The 2007 annual publication of the Forbes Global Tax Misery & Reform Index (“Misery Index”) is your global view of the key top marginal rates of taxation that apply to entrepreneurs with a look at the past, present and anticipating the 2008 future to spot trends such as the stable lower taxes of Asia, continuing “flat tax” revolutions of Central Europe and Russia and the surprises including, and contrary to the Asian trend and Confucius’ advise, the high level of tax misery in China, but  which is now starting to decrease. The Misery Index is also being used by academics to understand corporate policy and we will discuss this and the IMF’s flawed arguments against flat taxes in the second and third parts of the article.

THE FORBES GLOBAL TAX MISERY & REFORM INDEX

What’s important in the results of the Misery Index this year? The news is good and the marginal rates generally continue to decrease around the world. The misery points are lower in 25 of the 50 countries surveyed (and 28 of the 61 countries) this year; no change in 20 of the countries (and 26 of the 61 countries) and only 5 countries (and 7 of the 61 countries) increased tax misery slightly. The top reformers reducing taxes and flat taxes in this year’s index are China, Poland, Slovenia, Germany, Norway, Turkey, Czech Republic, Lithuania, Pakistan and with a full imputation system,  Malta (and Georgia if all 61 countries are used). Increasing Misery includes Finland, Hungary increasing flat taxes, Slovakia and Cyprus (and Ukraine if all 61 included). Overall, the Continental European original EU-15 and China have the highest levels of tax misery and the lowest levels are generally in the rest of Asia, Middle East, Russia and USA. The Central European countries of the new expanded EU-27 are in the middle or lower part of the index with their successful flat tax rates leading the economic expansion in Europe. Bulgaria and Romania joined the EU with new flat tax rates. Comparing the Misery Index of today to that of 2000, all countries in the index have reduced their tax misery with twelve exceptions including seven Asian increases (the twelve exceptions are Argentina, Hungary, Poland, Canada, Ukraine, Australia, India, Indonesia, Philippines, Thailand, Taiwan and Hong Kong with the note that the seven Asian countries that increased tax misery did so from low levels of taxation, but is it a trend for Asia?)

Although the above Misery Index analysis of top marginal rates is generally good news for entrepreneurs creating employment and economic growth, this is not the whole story. We now need to look at total taxes compared to the total economy (“GDP”). The separate Overall Tax/Spending Burden Table compares all taxes at all levels to each country’s GDP. The result is today it is still higher than the 1965 level of tax burden for all 30 of the OECD countries. This is despite growing taxes taking a slice of a dramatically increased pie as the economies have substantially grown since 1965. And only eight of the 30 OECD countries have slightly decreased the overall burden of taxation since 1980 and four of these eight countries are now reformed former Soviet block countries. Between 2005 and 2004,  23 of the OECD countries increased overall taxation and all but one OECD country is running a budget deficit. This means the countries are lowering top rates while increasing the base of taxation as we recently exposed in the future UK Prime Minister Brown’s recently announced reforms. This also shows that governments are failing to control growing government spending and the deficits mean more future taxation. Is the only solution more taxation in the future by tax base increases or can there be better control of government spending?  This also shows that the common argument of high tax countries arguing that tax reform is leading to a “race to the bottom” in taxation and declining government spending and services is far from the reality and merely an excuse to avoid reform and increase taxes and spending. (The Overall Tax Burden/Spending of all taxes and deficits by OECD country, generally follows ranking in the Misery Index country ranking, especially when total government spending is recognized.)

Our champion of the Forbes Global Misery & Reform Index is again France, but it has not changed its burden from last year’s Index that already anticipated the reforms which earlier became effective. However, 2007 is an important “last chance” election year in France and the final results for future tax policy will not be known until after the second round of elections on 6 May for the Presidential elections and 17 June for the  Congressional (Assemblée nationale) elections. How both the elections will go may be determined by where the currently undirected votes go, right or left, of the centrist candidate who came in third and thus lost in the first round of Presidential elections, François Bayrou. Or whether Mr. Bayrou accepts, contrary to what he has said, a position in the new right or left government.  There is also a risk that Presidential and Congressional elections may go in two different directions: one right and one left or left/centrist and thus a potential block on legislation. But what about the alternative direction of taxation?

