Russia’s Flat Tax

According to the Wall Street Journal (“Flat Tax Fred“), Presidential-candidate Fred Thompson has recently proposed instituting a flat tax in the United States “…with two tax rates of 10% and 25%.” One country has already beat Thompson to the punch: Russia.

In 2001, Russia enacted a flat tax rate of 13%.  The reform has been popular and has since been adopted by countries such as Serbia, Ukraine, Georgia, Romania, Slovakia and Macedonia.  But is the flat tax a good thing?

This is the question which Gorodnichenko, Martinez-Vazquex and Sabirianova Peter try to answer in their NBER working paper titled “Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia.”  It has generally been found that tax collections drastically increased after the introduction of the flat tax.  This trend, however, may not be due to the flat tax specifically.  Increased GDP from 2001 until the present certainly accounts for much of the increase in collections.  Also, an increase in voluntary tax contributions or stricter enforcement may be the cause of the increase in tax collections.

The authors use data from the Russian Longitudinal Monitoring Survey and measure tax evasion as the difference between  household consumption and reported household income.  Of course, this is not a perfect measure, but as long as the quantity of the measurement error remains constant over time, this methodology will provide researchers with a good understanding of how tax evasion evolved after the institution of the flat tax.

The authors find the tax evasion is more prevalent among younger, unmarried, individuals with fewer years of job tenure.  Individuals working at small companies were more likely to evade taxes, but surprisingly government workers tend to be among those who most frequently evade taxes.  This is likely due to increased non-reported income from accepting bribes.

The authors use a difference in difference technique comparing changes in tax evasion from low and high tax brackets.  The lower tax brackets were not significantly affected by the changing tax laws, but the higher tax brackets did see a substantial change in their marginal tax rates paid.  The authors also employed a regression discontinuity framework.  This methods compares income groups just below and just above discrete changes in marginal tax rates.

The authors found that the flat tax lead to a significant decrease in tax evasion.  This is likely due to the fact that lower marginal tax rates decreases the incentive to avoid reporting income.  Further, if there is a decrease in tax evasion, policy makers can lower the marginal tax rate further while still collecting the same amount of revenue.

Lower marginal tax rates should also lead to an increase in the labor supply.  The authors, however, did not find this to be the case.  The flat tax had minimal or no impact on worker productivity.  This is likely due to the fact that the supply of labor is very inelastic on both the intensive and extensive margins.

It seems that the flat tax is not only attractive according to economic theory, but may also work well in reality–at least in terms of reducing tax evasion.