Tag: OECD
Latvia Stumbling Towards Progressive Income Taxation: Episode II
In August 2017, the Latvian parliament adopted a major tax reform package that will come into force in January 2018. This reform was a long-awaited step from the Latvian authorities to make the personal income tax more progressive. Some of the elements of the adopted reform, e.g. the changes in the basic tax allowance are estimated to help reducing the tax wedge on low wages and help addressing the problem of high income inequality. At the same time, the way the newly introduced progressive tax rate is designed will effectively lead to a reduction in the tax burden on labor and will hardly introduce any progressivity to the system.
In recent years, reducing income inequality has become one of the top priorities of the Latvian government. Income inequality in Latvia is higher than in most other EU and OECD countries, and the need to address this issue has been repeatedly emphasized by the Latvian officials, the European Commission, the World Bank and OECD.
The main reason for high income-inequality is a low degree of income redistribution ensured by the tax-benefit system. The personal income tax (PIT) has been flat since the mid-nineties. While the non-taxable income allowance introduces some progressivity to the system, the Latvian tax system is characterized by a very high tax burden on low wages, compared to other EU and OECD countries.
Since the beginning of 2017, the government has worked on an extensive tax reform package that was passed in the parliament in August and will become effective as of January 2018.
Two years ago, we wrote about the tax reform of 2016. In this brief, we estimate the effect of the 2018 reform on the tax burden on labour and income inequality. We will only consider changes in direct taxes on personal income – the changes in enterprise income tax and excise tax are outside the scope of our analysis. Parts of our estimations are done using the tax-benefit microsimulation model EUROMOD (for more details about the EUROMOD modelling approach, see Sutherland and Figari, 2013) and EU-SILC 2015 data.
Tax reform 2018
We focus our analysis on four elements of the reform that are expected to affect income inequality and that are described below. In our simulations, however, we take into account all changes in the PIT rules.
First, the flat PIT rate of 23% will be replaced by a progressive rate with three brackets: 20% (applied to annual income not exceeding 20,000 EUR), 23% (for annual income above 20,000 EUR and below 55,000 EUR) and 31.4% (applied to income exceeding 55,000 EUR per year).
Second, the maximum possible PIT allowance will be increased and the structure of the PIT allowance will be made more progressive. Latvia has a differentiated allowance since 2016, which means that individuals with lower incomes are eligible for a higher tax allowance. Figure 1 shows the changes in the non-taxable allowance that will be introduced by the reform. Another important change is that the differentiated allowance will be applied to the taxable income in the course of the year. The current system foresees that, during a calendar year, all wages are taxed applying the lowest possible allowance (60 EUR per month in 2017), but workers eligible for a higher allowance have to claim the overpaid tax in the beginning of the next year.
Figure 1. Basic PIT allowance before (2017) and after (2018-2020) the reform, EUR
Source: compiled by the authors.
Third, the rate of social insurance contributions will be increased by 1 percentage point. Social insurance contributions are capped and the cap will be increased from 48,600 EUR per year to 55,000 EUR per year, i.e. to the same income threshold that divides the top PIT bracket.
Finally, the reform will modify the solidarity tax – a tax, which was introduced in Latvia in 2016 and which is paid by top income earners. When this tax was initially introduced, one of its objectives was to eliminate the regressivity from the tax system caused by the cap on social insurance contributions. Hence, the rate of the solidarity tax was set at the same level as the rate of social insurance contributions and was effectively replacing social insurance contributions above the cap. The reform foresees that part of the revenues from the solidarity tax (10.5 percentage points) will be used to finance the top PIT rate. This element of the reform implies that after January 2018 those falling into the top PIT bracket will, in fact, not face a higher PIT rate than those falling into the second income bracket – the introduction of the top rate will be offset by the restructuring of the solidarity tax.
Results
There are four main findings. First, the reform will reduce the tax wedge on labor income, whereas the tax wedge on low wages will remain high by international standards. Second, most of the PIT taxable income earners (93.5%) will fall into the bottom income bracket. Hence the reform will effectively reduce the tax burden, while the effect on progressivity is very limited. Third, the (small) increase in tax progressivity is ensured mainly by changes in the tax allowance, while the effect of changes in the tax rate on progressivity is negligible: Even those few PIT payers that fall into the top tax bracket will not experience any increase in the tax burden due to a compensating change in the solidarity tax. Finally, it is mainly the households in the middle of the income distribution that will gain from the reform.
