A. Horizontal vs. Vertical Equity

Equity concerns are often at the forefront of policy deliberations on the design of a PIT. It is common to express these concerns in terms of the following two widely-used concepts of equity: (1) horizontal equity (HE)—the equal tax treatment of equals; and (2) vertical equity (VE)—the unequal tax treatment of unequals. Both concepts are consistent with the ability-to-pay principle of taxation—one of two fundamental tax principles.²

Stated in general terms, few can disagree with either of the above two equity concepts: HE is generally seen as a rule to ensure fairness of a tax system, while VE as one to achieve distributive justice. Difficulties arise, however, when they have to be given operational contents. For HE, there are questions about both the definition of “equals” (e.g., equality of income or welfare, endowment or outcome, at a given point in time or over the life cycle) and the specification of “equal tax treatment” (e.g., equality in absolute tax payments or in tax payments relative to income). For VE, how unequal should unequals be treated is clearly a question of value judgment. On this, notions of distributive justice could range between two extremes: utilitarian (social welfare is the sum of individual welfare) and Rawlsian (social welfare is the welfare of the least well-off)—each giving rise to a different view on the extent of unequal tax treatment of unequals, and hence different implications for PIT design, such as its degree of progressivity.³

The disentangling of HE and VE effects of a PIT is a subject of some lively debate in the literature. To see the issues involved, note that the tax transforms any given pretax income distribution into a different, post-tax income distribution. If people with the same level of pretax income end up with different levels of post-tax income, then HE would be violated. According to one strand of the literature, the extent of this violation could be measured in the following way. First, compute the average of the post-tax income of all people with the same pretax income for each level of pretax income, thus producing a (hypothetical) distribution of average post-tax income. Then, on the basis of some social welfare function, compute the difference between the social welfare associated with the actual post-tax distribution and that associated with the hypothetical distribution. This difference would then be a measure of the degree of horizontal inequity. As regards the degree of vertical inequity, it would be measured by the difference in social welfare between the hypothetical distribution and some given distribution that is deemed to be socially optimal.⁴

A second strand of literature argues that the measurement of horizontal inequity above ignores the fact that the rank order (along the income scale) of individuals could be altered during the transformation of the pretax to a post-tax distribution of income. Such a re-ranking is considered an attribute of horizontal inequity. To take its impact into account, the construction of the hypothetical distribution of average post-tax income should be mapped so that the original (pretax) rank order is preserved. This rank-preserving hypothetical distribution could then be used to decompose, as before, the HE and VE effects of the tax.⁵

B. Global vs. Schedular

Another foundational issue to be confronted at the outset in designing a PIT is whether a single rate schedule should apply to the aggregate of different sources of income (the global income approach), or different rate schedules should apply to different sources of income (the schedular approach). This issue is of fundamental importance, as it would determine, among other things, whether labor and capital income should be taxed separately—and differently.

Until recently, the global income approach, underpinned by the classic works of Haig and Simons,⁶ dominated the thinking of the economics profession (although in reality few PITs, if any, can be regarded as truly global in nature). It is also an approach that would follow logically from the HE dictum, as the taxable capacity of an individual (i.e., the attribute by which equals may be defined under the PIT) is determined by the totality of income irrespective of the sources from which it is derived.

However, in view of the unprecedented degree of global capital mobility that has been observed over the last decade and a half—a trend that can only be expected to further accelerate in the future, a fundamental rethinking in the profession about the advisability of adopting the global income approach can now be clearly detected. It is increasingly recognized and accepted, for example, that the benefit from adhering to HE should be weighed against the considerable difference in mobility between labor and capital. Indeed, the reality of the difficulties in taxing a highly mobile tax base—without resorting to harmful quantitative controls—has already induced a number of countries to explicitly forsake HE and pursue differential (schedular) taxation of labor and capital income, with the latter bearing a much lighter tax burden (see further discussion in Section VI below). Hence, the attractiveness of the global income approach to taxing income seems to be fading unmistakably in a globalized world.⁷

C. Measuring Progressivity

While HE is an important consideration in the global-schedular debate, VE is the central concern when deciding how progressive the PIT should be. There are a number of different ways to measure the degree of progressivity of a tax. Before discussing the significance of these measures, however, it would be necessary to define more precisely what is meant by a progressive tax.

