Tax Reform in the Netherlands: Shifting the Burden1
1. This short paper studies and quantifies the likely macroeconomic effects of growth friendly tax reform options in the Netherlands. The note is a follow-up to last year’s selected issues paper on tax reform in the Netherlands, which reviewed the main features of the Dutch tax system and sketched the contours of a hypothetical reform of the tax system.2 This time around, the focus is on quantification. We use the Global Integrated Monetary and Fiscal model—GIMF—a multi-country, dynamic general equilibrium model to try and quantify the macroeconomic effects of various budget neutral fiscal reforms aimed at shifting the burden of taxation away from labor and towards property and consumption (VAT), a central recommendation of last year’s consultation.
2. The main conclusion from this exercise is that even a budget neutral shift of the tax burden away from labor can have sizable positive effects on growth and employment. First, fiscal policy is particularly effective in a currency union as monetary policy is not much influenced by developments in a single economy. Usual crowding out effects are replaced by crowding in effects, as real interest rates tend to be pro-cyclical when nominal interest rates are quasi-fixed. Second, labor income tax (LIT) is one of the most distortionary forms of taxation. By discouraging labor supply, LIT inflates product wages (wages paid by firms), weighing down on firms’ profits and investment. Shifting the burden towards less distortionary revenue sources boosts labor supply, capital accumulation, and potential output.
3. The effects remain significant even if the elasticity of labor supply is assumed to be low—as is arguably the case in the Netherlands. A drop in the labor income tax (or employees’ social contributions) props up labor supply and triggers general equilibrium effects that also boost investment and labor demand, magnifying the initial impulse. Although the magnitude of the stimulation depends on the value of labor supply elasticity, it remains significant even with fairly low calibrated values. In the following, we systematically document the impact of various tax reforms under high and low elasticity alternatives, acknowledging the uncertainty surrounding estimates of labor supply elasticity in the Netherlands.
4. The taxation system is particularly unbalanced in the Netherlands, where labor income taxation and social contributions are doing the heavy lifting. The system combines a very progressive and elevated labor tax scale with poor tax and benefit incentives for low income workers to join the labor force. Also, the level of social contributions paid by Dutch employees is one of the highest in Europe, while at the same time, the contribution of indirect taxation (VAT) and personal capital income taxation, in particular on housing, is among the lowest.3
Labor Income Taxation, 2014
5. By discouraging labor supply, the current tax system tends to shrink the tax base and overload taxpayers. Significant efficiency gains could, in principle, be achieved by shifting the tax burden away from labor and towards consumption and housing, which is the most subsidized item of the Dutch tax system. Housing (property) tax is the least distortionary instrument and the tax base is particularly large in the Netherlands. Minor increases in owner-occupied housing taxation could generate a lot of fiscal revenues. Table A shows that tax revenues on personal capital income are actually negative, reflecting the large subsidy on home ownership via mortgage interest deductibility and low taxation of imputed rents.
C. Why GIMF?
6. GIMF is a global dynamic general equilibrium model widely used inside and outside the IMF to analyze the implications of a vast range of policies (fiscal, monetary and financial) for growth, inflation, and the public and external accounts. Its multi-country, multi-goods structure allows a general equilibrium analysis of global interdependence and spillover effects of alternative fiscal policies, including through financial spillovers associated with the effect of debt on global interest rates. In GIMF, both households and firms (divided into the tradable and non-tradable goods sectors) are forward-looking and partly base their decisions on intertemporal maximization of utility and profit. Firms produce tradable and non-tradable intermediate goods, which are combined with imported tradable intermediate goods to produce final goods for consumption and investment, both private (which are also internationally traded) and public. The model features full intertemporal stock-flow consistency and various nominal and real frictions such as sticky prices and wages, real adjustment costs, financial frictions.4
7. Due to its non-Ricardian features, GIMF is particularly well-suited to analyze tax reforms. GIMF is based on the Blanchard-Weil-Yaari’s seminal overlapping generations (OLG) framework which results in a significant departure from Ricardian equivalence. This framework also has important implications for the impact of fiscal policy and structural changes on global savings and the equilibrium long-term interest rate. The non-Ricardian nature of the OLG households is complemented and enhanced by the presence of liquidity-constrained (LIQ) consumers. They directly consume their wage income every period, as well as any transfers they receive from the government. LIQ households are assumed to represent 25 percent of total households in advanced economies and 50 percent in emerging markets.5
8. GIMF also features important non-linearities. The endogenous response of monetary policy is key for the transmission of fiscal shock to the economy. At the zero interest rate lower bound (ZLB), fiscal consolidation is bound to have a larger detrimental effect on growth and employment as monetary policy will not be able to accommodate contractionary fiscal impulses. Inflation and inflation expectations would also tend to drop faster in this conjunction, increasing real interest rates, the cost of capital, and the public and private debt burdens.
