Commentaries

Now raising intellectual capital

IMF thumbs-down to flat tax raises doubts

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If the IMF thinks it’s time for Latvia to move away from its flat income tax, that must surely signal some kind of sea change among free-market conservatives.
    Flat taxes have got the citizens of former Communist east European countries used to the idea of paying tax on income. But they have often not lived up to their billing for revenue generation or fairness. In hard times, the IMF’s Anne-Marie Gulde concluded in Riga, social cohesion demands that the better-off make a bigger contribution to meeting the costs of the financial crisis.
    Latvia was in the first wave of more than a dozen ex-communist European countries that have implemented a single rate of tax for personal earned income. The so-called “Baltic tigers” enjoyed among the highest growth rates in Europe in the last decade. But all three face a severe economic contraction due to the unwinding of massive balance of payments deficits caused by a cheap credit binge.
    Now public spending cuts are reaching a political pain threshold, the IMF is keen to avoid past mistakes in Latin America and Asia by emphasising the need to preserve the social fabric.
    The flat tax was seen as business-friendly and attracted foreign investment, while persuading wary citizens to start paying tax and businesses to go legal. Bulgaria’s rate, at 10 percent, encouraged employers to stop paying wages in cash. In developed Western economies, calls for a flat tax have mostly been a euphemism for cutting impositions on the rich.
    Supporters contend that a flat tax is simple and cheap to administer, discourages tax evasion and encourages employment. Opponents say it is regressive because it places an unfair burden on those in the middle (the poorest usually fall below a tax-free threshold).
    Flat taxes in eastern Europe often exclude capital gains, taxed at a lower rate or not at all, along with dividends, inheritance and other income.
    A 2006 study by three IMF economists (*) concluded that key arguments on both sides of the debate were not supported by the facts. In particular, the evidence that lowering taxes on the better-paid generates additional revenue, as theorised by U.S. economist Arthur Laffer, is inconclusive.
    The authors found “no sign of Laffer-type behavioural responses generating revenue increases from the tax cut elements of these reforms”.
    It’s too early to read the rites on the flat tax in eastern Europe, but the omens are not good. As the IMF researchers concluded: “The question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it.”
    * The Flat Tax(es): Principles and Evidence, by Michael Keen, Yitae Kim and Ricardo Varsano, IMF Working Paper, 2006 http://www.imf.org/external/pubs/ft/wp/2006/wp06218.pdf

Latvia: hold that peg!

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 Latvia’s currency peg to the euro has become a punchbag for economists convinced that the Baltic state is inflicting unnecessary pain on its citizens. But devaluation of the lat risks mass defaults by citizens and companies. Four-fifths of private loans are in euros, and large-scale default would cripple the banking system. The Swedish banks that have lent billions of euros in Latvia would also be vulnerable.

Latvian devaluation would unleash a chain reaction around the Baltic and beyond. Lithuania and Estonia would face huge pressure to follow, and the knock-on effect could hit Bulgaria, which also has a currency board, and put pressure on other central European currencies. Devaluation would wreck any early prospect of Latvia joining the euro zone, which the former Soviet republic sees as a safe haven of financial stability and political independence. 

Latvia: let the lat go

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Do as you would be done by. This excellent rule surely applies as much in monetary affairs as it does in other fields of human endeavour. Those who loudly urge Latvia not to devalue its currency should reflect upon it.

Since Latvia’s monetary crisis started in 2007, a host of non-Latvians — led by the European Commission — have urged the small Baltic state to cleave to its currency board system, which pegs the lat at the wildly uncompetitive rate of 0.702804 to the euro. Regardless of the cost in terms of spending cuts, higher taxes and lower wages, this is supposedly all for the Latvians’ own good.

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