Overview of tax systems

1. Overview of taxsystems

2. Introduction • Viewthatgovernments use taxes to finance public goods and servicesthatcitizensreceivefor free isdetached from reality because: • Governmentsfinance part of theiractivities with non-taxrevenue (e.g. public debt, sale of assets etc.) • Taxpolicieshaveincreasinglybeenused to promote non-revenueobjectives (e.g., to stimulate or, attimes, slow down some activities, enterprises, regions, social behavior etc.) • Revenuerequirementschange: • over time, for the samecountries; • at a given time, are likely to be differentacrosscountries • The broaderis the economicrole of the state • the more revenue a country’sgovernmentwillneedat a given time • The more likely are taxsystems to change • Focus on 30 OECD countries

3. Main trends of evolution of T/GDP 1965-2007 • In 1965 for the wholegroup of OECD countries the unweightedaverage, of T/GDP was 24.2 • By 2007 only Mexico and Turkeyhadtaxratioslowerthan the 1965 average • After 1965 the changes in taxratiosweremostly up, untilrecentyears (financialcrisisamounts to a period of taxinstability) • In 2007 differences in taxlevelsamong the countries of Europe muchreduced→ significantdegree of convergence in taxlevelsbetween 1965-2007 • Excluding a fewcountries with differenteconomies or traditions (Mexico, Korea, Turkey, and some of the Nordiccountries with expensive welfare states) makesthisprocess more evident

5. Inversion of trend • Highestpeak of T/GDP reachedduringthisperiod→ inversion of trend? • Difficult to say because 2007-today is period of financial crisis → exceptional in many ways and source of instability • 1998 was average year when highest levels of T/GDP were reached • Some countries did it earlier by some countries (New Zealand, Ireland, the Netherlands, Norway, Sweden, to some extent the UK) → effort to reforms aimed at reducing the spending role of the state • Some later (Spain, Portugal, Mexico, Italy, and Iceland) • Only Korea still shows an increasing trend • Coming from an unusual low level of T/GDP and a major financial crisis in 1990s

8. An optimalunique T/GDP ratio? • Convergencedoesnotnecessarilymeansthatthereis an optimal T/GDP level or a unique Laffer curve • T/GDP ratiosdepend on • howwellgovernments use the taxrevenue; • howgood are the taxlawsused to collect the revenue; • howgoodis the taxadministration; • howcitizensreact to disincentiveeffectsthat high taxrates generate (e.g. tax morale) • Inversion of trend may indicate thathighestpoint of Laffer curve hasbeenreached

9. Evolution of taxstructures • Have the major changes in T/GDP between 1965-2007 producedchanges in in taxstructures? • Macro variablesoftenhide more thantheyreveal→ significant changes in composition of tax structures → micro indicators reveal more info • Macro changes → looking at shares of single taxes on total revenues • decline in importance of the personal income tax since 1970s- 1980s • Also specific consumption taxes and property taxes declined over same period • Social security contributions and general consumption taxes increased (from 32% in 1965 to 44% in 2006) • Since these items were growing shares of growing T/GDP → this growth is particularly significant

11. General consumptiontaxes • Increase in the share of general consumptiontaxeslargely the outcome of introduction of VAT in 1960s and laterdecades • VAT replaced turnover taxes and some specificexcises • True “technologicalinnovation” in taxsystems for both OECD and developingcountries→ provided an alternative to the personal incometaxes→ PIT hadbeenpopular and pushed by American taxadvisors in theirtechnicalassistance to countries • VAT was first introduced in France asearlyas 1948 • In the 1960s, in Denmark (1967), Germany (1968), the Netherlands and Sweden (1969) • In the 1970s, in Luxembourg and Norway (1970), Belgium (1971), Ireland (1972), Austria, Italy and UK (1973) • In Spainitwasintroducedlater (in 1986) • USA stillnot use VAT

12. VAT rate structures • VAT in Europe generate revenuesbetween 7% and 10% of GDP • Denmark, Iceland, Norway use the highestnominalrates (25%) • In Europe standard VAT rate around 20% • Manycountriesapplyreducedrates on some basicproductsaffirmingthatthishelpspoorer families • Taxexpertsgenerallyskepticalabouttheseclaims (public choice, seerestaurants in France) →supportVATs with single rates • Administratively a VAT with a single rate on the broadestpossible base isconsideredpreferable

13. Advantages of VAT • VAT hasprovidedcountries with a powerfulinstrument to: • raiserevenue • pursuestabilization policy (lesswellknown) • VAT muchsimplerthan PIT • VAT revenue can be changed by modifying a single feature→ rate • Changehas immediate effect on revenues→ revenue from the VAT notsubject to anycollectionlag • VAT lendsitselflesseasily to “social engineering” on the part of policymakersbent on influencingbehavior of citizens • “Taxexpenditures” and othertaxpreferences can be more easilypromotedthroughincometaxes • In non optimal common currency areas (e.g., Euro) shifting burden of taxation from inputs to consumption by increasing VAT rate and decreasing tax rates on L and K could be equivalent to a ‘fiscal devaluation’ • Gains in competitiveness not from currency devaluation but from reduction of L and K costs represented by taxes

