Nobel Prize winning economist, Joseph Stiglitz, remarked that American Presidential candidate, Mitt Romney, ought to pay his ‘fair share of taxes’. However, Mitt Romney, like most other high income earners across the globe, acts rationally – just as most of us do – in the sense that they try to reduce their total tax burden by avoiding whatever taxes they can; behaviour that is well within the laws created by government and perfectly legal. Any insinuation that high income earners do not pay their “fair share” is an indictment on the rules and regulations created by government.
Taxes penalise a targeted activity. For example, taxes on alcohol, cigarettes, fuel, imports, etc, are imposed to curb the consumption of such items. Similarly, taxes imposed on income and earnings reduce the source of that funding. They diminish the incentives and zeal of entrepreneurs to risk capital and sacrifice time and energy, they interfere with the ability of individuals to pursue their goals, they send workers home with smaller disposable incomes. Less disposable income means less saving, less saving means less capital formation, less capital formation means lower labour productivity, and lower labour productivity means lower real wages.
South Africa, at 40%, has one of the highest top marginal tax rates of all middle-income countries. Other middle-income countries have relatively low top marginal tax rates, for example, Botswana (25%), Brazil (27.5%), Malaysia (26%), Mauritius (15%), Namibia (35%) and Uruguay (25%). Not surprisingly, these countries also invest more in gross capital formation as a percentage of their GDP: Botswana (30.7%), Brazil (19.7%), Malaysia (21.4%), Mauritius (24.4%) and Namibia (26.5%) compared to South Africa’s 19.2%.
Unlike Stiglitz, Nobel Prize winning economist, Gary Becker, states, “Neither the modern history of high tax rates, economic analysis, nor their consequences for the budget deficit and income redistribution indicates that raising taxes on higher income individuals is a good idea”. Raising taxes on the small group of individuals at the top of the income scale may seem like a “fair” proposal to the majority of people but there are many unintended consequences. Chiefly, high income individuals are very mobile and may choose to live in a more favourable tax environment. If they choose to remain in South Africa, a higher tax rate will reduce their incentive to start a new business and invest in this country’s human capital and may even cause them to prefer to invest their money elsewhere.
Maximum tax revenue will be achieved at a tax rate that avoids negative taxpayer behaviour by providing them with what they judge to be an acceptable reward for extra effort and risk-taking – a rate that can be determined only by trial and error. Both higher tax compliance and the expansion of economic activity contribute to a broadening of the tax base. Just over a decade ago, there were ten different tax brackets in South Africa. These have since been reduced to six. The major impetus behind the rationalisation is that it is easier to administer fewer brackets. One bracket, obviously, would, therefore, be the simplest of all.
A proportional or flat rate tax system is one in which the ratio of tax to taxable income is the same at all levels of income. It replaces the various tax bands that feature in a progressive tax regime with a single rate. A ‘true’ flat tax makes no allowances for deductions and provides no special dispensation for low-income earners. However, for both compassionate and practical reasons, there is no merit whatsoever in taxing the poor. The compassionate reasons are obvious while the practical one is that below a certain level of income the cost of collecting taxes from the poor will exceed the amount collected. Low-income earners, therefore, should be exempt from paying any tax on personal income.
Well-known economist, Arthur Laffer, noted that government revenue is maximised at a rate somewhere between 0% and 100% of income earned by the taxpayer. At the extremes, no tax would be collected. At a level above the ‘optimal’ rate, it becomes counter-productive to raise tax rates further since people will evade tax or avoid it by not working, saving or investing. This explains one of the most paradoxical features of flat tax: because the lower rate is charged on more income, it rapidly brings in more revenue.
Several countries have introduced a flat tax in order to stimulate economic growth. Estonia introduced a flat tax on personal and corporate income at a single uniform rate of 26% in 1994. This rate has gradually been reduced over time and is currently sitting at 21%. Other Eastern European countries with flat tax rates include the Czech Republic (15%), Georgia (20%), Latvia (25%), Lithuania (15%), Montenegro (9%) and Russia (13%). African countries such as Mauritius, Madagascar and Seychelles also have flat rates of 15%, 22% and 15% respectively.
The evidence tells us that the best way to achieve economic and political objectives is not always obvious. It may seem like a good idea to increase taxes on the wealthy but such an action invites considerable uncertainty. Higher rates of economic growth are a more certain means to increase the national tax base. Contrary to Prof Stiglitz’ view that the state should play a greater role in the economy, time and time again history has demonstrated that economies that allow their entrepreneurial and hardworking citizens more freedom to use their skills to the best of their ability and earn a worthwhile reward tend to grow faster and prosper.