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Abstract
Introducing a flat-rate income tax is a popular reform proposal. The 2004 tax reform in Poland implemented an optional broad-base low-rate “flat” tax for business incomes. Taxpayers who chose the flat tax treatment had to give up most tax preferences (resulting in a variation in incentives to adopt), but they benefited from the lower tax rates. For the highest income taxpayers, the
marginal tax rate fell from 40% to 19%. using a large panel of individual tax returns, I demonstrate massive increases in reported incomes that resulted in small tax revenue consequences despite large reductions in tax rates. Conservative estimates indicate that a suitably designed flat tax option would increase revenue. The responses are most likely operating through a reduction in
tax avoidance or participation in the gray economy, implying that when the avoidance margin is responsive, a reform involving base-broadening combined with marginal tax rate reductions that allows taxpayers to self-select can be Pareto improving. The paper also highlights empirical issues
involved in estimating the responsiveness of taxable income and suggests that violations of exclusion restrictions due to heterogeneous earnings dynamics may be responsible for the “sensitivity” of results claimed elsewhere in the literature.