SWEDISH TAX POLICY: RECENT TRENDS AND FUTURE CHALLENGES

SWEDISH TAX POLICY:RECENT TRENDS ANDFUTURE CHALLENGES

A report toExpertgruppen för Studier i Offentlig ekonomi

by professor Peter Birch Sörensen

Presentation at ESO seminarin Stockholm, May 31, 2010

Main themes of the report

• What were the guiding principles of Swedish tax policy during the last twenty years?

• How big is the income loss (loss of economic efficiency) caused by deviations from neutral and uniform taxation?

• How could the income loss be reduced without sacrificing the goal of equity in taxation?

Chapter 1: The Swedish tax system in international context

Evolution since 1990:

• The total tax-to-GDP ratio has been roughly constant in the OECD but has fallen by several percentage points in Sweden

• The total average tax rate on labour income has been roughly constant in the OECD but has fallen in Sweden

Chapter 1: The Swedish tax system in international context

• Sweden relies more heavily on the personal income tax than the average OECD country

• Social security taxes and the VAT generate about the same share of total revenue in Sweden as in the average OECD country

• Excise taxes, property taxes and the corporate income tax contribute a smaller fraction of total revenue in Sweden than in the EU15 area

Chapter 2: The Tax Reform of the Century• Very ambitious reform: tax shifting amounting to 6% of

GDP• Guiding principles: neutrality and uniformity of taxation;

dual income tax to account for inflation• Significant tax base broadening combined with large tax

rate cuts• Corporate income tax rate almost cut in half, financed by

tax base broadening• Uniform VAT• Cut in marginal and average tax burden on labour,

financed in part by higher property tax

Chapter 2: The Tax Reform of the Century

• Unfortunate timing of the reform: in the short term it exacerbated the recession of 1992-93

• In the long term, the 1991 reform has improved economic efficiency by reducing tax distortions to labour supply, investment and portfolio composition

Chapter 3: Trends in Swedish tax policysince the Tax Reform of the Century

• Introduction of Earned Income Tax Credit• Selective cuts in social security taxes• Abolition of inheritance tax and wealth tax• More lenient taxation of closely held companies• Tax deduction for purchases of household services

Major departures from the principles of the 1991 reform:

• Reintroduction of a differentiated VAT• Värnskatten• Property tax reform of 2008

Chapter 4: The deadweight lossfrom taxation in Sweden

• Purpose of chapter: to estimate the loss of economic efficiency (”the marginal deadweight loss”) caused by an increase in taxes on

• labour income• savings income• business income• consumption

Measuring marginal deadweight loss

= "static" revenue change ( )

= "static" revenue change ( ) + "

Additional burden on taxpayers

additional revenue to the government

Marginal deadweight loss from tax increase ( ) =

s

s

R

R

DWL

dynamic" revenue change ( )

revenue change in the absence of behavioural responses revenue change caused by behavioural responses

Degree of "self-financing"

d

d

R

s

d

s

R

RR

DWLR

d

sRR

Calculating the dynamic revenue effects of a tax change

• Calculation of dynamic revenue changes requires estimates of the elasticities of labour supply, savings and investment plus estimates of initial effective marginal tax rates plus national income accounts data on the size of tax bases

• Novelty: the calculation of dynamic revenue changes accounts for the interaction among tax bases

• Because of substantial uncertainties, the main scenarios in the report make conservative assumptions on the size of elasticities (sensitivity analysis is also carried out)

Degree of self-financing (DSF)associated with a tax rate cut (%)

Cut in effectivemarginal tax

rate on1

Contribution to DSF from higher revenuefrom taxes on Total

DSFLabour income

Consumption Business income

Savings income

Labour income 18.2 4.8 0.4 0.6 24.0

Consumption 12.1 3.2 0.3 0.4 16.0

Business income

18.2 4.8 5.8 0.6 29.4

Savings income

14.2 3.7 0.3 17.2 35.4

1. The numbers indicate the effect of an identical cut in the marginal tax rate for all taxpayers.

Chapter 4: The deadweight lossfrom taxation in Sweden

Robust findings:

DSF (consumption tax)

< DSF (labour income tax)

< DSF (business income tax on normal return)

The estimated DSF for the savings income tax is more uncertain, but the high value of the DSF suggests that the principle of dual income taxation is well motivated

Chapter 5: Taxes on consumptionand pollution

Issues treated in the chapter:

• optimal design of the VAT

• optimal design of the excise taxes (”sin” taxes and ”green” taxes)

The chapter offers an estimate of the deadweight loss from the non-uniform VAT

How should the VAT be designed?

