The Detroit of Europe

The Daily Reckoning - March 8, 2006  
The Detroit of Europe
The Daily Reckoning PRESENTS: Much like Russia and the Baltic States, the  formerly communist state of Slovakia badly needed to simplify its overly  complicated tax code to free itself from the stagnation and corruption of  its formerly state-controlled economy. Steve Forbes explores...

THE DETROIT OF EUROPE  
by Steve Forbes

"Complex" does not begin to describe the shortcomings of Slovakia's former  tax code. It had five tax brackets ranging from 10% to 38%; 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%, others at 20%, 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%.  

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% to 38%  down to 19%. 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%,  shrinking the budget deficit by 93% 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% 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 U.S. 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  Westernized 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 subsidizing their low taxes with EU aid money. Yet  beneath these accusations are the stirrings of reform. As they call for more  equitable "tax harmonization" within the union, Germany, France, and others  are ever so slowly inching towards serious consideration of the flat tax. In  Germany, Chancellor Gerhard Schroeder is leading 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  neighboring, 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.