THE DETROIT OF EUROPE
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"Complex" does not begin to describe the shortcomings of Slovakia's former tax code.
It had five tax brackets ranging from 10 percent to 38 percent; 90 different exemptions; 19 unique sources of tax-free income; 66 items that were themselves tax-exempt; and an additional 27 items that carried their own particular tax rates.
A split value added tax (VAT) taxed some items and services at 14 percent, others at 20 percent, which made the code even more pretzel-like. Confusion reigned because tax laws changed twice a year.
Not surprisingly, countless citizens avoided the tax system altogether. Slovakia's shadow economy accounted for a high percentage of the country's actual economic output. Slovaks had little incentive to create domestic capital because of onerous tax rules. And foreign investment would not come rolling in without reform.
Government leaders knew something had to be done to address this growth-suppressing mess. In October 2003, parliament passed a flat tax reform bill that was initially vetoed by the president, Rudolph Schuster. Parliament overrode the veto in December. This reform bill unified and simplified the Slovakian tax regime, creating one rate across the board. The personal income tax, the corporate income tax and the VAT, were all set at 19 percent.
Personal income taxes dropped for almost all Slovaks. Those at the high-end of the income scale have seen their highest tax rate fall from 35 percent to 38 percent down to 19 percent. The flat tax avoided a tax increase on lower income taxpayers by including a personal deduction of $2,600; this exempted half the average yearly wage in Slovakia. The previous personal exemption was only $1,246.
The new law reduced the perverse incentives that had driven so much of the economy into the informal sector. As tax rates were slashed and simplified, individuals and businesses began to emerge from the shadows. The government projected that it would maintain its current level of revenues despite the cuts in tax rates. It did even better: Tax collections soared by 36 percent, shrinking the budget deficit by 93 percent in the first quarter of the new fiscal year.
The country is beginning to see a dramatic increase in foreign direct investment. The New York Times, for instance, has dubbed Slovakia the "Detroit of Europe" because of the recent contracts for new facilities for Hyundai-KIA and Peugeot. These agreements will bring billions of dollars of investment to Slovakia for new manufacturing plants that will employ thousands of Slovakians. By attracting businesses with its very competitive tax system, Slovakia hopes to become a beachhead for capitalism's spread across central and eastern Europe.
When international automakers signed billion-dollar agreements to relocate manufacturing facilities to Slovakia, the nation proved it had embarked on the same kind of journey that had transformed Ireland from an economic laggard into the economic dynamo it is today.
In drastically lowering taxes, Slovakia and its fellow Baltic states will likely follow in the footsteps of Ireland, which has become the economic model for many central and eastern European counties. Decades ago, Ireland adopted an aggressive corporate tax reduction policy in order to attract investment and serve as a platform for businesses targeting Continental Europe.
Many American companies saw this English-speaking island as an ideal jumping-off point for their business invasion of the rest of Europe. Ireland cut business taxes. In the 1980s, to counteract an economic slide, it cut taxes, especially on personal income, even more. It worked. Ireland earned the nickname "Celtic Tiger" as a result of its ability to attract foreign investment and market itself as a location where corporations could thrive. Ireland has had a long, troubled history with Britain. However, it has now achieved the best revenge: Ireland's per capita income is higher than that of Great Britain.
Remember, taxes are a price. By reducing tax rates, Slovakia rewards and encourages more productive work, risk-taking and success. Slovakia is now enjoying more job creation as its economic growth tops 5 percent a year - a miracle level by western European standards. Its success in making the transition from communism to free markets is making Slovakia a poster child for economic reform. President Bush, who has pledged to reform the US tax code, publicly praised Prime Minister Mikulas Dzurinda for his reforms.
During their February 2005 meeting in Bratislava, Bush, without prompting, made a point of touting the flat tax: "I complimented the Prime Minister on putting policies in place that have helped this economy grow...the president put a flat tax in place; he simplified his tax code, which has helped to attract capital and create economic vitality and growth. I really congratulate you and your government for making wise decisions."
The Slovaks still smart from being regarded as poor, backward cousins to the Westernised and supposedly more sophisticated Czechs during the days of the Czechoslovakian union. As the Irish did with the English, the Slovaks are determined to turn the tables. Success is indeed the best revenge.
Slovakia has chosen a course of action that will enable it to become a vibrant state in the twenty-first century's global economy. The World Bank ranked Slovakia as the most successful nation among those implementing reforms in 2003. The World Bank's report on 'Doing Business in 2005' placed Slovakia among the top twenty nations in the world for ease of doing business.
Because of their flat tax reforms, Slovakia and other "transition" nations new to the European Union have become fierce economic competitors. Their success is eliciting accusations of unfair play from established nations. Germany and France are accusing Slovakia and other tax-smart countries of creating tax havens and subsidising their low taxes with EU aid money.
Yet beneath these accusations are the stirrings of reform. As they call for more equitable "tax harmonisation" within the union, Germany, France, and others are ever so slowly inching towards serious consideration of the flat tax. In Germany, former Chancellor Gerhard Schroeder led the charge in brow-beating Slovakia, Estonia, Lithuania, and Latvia. Germany's burdensome tax regime smothers economic growth, and its corporate tax rate is twice that of Slovakia. Yet at the same time, forces within the German government, particularly in the finance ministry, are seriously studying the flat tax reform. Moreover, Chancellor Schroeder reluctantly announced that Germany would reduce its corporate tax rates to avoid losing more businesses to neighbouring, lower-tax countries.
France is also critical of the low taxes in transition states such as Slovakia. France's former finance minister, Nicolas Sarkozy, hammered eastern and central European nations over their tax cuts while in office. He even proposed eliminating the EU subsidies that support economic development in the new EU members. Sarkozy demanded that if tax cutting EU nations were "rich enough" to avoid sky-high tax rates, then they should not expect EU development money.
Isn't this a little hypocritical? The French, of all people, are masters at attracting foreign investment. The Wall Street Journal reported that France offers "a dazzling array of tax benefits" to lure foreign businesses. Yet Paris can't understand that tax reform is also an essential part of the recipe for a vital economy. Instead the country keeps adding more special provisions that further complicate its tax code. Since France offers specific incentives for foreign investment, why doesn't it just go with across-the-board tax simplification?
While the winds of reform are blowing, Germany and France continue to suffer for their reluctance, to date, to make needed tax reforms. Bureaucracies that think they are dependent on overburdened taxpayers for survival cannot tolerate the competition from agile, adaptive nations like Slovakia or Ireland.
EU bureaucrats in Brussels, prompted by Paris and Berlin, constantly pressure Ireland to substantially raise its taxes. But the Emerald Isle refuses - and enjoys more and more prosperity.
Steve Forbes
Editor's Note: This essay was adapted from Steve Forbes' latest book, 'Flat Tax Revolution'. Steve Forbes is president and chief executive officer of Forbes and editor-in-chief of Forbes magazine. Mr. Forbes is also chairman of the company's American Heritage division and publisher of American Heritage magazine.
In both 1996 and 2000, Mr. Forbes campaigned for the Republican nomination of the American presidency. Key to his platform were a flat tax, medical savings accounts, a new Social Security system for working Americans, and school choice. He lives with his wife and family in New Jersey, USA.
