Land of the free

National Review, Feb 24, 1997 by Radek Sikorski

Imagine a country with a flat tax and a currency fixed to a generally recognized standard, but with no tariffs and no government deficits. Imagine further that it has a beautiful historic capital, miles of unspoiled beaches, and agriculture unsullied by modern industrial methods. If such a country were also a solid democracy and a candidate for membership in the European Union, would one not be tempted to invest a few dimes in its dynamic stock exchange? Incidentally, its citizenry is encouraged to own guns, but you have to pass a psychological and an aptitude test to get a license. You read it here first: All these things are true of Estonia, the northernmost of the Baltic states and once the smallest republic of the Soviet Union.

Estonia's equivalent of the IRS is the eighth wonder of the world. Its headquarters is a privately owned house in downtown Tallinn with computers standing on makeshift tables. Stacks of old filing cabinets do for partition walls. Its chief, Mr. Kalev Jarvelill, is chubby and reserved, and he wears an unfashionable suit, exactly how an honest tax official should be. He is 31. Mr. Jarvelill sounds apologetic because the expenditure on building a permanent office for his staff is about to push up the cost of collecting taxes this year to just over 1 per cent. In the U.S., the cost of collecting the tax plus the cost of compliance is about 25 cents per dollar collected.

The Estonian tax bureau's budget director, Mr. Tony Smith, age 22, is a more enthusiastic sort. He is delighted to explain that most Estonians do not fill out any tax forms at all. The others use a single sheet of paper. No Estonian I met needed an accountant or a tax lawyer. Everybody pays the same rate of 26 per cent. That is also the rate of the corporate tax; so it makes no sense to fiddle about founding bogus companies. Estonia's youthful tax officials are still dissatisfied. At 33 per cent, employees' health and unemployment insurance, which is collected like a tax, is too high and hence responsible for bigger arrears than all the other taxes combined.

What is most remarkable about the Estonian flat tax is that it was entirely a native invention. Mr. Jarvelill and Mr. Smith speak only halting English and had never heard of Dick Gephardt or Steve Forbes. "It was simple," they told me. "We inherited this ridiculous Soviet system where everybody spent weeks filling forms, so we changed it to something more convenient for all."

Estonian monetary policy is also simplicity itself. The Estonian Central Bank simply has to match with a Deutschmark every 8 crowns it issues in cash and commercial bank reserves. Estonians argue that the arrangement is better even than the gold standard because instead of bearing the costs of stockpiling gold, they get the interest on keeping German government securities. The fact that it would take an act of parliament to change the exchange rate has some remarkable consequences. At 12 to 15 per cent, Estonia's market-based lending rates are among the lowest in the region.

Nor does the Bank of Estonia need to worry about the viability of commercial banks. Because money cannot be printed at will, the central bank cannot pump liquidity into the system, even during a recession. The government does not borrow, and so there are no government bonds. No government bonds, and so banks cannot sponge off the state. In Estonia, when banks do not behave responsibly, they go under, and so the country already has banks like the Hansa, with one of the safest portfolios anywhere in Europe.

Relieved of the tasks of selling Treasuries and playing nanny to the banks, Estonia's finance minister, Mr. Mart Opmann, can focus on the main task at hand: making sure that departments keep within their spending limits. Thanks to this, Estonian government spending as a proportion of GDP is about 36 per cent, a good 10 percentage points below the European average. This is largely because the unemployment benefit is low, about $50 per month. "I think about 10 per cent are without work at any time," says Mr. Opmann, "but people find jobs quickly when they have to. People in Estonia know that we cannot afford socialism." Sternness produces results. Inflation has dropped from 89 per cent in 1993 to below 20 per cent last year, to a projected 13 per cent this year.

Naturally, the policy will not really be tested until there is a major recession. But Estonian financiers are confident that the system is to some extent self-regulatory. In a recession, the economy would contract sharply, driving down prices and wages, making Estonian goods competitive again. In other words, Estonia would take any punch on the chin rather than try to cheat through debasing the currency. That's the theory, at least.

In practice, do employees anywhere in the world accept wage cuts these days? The president of Estonian Air, Mr. Borge Thornbech, a Dane, thinks his staff would. Estonian airline pilots still earn only a fifth as much as their Danish colleagues. Their incomes are rising fast, but on the understanding that cuts would be swift in case of a business downturn. Estonians stress that they know they will have to rely on their own savings when times are lean. "But at least our savings are in a strong currency that will keep its value."