Flat tax reform: The Baltics 2000-2007

The paper presents an endogenous growth economy with a representation of the tax rate system in the Baltic countries. Assuming that government spending is a given fraction of output, the paper shows how a flat tax system balanced between labor and corporate tax rates can be second best optimal. It then computes how actual Baltic tax reforms from 2000 to 2007 affect the growth rate and welfare, including transition dynamics. Comparing the actual reform effects to hypothetical tax experiments, it results that equal flat tax rates on personal and corporate income would have increased welfare in all three Baltic countries by more than the actual reforms. Experiments show that movement towards a more equal balance between labor and capital tax rates, through changing just one tax rate, achieve almost as high or higher utility gains as in actual law for all three countries.