Conservative (from a French point of view or Democrat or New Labor from a US or UK point of view, respectively) Presidential candidate Nicolas Sarkozy favors a five point or larger reduction in the top corporate tax rate. While current President Jacques Chirac, who has realized a Forbes recognized reduction in the French Misery Index of 26.3 points during his twelve years in office including an eight point reduction last year, has proposed a larger fifteen point reduction in corporate taxes to a flat tax rate of 20 percent. This proposed reform combined with the expatriate tax reform already realized by Congressman Sebastien Huyghe, France becomes truly competitive for corporations and expatriates. This further corporate tax reform is necessary due to France having one of the highest marginal and effective corporate tax rate in the world except for the US (and after German reform, discussed below), according to the detailed analysis of the prestigious C.D. Howe Institute.  If this corporate reform is realized, it will then be the distinction of the US to have the highest corporate tax misery in the world. For more details on his ideas, see Mr. Sarkozy’s recent book in English, Testimony: France in the 21st Century.

However, the Socialist Presidential challenger, Ségolène  Royal, says that although the overall tax burden (as opposed to top marginal rates) will not increase, she will create another individual flat tax (impôt citoyen) on top of the existing progressive income tax and flat tax (CSG/CRDS) as well as eliminating the 60% individual tax ceiling (bouclier fiscal) to let individual taxes rise to whatever level possible under existing law or as will be legislated in the future. As she said to the The Times of London, “The capitalists have to be frightened.” So they can show their courage? While also saying to The Financial Times that there are certain things that she admires in UK Prime Minster Tony Blair’s program. Her proposed substantial increase in social spending (government spending is already at almost 54% of GDP as shown in the Overall Tax/Spending Burden table, despite the important efforts of the Minister of Finance to reduce spending and the budget deficit which until now violated EU deficit spending rules), stricter 35 hour workweek rules while increasing the minimum wage to 1 500€ or $2 000 per month, renationalization of certain companies and the lack of any labor reform will mean her anticipated new high level of economic growth and resulting increased government revenues on which she makes her projections will be very difficult to realize. Resulting finally in the probable need for her to increase total taxes as well as marginal rates.  How this will be done is already determined by her Socialist  party president, partner and father of her four children, François Hollande. He has said and as is shown on the party web site, all reform including the reduction of the top marginal rates realized by President Chirac since 2002 and 1995 will be eliminated; resulting in a potential 26.3 point increase in the French Misery Index and the clock being turned back 12 years to the dim economic history President Chirac received in 1995 after a 14 year reign by a prior Socialist president, François Mitterrand. For more details, see her book Maintenant as well as the book by the former National Economic Secretary of the Socialist party, Eric Besson, Qui connais Madame Royal? (Who knows Madame Royal?). Mr. Besson has recently resigned his economic post in the socialist party to join Mr. Sarkozy’s campaign for president.

Reform is happening elsewhere in Europe including by the newly reclaimed powerhouse of Europe: Germany. Chancellor Merkel is now adopting the corporate tax reforms proposed by former Chancellor Schroder to eliminate the world’s highest marginal and effective corporate tax rate (Japan’s marginal rate is higher, but not its effective rate) to bring them to a more competitive 30% as the UK and future Prime Minister Brown moves its corporate rate further down to 28 percent. Sweden has now shown the courage to kill the tax that kills other taxes and results in delocalizations of entrepreneurs: the wealth tax. This is a property tax on all assets worldwide at tax inspector determined current market value. Perhaps Sweden, a social model for France, will give France the borrowed courage, as Germany did earlier, to eliminate the world’s highest wealth tax and not to the contrary to extend it to French citizens who are nonresident as the Socialist party and a former Socialist Minister of Finance have proposed (the idea of taxing nonresident citizens of course being borrowed from US corporate and expatriate tax law).

Another leader and country requiring special mention is President Hu Jintao’s China. Although Hong Kong, Taiwan and Russia are near the bottom of the Misery Index, China is again at the top but now in third place. This is the result of the announced reform to bring the corporate tax rates down to 25% and to apply these rates to all domestic and foreign companies. Even though we know that some of the floating tax ceilings are today low and previously granted special tax holidays for foreign investors and expatriates currently keep the “effective” as opposed to the top “marginal” rate of taxation in China closer to the other Asian countries in the index, a specific comparison of the net after tax from a 200 000 euro salary, shows only one of the other Asian countries in the index results in a higher individual tax burden. That country is Malaysia. And floating ceilings on taxes only go up as we saw in prior years in Turkey.  Despite the improving China exception and increases in the seven Asian countries since 2000, the overall trend shown in the Misery Index to take particular note of this year is the continuing Asian advantage for stable low tax misery. Japan, Malaysia and Pakistan reduce misery compared to last year, while the others maintain their favorable rates and Hong Kong’s optional flat tax rate.

In the next two sections of the article, we show how the Misery Index is being used by academics to understand corporate policy and then to question why the IMF is opposed to the success of the flat tax revolution.  