Effect on tax wedge
We start with a simple comparison of the average labor tax wedge in Latvia and other OECD countries for different wage levels before and after the reform. The tax wedge measures the share of total labor costs that is taxed away in the form of taxes or social contributions payable on employees’ income.
Table 1. Average tax wedge for single wage earners without dependents in Latvia and other OECD countries, before and after the reform
|
67% of average worker’s wage |
100% of average worker’s wage |
167% of average worker’s wage |
|
| OECD average in 2016, % (a) | 32.3 | 36.0 | 40.4 |
| Latvia 2016, % (a) | 41.8 | 42.6 | 43.3 |
| Latvia’s rank in 2016* (a) | 6 | 11 | 16 |
| Latvia 2018, % (b) | 39.4 | 42.3 | 42.6 |
| Latvia 2019, % (b) | 39.1 | 42.1 | 42.6 |
| Latvia 2020, %(b) | 39.0 | 41.9 | 42.8 |
Source: (a) OECD and (b) authors’ calculations. Note: * Ranking across 35 OECD countries. Higher ranking implies higher tax wedge relative to other countries.
Table 1 shows that the tax wedge on low wages (67% of an average worker’s wage) in Latvia is pretty high. In 2016, it was the 6th highest across OECD countries, while the tax wedge on high incomes (167% of the wage) is much closer to the OECD average.
While the reform will slightly reduce the tax wedge for low wage earners (from 41.8% to 39.0% in 2020), it will still remain high by OECD standards. Despite an increase in PIT rate for high-income earners, the reform will also lower the tax wedge for those who earn 167% of the average wage. Why? The explanation comes from the income thresholds for the tax brackets. The income of those earning 167% of the average wage is estimated to fully fall into the first tax bracket in 2018–2019 and only slightly exceed the income bracket for the second PIT rate by 2020. This means that most of the incomes of people earning 167% of the average wage will be taxed at the rate of 20%, which is lower than the current flat rate of 23%. Moreover, in 2020, only a small share of their income will be taxed at 23% – the same rate that these individuals would have had faced in the absence of the reform. Hence, we observe a reduction in the tax wedge for high-income earners.
Generally, only a very small share of taxpayers will fall into the middle and the top income brackets. According to our estimations, as many as 93.5% of all PIT taxable income earners will fall into the lowest income bracket, and only about 6.5% will fall into the second income bracket and about 0.5% will face the top PIT rate.
Apart from the progressive PIT schedule, the reform envisages important changes in the solidarity tax. As explained above, part of the revenues from the solidarity tax will be used to finance the top PIT rate. Therefore, even those (very few) taxpayers whose income will exceed the threshold for the top PIT rate, will not experience any increase in the tax burden because of the compensating change in the solidarity tax. Therefore, the reform will effectively reduce the tax burden on labour with very little effect on progressivity.
While lowering the tax burden is generally welcome, the motivation for applying the top rate to such a small group of taxpayers is not clear. For example, in their recent in-depth analysis of the Latvian tax system, the World Bank (World Bank, 2016) came up with a tax reform proposal that envisaged a considerably lower threshold for the top PIT rate, which, according to our estimations, would cover about 12% of the taxpayers. Given the limited budget resources and an especially high tax wedge on low wages, a more targeted reduction in the tax burden would be preferable. Similar concerns about insufficient reduction in the tax burden on low-income earners are expressed in the latest OECD economic survey of Latvia (OECD, 2017).
Effect on income distribution
Below we present the results from the tax-benefit microsimulation model EUROMOD. Figure 2 shows the simulated change in equivalized disposable income by income deciles compared to the baseline “no-reform” scenario in 2018-2020.
Figure 2. Change in equivalized disposable income by income deciles caused by the reform compared to “no-reform” scenario, %
Source: authors’ calculations using EUROMOD-LV model
The first thing to note is that these are mainly households in the middle of the income distribution who will gain from the reform – their income will increase due to both the increase in non-taxable allowance and the introduction of the progressive rate.
The gain in the bottom of the income distribution is smaller for several reasons. First, the proportion of non-employed individuals (unemployed and non-active) is larger in the bottom deciles. Second, individuals with low wages are less likely to gain from the reduction in the tax rate and the increase in the basic allowance, since they might already have most of their income untaxed due to the currently effective basic allowance. The same applies to pensioners who have a higher basic allowance than the employed individuals and who are mainly concentrated in the bottom of income distribution.
