The countries that introduced a flat tax rate – and what happened next

Britain could one day join Estonia and Guernsey in introducing a flat rate of tax on personal income.

Kemi Badenoch, the Tory leader, said on Monday she found the fiscal concept “very attractive”.

Generally a flat tax means replacing the current income tax and National Insurance rates with a single rate.

The main argument in favour of a flat rate system lies in its simplicity. By charging everyone the same tax rate, it is hoped the Government would cut administration costs, improve compliance and eliminate distortions in the system.

Other countries have experimented with flat taxes – to varying degrees and levels of success.

Both Guernsey and Jersey in the Channel Islands operate a flat 20pc tax system. A relatively low rate for higher earners has helped both islands grow highly successful financial services industries. In Guernsey, this now makes up 40pc of the island’s economy.

After the collapse of the Soviet Union, Eastern and Central European countries embraced the idea of a flat tax. The first wave of adoption was among the Baltic states in the mid-1990s, with Estonia leading the charge. Then, Slovakia became the first country in the Organisation for Economic Co-operation and Development (OECD) to introduce a flat personal income tax in 2004. Many others followed suit with the aim of boosting their formerly communist economies.

A key issue with measuring the impact of the flat tax revolution in the post-communist world is that it took place during a time of major economic change. This makes it difficult to say for certain whether the flat tax drove up tax revenue or fuelled growth.

For example, after Russia replaced its three-bracket system with a flat rate of 13pc in 2001, income tax revenues rose by about 26pc in the first year.

However, the income tax change was not a standalone reform. A working paper by the International Monetary Fund (IMF) concluded there was limited evidence that the flat tax had led to the revenue boom in Russia – attributing this instead to “an increase in real wage rates”. That said, the authors found a “significant” improvement in tax compliance – with the proportion of income declared increasing by 16 percentage points in the wake of the reform.

In Slovakia, the overall tax burden fell from 39.6pc in 1995 to 29.6pc in 2013. During this time it was one of the fastest-growing economies in Europe, thanks to an influx of foreign investment.

The OECD acknowledged in a working paper that the flat rate tax had contributed to this “strong economic performance”. However, it also said the flat rate had created weaknesses in the tax system – including low revenues and limited progressivity. Slovakia therefore introduced a higher income tax rate in 2013.

Many of the Eastern and Central European countries have since abandoned the flat tax system. For example, Russia launched a two-tier system in 2021.

Changes would cost UK £100bn

Estonia, however, still applies a flat rate tax of 20pc on income. Its tax system is the most competitive in the world, according to the OECD, because it is efficient and simple to understand, with a broad tax base.

But, Dan Neidle, of the think tank Tax Policy Associates, points out that countries like Estonia were “essentially creating a tax system out of nothing” – meaning they did not face the constraints we would encounter implementing a new system.

He estimates forfeiting the higher and additional rate would cost the UK about £100bn.

“A flat tax is expensive. Meaning either large tax increases on median earners or very substantial cuts in public services. To put that in context: the NHS costs about £180bn. Defence budget about £60bn.”

Britain has one of the longest tax codes in the world, which is why some economists and politicians find the idea of a single rate so appealing.

A flat tax would eliminate punitive marginal rates, like the 60pc tax trap affecting those who earn between £100,000 and £125,140. Proponents argue it could also boost work incentives by reducing tax for higher earners.

Madsen Pirie, of Adam Smith Institute, says: “The idea is not to benefit the rich, but to boost economic growth and make everyone better off. A flat tax makes work more rewarding, and is not worth avoiding or evading.”

The flat tax is not a new concept, however it has never been implemented in the UK.

Even when income tax was first introduced by William Pitt the Younger in 1799 to pay for the Napoleonic Wars, it began at two pence in the old pound for incomes over £60, with lower rates for incomes between £60 and £200.

Mr Pirie adds: “The nearest we came was when Nigel Lawson set two rates of 40pc and 25pc. It raised more money and saw the richest pay a higher share of the total. We should do it again.”

Others, like Mr Neidle, disagree. He says: “There are lots of problems with complexity in the current tax system, but having different tax rates isn’t one of them.

“Removing all the rules that create anomalously high marginal rates would be a good idea. But having a 40pc rate and a 20pc rate is not a material source of complexity.”