FLAT TAX REVOLUTION?: POLICY CHANGE AND POLICY DIFFUSION IN EASTERN EUROPE __________________________________________________________________ A Dissertation Submitted to the Temple University Graduate Board __________________________________________________________________ in Partial Fulfillment of the Requirements for the Degree DOCTOR OF PHILOSOPHY __________________________________________________________________ by Joseph Michael Ellis August, 2010 Examining Committee Members: Dr. Richard Deeg, Committee Chair, Political Science Dr. Sandra Suarez, Political Science Dr. K. Orfeo Fioretos, Political Science Dr. Mitchell Orenstein, External Reader, Johns Hopkins University i © Copyright 2010 by Joseph Michael Ellis All Rights Reserved ii ABSTRACT Why have Eastern European states adopted flat tax policies? That is what this dissertation answers. This is a curious development given that flat tax policies were noticeably absent from the landscape of most of the world, including Eastern Europe. Fives cases of adoption are examined, including Estonia, Latvia, Lithuania, Slovakia and the Czech Republic. I argue that two simultaneous processes occur in Eastern Europe that makes adoption viable. First, at the domestic level, the idea of the flat tax is held in esteem by a number of actors, specifically: elite carriers, tax and financial ministers, think tanks and right-wing political parties. They champion this idea to its adoption, or at the least, introduce the flat tax into the policy-making apparatus. Second, at the international level, policy diffusion of the flat tax is taking place. In other words, the experience of previous adopters impacts the decisions of future adopters. Examining both cognitive heuristics theory and rational learning I argue that there are “varieties of diffusion” during the diffusion of the flat tax. Additionally, though this dissertation concerns itself primarily with adoption, I also investigate two cases of non-adoption in Poland and Hungary. What is argued is “diffusion without adoption” occurs. The idea of the flat tax diffused, but the adoption was not politically, ideologically, and economically feasible. iii ACKNOWLEDGMENTS This dissertation grew out of a short, six-page essay I first completed in Prof. Orfeo Fioretos’ Political Economy course in Fall 2005. I further developed this idea in Prof. Gary Mucciaroni’s Qualitative Methods course the following semester. I first must thank Prof. Richard Deeg for all of his guidance and advice during this process. He read the work closely and offered good advice from the prospectus stage through the finished project. He also dealt well with the constraints of distance imposed by my time at the University of Tennessee. Profs. Fioretos and Sandra Suarez also offered good advice. Prof. Fioretos helped refine my explanations and focus the work. The latter drafts were greatly improved by his close attention to detail. Prof. Suarez suggested that I discuss policy diffusion as an additional mechanism to explain policy change, making this a better dissertation for it. Prof. Hagen – though not a reader – helped me navigate the bureaucratic aspects of the graduate program which is a very thankless job. Lastly, I have to thank my wife Joanna and daughter Lena who allowed me time to work on this dissertation which I am sure seemed for them interminable. iv DEDICATION To Don and Pauline Barnett. v TABLE OF CONTENTS PAGE ABSTRACT ....................................................................................................................... iii ACKNOWLEDGMENTS ................................................................................................. iv DEDICATION .....................................................................................................................v LIST OF TABLES ............................................................................................................ vii CHAPTER 1. INTRODUCTION ...................................................................................................1 2. LITERATURE REVIEW, METHOD AND THEORY ........................................24 3. THE FIRST: ESTONIA ADOPTS A FLAT TAX ................................................53 4. LATVIA AND LITHUANIA: EARLY ADOPTION OF THE FLAT TAX ........80 5. LATE ADOPTION: THE FLAT TAX IN SLOVAKIA AND THE CZECH REPUBLIC ............................................................................................109 6. DIFFUSION WITHOUT ADOPTION: THE CASES OF HUNGARY AND POLAND ....................................................................................................135 7. CONCLUSION ....................................................................................................159 REFERENCES CITED ....................................................................................................177 vi LIST OF TABLES Table Page 1. Tax adoption and rates (flat and corporate ) ..........................................................2 2. Explanatory approaches .......................................................................................7 3. Causal variables in relation to three explanatory approaches. ..............................7 4. Causal process .....................................................................................................12 5. Additional variables ............................................................................................13 6. Political system ...................................................................................................15 7. GDP per capita ....................................................................................................16 8. Varieties of diffusion ..........................................................................................20 9. Policy diffusion ...................................................................................................21 10. Explanations and rival explanations ...................................................................48 11. Validation of explanations ................................................................................163 12. Validation of rival explanations ........................................................................165 13. Elite carriers ......................................................................................................167 14. Political parties aligned with the flat tax ...........................................................168 vii CHAPTER 1 INTRODUCTION Research Question In 1994 Estonian Prime Minister Mart Laar came to power behind a strict policy of liberalization of the economy and an adherence to the principles of neoliberalism. Laar’s first order of business was to figure out a way to solve Estonia’s tax revenue and collection problems (Smith 2002, 119). He answered by eliminating Estonia’s gradual, or progressive, taxation structure in favor of a 26-percent flat rate on incomes, a rate that is now just 21-percent. Since the adoption of the flat tax the fortunes of Estonia have greatly changed. Estonia gained admission into the European Union and has become a showcase country for economic growth and acquiring foreign direct investment. This is not to argue that flat taxes caused the above events. In fact, it is beyond the scope of this dissertation to draw any kind of conclusions about the efficacy of the flat tax in relation to economic windfalls. However, straightening out its budget and revenue woes went a long way toward signaling to others that Estonia was at least serious about reforming their country. All told, thirteen countries in Eastern and Southeastern Europe have adopted flat taxes in the last fourteen years. 1 (See Table 1). This development is all the more surprising because only one country in the world – Hong Kong – had a flat tax prior to Estonia. 1 The other twelve countries are: Albania, Montenegro, Macedonia, Georgia, Romania, Russia, Czech Republic, Bulgaria, Slovakia, Ukraine, Latvia, and Lithuania. See Table 1 for tax rates and adoption dates. 1 Table 1. Tax adoption and rates (personal and corporate) RATE COUNTRY ADOPTION YEAR (PERSONAL/CORPORATE) Estonia 1994 21/21 Latvia 1995 25/15 Lithuania 1995 24/15 Russia 2001 13/24 Serbia 2003 14/14 Ukraine 2004 15/25 Slovakia 2004 19/19 Georgia 2005 12/15 Romania 2006 16/16 Macedonia 2006 10/10 Montenegro 2007 15/9 Albania 2007 10/10 Czech Republic 2008 15/21 Bulgaria 2008 10/10 The adoption of the flat tax was a surprising development that caught not only practitioners, but also scholars, off guard. It is surprising because the flat tax had little real world use, and also because Eastern Europe was in disarray and would be one of the last places to look for policy innovation. The problems were serious. “Postcommunist governments [in Eastern Europe] suffered from both tax evasion and weak control over the use of resources that were collected,” noted political scientist Linda Cook (2007, 21- 22). What made it more difficult was the rapid switch to privatize formerly state-led economies. The tax bureaus had no way to track financial transactions and outflows. Governments lost revenue, could not fund basic social services and corruption was rampant. As Cook also stated, governments would go on to cut public sector salaries, increasing the incentive for bribery and under-the-table operations (Cook 2007, 22). One of the foremost experts on Eastern Europe’s transition, Anders Aslund, argued that the socialist economy had “no real tax system” to begin with. “At the end of