Eastern European countries, most notably Russia, have made their economies more competitive by adopting low, flat, tax rates. Russia cut its tax rate to a flat 13% in 2000 and almost doubled its tax receipts as a percentage of GDP in 2001. Estonia (26%) and Latvia (25%) led the way in the 1990s, but were less bold in cutting the rate. However, they are remarkably successful, with average growth rates of 6.1% in 2002. The Slovak Republic is introducing a 19% flat tax this year and Iraqs top tax rate is to be slashed from 45% to a flat 15% for individuals and businesses. A generous personal allowance that exempts the poor from income tax.
Low flat taxes reduce compliance costs and minimise the economic distortions caused by taxes. Taxes change the behaviour of citizens and tax systems that are designed to have the least negative effect on their behaviour allow economies to achieve the best results.
If the flat tax system developed and refined by economists Robert E Hall and Alvin Rabushka of the Hoover Institution, USA, were to be adopted by South Africa it would simplify South Africas tax system to such an extent that it would be understood by the vast majority of taxpayers. The system taxes all income at a low flat rate and has various features that reduce complexity:
Two postcard-size tax returns, one for Business Tax and another for Individual Wage Tax.
An integrated system applying the same rate to businesses and individuals, removing the incentive to utilise companies and Close Corporations to reduce tax.
Consumption is taxed and saving is not because all investment spending is removed from the tax base.
There are no special allowances.
Fringe benefits are not deductible by businesses or taxable in the hands of employees.
Capital equipment, structures and land purchased by businesses are deductible when purchased and taxable when sold.
Interest paid is not deductible as a business expense and interest received is tax-free in the hands of recipients.
A flat rate of about 19% would raise the same amount of federal revenue for the American government as their existing complex system.
The draft tax act prepared by the authors to replace the existing U.S. federal tax laws is 3½ pages long, compared to over 2000 pages of basic tax law and 10,000 additional pages of tax regulations.
South Africa is a developing country and needs to simplify its laws and administration to enable its citizens to understand and cope with them. A 3½-page tax act and 13% flat tax perhaps 18% if VAT is abolished would be a great improvement. Citizens should be allowed to concentrate their minds on earning a living and not be forced to waste their time and hard-earned money dealing with time-consuming complexity. A simple, low, flat tax system would lift the burden of the current system yet raise the same amount of revenue, given the propensity of low tax rates to raise unexpectedly high revenues, as predicted by Arthur Laffer and demonstrated by Russia.
A highly complex progressive tax system costs as much as 62% of actual taxes received by government. While wealthy countries may be able to afford this waste, South Africa cannot. Our developing economy has too many serious socio-economic problems to resolve and should seek to cut waste to a minimum. As demonstrated by the Eastern European countries, and by Hong Kong which introduced a low flat tax many decades ago, increased economic efficiency, reduced compliance costs and lower tax rates have substantial positive effects on economies.
Many newspaper columns have been filled with reports on tax evasion and how SARS is dealing with the issue. Yet the evidence shows that the best way to reduce tax evasion is to reduce the tax rates. Taxpayers who are risk-takers will evaluate the risk of being caught against the benefit gained from tax evasion. As tax rates are reduced, more and more people will choose to pay the taxes rather than risk the penalties imposed on evaders.
An estimated 500,000 American lawyers, accountants and other professionals make a living out of U.S. tax laws. Even if South Africas numbers are not in the same proportion to total population, we could still have in the region of 40,000 professionals living off the tax laws. Introducing a simple flat tax would allow these highly skilled people to do something more productive.
South Africa's tax system is not yet as complex as that of the U.S. but it is unfortunately moving in that direction. Tax systems should be adapted to accommodate citizens, rather than have the citizens change or incur high costs to accommodate the tax system. Hall and Rabushka propose an integrated flat tax that applies to both businesses and individuals but with separate half-page tax forms for the two types of taxpayer. All businesses, whether owned by companies, close corporations, partnerships or individuals would complete the same tax form. This is the kind of simplicity we need in South Africa to accommodate the thousands of emerging entrepreneurs who have great difficulty in dealing with the current complexity.
Tax equity can be maintained by exempting the poor from income tax. Exempting everyone from tax on the first part of income could do this. This way the poor pay zero and the wealthiest continue to pay the highest average rates. For example, if the exempted income is R60,000 per year and the tax rate 13%, a person earning R60,000 would not pay tax, on R100,000 the tax would be R5,200 (6.5%), and on R2 million it would be R252,300 (12.61%). The Hall/Rabushka system would be fair, broaden the tax base, improve incentives to invest, make tax evasion more difficult and less lucrative, increase economic growth, raise local investment by encouraging capital formation, create new jobs by increasing real wages and improving incentives to work, reduce interest rates immediately, encourage taxpayers to be more honest, and attract foreign investment.
Objections to a flat tax system can be expected from vested interests, including:
Taxpayers that currently receive special privileges that reduce their taxes below the low flat rate.
Tax lawyers, accountants and other professionals that earn high incomes from the complexity of the existing system.
Tax experts hired by the state to deal with the current complexity and track down tax evaders.
Globalisation makes tax reform not only desirable but essential, especially for developing economies. The globalisation process consists of increased movement of goods, capital, technology, ideas and people across borders. Gone are the days when governments, firms, and organised labour could cosily ignore the rest of the world while providing citizens and consumers with below-average service at high cost. Competition for capital, both financial and human, requires countries to have attractively competitive tax systems. South Africa is not exempt and our tax system should be urgently re-investigated. However, government should avoid the past policy of appointing highly paid tax professionals to investigate tax reform, which is comparable to asking wolves to look after the sheep.
Author: Eustace Davie is a director of the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the authors and are not necessarily shared by the members of the Foundation.
FMF Feature Article /13 January 2004 - Policy Bulletin / 22 September 2009
Eustace Davie is a director of the Free Market Foundation.
Publish date: 01 October 2009
The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.