9. The model’s fiscal rule maintains a stable long-run debt-to-GDP ratio. Fiscal policy is conducted using ten different instruments: government consumption, government investment (infrastructure spending), general and targeted lump-sum transfers, consumption tax (VAT), corporate income tax, labor income tax, employer and employee social security contributions, and property tax. In each region, monetary policy follows a standard CPI-inflation-forecast-based interest rate reaction function, which in regards to the Netherlands, responds exclusively to euro area wide developments.
10. The model has been calibrated to reflect the Netherlands’ great ratios and long-term fiscal characteristics. A 3-country version of GIMF has been calibrated around the three regions’ (Netherlands, rest of euro area (ROA), and rest of the world (ROW)) great ratios in the steady state (e.g., trade shares, labor and capital shares, etc…).6 Given the focus on fiscal policy in the Netherlands, steady-state tax revenue to GDP ratios for the different tax instruments have been computed based on published 2013 values.7
11. Note, however, that GIMF abstracts from important distributional issues and the complexity associated with the co-existence of different employment status in the Netherlands. Therefore, the policy simulations reported in sections D and E should be understood as reflecting average effects for given aggregate labor supply elasticity. There is also no differentiation between extensive and intensive margins as employment is measured in terms of total hours worked.
D. GIMF’s Implicit Tax Multipliers
12. Overall, tax multipliers are smaller than 1 in the short to medium run, but could rise above 1 in the longer term for permanent tax changes. The table below shows the effect of a permanent increase in capital, labor, consumption and property tax revenues on real GDP. In each case a permanent increase in budget surplus (or decrease in deficit) of 1 percent of GDP—corresponding to about 20 percent drop in long-term debt to GDP—is engineered by permanently increasing tax revenues by the same amount.8 The effect on output depends on the type of tax instrument, the horizon in years and the elasticity of labor supply. There is quite a bit of uncertainty surrounding the value of labor supply elasticity in the Netherlands (Vlasblom, 2001, Bloemen, 2010, Bargain et al., 2011, Jongen et al., 2014), thus the table shows two sets of results simulated under a high labor supply elasticity assumption (Frisch labor supply elasticity—FLSE—of 0.5) and a low elasticity assumption (FLSE = 0.2).9 As expected—with the notable exception of capital income taxation (CAPIT)—the lower the FLSE, the smaller the multipliers, especially in the long term.10
13. Even in the case of a low FLSE, permanent changes in tax rates have non-negligible effects on output and employment. This outcome can be explained by the fact that country level fiscal policy is particularly effective in a currency union as monetary policy is not responsive to developments in a single economy. Crowding-out effects that usually follow fiscal impulses are replaced by crowding-in effects, as real interest rates tend to be pro-cyclical if nominal interest rates are fixed. For instance, an increase in capital income taxation depresses demand and prices, and push inflation expectations downwards. Because nominal interest rates are set at the euro area level, they will remain quasi-fixed following a Netherlands’ based fiscal shock, pushing real interest rates up in the Netherlands, which further weighs on domestic demand.
|GDP Effect - level % deviations (FLSE = 0.5)||GDP Effect - level % deviations (FLSE=0.2)|
|Social security (employees)||−0.2||−0.4||−0.5||−0.7||−0.7||−0.2||−0.2||−0.3||−0.3||−0.3|
|Social security (employers)||−0.6||−0.4||−0.3||−1.2||−1.2||−0.5||−0.3||−0.3||−0.6||−0.6|
14. Capital income taxation (CAPIT) has the largest effect on employment and output, followed by social security contributions (SSC) and labor income tax (LIT). Distortionary tax measures that directly affect capital accumulation and labor supply have the largest effects on output and employment, especially in the long term. CAPIT is the most distortionary as it tends to directly discourage capital accumulation and therefore penalizes the whole path of future consumption by pushing down labor demand, real wages, and potential output. Similarly, LIT discourages participation in the labor market and weighs on potential output. However, the fiscal multiplier is smaller than for CAPIT as higher LIT triggers both an income effect, which stimulates labor supply, and a substitution effect which discourages it, with the latter effect being typically larger than the former for usual calibrations.