USING THE MISERY INDEX TO UNDERSTAND COMPENSATION

We know from our many conversations that the Forbes Misery Index is considered by country leaders in developing their tax policy and we can now see how it is used by researchers to analyze company compensation policy. The Misery Index indicates where delocalizations are more likely and where companies and individuals may want to go.

What if your company can not move to a tax paradise?  Management researchers uncovered an interesting tax reduction strategy.  Professors Dominique Rouzies (HEC School of Management, Paris), Anne Coughlan (Kellogg School of Management), Erin Anderson (Insead), and Dawn Iacobucci, (Wharton School) analyzed Hay Group salary data and Ernst & Young tax data for nearly 20,000 sales people and managers from five European countries.[1]  In high social security tax countries firms face higher labor costs and more potential for employee dissatisfaction.  To insure that the post-tax income differential between top and lower level performers is large enough to be motivating, firms must create very large gross pay differentials.  But tax brackets change as gross pay increases boosting employers into higher social security tax brackets.  The combined tax burden—employee and employer—leads to large total company cost differences across countries. 

But to remain competitive on the job market, firms must pay high-performing employees enough to motivate them after paying taxes.  The problem is exaggerated if high fixed wages are also paid to under performing employees.  According to Rouzies and her colleagues, firms succeed to alleviate high taxes and defuse potential employee mutiny by reducing fixed pay and replacing it with variable, performance-based pay.  This is still taxed of course, but firms only pay additional taxes for employees actually generating higher levels of profits.  Excellent employees are well rewarded and under performers are less costly to the firm.  The net effect is that is that firms reduced social security taxes on fixed wages of under performing employees.  Firms paid higher taxes only for employees actually generating more profit.

Dr. Michael Segalla, Professor of Management at HEC School of Management, Paris, further analyzes this study to show that the average company’s social security tax cost in Germany, Netherlands, and UK was over €16,000 less per employee compared to French firms.  Most of this saving was not shared with employees except in Germany where sales managers averaged €5,200[2] more take home pay than Dutch and British sales managers.  Additionally, firms were able to pay good performers more, potentially lowering turnover of high quality employees.  French sales managers received less fixed pay (µ=€43,520) but more variable pay (µ=€7,680 variable).  In lower social security tax countries they received more fixed pay (µ=€49,816) but less variable pay (µ=€3,954).  Overall, French sales managers assumed the highest risk (15% variable pay) but took home the lowest pay.  British sales managers had the least risk (6% variable pay) but took home nearly €1000 more.

The graph above displays the relationship between high employer social security taxes and the average percent of variable pay for sales managers.  Clearly high social security taxes are correlated with high variable pay.  Adding current data for Chinese sales managers suggests that the academics’ thesis runs true.[3]  Chinese employers face even higher taxes, at lower levels of salary, and therefore resort to more variable pay.  The irony of these high taxes is that they hurt workers by decreasing pay while increasing risk.  Governments hurt the people they want to protect. Another lesson from the Misery Index. And now a lesson for the IMF.

WHAT DOES THE IMF HAVE AGAINST FLAT TAX RATES?

The Forbes Misery Index has been emphasizing over the years the resulting economic success of the Steve Forbes inspired flat tax revolution around the world and particularly in our 2005 edition, “The Tax World Gets Flat and Happy”.  However, in a 2006 paper the International Monetary Fund (“IMF”) argues that flat taxes are a failure. We disagree, except in cases as in France where flat taxes are added to progressive taxes as opposed to being an alternative to them.  

As Dr. Miles, University of Chicago economist and recently retired International Director of the Heritage Foundation, shows below, the success of flat taxes is reflected in economic fundamentals -- with better incentives, people behave in ways that improve the economy:

• Tax revenues rise over time because incentives for tax avoidance diminish. The gap between before- and after-tax rewards shrinks   Why hire the same cadre of accountants, lawyers and other advisers when there are less potential savings? 

• Money previously diverted into tax shelters is now invested where both the investor and the economy get a bigger bang for the buck. 

• More remains in pay packets, so existing and potential workers are willing to work longer and harder.  Why bargain for non-taxable fringe benefits when bigger paychecks now mean more cold hard cash?

• Over time this increased investment and willingness to work shows up in more jobs and more cash in the Treasury.

Flat taxes are a simple recipe for how tax rate cuts boost the economy.  Ireland has adopted a “flat” corporate tax rate of 12.5%.  With it and prior low tax reform it has become the European headquarters for manufacturing and decision making for many non-European and European firms. Ireland evolved from a poor neighbor to the second highest GDP per capita in the EU. Well ahead of its poor cousins in the UK who continue to suffer relatively high taxes which are not yet completely flat nor low.

