What tax system is in Iraq's future?

Posted: Apr 23, 2003 12:00 AM

 With the end of war, the United States is now working rapidly to restore civil administration in Iraq and get its economy moving again.  A key issue will be the Iraqi tax system, which cannot wait until all the questions about Iraq’s form of government are worked out.  The interim authorities will need revenue to pay for police, firefighting and other basic services.  Hence, some sort of tax system will need to be put in place quickly.
As best anyone can tell, Iraq really had no tax system under Saddam Hussein.  Sales from the state-run oil monopoly provided all the revenue that the government needed for what little it did.  Hence, in creating a new Iraqi tax system, the new government will be starting from scratch.  In essence, it will have a blank slate to write on.

 In this respect, the situation in Iraq is not altogether different from what it was in formerly communist states such as Russia.  Although the old Soviet Union had a tax system, it existed neither to provide revenue to the government nor to change the distribution of income.  Neither function was necessary in a socialist state, because the government owned everything and everyone worked for it as well.  Thus, the state could get all the revenue it needed and achieve whatever income distribution it desired just by changing wages and prices as it saw fit.

 As best I can tell, the Soviet tax system functioned like a Federal Reserve open market operation.  Its main purpose was to soak up excess money circulating in the economy.  (See Soviet Taxation by Franklyn Holzman, Harvard University Press, 1955.)  Needless to say, a tax system designed for this purpose was wholly inappropriate for a post-communist, quasi-free economy.

 The Russian government struggled for some years to come up with an appropriate tax system.  Under extreme pressure from the International Monetary Fund to raise revenue in order to get inflation under control—the central bank was just printing money to cover large deficits—tax rates were raised, many new taxes imposed, and extreme pressure was brought to bear on those evading taxes.

 It all proved to be for naught.  Tax revenue fell to just 8.6 percent of the gross domestic product in 1998, from 11.1 percent in 1995.  In 1996, the IMF suspended its program in Russia because its tax revenues were too low.  In effect, the IMF wanted Russia to raise taxes still more.

 Rather than follow the IMF advice, the Russians rethought their tax policy and opted to replace the whole system with something much simpler and less punitive.  The key element of the new tax system was a 13 percent flat rate tax on individual incomes.  Tax rates on corporations were also slashed and many taxes abolished.  The new system took effect on January 1, 2001.

 Contrary to IMF predictions, revenues under the new system shot up.  It was no longer worth the risk of cheating to evade a 13 percent tax.  In 2001, tax revenues rose to 16.2 percent of GDP—almost twice what they had been 3 years earlier when tax rates were much higher.  The New York Times even praised the new Russian flat tax, calling the results “stellar.”  (For more information, go to www.russiaeconomy.org.)

 The results in Iraq could be similar.  Like Russia, it is in a position to build an entirely new tax system from nothing.  Thus it need not worry about all the political and transition problems that have made adoption of fundamental tax reform here so difficult.  It is gratifying, therefore, that leaders of the new Iraq are said to be looking at a flat rate tax system for their country, according to an April 14 report in Tax Notes.

 U.S. officials advising the Iraqis are said to be looking at the example of Japan after World War II.  There, General Douglas MacArthur, who governed Japan in the immediate postwar period, had some U.S. economists, led by Carl Shoup of Columbia University, design an entirely new tax system.  This led to the adoption of a tax system in Japan that had much lower tax rates than in the U.S. until the 1980s, with saving and capital formation also taxed much more lightly.  By all accounts, Japan’s excellent tax system in the 1950’s and 1960’s was a key to its astonishing growth.

 Some say that Iraq doesn’t need a tax system at all.  It can just continue to tax oil and, in effect, shift the burden on to oil purchasers.  But since the price of oil can go no higher than the world price, the burden would actually fall on producers, thereby hindering development of Iraqi oil.  It makes more sense for the new Iraqi government to get oil revenue by selling leases for production than by taxing oil directly.

 Whatever happens with Iraq’s tax system will be important for its economy and the political viability of the new government.  It’s important to get it right.