Flat tax

During this week there was a discussion about the change in taxation of the personal income, which consists of the introduction of proportional tax from the beginning of 2008. The social security burden is not likely to be reduced, however the ratio of payments by the employer and the employee is changing from 65:35 to 60:40.

Proportional tax is the one where regardless of the size of your income the same tax rate is applied. In this case the rate will be 10%. That means that it is applied for income of 300 levs (30 levs tax) and for income of 1 000 levs (tax burden of 100 levs).

The opponents of this type of tax claim that, it is not fair, since it levies the same rate on all people. According to them the taxation should be progressive and thus fairer, since large incomes are levied higher taxes. However, here a very important fact is omitted, which refers to the essence of levying taxes. The tax is a mandatory payment to the state – in other words it is not a voluntary means to finance the government expenditures. In that sense it could not be fair, since against the will of the people part of their income is taken. Hence it is not possible to speak about fair tax, however the lower the rate less damage it makes.

Something more – the proportional taxation means that the marginal rate is the same. Thus for every additional euro earned are paid exactly 10 cents taxes regardless whether before hand we have earned 250, 500 or 1 000 euros. That means that taxation does not aim at hindering employment additionally by imposing higher tax rate. In other words, this is a clear sign that through tax policy the state is aiming to encourage additional efforts and improved productivity and, as a result, higher incomes for the people.

The reduction of the maximum rate of taxation from 24% to 10% will affect significantly the income of the people from the so called middle class.  The immediate effect will increase the available incomes as a result from the lower tax rate. The long term effect will be that the people will be encouraged to work, since this is the way to influence their choice between work and leisure. In addition the so called excess burden is reduced – that is the difference between the expenditure for society from the existing taxes and the state revenues. In other words the net loss of society from taxation will be reduced, which will result in more goods and services produced, which will mean higher real incomes.

One group of taxpayers will bare initially the costs of introducing the proportional tax. These are the people with gross monthly income of up to 450 levs (EUR 230). They will lose income due to the removal of the untaxed minimum, which for them means an increase in the effective tax rate. In the budget sector it is proposed to compensate the employees, but this does not apply to the private sector. Most affected will be respectively the people with low productivity, the young employees, which are at the beginning of their career, as well as those who are paid per working hour. According to the official data provided by the National Statistical Institute the average wages in several sectors are below the 450 lev (EUR 230) limit. An important fact in this case is that this data may be different from the actual situation due to the existence of informal economy. This applies to a very large extent to the construction industry, where the salaries are much higher than reported. In other words, the claims that over 1 million employees will receive lower net income are too fare fetched, since a large portion of these people are better paid, but do not declare the full amount of their incomes.

Besides, the growth of the incomes in the private sector for 2007 is over 20% and this high rate will probably remain similar over the next year. Factors leading to this effect are the continued growth of the money supply and the inflation, as well as the increased productivity of labor. For that reason part of people which at present receive lower incomes will go over the limit of 450 levs and will not be affected by the higher rate.

The other advantage of the proportional tax is the ease of administration due to reduction of part of the existing preferences.  This will allow for reduction in the number of people in the tax administration.

Overall the progressive tax is replacing the proportional with a lower rate. Without any doubt this is a positive measure, which will affect positively the economic development of the country. In the long term this will mean higher productivity, growth in supply and higher real incomes. Stimulating the middle class, which are the generator of economic growth, is actually a social measure since it is directed at higher wealth.

Figure 1: Taxation of labor during 2007 and 2008 (percentage of the cost of labor for the employers)

Source: Author's calculations.