GDP in the period of 1994-1998. However, it was thanks to expansive fiscal policy with annual deficits running around 6% of GDP annually. Unlike other Czech Republic, Hungary or Poland, Slovakia was seriously failing to lure foreign capital to the country. In 1993-1998, FDI average was 1.6 % of GDP while our neighbors were reaching multiples of this level. Instead, the industry was handed over to the political clique around the prime minister. With no capital and unable to reform extremely inefficient heritage of socialism, the new owners were trying to drain cash out of these businesses as fast as possible (again, with very few exceptions). In 1998, these companies were quickly failing and Slovak economy was in dangerous downslide.

In 1998 Vladimír Mečiar lost the election and a new broad coalition took place. Under the same leadership, but with a bit reshuffled and more coherent central-right roster the coalition ruled also during 2002-2006 period, which enabled to execute a continuous string of reforms.

The most urgent case was the recapitalization of Slovak banking sector. For the past few years, Slovak banks were used as a cheap loan pool for the failing Slovak industries. Those loans were quickly becoming nonperforming and a collapse of the whole banking system was a real danger. The new government spent 125 billion crowns (around 4 billion euro), or 12% of GDP, to save the banks. In comparison, current Spanish bailout was agreed to reach 10% of GDP. It was a huge burden for taxpayer, but prevented immediate collapse. Banks were sold to foreign investors and today Slovak banking system remains in a relatively good condition when compared to Eurozone counterparts.

Foreign investors entered number of crumbling companies (for example US Steel bought VSŽ, the biggest employer in eastern Slovakia near collapse) and also entered the utilities sector. Utilities were regularly used as cash cows for the previous government and were often reporting huge losses, which were turned into profit within a short period of time.

In the period of 2002-2006, the refreshed government focused on fiscal reform. Debt and Liquidity Management Agency was established with intention to professionalize management of debt. ESA95 with accrual (next to cash) budgeting was implemented and mid-term budgeting was included. Financing of municipal budgets, as a part of decentralization process, was simplified; former negotiations were substituted by direct transfers of defined share of personal income tax.

The flat tax reform of 2004 was a flagship project; however, much broader scope of actions took place. Quintuple of personal income tax rates spreading from 10% to 38% were unified to 19 %. Corporate tax rate exemptions were swept away and the basic rate was slashed from 25% to 19%. Also two VAT rates of 14% and 20% were unified at 19% level. Dividend tax was abolished, the same as inheritance tax and gift tax. The tax code was substantially simplified.

But the reforms were not limited to taxes. Also the labor code was reworked into a more flexible one and the government used tons of taxpayers’ money to buy large foreign investors. And we should not forget it was the happy time of global economic boom, which came just in the right time to offer helping hand.

First fruits came soon. Around 2001 the downward economic trend turned and Slovakia became known as the “Tatra Tiger” in the mid 2000′. Unemployment halved and FDI grew eleven fold nominally just between 1999 and 2002.

As you can see, flat tax was just a piece of the reform puzzle in the 1998-2006 period. Would the idea work without the entry of foreign capital, without bank recapitalization, or without simplification of the tax and labor code? Hardly so. At least personal income tax wasn’t even flat, due to high tax deductible – around 6% of all employees pay no income tax at all and average real tax rate is 9%.

However, the idea of flat tax worked as a great marketing tool for the whole package of reforms both internally and externally. It was presented as a modern economic tool, which will finally decouple Slovak economy from its communist past – and both citizens and foreign investors listened.

The recipe for successful economic reforms is simple and universal as the Ten Commandments – cut, simplify, deregulate. Leave more money for consumers and entrepreneurs to spend on their wants and ideas; let them spend their time on doing business instead of filling dozens of papers and queuing; do not forbid, order or force where not absolutely necessary. Flat tax can’t do harm and can serve as a tasty topping – but first you need to bake the pie.

The article was originally written for Hungarian online daily vs.hu