Our results suggest that the wealthiest households will also see their incomes grow as a result of the reform (by about 1% in 10th decile). The growth is ensured by the fact that annual income below 20,000 EUR will be taxed at a reduced rate of 20%, and, taking into account that even in the top decile only about half of the individuals get income from employment that exceeds 20,000 EUR per year, the gain from the tax reduction is considerable even in the top decile. A reduction in the tax allowance for high-income earners will have a negative effect on wealthy individuals’ income, but this will be more than compensated by the above positive effect of the change in the tax rate. Hence, the net effect on the incomes in the top deciles is estimated to be positive.
Finally, Table 2 summarizes the effect of the reform on the income distribution, measured by the Gini coefficient on equivalized disposable income. On the whole, the reform is estimated to slightly reduce income inequality – in 2020, the Gini coefficient is expected to be 0.6 points lower than it would have been in the absence of the reform. This reduction is mainly driven by the changes in the non-taxable allowance, while the three PIT rates are estimated to have an increasing impact on income inequality.
Table 2. Gini coefficient on equivalized disposable income in the reform and “no-reform” scenario
| 2018 | 2019 | 2020 | |
| “No-reform” scenario | 35.2 | 35.4 | 35.7 |
| Reform scenario | 35.0 | 35.0 | 35.1 |
Source: authors’ calculations using EUROMOD-LV model
Conclusion
The 2018 tax reform was a long-awaited step from the Latvian authorities on the way to a more progressive tax system. The planned changes in the basic tax allowance are estimated to help reducing the tax wedge on low wages and help addressing the problem of high income-inequality.
At the same time, the second major aspect of the reform, the introduction of a progressive PIT rate, raises more questions than answers. The progressive rate, the way it is designed, will effectively lead to an across-the-board reduction of the tax burden on labor and will hardly help to reach the proclaimed objective of taxing incomes progressively. Given the limited budgetary resources and given that taxes on low wages will remain high compared to other countries even after the reform, a more targeted reduction of the taxes on low-income earners would have been a more preferred option.
References
- OECD, 2017. “OECD Economic Surveys: Latvia 2017”, OECD Publishing, Paris. http://dx.doi.org/10.1787/eco_surveys-lva-2017-en
- Sutherland, H. and Figari, F., 2013. “EUROMOD: the European Union tax-benefit microsimulation model”, International Journal of Microsimulation, 1(6), 4-26.
- World Bank, 2016. “Latvia Tax Review”, available at http://fm.gov.lv/files/nodoklupolitika/Latvia%20Tax%20Review%20Draft%20231216%20D.pdf
Financing for Development: Two Years after Addis
At the Third International Conference on Development Finance in Addis Ababa on July 13—16, 2015, the world committed itself to an action agenda to raise resources to realize the 2030 sustainable development goals. The question is how much progress the world has achieved two years down the road, when the initial enthusiasm and commitments are no longer in the immediate spotlight. This policy brief reports on the discussion from a conference on this topic, Development Day 2017, held in Stockholm on May 31.
The year 2015 has been lauded as a landmark year for sustainable development. As many as three major global agreements were negotiated and signed: the 2030 Agenda for Sustainable Development; the Paris Agreement on Climate Change; and the Addis Ababa Action Agenda (AAAA) on Financing for Development. The latter may be less known, but is essential to the ambition to achieve the first since it concerns how to finance the necessary investments to achieve the Sustainable Development Goals (SDG). The AAAA identified seven action areas spanning both the public and the private sectors, and involving both domestic revenues and international transfers (domestic public resources, domestic and international private business and finance, development cooperation, trade, debt and debt sustainability, systemic issues and science, technology and innovation). This event focused primarily on international commercial private capital flows, and indirectly on development cooperation as a facilitator and catalyst for such private transfers.
Combining good business and good development
A major theme of the conference was combining good business with good development. Should private companies also take responsibility for environmental and social sustainability, or is the “only business of business to do business”? If firms do engage in sustainability investments, does it eat into profits or does it rather create a competitive edge? Reading business journals, it is easy to get the impression that there is a win-win situation. This picture is, however, based on rather limited information and the relationship is fraught with methodological challenges as both profitability and sustainability investments may be driven by other factors (such as competent leadership), and firms performing well may have the capacity and feel the obligation to invest part of their surplus into corporate social responsibility (CSR). Hence, there may be a question of reverse causality.