15. SSCs have differentiated effects on the economy depending on whether they are collected at the employees’ level (akin to LIT) or the employers’ level. The difference arises from general equilibrium effects involving both labor supply and demand, wages, LIQ consumption, inflation expectations and the real interest rate.11 In the case of employers’ SSC, higher tax tends to increase firms’ marginal costs, depress profits, and therefore reduces their total demand for all factors, and in particular for labor. Real wages, consumption, and investment drop as a result pushing down inflation and inflation expectations, increasing real interest rates which further depresses consumption—in particular LIQ’s which depends directly on labor income—and investment in a negative feedback loop that leaves output significantly depressed. In comparison, output reacts in a more muted fashion following a rise in employees’ SSC. Higher SSC discourages labor supply (substitution effect), leading to relatively higher real wages and inflation and lower real interest rate than in the case of the employer’s SSC. Consumption—in particular LIQ consumption is less affected—and investment holds up better than in the employers’ SSC case.
E. Growth Friendly Budget Neutral Tax Reforms
All descriptions in this section refer to the high elasticity case (FLSE=0.5) and are shown on Figure 1. The low elasticity case is a dampened version of the high elasticity case and results are shown on Figure 2. In all simulations, the monetary policy rate is assumed fixed for 3 years. Both sets of simulations are summarized via their effect on GDP in the table below.
Figure 1.The Netherlands: Growth Friendly Fiscal Packages (FLSE = 0.5) Figure 2.The Netherlands: Growth Friendly Fiscal Packages (FLSE = 0.2)
16. We study four different budget neutral tax packages, which all amount to shifting the burden of taxation away from labor towards less distortionary alternatives. Lower labor income taxation (either via LIT or SSC) is combined with commensurate increases in consumption (VAT) or property taxes.12 The first tax reform package (TRP1) combines a permanent drop in labor income taxation and a simultaneous increase in VAT. We assume a permanent drop of 1.2 percent of GDP in labor income tax revenue offset by an increase in VAT revenues, which corresponds to the amount (8.1 billions) that could be collected by unifying the country’s multiple VAT rates (see IMF, 2015). The second tax reform package (TRP2) is a variation on the first one but where the drop in labor tax revenue is financed through an increase in property taxes. In the Netherlands, this could be achieved by either shifting housing taxation to Box 3—in essence a wealth tax—or by decentralizing some of the revenue collection to local governments which mainly rely on real estate taxes.13 TRP3 and TRP4 are variations on TRP1 and TRP2, but where the decline in labor income taxation is achieved through a decrease in SSC which is assumed evenly distributed between employers and employees, stimulating both labor supply and labor demand.
17. TRP1—shifting the burden of taxation away from labor income towards consumption is positive for growth and employment. TRP1 has a positive long-term effect on employment, capital accumulation, and potential output, and a short-lived positive impact on the output gap. In the high labor supply elasticity case, hours worked increase by almost 0.3 percent, which amounts to about 17’000 full-time-equivalent (FTE) jobs.14 The positive net effect can be traced back to the positive impact of TRP1 on labor supply. While in principle equivalent changes in labor income and consumption tax rates should exert the same income and substitution effects on labor supply, VAT also implicitly taxes the existing capital stock—a non- distortionary levy—making it less distortionary on balance. Higher labor supply pushes real wages, marginal costs, inflation and the real effective exchange rate (REER) down. Improved competitiveness stimulates real exports, which nonetheless increase by less than imports in the short-term. There is a slight but sustained deterioration of the current account as higher expected future output stimulates investment in the short term, while higher expected future labor income boosts consumption. The short-term positive effect of TRP1 on domestic demand also tends to be magnified by our fixed policy rate assumption.