Lessons from the theory of optimal taxation:

• A differentiated VAT is an inefficient way of redistributing income compared to a progressive income tax and targeted income transfers

• A differentiated VAT with relatively high (low) indirect taxes on goods that are consumed jointly with leisure (work) can offset the tendency for the income tax to discourage labour supply

Beyond optimal tax theory:The case for a uniform VAT

• We lack the information needed to implement the optimal differentiated VAT rate structure

• Optimal taxation would require frequent tax rate changes due to changes in tastes and technology

• A uniform VAT is easier to administrate and less susceptible to fraud

• A differentiated VAT may distort product innovation• A differentiated VAT violates horizontal equity• A differentiated VAT invites lobbyism

Estimated efficiency gain from a move to a uniform VAT ≈ 9.4 billion SEK = 0.64% of private consumption (2008 level)

Chapter 6: The taxation of labour income

Issues treated in the chapter:

• Effective marginal tax rates on labour income in Sweden

• Lessons for Sweden from the theory of optimal labour income taxation

• The degree of self-financing associated with alternative ways of cutting labour income taxes in Sweden

Would an abolition of the värnskattpay for itself?

Top marginal tax rate (including social security tax) in percent of the employer’s gross labour cost:

• Excluding consumption taxes: 66.9%• Including consumption taxes: 75.1%

Estimated DSF for a cut in the värnskatt:

• Elasticity of taxable income = 0.1 → DSF = 1.23

• Elasticity of taxable income = 0.2 → DSF = 1.85

The taxation of labour income:Summary and policy proposals

• An abolition of the värnskatt would almost certainly pay for itself

• The DSF associated with an increase in the progressivity threshold is also likely to be quite high

• The introduction of the Earned Income Tax Credit (jobbskatteavdraget) was well motivated, but the interaction of the EITC with the standard deduction (grundavdrag) is very complex. A simplification could be achieved by making the standard deduction independent of income

Chapter 7: The taxation of income from saving and investment

Main distortions in the taxation of savings income: the current tax system favours

• retirement savings• savings in owner-occupied residential property• savings in assets with a high capital gains component

The current system of business income taxation implies tax distortions to

• the overall level of investment• the choice of organizational form• the choice between debt and equity• the choice between long-lived and short-lived assets

The taxation of savings income

• Estimated efficiency loss from current tax subsidy to retirement savings ≈ 3.4 billion SEK (2008 level)

• Suggested solution: a uniform 25% capital income tax rate on all capital income, including the imputed return to retirement savings

The taxation of residential property

• The combination of a low property tax rate with deductibility of mortgage interest payments favours owner-occupied over rental housing and housing consumption over other consumption. Resulting efficiency loss ≈ 7.4 billion SEK (2008 level)

• Suggested solution: replace the current municipal property tax, the current tax on realized capital gains on owner-occupied residential property and the stamp duties on transactions in such property by a flat property tax rate of 1% on a realistic assessment of the market value of the property (apply the same tax rules to rental property).

The taxation of capital gains

• Problems with current tax regime: the deferral of tax until the capital gain is realized implies a tax subsidy and creates lock-in effects. At the same time imperfect loss offsets may hamper risk-taking

• Suggested solution: tax all capital gains on listed shares as they accrue (with full loss offset) and tax the unrealized gains on unlisted shares resulting from the retention of corporate profits on a current basis, with an obligation for the company to pay the tax on the shareholder’s behalf.

The taxation of corporate income• The current corporation tax falls on the normal

return as well as on ”pure” profits

• In a small open economy, it is inoptimal to levy a source-based tax on the normal return (labour bears all of the burden)

Solution: • Introduce an Allowance for Corporate Equity

(ACE): Allow companies to deduct an imputed normal rate of interest on their equity (neutral treatment of debt and equity)

The taxation of closely held companies• Problem with current rules: non-neutral tax treatment of

proprietors and active shareholders in closely held companies

Suggested solution:• Reform the 3:12 rules to secure that any income up to a

cap given by the normal return to business equity (the ACE) is taxed only once at the capital income tax rate, whether it is realized or not. Income above the normal return should be taxed as labour income when it is realized in the form of a dividend or a capital gain, with a credit for the corporation tax already paid

Implication: Equal tax treatment of proprietors and active shareholders

The taxation of business income

Problem: the current asymmetric tax treatment of profits and losses hamper risk-taking (”Heads, I win; Tails, you lose”)

Suggested solution: • Liberalize the rules for offset of business losses, e.g., by

allowing business losses to offset other tax liabilities for the same year such as VAT, Pay-As-You-Earn income tax and fringe benefits tax

Further proposal: reduce the corporate income tax rate from the current 26.3% to 25%, corresponding to the proposed capital income tax rate

Effects of the main reform proposals on public revenueand economic efficiency (billion SEK, 2008 level)

Reform elementStatic

revenueeffect

Dynamic revenue effects (efficiency effects) Total neteffect onrevenue

Effect of move to uniform taxation

Effect of change inlevel of taxation

Total dynamicrevenue effect

Move to uniform VAT 0 +9.4 0 +9.4 +9.4Abolition of värnskatt -3.3 0 +3.1 to +6.2 +3.1 to +6.2 -0.2 to +2.9Move to uniform 25% savings income tax +3.0 +3.4 -0.8 to -1.1 +2.3 to +2.6 +5.3 to +5.6

Property tax reform+13.8 +7.4 -1.1 to -2.2 +5.2 to +6.3 +19.0 to +20.1

Allowance for Corporate Equity -9.0 +7.2 +1.6 to +2.7 +8.8 to +9.9 -0.2 to +0.9

Cut in corporate income tax rate to 25%

-4.0 0 +0.7 to +1.2 +0.7 to +1.2 -3.3 to -2.8

Total effect +0.5 +27.4 +3.5 to +6.8 +30.9 to +34.2 +31.4 to +34.7

Do the efficiency gains come at the expense of equity?

