Flat Tax, FDI and Government Spending

Over the last 15 years waves of flat tax reforms have been rippling across the transition economies of Eastern Europe. Resulting economic consequences, globalization and special interest activities have spurred debates among politicians and economists in the U.K., Germany, the U.S., and elsewhere. This essay investigates the potential efficacy of flat tax reform in the U.S. with public choice tools. In this paper I develop two testable hypotheses to study the effects of the flat-tax proposal. The sections below include: 1) facts on tax reforms, 2) public choice analysis of the flat tax reform, and 3) two testable hypotheses. 1) Facts on Tax Reforms The Coolidge tax cuts, which reduced the top rate from 73 % to 25 % during the 1920s, produced average 6 % GDP growth in the U.S. The tax revenues grew by 61 % in the same period. Somewhat similar were the growth effects after the Kennedy tax cuts in 1960s (GDP grew by 5%) and the Reagan tax cuts in 1980s (GDP grew by 4%, although 1980s were also accompanied with high fiscal deficits). None of these tax cuts were flat-tax reforms, but each significantly flattened tax rates1. One of the first adopters of the flat tax was Hong Kong in 1947. Many credit Hong Kong’s economic prosperity to non-interventionist policy of its government and to flat rate taxation. Estonia adopted the flat tax rate of 26 % in 1994 to encourage foreign capital inflows and capital accumulation. By 2003 its foreign direct investment (FDI) ratio over GDP reached 10.2%. The competition for FDI flows became fierce after Russia approved the 13 % flat tax. It prompted Estonia to lower its flat tax rate t