In 1994 Estonia introduced a flat tax rate of 26%. The flat tax is a system with only one tax rate for all personal income and corporate profits. Almost overnight this led to a phenomenal economic expansion. Contrary to the situation in a tax system with progressive rates, people were no longer punished fiscally if they worked harder. Very soon the Estonian example was being followed by its Baltic neighbours Lithuania and Latvia. In 1997 Russia introduced a flat tax of 13%. Serbia followed suit, as did the Ukraine, Slovakia and Georgia. Romania followed in 2005. So far nine countries have introduced a flat tax.
Next year Estonia plans to lower its flat rate to 20%, while the Czech Republic, Poland and Iraq are also considering abolishing their progressive tax rates. The man who sparked the flat tax revolution is former Estonian Prime Minister Mart Laar. He governed his country from 1992 to 1995 and from 1999 to 2002. When the historian became Prime Minister in 1992 at the age of 32 he knew nothing about economy. Laar’s area of expertise were Europe’s 19th-century national movements. “It is very fortunate that I was not an economist,” he says. “I had read only one book on economics – Milton Friedman’s “Free to Choose.” I was so ignorant at the time that I thought that what Friedman wrote about the benefits of privatisation, the flat tax and the abolition of all customs rights, was the result of economic reforms that had been put into practice in the West. It seemed common sense to me and, as I thought it had already been done everywhere, I simply introduced it in Estonia, despite warnings from Estonian economists that it could not be done. They said it was as impossible as walking on water. We did it: we just walked on the water because we did not know that it was impossible.”
When Laar became Prime Minister, inflation in Estonia was over 1,000%, the economy was falling at a rate of 30%, unemployment was over 30%, 95% of the economy was state-owned and 92% of Estonian trade was dependent on Russia. Today, inflation is 2.5%, economic growth is between 6 and 7%, unemployment is low, the government budget is balanced and there is a high level of investment. Moreover, Estonia is leading the world in the field of e-government.
Meanwhile Mart Laar hopes to resume his career as a historian, having just completed a study on the anti-communist partisans in the Estonian forests who fought the Soviets from 1944 to 1978, when the last of them was shot. “They have saved the soul of my country,” he says. “They are the great heroes of Estonia that should never be forgotten.”
The Brussels Journal interviews Mart Laar
Paul Belien: You turned Estonia into an economic miracle model. Can you tell us how you did it? You are not an economist. What did you do? Where did you get the inspiration from?
Mart Laar: I am not an economist. I am a practical man. I had read only one book on economics. This was Milton Friedman’s “Free to choose.” I must say that to my mind all the ideas which were presented there looked to be very practical. I was not too informed. I did not know that not many countries or rather no country at all had ever used the same policies. It looked very logical to me. Hence I introduced these things. They have worked very well in Estonia and are now being followed in lots of other countries.
PB: How was the economic situation in Estonia when you came into power?
ML: We were completely down. In 1992, the year when I became Prime Minister, we had an inflation of more than 1,000%. We had a drop in the economy of more than 30%. We were totally dependent on Russia. Most of our economy was state owned. Food was rationed. There was no gasoline, which means no cars in the streets. If I look back now and see the traffic congestion on Estonian streets I sometimes think that perhaps it was not such a bad time when there were no cars at all.
PB: You came up with this revolutionary idea of the flat tax. You were actually the first country in Europe to introduce this. Where did you get this revolutionary idea?
ML: This was also from the Milton Friedman book, but I really did not know that I was the only one to try it. It just looked so logical to introduce this, so this was one of the first reforms that we did. It was enforced on 1 January 1994.
PB: Did you have a hard time convincing your party members in Estonia to accept this brand new idea?
ML: Yes, indeed. I must say, however, that it did not take too long. We passed flat tax legislation in 1993 in order for it to become effective on 1 January of the next year. But, yes, sometimes to convince your own party is the most difficult part. When we introduced it, it was a highly unpopular idea. It was attacked by all the specialists. Most economists said that I was completely mad and that I did not know anything about economics. To say that this man really does not know anything about economics, was actually true.
