The flattening of tax systems in the OECD Countries

The OECD published on 29 March 2006 a Policy Brief entitled “Reforming Personal Income Tax”. As the name says, this brief looks at the recent trends in personal income taxation in OECD countries and (very briefly) evaluates several types of personal income tax reforms.

The OECD addresses the issues of introducing a “flat personal tax” and its possible consequences. One can even derive (although the OECD wording is rather mild) a "implicit" recommendation that “flat tax” reforms should not be pursued in OECD Member countries due to possible effects such as the weakening of income redistribution and potential “side effects” on the benefit systems in place in several of the OECD Member Countries.

The OECD looked at recent reforms in selected countries and concluded that the key result of these reforms has been the reduction of the tax rates, compensated by the broadening of the tax base. These reforms also resulted in a move away from comprehensive personal income tax systems, through the introduction of alternative tax systems, such as the (Scandinavian) dual income tax system or the introduction of a flat tax system.

To more easily understand the differences between the various systems, a comprehensive income tax system taxes wage and capital income (less deductions) according to the same progressive rate schedule, while under a Dual income tax system personal capital income is taxed at low (and proportional) rates and labour income is taxed at high and progressive rates. The flat tax system, on the other hand, is based on a flat tax rate on all net income (i.e. capital, labour and other income less deductions).

With regards to recent flat tax reforms, the OECD mentioned the introduction of a flat tax in Russia (January 2001) and Slovak Republic (January 2004). In both cases, the reforms were said to broaden the personal income tax base (by eliminating tax allowances and credits) and introduce a flat personal income tax rate of 13% and 19% respectively. Interestingly, the OECD pointed out that it is unclear if the revenue increase (in Russia) should be attributed to the flat tax reform or to the administrative reforms and stronger tax enforcement that followed the reform. The OECD (for the safe side) even referred to a study by IMF that concluded that "there is, in short, no strong evidence that (Russian) tax reform itself caused the PIT revenue boom".

With regards to dual income tax reforms, the OECD referred to the case of Norway, whereby self-employed income is split into a labour income component and a capital income component. Accordingly, Norway taxes all personal income at a flat personal income tax rate of 28% (same rate as for corporate income). In addition to the flat rate, a progressive surtax is levied on gross income from wages and pensions above a certain threshold. As a new development, the OECD pointed out to the fact that Norway recently introduced (January 2006) a higher shareholder income tax on realized income of shares above a “normal” rate of return (i.e. above a risk-free return on investment).

This new regime, remembered-me about one Dutch novelty, introduced back in 2001. In short, investment income (such as dividends, interest, royalties and rental payments) received by Dutch resident individuals (other than substantial shareholders) is not taxed at the ordinary progressive rates but instead, the average annual value of property and assets are deemed to produce a net yield of 4% per year, which is taxed at the flat rate of 30% (the so-called “box 3” income). This means a tax of 1.2% on the average net annual value of the capital assets.

In fact, if one looks across the OECD countries you immediately note that the current taxation of personal capital income varies substantially: (i) with some countries taxing all personal capital income at a flat rate; (ii) other countries taxing all or most capital income according to a progressive schedule at more or less the same rates as labour income; (iii) other countries having a “semi-dual” income taxation, whereby all or some personal capital income is taxed at lower rates than wage income (e.g. Italy); and (iv) others having some sort of “deemed income” provisions.

What is interesting is that the OECD appears to focus on the dual income tax systems in comparison with the flat tax option. In fact, although both systems have their problems, the OECD “implies” that the problems of the flat tax are more of a structural nature (lack of progressivity) as compared with the dual income tax. It is usually said, that vertical equity(i.e. the unequal tax treatment of unequals) is an important element in a personal income tax system in order to achieve the so-called "distributive justice"! The flat tax would simply compromise that vertical equity.

It will be interesting to see the evolution, in the next years to come, of the personal income tax systems, namely whether the dual income tax systems adopted in the early 1990’s in Norway, Sweden, Finland and Denmark will eventually widespread throughout OECD Countries. The Dutch "Box-3" system is also an option, but its implications on an international level are still to explore (at least to me!).