14. Disadvantages of VAT • Recentelimination of customscontrols on tradebetween EU countries→ increasingevidence of taxevasion and, especially, of taxfraudslinked to fakeexportswithin EU countries • Increase of internet commerce, combined with the increasingtrade in virtualproductsthat do nothave a physicalcontenthasalsofacilitatedtaxevasion • VAT self enforcingvirtue no longerseems so relevant

15. Personal incometaxes • In 1950s-1960s PIT, especially in itsversion of a “global, comprehensive and progressive tax’ wasseenas the “fairest and the best of alltaxes” • Surveypollsshowedthattaxpayersreactedfavorably to it • Progressivityseemd to ensurefairness • Taxexpenditurescould be substitues for high expenditures (especially in Anglo-Saxoncountries) • Disincentiveseffectswetestillperceivedas minor • Taxevasionwasminimal • In 1970s and 1980s thisvisionbecame the opposite • Taxexpendituresenabled social engineering and vote buying→ PIT not so fair • Econometric evidence of large EB due to high marginal tax rates • Laffer curve and supply side economics • Globalization and spread of multinational corporations increased costs of tax collection → growing evidence of international tax evasion and competition • TRA 1986 in US was a turning point with important “demonstation effect”

16. Evolution of top marginaltaxrates 1975-2007 • Remarkablereductions in MARTAX • In 1975 therewerestillmanycountries with MARTAX >70% or more • In the 1960s the rateshadbeenevenhigher • By 2007 no country with MARTAX>60% and only 7 with MARTAX >50% • Significantconvergence in the top rates • Ignoring East Europe, mostcountrieshad MARTAX between 40-50% • Number of incomebracketssignificantlyreduced in mostcountries

18. Taxwedges due to combination of PIT and SST • TRA opened the way to reduction of taxrates by extendingtaxbasesthroughelimination of taxexpenditures • Notalwayssuccessfull • Reduction of MARTAX on PIT made difficult by revenuerequirements • Combination of PIT and SST createdimportanttaxwedgesespecially for dependentworkers • Taxwedges negative indicator of freedom • In 2007 stillvery large

20. Hiddenproblems with PIT –taxthresholds • Same MARTAX may be more or lessharmful to work incentives - and more or lessproductive of taxrevenue - depending on incomethreshold of atwhichisapplied • In 2007 MARTAX for averagewagesemployeesvariedsignificantly • amongcountries (from 28% in Mexico to 56.5% in Sweden) • and the level of incomeatwhich the rate appliedalsovariedsignificantly (from 0.3 of an averagewage in Iceland to 8.7 in U.S.) • For anygiven MARTAX the higheris the thresholdatwhichitisapplied the lessdamagingitis to incentives • Point neglected by analysts • Increases in thresholdshavesame impact on work incentivesasreductions in MARTAX

22. Otherevolutions of PIT • Progressive abandoning of comprehensive and progressive incometaxes • Return to schedular (single rate) incometaxes common in continental Europe in early XX century→ mainly the result of globalization and taxcompetition • The introduction of dualincometaxes (DITs) by Nordiccountries and then by othercountries, includingSpain and Italy (brieflyduring Prodi government) • The growingpopularity of flat rate taxes and theirintroduction in a number of (mainly small) countries

23. Schedular PIT and DITs • Schedular approachevident from lack of interest in taxingunrealized capital gains (a hot issue in 1970s) • Severalcountriesnowtaxrealized capital gains and dividensatdifferent, and often more favorable, ratesthanlaborincome→ DIT consistent with this approach • DITs impose lower flat tax rates on K income but maintain higher and progressive rates on L income • Two goals • Simplifying tax administration • Reducing incentives for K flight toward tax havens → these incentives are particularly strong when K incomes are taxed at the top marginal tax rate within a comprehensive income tax • Assumption behind DIT is that L is internationally less mobile → high, progressive tax rates on L income do not encourage the emigration of workers → especially when the high taxes are used to pay for efficient welfare states