At the conference, new research was presented using data on investments in low and middle-income countries from the International Finance Corporation that includes both measures of financial rates of returns and subjective ratings of environment, social and governance (ESG) performance. Simple correlations suggested a significant positive relationship, or a win-win situation. However, once care was taken to identify a causal effect from ESG on profits, the results became insignificant. That is, the causal effect of ESG investments on profits seemed neither positive nor negative. However, when looking at broader measures of private sector development, the results suggest that both profits and ESG investments have a positive impact on sector development. This implies that there are good reasons for the public sector to encourage ESG activities even beyond the direct sustainability benefits through for instance public-private partnerships but also regulations that encourage good behavior.
How should results like these be interpreted? The presentation spurred an interesting debate on what are reasonable expectations and whether “the glass is half full or half empty”. It was emphasized that systematically beating the market should not really be expected from any group of investments, so a half-full interpretation seems more plausible.
This debate also came up in a panel discussion on institutional investments in developing countries, and where the growing success of green bonds was presented. Though still small in absolute size (1-2% of the bonds coming to the market are green bonds), there has been an impressive growth in the last 3-4 years. Currently, the Swedish bank SEB is cooperating with the German government in developing a green-bond market in emerging markets. Some of the lessons emphasized from the green-bond market were the importance of being clear towards investors about the motivation and the value proposition, to package the information in a credible way emphasizing independent verification, and to continuously monitor and give feedback to investors.
From the institutional investor side, it was mentioned how important it is to tell investors a compelling story. This may be easier with regards to environmental sustainability relative to social sustainability, both in terms of conveying the urgency and in developing indicators that can be monitored and communicated. It was also argued that even though there are initiatives out there, emphasizing how sustainable investments can be competitive in terms of profitability (such as green bonds), it would also help to change the relative price on the other end of the spectrum, i.e. through regulations, taxes or other instruments that can make investments with particularly negative externalities less profitable.
Finally, an overarching theme of the discussion was the challenge to have institutional investments reach the places with the most needs, i.e. the fragile and least developed countries. If this is to happen, pension funds and insurance companies have to be allowed to take on more risks, and it would be essential to reduce the corporate risk in public-private partnerships (more on this below).
In a second panel discussion, different Swedish corporate initiatives, emphasizing sustainability, were showcased. For example, the Swedish steel producers’ association, Jernkontoret, showcased the Swedish steel industry’s vision 2050 with the target of domestically based steel production using hydrogen and with zero CO2 emissions. Another example is the Sweden Textile Water Initiative, launched in 2010 by major Swedish textile and leather brands together with the Stockholm International Water Institute, has created the first guidelines for sustainable water and wastewater management in supply chains. Currently working with 277 suppliers in 5 countries, the initiative features clear win-win situations and is now self-sustaining and in the process of going private.
Skandia, a major Swedish insurance company, emphasized the business costs of socially unsustainable situations with examples from the costs in Sweden of sick leave, and the costs for protection and security for Swedish retailers and mall developers. Positive preventive work focusing on rehabilitation and the development of blossoming and inclusive neighborhoods were featured. These examples showcased how the SDGs are feeding into the thinking and planning of the private sector in Sweden, and how important it is to identify the business cases for thinking about sustainability in order for this to become mainstream.
However, the case for private capital to be the panacea for reaching the SDGs is by no means obvious. The non-governmental organization Diakonia pointed out that for every dollar flowing into a developing country, more than two dollars are lost. The biggest loss is coming from illicit financial flows, and within this category, tax evasion is the biggest problem. While the private sector is key to development, the main contributions this sector can do for development is to pay taxes where they are due, abide by international standards, and be transparent and accountable to the citizens and governments in the countries where they operate.
Swedwatch, used two examples from Borneo and what is now South Sudan, to illustrate how investors at times turn a blind eye towards human rights and environmental abuses by private multi-national companies. Transparency, due diligence in evaluating human rights risks prior to investment decisions, and a readiness to push for compensation and remedy if abuse is still unearthed were pointed out as key components to avoid this type of malpractice.
