Flatliners: Ideology and Rational Learning in the Diffusion of the Flat Tax



negotiations — in fact, the Central European and Baltic states are being pressured to
dismantle their tax systems now that they have become EU members. Thus, though
the EU as well as international financial institutions are often the drivers of reform in
developing countries, it may be that proximity to the EU would make a country less likely
to champion a flat tax. The expectation here is mixed.

Other research that attempts to specify the mechanism behind spreads and fashions
has often rejected rational learning in favor of a more pessimistic view of human nature.
Bikchandani, Hirshleifer & Welch (1992, 1998) call these processes “informational cas-
cades,” noting that after a certain point in the cascades, adoptees stop accumulating new
information and simply adopt the trend blindly. Similarly, Weyland (2005) attributes
the geographic and temporal pattern and substantive nature of pension reform in Latin
America to “cognitive heuristics.”21 Empirically as well as anecdotally, we hope to show
that this is not the case for Eastern Europe.

We posit that countries signal their business-friendly ‘type’ to potential investors by
adopting flat taxation. In turn, this adoption leads to increases in FDI inflows to “flat”
countries and the latter and their policies become more attractive in the eyes of their peer
group, in addition to foreign investors. On average, “flat” countries receive 4.3 percent of
their GDP in FDI inflows after adoption, while non-flat countries receive 2.5 percent.22
Also, on average, FDI inflows increase by 2.5 percent after country adopts flat tax. As
21 Weyland delineates among four different theoretical frameworks that characterize diffusion processes,
including external pressure, normative imitation, rational learning, and cognitive heuristics, championing
the latter to explain most aspects of diffusion. Policymakers, he argues, adopted the reform not through
a process of sober consideration, but through a three-fold psychological process in which, once an idea
becomes available, individuals place exaggerated stock in a measure’s superiority and adopt it wholesale,
regardless of its appropriateness for their own context. He also describes the temporal pattern of diffusion
as an S-shaped curve, mapping a surge and then a levelling of policy adoption. It remains to be seen
whether the path of the flat tax will take this shape, since, as we note below, ideology is also an important
predictor of adoption, and indeed many opposition parties in both Eastern and Western Europe have
dropped hints about the reform.

22Standard deviations are 2.7 and 2.7, respectively.

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