Proportional (“flat”) personal income tax rate and competitiveness in Slovenia: Towards understanding the policy issues and policy implications International Academic Forum on Flat Tax Rate (February 2006) Gonzalo C. Caprirolo The views expressed are those of the author and do not necessarily represent those of the Ministry of Finance

1 Outline  The level playing field — Slovenian social model — Labor cost/competitiveness — Productivity — Labor market conditions  The current personal income tax system — Characteristics; rates, revenue; other taxes; comparison — Degree of progressivity of PIT  The “flat tax” proposal on personal income — The objective — The means — Net wage constant — VAT increase  The impact of the flat tax reform  The way forward

2 Four different social policy models in Europe (Boeri 2002) Source. Eurostat data base

3 Relatively satisfactory participation rate year range Source. EU commission. Employment in Europe 2004

4 Wage, income in line with productivity level Source. European Commission. Ameco data base

5 Growth potential in line with productivity level A key challenge: to increase employment of individuals Source: European Comision 2006

6 Relatively tight labor market conditions Source: Eurostat data base 2006

7 Most unemployed are low-skilled individuals Source: SORS, 2005

8 Flexibilty of labor market is average Source: IMAD, Economic Mirror No

9 Relatively low supply of high skilled workers Source: SURS

10 Elasticity of labor supply  Slovenian labor market characteristics and institutions might argue for a relatively inelastic labor supply at least for high skilled workers (short in supply) an a relatively high degree of real wage rigidity, particularly in private sector  Empirical work need to determine labor supply elasticity gross wage Dh = f (gross wage) S = f (net wage)

11 Competitivenes has remained stable Source: Ameco web page Jan 2006

12 Not even the elimination of total taxes related to labor will provide a lower labor cost than in most new EU members Source: Eurostat. Statistics in Focus 9/24. Labor Cost in Europe June 2004

13 Key challenge: to rise level of education, training and R&D Source: SURS 2004, own calculation

14 Social model underpinned by relative high share of tax revenue in GDP Source: Structures of the taxation systems in the European Union., Edition European Commission, Eurostat

15 The bulk of revenues soc. sec. contributions and indirect taxes

16 VAT tax revenue one of the highest in EU in 2003 amounted to 9 % of GDP only lower than DK and SE Source: OECD revenue statistics MF, Slovenia

17 while personal income tax revenue among the lowest in EU

18 Relatively low PIT revenue reflects low tax rates OECD: Taxing wages and MF, own calculation

19 although high top statutory and marginal rates OECD: Tax data base 2005 and MF, own calculation

20 PIT progresivity slightly above EU average OECD: Taxing wages and MF, own calculation

21 Up to 100 % APW earners, represent 68% of total taxpayers, paying 20% of PIT revenue (2003) Source: MF and own calculations

22 Concentration of PIT payments on top quintil not unusual Source: US Congressional Budget Office MF data for 2003 Note. US 2002 and Slovenia 2003

23 Important tax reform in 2005  Gradual elimination of the payroll tax until Payroll tax revenue about 2% of GDP. Total tax revenue to decline by 1% up to In Slovakia after first year of reform total tax burden drop by about 0.5% of GDP.  Systemic change in PIT system

24 After payroll tax elimination the tax wedge will be reduced significantly Source: MF 2003, own calculation

25 Payroll tax elimination to reduce importantly the cost of skilled labor force Source. OECD Taxing Wages and MF

26 Flat tax proposal  Purpose: — Unburdening the Slovenian economy and establishing conditions for increasing its competitiveness.  Means: — the current progressive personal income tax system with five tax brackets is replaced with a single tax rate system with a rate of 20 percent.  Key assumption: Unchanged net wage flat tax reform — net wages (wages in general) will not increase after the change in the tax system and  Impact: The flat tax rate on income will: – reduce the gross labor costs in order for businesses to increase profits that will be spent on enhancing their technological capacity and increase employment and; – reduce the relative price of high skilled workers with respect to low skilled workers thus enhancing their employability  Revenue neutral reform: — revenue neutrality is achieved by setting a flat tax rate of 20% on income and raising the existing lower VAT tax rate on necessities from the current level of 8.5% to 20% (single VAT rate)

27 Under assumption of net wage constant flat tax reform, gross wage will change labor cost will increase for low skilled workers and decrease for high skilled workers Source: MF own calculation. Data for 2003

28 If gross wage remains constant after flat tax reform, net wage will change net wage will decrease for low skilled workers and increase for high skilled workers Source: MF own calculation. Data for 2003

29 Average tax rate to increase for low skilled workers while decrease for high skilled workers or wage earners Source: MF own calculation. Data for 2003 there will not affect labor supply decisions as net wage will remain constant

30 Effective tax rate to increase for 70% of tax payers

31 The METR after the constant net wage flat reform will remain constant at current level Source: MF 2003, own calculation

32 The tax burden will be higher for individuals with one child Source: MF 2003, own calculation

33 Under assumption of net wage constant overall tax burden increases with adverse impact on labor supply Not only participation but effort to be reduced by low skilled workers under a non constant net wage flat tax reform Source: MF 2003, own calculation