Development cooperation as facilitator for private flows
The second main theme of the day dealt with the ability to use development cooperation as a catalyst for private investments.
Swedfund, the Swedish government’s development financier, emphasized the need to move fast and find a business model in which one dollar spent becomes ten dollars on the ground. Based on a business model around three pillars (societal impact, sustainability and financial viability) Swedfund focus on areas with relatively high risk and where private capital are in short supply, with the hope to foster job creation, inclusive growth and poverty reduction.
Sida, the Swedish main aid agency, showcased their guarantee instruments. Through partnerships with bigger actors such as the International Finance Corporation (IFC) of the World Bank group as well as local banks in developing countries, Sida can shoulder part of the default risks involved when trying to reach more high-risk investors (such as small and medium sized enterprises) with great potential development impact. In this way, one dollar from the public aid budget can lure a multiple of dollars in private capital towards sustainable development.
The OECD Development Assistance Committee (DAC) emphasized that governments generally lack a policy for how to deliver official development assistance (ODA) in a sustainable way and a strategy for how to enable capital flows from the private sector. A DAC initiative to better track all financial flows going towards development, beyond just ODA, was presented.
From the Center for Global Development, the case for using public resources to facilitate private sector insurance mechanisms against human disasters was presented (concessional insurance). Benefits emphasized from explicit insurance contracts included faster and better-coordinated payouts, more certainty that compensation will come, incentives to invest in disaster prevention (to reduce premiums) and involvement of commercial insurance professionals.
Importantly, though, it was emphasized that it is crucial that aid money are truly complementary in the sense that they crowd in private investments that otherwise would not have taken place (and not end up subsidizing private investors in donor countries). It was also emphasized that donors must not forget about the focus on the poorest and people in fragile states.
In some environments donors must shoulder 100% of the risk to lure private capital. In those cases alternatives must be considered. Sida emphasized the importance to match financial instruments with the appropriate context, i.e. there is a need to identify where different instruments should be used. For instance, big institutional investors need investments that are manageable, predictable, and of a reasonable size. Aid agencies can help through subsidized risk management, but also by helping build strong institutions in partner countries that can work as counterparts, and encourage public-private collaborations to package investment deals and reduce information asymmetries.
Where are we now?
Turns out that this is not a simple question to answer. The Ministry for Foreign Affairs presented the Swedish government’s priority areas – strengthening the implementation of SDG 5, 8, 14 and 16 (all goals can be found here: https://sustainabledevelopment.un.org/?menu=1300) – and reported from a recent follow-up meeting at the UN.
In principle the Addis Agenda identifies action areas and connects areas and actors, which makes it possible for systematic follow-ups, and an inter-agency task force produces an annual report of the general state of the implementation of the Addis Agenda. The Swedish government has produced a report on the implementation of the AAAA covering all seven action-areas with examples of progress. This initiative was commended at the UN meetings, and together with the private sector engagement, as showcased during the 2017 Development Day, it paints a rather positive picture of progress and engagement in Sweden.
However, globally, there are many uncertainties and challenges. The Center for Global Development reported on the budget proposal of the US president, which among other things includes a 32% cut to topline funding for the Department of State and Foreign Operations. There are also plans to eliminate the Overseas Private Investment Corporation and to zero out US food assistance. On the other hand, in this fiscal year, the US Congress (controlled by the Republicans) increased the amount going into foreign aid compared to what previous president Obama suggested. What will eventually come out of the current president’s budget proposal for the coming fiscal year is thus highly unclear.
Participants at the conference
- Rami AbdelRahman, Sweden Textile Water Initiative
- Frida Arounsavath, Swedwatch
- Owen Barder, Center for Global Development
- Eva Blixt, Jernkontoret
- Magnus Cedergren, Sida
- Penny Davies, Diakonia
- Raj Desai, Georgetown University and the Brookings Institution
- Ulf Erlandsson, Fourth Swedish National Pension Fund (AP4)
- Måns Fellesson, Ministry for Foreign Affairs
- Charlotte Petri Gornitzka, OECD-DAC
- Anna Hammargren, Ministry for Foreign Affairs
- John Hurley, Center for Global Development
- Lena Hök, Skandia
- Måns Nilsson, Stockholm Environmental Institute
- Mats Olausson, SEB
- Anders Olofsgård, SITE
- Anna Ryott, Swedfund
- Elina Scheja, Sida