24. Flattaxes • Brainchild of supply side economics • Linear taxes with: • nominallyfixed personal exemption (0 rate bracket) • incomeabove the exemptiontaxedatone, flat rate • → Flattaxes are progressive, notproportional • Fotranyrevenuerequirement→ the higher the size of the exemption, the higher the tax rate must be • Manyrationales for flattaxes • Reduces the pressures by lobbies to ask for preferentialtaxtreatments; • Simplify the taxsystemwhilemakingit more efficient and more pro growth • Claim of simplicityhaslittle to do with number of taxratesbut with comprehensiveness of tax base → mostcomplications come from identification of the tax base • Even with a single rate, the higheris the personal exemption and the greater are the revenueneeds, the higher must be the tax rate and the stronger the pressures for special taxtreatments • Also a single but high tax rate may create strong disincentiveeffects

25. Flattaxesaround the world • In 2007 24 countrieshadintroducedflat-rate taxes (e.g. Iceland, Turkey and Slovakiaamong the OECD countries) • Mainly small countries, especially in Eastern Europe • Russia, not a member of OECD, and Turkey are the only major countriesthathaveintroducedflatrates • Revenueneeds of most OECD countries, and growingconcernsaboutpoverty and incomedistributionmake the introduction of flat-rate taxesunlikely • The flat rate wouldhave to be very high.

26. Overallimprovements of taxsystems • Expertsbelievethattaxsystems are evolving in the right direction • replacement of manyexcise and turnover (cascades) taxes with non-cascadingVATsdistortsless the pricesatwhichgoods are sold. • Greater dependency on VAT, ratherthan on incometaxes, improved allocative efficiencybecause the VAT exemptsaving. • Lowering of taxrates, for bothindividuals and corporate taxpayersreduces welfare costs of incometaxes • Reduction in the number of taxrates, in the taxsystems of the countries’ personal incometaxes, simplifiedtaxsystems • Substitution of DIT instead of “global, comprehensive and progressive personal incometax” reduceddistortions and taxexpenditures • Reduction of inflationeliminated fiscal drags and severalotherproblemsrelated with lack of indexation

27. New problems - 1 • Fiscal decentralization • Loss of power by CG • Taxcompetition– soft budget constraints • Increasingoverlap of nationaltaxbases with global tax base → global tax base hasacquiredcharacteristics of “commons”, that can be exploited by especially small countries • Some countries export taxes by attractingforeign capital, foreign consumers, and foreign high incomeindividualsincludingpensioners • Taxcompetitionaimedespeciallyat mobile taxbases by • loweringtaxrates on K and on consumption for highlypricedproducts. • eroding the taxable base, especially for corporate income • Taxcompetition can be carried out in several ways • Transparentcompetition on taxrates; • Lesstransparentthrough the manipulation of taxbases; • “unfaircompetition” carried out throughbanksecrecylaws and othertoolsused by taxhavens and by off-shore centers

28. New problems - 2 • Taxevasion and taxavoidance are increasinglybecoming global phenomena • Oftenconnected with banksecrecy and with special regulatorytreatments of foreign companies (in 2008 18857 U.S. businesses hadreported to be housed in one single building in the Cayman Islands!) • Money launderingat the state level (Moldavia, Lichtenstein) • In a globalized world multinationalcorporations can earnprofits in one country but, throughvariousaccountingstrategies, allocate them to an other country wheretaxrates are verylow or where the identity of the realbeneficiaries of the profits can be hidden • Reliance on the residence principle, withouteffectiveexchange of information, can lead to large taxavoidance • → progressive movetowardsarrangementsthatdepend on source-basedtaxation and/or on a fullerexchange of information • Secrecy of bank account is an element of freedom

29. New problems - 3 • Taxcomplexityhasincreasedbecause of cumulation over time of many small micro changes. • Over the yearsthese micro changes • weaken the structure of taxsystem, • increasecost of compliance • reduce the efficiency and the equity of taxsystems

30. Taxcomplexity • Becker: “Complications in the tax code are an excellentexample of the conflictthatsometimesarisesbetweenwhatisrationalat the individuallevel, and whatisrational to society as a whole” • Reducingcomplexityis a pure public good • Itdoesnothappenbecause of individual free riding • Tax Foundation reports thatcomplexity in the U.S. is a regressive tax • 56% percent of the totalcompliancecostsborn by businesses and the rest by individuals • Compliancecostsamount to 5.9% of income for taxpayers with incomelessthanUS$200,000 and 0,5% for those with income greater than that • Tax complexity affects growth of the economy because of overhead costs and opportunity costs. • Overhead costs consist of • tax planning; • tax audits and litigation; • tax compliance. • Opportunity costs consist mainly of time and effort allocated to tax matters

31. Quantitative measures of tax complexity Chris Edwards (2006) of CatoInstitutehasestimated the number of pages of U.S. Federal incometaxrules (seediagram) The Special Report of the Tax Foundation hascalculatedthat the number of words in the U.S. Tax Code and IRS Regulationsbetween 1955 and 2005 increased from 718 thousand to 7.1 million. Increasewas once again due to difficulties in defining the tax base Sameapplies to othercountries