18. TRP2—shifting the burden of taxation away from labor income towards property jolts labor supply. TRP2 has a much larger effect on output and employment than TRP1. Output increases by 0.9 percent in the long term (by year 2055) as does employment (about 45,500 FTE jobs).15 This is due to the fact that both tax measures stimulate labor supply. A lower labor income tax increases the opportunity cost of leisure and boosts labor supply (substitution effect larger than income effect), whereas a higher property tax decreases disposable income and also prompts higher labor supply (income effect) in the medium term. Competition on the labor market increases so much that real wages drop by more than 1 percent in the first three years, and the induced REER depreciation boosts exports. At the same time, lower inflation increases real interest rate and temporarily holds back OLG consumption, investment and imports. The trade balance improves transitorily and the current account permanently.
19. Real wages increase in TRP3 and TRP4, as lowering employers’ SSC stimulates labor demand. In these two variants the labor tax wedge is trimmed by exonerating both employers and employees from part of their SSC. We assume that fiscal revenues from employers’ and employees’ SSC are reduced by 0.6 percent of GDP each. This revenue shortfall is compensated by increasing VAT (TRP3) and property tax (TRP4) revenues by 1.2 percent of GDP, like in TRP1 and TRP2. As expected, TRP4 is the most effective at boosting output and employment (about 80’000 FTE). 16 Cutting employers’ SSC props up labor demand and compounds the positive effects on labor supply of lower employees’ SSC contributions and higher property taxation. In both experiments, the REER depreciates despite an increase in real wages (ex-SSC) as firms’ real marginal costs drop following the drop in employers’ SSC. But the REER depreciation is too small to compensate for the short term increase in consumption and investment and the current account deteriorates despite an increase in exports.
|Frisch labor supply elasticity = 0.5||Frisch labor supply elasticity = 0.2|
20. Growth-friendly and budget neutral tax reforms should be considered and studied in countries like the Netherlands, where unused productive capacities are scarce and the fiscal space relatively small. This short paper shows that these reforms may have long-lasting positive effects on output and employment. By shifting the burden of taxation away from labor towards less distortionary alternatives, significant efficiency gains can be reaped. In this regard, dropping social security contributions in favor of higher property taxation would bring the largest benefits.
|A. Structure of revenues||Ranking||Bil. Euros|
|Other taxes on products||2||2||1.8||1.8||1.6||1.5||8||8.9|
|(incl. import duties)|
|Other taxes on production||1||1.1||1.2||1.2||1.2||1.2||14||7.5|
|Self- and non-employed||2.9||3.1||3||3.1||3.3||3.6||1||21.4|
|B. Structure by economic function|
|Capital and business income||4.7||4.6||3.5||3.7||3.5||3.4||20||20.3|
|Income of corporations||3.5||3.4||2.1||2.3||2.2||2.1||20||12.7|
|Income of households||−0.9||−1||−0.9||−0.9||−1||−1||28||−6.2|
|Income of self-employed||2.1||2.2||2.2||2.3||2.3||2.3||7||13.8|
|Stocks of capital wealth||2.6||2.5||2.4||2.4||2.2||2.2||12||12.9|
The ranking reflects relative levels of revenue-to-GDP ratios for each revenue source among the EU-28, with rank 1 being the highest ratio.
The ranking reflects relative levels of revenue-to-GDP ratios for each revenue source among the EU-28, with rank 1 being the highest ratio.
BlanchardO. J. “Debt, deficits, and finite horizons.” Journal of Political Economy93223–2471985.
BargainO.OrsiniK. and PeichlA. “Labor supply elasticities in Europe and the US.” IZA Discussion Paper 5820 Bonn2011.
BloemenH. “Income taxation in an empirical collective household labour supply model with discrete hours.” Tinbergen Institute Discussion Paper 10-010/3 Amsterdam2010.
De MooijR. and KeenM. “Fiscal Devaluation and Fiscal Consolidation: The VAT in Troubled Times” NBER Working Paper No. 179132012.
JongenE.De BoerH.-W. and DekkerP. “MICSIM - A behavioural microsimulation model for the analysis of tax-benefit reform in the Netherlands” CPB Background Document2014.
KumhofM.LaxtonD.MuirD. and S.Mursula2010 “The Global Integrated Monetary and Fiscal Model (GIMF)—Theoretical Structure” IMF Working Paper WP/10/34.