PB: What happened then? Did you have an immediate economic recovery after the introduction of the flat tax?
ML: Of course it was not just the flat tax that did the trick but, indeed, it helped Estonia very much. We introduced it so quickly, because we thought it was a good method to fight unemployment. We had to encourage the people who were losing their jobs. The old fashioned dinosaur factories just closed down. We could not keep them running. This meant that we had to encourage the people to do something for themselves which meant they had to start their own businesses. But when you have to start your own business with a high level of taxation you will be killed. In a progressive system of taxation those who work more are taxed more. This is not encouraging people to do something. We needed to wake them up. It worked. The immediate result was the creation of an enormous number of new working places. According to the prognoses about unemployment approximately 30% of the people were set to lose their jobs during the following year. In reality, however, we had a very low level of unemployment, only 5 to 6%, as the result of the introduction of the flat tax, because the people just created their own businesses.
PB: When did the world start to notice that something was happening in Estonia?
ML: It started soon, in 1994 when people first started to talk about the Estonian economic miracle. Then this reputation began to grow. Of course we always tried to find new things to add to this reputation and to really be succesful. We have been quite good in this. After a first wave of reforms we had a second and a third wave too.
PB: You triggered a revolution that gradually expanded all over Eastern Europe and is now even moving into Western Europe.
ML: I hope so. Last year I predicted that during the next five years the whole of Eastern Europe will move to the flat rate. It now looks as if I was wrong, because it is happening faster. I recently had the great pleasure of participating in seminars in Western Europe. In Denmark for example where they are seriously discussing the flat rate. I was surprised how serious these plans are. And in Great Britain where Madsen Pirie is leading the discussion on the same topic. So I must say things look even more promising than I thought.
PB: But you would like to return to your professional work as a historian.
ML: Yes, I am doing everything I can to achieve this. It is working out quite well at the moment with my doctoral degree. I am now trying to win back some of the time that I lost as a historian while in politics. So I have a lot of things to do. But at the same time, of course, I continue trying to help those governments, political forces or people who are interested in introducing economic reforms in their countries. As I said I am not an economist but a practician. I give very practical advice and sometimes it can be useful, especially in those neo-transitional countries like the Ukraine or Georgia, to encourage the people and to say: “Look, guys, we were in the same situation that you are in now. Look at us: we got out of this situation. You can do this, too, when you have enough willpower, when you have enough courage and when you take the necessary decisions.”
PB: And that is a lesson we can also learn in Western Europe.
ML: Yes, indeed. I try to be very active in Europe. Estonia is a member of the European Union and I am a European. We must make the whole of Europe into a “new Europe.” I am very hopeful that the competition from the new member states will lead to a slightly more normal economic model in the whole of Europe. I must say I think it will be very positive for Europe. This is not a question of a so-called “Anglo-Saxon” model versus another model. There are governments which deliver, there are governments which do not, and this is not a question of left versus right. Some left governments have introduced reforms while right governments have not. It is sometimes said that these reforms are a sign of neo-liberalism. I think such a discussion is complete nonsense.
PB: You know that the European Union would like to harmonise taxation.
ML: Oh, actually they do not, or rather if some might want to do so, they will fail. We have won this debate. Clearly it will not happen in Europe. That I think is good news for the whole of Europe. Because when there is tax competition, taxes go down. I can guarantee you that taxes will go down not only in central and Eastern Europe, but very soon also in the Baltic Sea area. Not only in the new member states along the Baltic, but also in Finland, in Sweden, in Denmark. There is no other option left for them.
PB: They have to.
ML: Exactly. That I think is a positive sign. In this context I am really working towards European tax reform as well. I think this is a great continent with huge possibilities. Why shouldn’t we do better? We can do better.