• The abolition of the värnskatt will benefit the top income earners, but the analysis in Chapter 8 of the report shows that the property tax reform and the reform of capital income taxation will have a progressive distributional impact

• In the long run, the gain from the ACE will accrue to workers in proportion to their earnings

• In the long run, a broad-based tax system with a low loss of economic efficiency is the best safeguard of the welfare state arrangements that ensure an equitable distribtution of income

Supplementary slides

Calculating the base for ACEEquity base in previous year+ taxable profits in previous year (gross of the ACE)+ exempt dividends received+ net new equity issues- tax payable on taxable profits in previous year- dividends paid- net new acquisitions of shares in other

companies- net new equity provided to foreign branches

= Equity base for the current year

Neutrality of the ACE

rate of interest = imputed rate of return rate of depreciation for tax purposes

Present value of total allowances triggered by one unit of investment:

1: Equivalent to ful

i

ii

l expensing

Note: the present value of allowances is independent of the rate ofdepreciation for tax purposes no distortion from accelerateddepreciation. Any mismeasurement of profit is offset by a co

rresponding

change in future ACE allowances

Setting the imputed rate of returnunder the ACE

• Full neutrality requires that the imputed return be equal to the shareholders’ discount rate

• With full loss offsets, the tax saving from the ACE is a risk-free cash flow, so the imputed rate of return should then be the risk-free interest rate

• With imperfect loss offsets, rough neutrality could be achieved by setting the imputed return equal to the average corporate bond rate

• Neutrality could be improved by allowing companies to offset tax losses against other taxes (e.g. VAT, pay-as-you-go income tax)

Taxing closely held corporations(fåmansföretag)

• Dividends and capital gains up to the level of the ACE allowance should be taxed as capital income

• Retained profits up to the level of the ACE should be taxed as capital gains at the shareholder level; with a corresponding step-up of the basis value of shares

• Dividends and realized capital gains above the ACE should be ’grossed up’ and taxed as labour income, with a credit for the underlying corporation tax

• The ’normal returns’ from closely held companies should be taxed at the standard capital income tax rate at the shareholder level

• The wage-based allowance should be abolished

Implication: (roughly) identical tax treatment of proprietorships and closely held corporations

The problem with the wage-based allowance for closely held companies Distortion of input choice: Penalty on capital that substitutes for

labour; subsidy to capital which is complementary to labour

METR on investment financed by

New equity Retained earnings Debt

No wage-based allowance -20.9 53.0 30.0

Marginal ratio of employee wagebill to capital stock: 0

9.3 53.0 30.0

Marginal ratio of employee wagebill to capital stock: -0.05

21.3 56.4 37.4

Marginal ratio of employee wagebill to capital stock: +0.05

-7.0 48.9 20.7

Source: Own calculations, based on 2007 tax rules

The taxation of capital gains on shares in widely held corporations

• Shares in listed corporations: taxation of gains upon accrual (mark-to-market)

Shares in widely held unlisted corporations:• Step up the basis of shares each year by the minimum of

the company’s retained profit and its ACE allowance and impose standard capital income tax on the increase in basis value

• If a share is sold at a price exceeding the stepped-up basis value, the additional gain is taxed as capital income at the standard rate

• If a share is sold at a price below the stepped-up basis value, the loss is deductible against other capital income (or entitles the taxpayer to a tax credit against the tax on labour income)

Advantages of capital gains tax regimefor unlisted shares

• No valuation problem: capital gains tax liability is based on the company’s taxable retained profits

• No liquidity problem: tax is only liable in so far as the company earns positive taxable profits. The company can pay the flat tax on behalf of resident individual shareholders

• Taxation of additional realized gains ensures taxation of gains stemming from higher expected future earnings and loss offset protects against overtaxation

Chapter 4: The deadweight lossfrom taxation in Sweden

• Marginal deadweight loss from a tax increase = the amount taxpayers would be willing to pay to avoid the extra tax – the net revenue gain

• The amount taxpayers would be willing to pay to avoid the extra tax = static revenue gain

• Net revenue gain = static revenue gain – dynamic revenue loss

Hence:• Marginal deadweight loss from a tax increase = dynamic

revenue loss

Chapter 4: The deadweight lossfrom taxation in Sweden

• Note: dynamic revenue loss from tax increase = dynamic revenue gain from tax cut. Hence

Marginal deadweight loss from tax increaseStatic revenue gain from tax increase

Dynamic revenue loss from tax increaseStatic revenue gain from tax increase

Dynamic revenue gain from tax cutStatic reve

nue loss from tax cut

Degree of self-financing ( )DSF