NatalJ.-M. “Tax Reforms in the Netherlands: Moving Closer to Best Practices” Selected Issues Paper for the 2015 Article IV Consultation for the Netherlands (IMF Country Report No. 16/46) IMFDecember2015.
OECD2016Taxing Wages 2016, Special Feature: Measuring the Tax wedge on Second Earners OECD Publishing Paris.
SørensenP. “Can Capital Income Taxes Survive? And Should They?” CESifo Economic Studies Vol. 53172–2282007.
VlasblomJ.de GijsselP. and SiegersJ. “Taxes, female labour supply and household income: differences between the Netherlands and the Federal Republic of Germany.” Applied Economics33(2) 2001.
Prepared by Jean-Marc Natal. The author would like to thank Bas Jacobs, and officials at the Ministry of Finance of the Netherlands for useful suggestions. Particular gratitude goes to Benjamin Carton (RES) and Dirk Muir (APD) for effective coaching with Dynare-GIMF and inspiring discussions.
See “Tax Reform in the Netherlands: Moving Closer to Best Practices”, in the Selected Issues paper for the 2015 Article IV Consultation for the Netherlands (IMF Country Report No. 16/46).
See The Netherlands Staff Report, 2016 and the Selected Issues paper “Tax Reforms in the Netherlands: Moving Closer to Best Practices”, for the 2015 Article IV Consultation for the Netherlands (IMF Country Report No. 16/46)
See Kumhof et al. (2010).
The share of LIQ consumers may be higher in the Netherlands as voluntary savings are usually considered low in the country. Assuming a higher share of LIQ agents would magnify all non-Ricardian effects.
See Kumhof et al. (2010) and Anderson et al. (2013) for further details
See Taxation Trends in the European Union, 2013
As debt to GDP declines, so does interest rate payments which are redistributed to households in the form of general transfers so as to maintain fiscal consolidation at exactly 1% of GDP per year.
CPB 2014 concludes that the combined (extensive and intensive margin) labor supply elasticity is 0.17, close to our lower bound simulations.
For CAPIT, the multiplier is larger when the FLSE is smaller. An increase in CAPIT increases the price of capital for firms pushing down investment and leading to a drop in the marginal productivity of labor. Labor demand also drops (although less than investment demand) until unit labor costs drops back and adjusts to the higher cost of capital. The more elastic the labor supply, the less will wages have to drop for labor supply to adjust and the smaller will be the impact on LIQ consumption and output. It is a transitory effect though. The final impact is unaffected by the value of the FLSE.
In a standard partial equilibrium analysis, it is easy to show that equilibrium employment is determined by the total wedge between product wage (paid by firms) and consumer wage (received by households), and is invariant to whether the tax is perceived at the employers’ or employees’ level.
On efficiency grounds, it would also make sense to consider a reduction in CAPIT. But capital income taxation is already quite low in the Netherlands and simple equity considerations would rather plead for an increase rather than a decrease in CAPIT. This is particularly the case for capital income taxation at the personal level which entails regressive features (see IMF, 2016). Because GIMF cannot distinguish between the taxation of capital under the source (corporate income tax) versus residence (tax on saving) principles—a key distinction in a small open economy (see Sorensen, 2007)—we leave the analysis of shifting the burden of taxation away from labor and towards savings (see IMF, 2015) to further studies.
Note that the property tax is modelled as a drop in lump sum transfers targeted at OLG households. Lower transfers lead to less leisure consumption and higher labor supply. Given the absence of a residential sector in GIMF, the property tax does not distort investment in construction and can be thought of as a tax on unimproved land.
Dutch worked 9,856 million hours in 2015 (CBS) in total and OECD estimates that they worked an average of 1,420 hours (which includes full time part-time, part-year, self-employed, paid and unpaid overtime, etc…). An increase of 0.3 percent in hours worked amounts to 20’822 jobs if we assume a constant number of average hours worked per year or 16,422 full time equivalent jobs assuming 40 hours per week and 7 weeks of paid leave per year (OECD).
In the low elasticity of labor supply case (FLSE=0.2), the effect on employment is about half. About 21,500 FTE jobs would be created by 2055, and only half of that by 2025.
Job creation is more modest in the case of the lower labor supply elasticity (FLSE = 0.2); TRP4, the most expansionary option, yields only about 40,000 FTE in the long-term (by 2055), and about half this amount by 2025.