Assessing the benefits of flat tax on businesses

Agam Fatchurrochman, Nottingham, UK

Today's hot topic in the business community is that the government is getting ready to revise the tax laws of 2000, particularly regarding the proposal for applying a flat tax rate to provide business and fiscal incentives for public companies.

The flat rate, as proposed, would be set at 30 percent while public companies would be taxed at 20 percent to 25 percent.

However, the flat tax proposal is still receiving mixed responses. Some positively accept the proposal, citing the tax simplicity, but others argue that the scheme is not sufficient to cope with the tax simplification objective and global tax competition.

The main feature of a sound flat tax system is simplicity, by removing all kinds of relief and allowances, thus creating a simple system of taking total revenue and subtracting three kinds of payments, purchases of inputs, wages and pensions, as well as plant and equipment expenditures.

By simplifying tax procedures, the transaction costs, which are quite significant in collecting tax, can be reduced. By eliminating allowances and fiscal incentives, the flat tax gets rid of all tax lobbyists, negotiation and extortion and the bureaucrats needed to interpret them.

The second feature is to provide an investment-friendly climate for domestic and foreign investors. Combined with a lower tax rate, the scheme then encourages capital formation and productive activities.

The third feature is lowering the opportunity costs for avoiding taxes. Under a flat tax, business is less willing to cheat and risk being audited by the tax office. In addition, the government spends less money on monitoring and auditing in a simpler fiscal system.

In a global economy in which investors freely move across country borders, a simple fiscal system attracts global businesses. In turn, foreign investments further boost an economy with a simple, efficient fiscal system. As a result of a more dynamic economy and less tax evasion, the government actually collects more revenue.

One of the most cited examples is in Ireland, although not fully applying a flat tax, it has slashed its corporate tax rate from 50 percent to 12.5 percent. Combined with other tax cuts, this helped turn the "sick man of Europe" into the "Celtic Tiger" with unemployment rates dropping from 17 percent a decade ago to 5 percent.

Flat tax is gaining popularity among small and open economies. But even such big countries as Russia have dumped the progressive tax system and replaced it with a 13 percent flat tax. This new system took effect in 2001 and already has boosted economic growth and tax compliance.

Subsequent tax reforms after 1984 have created a more complex tax system in Indonesia, and therefore a lot of room for interpretation and extortion, by reintroducing many concessions, which had been revoked in the 1984 reform.

Coupled with corrupt tax auditors, businesses bear the high compliance costs, which are the value of resources expended by taxpayers in meeting their tax obligations, such as costs of maintaining tax records, hiring tax consultants and, in the case of Indonesia, costs for servicing corrupt tax auditors.

Therefore, the introduction of a flat tax scheme is turning the time back to the original tax reform.

Although the proposal for a flat tax rate has not been fully revealed yet, there are several features at least, which should be considered so as to fully utilize the flat tax features.

First, the proposed rate of 30 percent is considered too high compared to neighboring countries. For example, Malaysia and Vietnam are taxing business at 28 percent, Singapore at 25 percent and Hong Kong at a 16 percent flat tax.

It is obvious that the fiscal regime is not the sole feature of an investment-friendly economy. But with the lack of infrastructure, an unskilled workforce and a corrupt bureaucracy, the proposed rate might jeopardize our efforts to attract more foreign direct investment.

Furthermore, to cope with regional tax competition, the government might be forced to provide various fiscal incentives and obviously this will destroy the spirit of simplicity.

Second, the proposed rate of 30 percent appears to be just a way to remove the existing marginal rates (10 percent, 15 percent and 30 percent) and settling on the maximum rate, but the rest of the system remains intact. That proposal would maintain all tax relief rules, and so allowances and concessions would still by expected from lobbyists. Consequently, business still has to bear the high costs of compliance

Third, under a flat tax with a high rate and a complex system, there is still an incentive for evading the system. This, in turn, will compel the government to maintain high administrative costs of tax collection for monitoring and auditing taxpayers.

The next tax reform has to be designed to reduce the transaction costs of transferring resources to the public sector, that is, reducing the scope for corruption in tax collection. But although the tax system can be redesigned in ways that hamper corruption, still no purely technical redesign can wholly eliminate collusion.

Switching from a progressive fiscal system to the flat tax is a very radical reform and has to be carefully managed. By conforming to the basic features of a flat tax, lower rates and simplicity, it is expected that we can achieve economic efficiency, and fairness in the tax collection. This in turn will provide a healthy fiscal environment required to advance the economy, by generating new business and attracting foreign investment.

The writer is studying at Nottingham University Business School in Britain. He can be reached at lixaf2@nottingham.ac.uk