Estonia pioneered a system where each person pays the same flat few pennies on money earned.  Like Hong Kong before it, a broad base (few deductions) and a low tax rate generated strong growth and growing revenues out pacing most of the EU. Estonia’s success encouraged other countries throughout Eastern Europe to whip up new versions of this recipe. As well as encouraging Russia to adopt a flat tax as implemented by US Tax Court Judge David Laro which dramatically increased tax revenues and helped expand economic growth. This route to success has been followed in Hungary, Slovakia, Czech Republic, Latvia, Lithuania, Georgia. Romania and Bulgaria decided it was key for their success in joining the EU this year and adopting flat taxation. Steve Forbes proposed flat taxes to the Presidential Commission on Reform for the US.   

Given the track record, it’s puzzling why the IMF last fall published a study questioning the success and viability of Eastern European flat tax rates.  The IMF’s chief complaints were that different countries adopted different recipes, that the new tax regimes produced neither “Laffer-type” tax revenue increases nor changes in behavior of workers and investors, and that reduced tax avoidance theoretically is not a slam dunk despite Russian, Irish and Central European empirical economic evidence to the contrary.  From these dubious questions the IMF hypothesizes that these countries may be forced to abandon flat tax systems.  In short, the IMF sees this flat tax movement not as a “revolution,” but only a “craze,” a barrier to good policy and increased taxes.

Interesting assertions. However, in the IMF’s distaste for the new tax ideas it ignores important aspects and incorrectly measures the success of the flat tax systems.  For example, take what the study purports to measure -- that there are no “Laffer-type” increases in tax revenues. How can we tell?  The IMF sets the bar unreasonably high by insisting that within one year tax revenues increase as a percentage of GDP.  Rising tax revenues are not enough.  Even a jump in revenues sufficient to offset the immediate static loss from cut tax rates is not enough.  No, within one year, the extra revenue must also increase to match growth in the economy!

What a straw man!  Arthur Laffer never asserted that tax rate cuts would generate that much revenue in that short a time.  His point was that a country in the “prohibitive range,” where tax rates are so high that they are scaring away tax revenue, encouraging noncompliance and changing behavior, gets more revenue from lower tax rates.  But the full benefit could take several years.  The IMF standard is demanding all that immediately.  Conversely, take what the IMF glanced over. Does growth accelerate as incentives improve? Were jobs created at a faster pace?  Did unemployment fall?  Pivotal issues, but totally ignored.

Perhaps most puzzling is the opposition in the face of remarkably good results.  The study measures combined revenue from personal, corporate and indirect (social contribution plus VAT) taxes for eight Eastern European personal income flat tax plans. How much does revenue go up in the year the plan is introduced? The study downplays that five of these eight countries beat the IMF’s unreasonably high bar in just one year, and the remaining three did not miss by much.

Of course by conventional reasoning the good results could come from corporate or indirect tax rates going up as personal rates went down.  That combination happened in just two countries, one where the country beat the bar, and one where it fell short.  The results are even more impressive because six of the eight countries simultaneously cut at least one of these two other tax rates.

So why is the IMF so negative about the future of flat taxes?  We can only speculate.  What we do know, however, is that more and more Eastern European countries do not share this concern.  How else could we explain why Kyrgyzstan and Macedonia not only recently adopted flat taxes, but at rates lower than all the other countries?  We also know that Western Europe is feeling the competitive heat from these low rates.  How else could we explain the cuts in corporate tax rates in Austria and Germany, and the feeble attempts by France to loosen hiring rules?

Forbes Global Tax Editor:

Jack Anderson is the and an international tax attorney in the US and EU, member of the US Supreme Court and Tax Court and French bars as well as a CPA, MBA and President of Fairvest ICX, consulting to global entrepreneurial corporations. He is also a speaker at Forbes Forums on comparative international taxation.
jack.anderson@fairvesticx.fr

Contributing editors:

Dr. Michael Segalla is Professor of Management at HEC School of Management, Paris.  He studies the cross cultural risk of moving people, products, and processes across national boundaries.  He is the French Scientific Advisor to the European Attractiveness Scoreboard. He is also a speaker at Forbes Forums on human capital and cultural leadership issues.
segalla@hec.fr

Dr. Marc Miles of the University of Chicago is the co-author with  Professor Arthur Laffer of the book on  the “Laffer Curve” and supply side economics, Global Strategist in Boston, retired International Director of the Heritage Foundation in Washington DC and Editor of “The Index of Economic Freedom”. He is also a speaker at Forbes Forums on international tax issues and reform.