A tax scandal involving the tiny principality of Liechtenstein is causing waves of outrage in Germany, and its effects are spreading across Europe, as Berlin demands a crackdown on other tax havens such as Monaco and Switzerland. The United Kingdom and the Netherlands are now investigating to see if their own nationals have violated any tax laws. Even some U.S. politicians have joined the fray: according to Reuters, Senator Carl Levin, a Michigan Democrat, plans to launch a probe to see if Americans are unlawfully stashing money in Liechtenstein. The IRS is already “initiating enforcement action” against more than 100 American taxpayers in connection with the scandal, Reuters notes. 

At the root of it all: several hundred of Germany’s wealthiest and most influential citizens are under investigation for evading domestic laws through the use of foreign tax havens, most notably Liechtenstein. According to Bloomberg News, dozens of the raided suspects have confessed and started paying arrears. The culprits, including the former CEO of Deutsche Post, Klaus Zumwinkel, and Bavaria’s state commissioner for data protection, Karl-Michael Bentz, are mostly rich German businessmen. 

How did the government uncover this scandal? It paid an informant named Heinrich Kieber roughly 5 million euros ($7 million) for DVDs containing information on 1,000 alleged tax dodgers. Yet the money is apparently of little solace to Kieber: according to reports published in the German magazine Der Spiegel, he fears for his life. 

The German newspaper Süddeutsche Zeitung reports that the scandal may have cost Berlin as much as 3.4 billion euros in tax revenue ($5.3 billion). In Germany, the punishment for tax evasion can be relatively lenient if the culprits confess voluntarily and pay arrears in a timely manner (though prosecutors may even file charges in those cases). As a result, dozens of tax evaders have stepped forward. 

Germany's cumbersome and grossly inefficient tax system, with high rates and thousands of loopholes, increases the odds that people will cheat. By one estimate, the country's losses from tax evasion amount to $44 billion each year.

But the scandal is still growing. On Friday, March 7, the German finance ministry revealed it had been approached by a man offering a CD with information on another 2,000 possible tax dodgers. Political anger, meanwhile, is spiraling upward. German interior minister Wolfgang Schäuble has said, “I have zero understanding for this kind of greed. Uncontrolled capitalism, greed, and massive losses on speculative investments—that is a combination that makes people furious.” Meanwhile, the finance minister, Peer Steinbrück, has accused “greedy” Germans of costing the state “hundreds of millions” of euros. Threatening financial sanctions against Liechtenstein, Steinbrück has said that “we have to put on the screws,” while finance ministry spokesman Thorsten Albig has said that “taxing all transfers at the source is an option.” 

Kurt Beck, the leader of Germany’s center-left Social Democratic Party, has said that Liechtenstein, a tiny city state of 35,000 people, is guilty of “robber baron” policies, while Chancellor Angela Merkel has pressured Liechtenstein to change its banking secrecy laws, saying on February 20 that “the clock is ticking.” 

German political leaders are drawing all the wrong lessons from this scandal: the problem lies not with Liechtenstein and its low rate of taxation, but with Germany and its Byzantine tax system that drives out productive capital and incites abuse among otherwise law-abiding citizens. 

Indeed, a cumbersome and grossly inefficient tax system—one with high rates and thousands of loopholes—actually increases the odds that people will cheat. So bad is the German tax system—with a top rate of about 47 percent (and higher in some cases) and incomprehensible rules—that Dieter Ondracek, head of the German Tax Union, told the German broadcaster Deutsche Wellethat Germany loses about 30 billion euros ($44 billion) each year due to tax evasion. 

What can Germany do to change this? It is currently throwing its political weight around the European Union and seeking to crack down on small, vulnerable European tax havens such as Liechtenstein, Monaco, and Andorra, while striking fear into the hearts of its business leaders and giving them one more incentive to emigrate. 

Instead, Germany should eliminate the root cause of its current tax predicament. It should do something guaranteed to greatly increase tax compliance, raise tax revenues, and boost economic growth—namely, simplify the tax code and create a flat tax, or else a code with two tax brackets and no deductions. Under such a system, unethical people would still cheat; but the rate of cheating would be greatly reduced as the payoff for unethical behavior would be much lower. Tax revenues would rise significantly, as would capital circulating in Germany, as money stationed abroad was gradually brought back home. 

The idea of a flat tax in Germany is not as revolutionary as it might seem. During the 2005 German election campaign, Merkel tax adviser Paul Kirchhof proposed a 25 percent flat tax on income, in part to curb tax evasion. Unfortunately, Merkel blamed the flat tax idea for hurting her at the ballot box—her party, looking at a strong victory early on in the campaign, eventually “won” by a razor-thin margin and saw itself forced to rule with the center-left Social Democrats. After Merkel’s small victory, Kirchhof was sent back to academia. Now it’s time to give his tax plan a second hearing. 

That will require true political leadership—and right now the outlook for reform is bleak. The tax scandal has outraged millions of Germans, who feel the wealthy are benefiting from a type of lawless capitalism. Public sentiment has drifted in a populist direction. A new left-wing party, appropriately named the Left Party, is already capitalizing on public dissatisfaction in various elections around Germany. Consisting of various elements of the extreme left and former communists, the new party is highly controversial. Some of its members seem to long for the days of Communist East Germany. The tax scandal will enable the Left Party to win even more support. 

Trying to contain public anger, Germany’s political elite has vowed to punish tax dodgers harshly and force Europe’s tax havens to change their rules. Yet no amount of punitive measures can make people comply with a tax code that is fundamentally flawed. 

Jurgen Reinhoudt is a research assistant at the American Enterprise Institute.