34 Magnitude of adverse impact on low wage earners depending on individual profile high skilled workers to be unburdened Source: MF 2003, own calculation

35 Overall impact on labor supply Most efficiency gains should come from labor supply changes  Under constant net wage flat tax reform the overall labor supply could decline — Average and marginal tax rates will remain unchanged — Composite marginal tax rates to increase due to VAT single rate  Under no constant net wage tax reform the labor supply response will be mixed — The higher average tax on low skilled labor force (above general allowance) will deter labor participation and high marginal rates reduce labor effort — Low average effective and marginal rates could increase labor supply of high skilled workers (particularly effort) — Overall response of labor supply will be undermined depending on its elasticity

36 Labor demand response  Under an unchanged net wage flat tax reform the relative price of low to high skilled workers will increase — Low wage intensive industries to reduce labor demand — High skilled industries to increase labor demand. Although, skill biased investment to reduce labor demand unskilled labor  Under an unchanged gross wage flat reform the labor demand will remain in equilibrium  The impact of VAT on wages and labor demand in the two scenarios is uncertain depending on outcome of wage negotiations

37 Labor market response and impact on output  Under unchanged net wage flat tax reform, the likely impact is to be as follows: — Labor demand for low skilled workers to be reduced and labor supply decisions to be affected by VAT increase. Gross wage, employment and output in labor intensive industries could decline — Interaction of higher labor demand and high skilled labor supply (depending on its elasticity) could increase gross wages, employment and output. — The overall economy will enter into uncertain adjustment path towards the new Slovenian social economic model  Under an unchanged gross wage reform, the likely impact is to be as follows: — Participation of low skilled workers could decline as net income will be reduced — High skilled labor supply effort could increase depending on labor supply elasticity — Overall effect on output will depend on high skilled labor supply response (relatively scarce) offsetting the adverse impact on low skilled labor — Transition to the new Slovenian economic model could be less uncertain

38 Labor market adjustment towards the groos wage level prevailing before the constant net wage flat tax reform Source: SURS own calculation. Note. Difference in gross wage (before and after flat tax reform) weighted by the share of individuals clasified within a wage bracket in total amount of individuals employed

39 Short-term adjustment is to hurt tradable sector and low skilled labor industries (reduce labor participation and competitiveness) Source: SURS own calculation. Note. Difference in gross wage (before and after flat tax reform) weighted by the share of individuals clasified within a wage bracket in total amount of individuals employed

40 Tax burden to increase for individuals earning up to the average gross wage Source: MF own calculation. - the average tax burden for individuals earning up to AW will increase by EUR the average tax burden for individuals earning above AW to 200% AW will decline by EUR the average tax burden for individuals earning above 200% AW will decline by EUR 4187

41 Shift of tax burden to individuals earning up to the average gross wage - Tax burden to increase for about 70% of total tax payers - Total net tax burden to decrease by 45 billion SIT Source: MF own calculation.

42 Effect on disposable income due to change in VAT Source: SURS, MF, own calculation.

43 Consumption will decline for low wage earners Source: SURS, MF, own calculation.

44 Impact of reform summary  The cost of labor for the employer is not likely to change in equilibrium, thus there will be no competitive gains in absolute terms  Uncertain response of labor supply as tax reform to discourage labor participation and distimulate additional labor effort of low skilled workers while create incentives for additional work effort of high skilled workers  Output could potentially expand in medium to long run depending on labor supply response (high elasticity of low skilled labor supply while relatively low elasticity of high skilled labor supply). If net wage is enforced administratively severe adjustment to take place in labor intensive industries  The tax burden will shift from high wage income earners (high skilled) to low income earners (low skilled) or about 70% of tax payers  Change in education incentives (with unclear effect on education attainment particularly in short-term)  Reduction (elimination of progressive taxes) to increase inequality in the distribution of income (abandonment of current Slovenian social policy model)

45 The way forward: take into account 12 years of Danish experience ( ) reforms based on the following principles: — Tax base broadening and marginal tax rate reduction — Introduction of new taxes (e.g. green taxes) Source: Danish Ministry of Finance. Arne Hauge Jensen orking paper no. 2/2001. Title: Summary of Danish tax policy

46 The way forward: searching for a win-win situation  Ensure financing of elimination of payroll tax (2% GDP)  Assess impact of new personal income tax system (split system) recently adopted (i.e. impact on average and marginal rates on high skilled workers)  Reduction of progressivity of PIT without compromising distributional objectives (i.e. maintaining existing Slovenian social model), avoiding creation of labor market disincentives and ensuring revenue neutrality. Pursue Lisbon strategy oriented tax reform that would not hinder (i.e. does not burden) low skilled workers but would at the same time increase effort of high skilled workers. – gradual lowering of average and marginal tax rates for low and high skilled workers taking into account: 1. partially self-financed tax reduction 2. introduction on tax on immovable property 3. reduction of general government expenditure