Consider a tax, t, that varies with the level of pretax income, y. t is, therefore, a function of y, denoted by t(y). The marginal tax rate at a given y, denoted by m(y), measures how the tax would change in response to a one-unit change in pretax income at that given pretax income level. In other words,

where Δ is a symbol representing the change in a variable. We assume for simplicity in the present discussion that the marginal tax rate is always nonnegative and less than unity, that is, 1 > m(y) ≥ 0. The average tax rate at a given y, denoted by a(y), is simply the ratio of the tax to pretax income at that given pretax income level:

which is also assumed to be always nonnegative and less than unity, that is, 1 > a(y) ≥ 0. A tax is said to be globally progressive if its average tax rate rises with pretax income over the entire income range, that is,

Given equations (1) and (2), condition (3) can be equivalently stated as:⁸

Condition (4) is fairly intuitive: the only way the average tax rate can rise with pretax income—to satisfy the definition of progressivity as stated in condition (3)—is to have the rate at which the tax increases with rising pretax income, i.e., the marginal tax rate, be greater than the average tax rate itself. In contrast, a tax would be proportional if m(y) = a(y), and regressive if m(y) < a(y).

Having a definition of progressivity alone is not sufficient to enable one to compare the relative progressivities of different taxes. For that, a measure of the tax progression, or the degree of progressivity, would be needed. Four prominent progression measures have been used in the literature:⁹ marginal, average, liability, and residual.

D. Efficiency Implications: Impact on Labor Supply and Savings

A PIT, like any other tax, will inevitably affect the behavior of individuals. If the PIT taxes both labor and capital income, then the primary behavioral impact of interest would be on labor supply and savings decisions. How these decisions would be distorted by the PIT is, therefore, a central consideration in determining both the shape of its rate schedule and the structure of its base.

In discussing the above PIT distortions, care should be taken to separate two related but different issues: (1) the observed tax-induced changes in the behavior of interest (i.e., the amount of labor supplied and income saved); and (2) the efficiency costs associated with the tax-induced behavioral changes. The efficiency costs may well be significant even if the relevant behavioral changes are observed to be small. To see how this could come about, it would be necessary to understand the income and substitution effects of the PIT. These effects are discussed below with respect to labor supply and savings decisions separately.

E. Equity Implications: Impact on Progressivity and Income Distribution

While the above discussion on the efficiency implications of the PIT points to keeping both its rate level and progression low to minimize efficiency costs, this may well have to be weighed against the policymaker’s VE (i.e., distributive) concerns, which, as already noted, are also central to the PIT design. The fundamental questions of policy interest here are two: (1) ascertaining whether one PIT would reduce income inequality more than another at all pretax income levels; and (2) identifying gainers and losers from reforming the PIT. These two questions are related but not identical: the first relates to comparing relative global progressivities of different PITs, while the second their explicit redistributive effects among different income groups. The difference between the two lies in the fact that, though all progressive taxes have a implicit redistributive effect, in the sense that the post-tax income distribution would be less unequal than the pretax income distribution, a PIT reform may well have the explicit objective of benefiting some income groups at the expense of others.

Global tax progressivity

The various measures of tax progressivity discussed earlier, being local measures at given pretax income levels, cannot provide an answer to the above question. What is needed, instead, is an index of global progressivity covering the entire pretax income scale.

One prominent global progressivity index is known as the Kakwani index, K, which involves the use of the so-called concentration curve for tax liability.¹⁶ As in well known, the (pretax) Lorenz curve depicts the relationship between two variables: the cumulative share of (pretax) income on the vertical axis (ranging from zero to unity) and the cumulative proportion of individuals receiving the (pretax) income on the horizontal axis (ranging also from zero to unity). Thus, if (pretax) income were perfectly equally distributed, the Lorenz curve would coincide with the 45 degree ray from the origin (the diagonal line); otherwise, it would always lie below the diagonal line. A typical Lorenz curve is shown in Figure 1 as the curve L. It is also well known that the Gini coefficient, G, which is one of the most widely-used indices of income inequality, is related to the Lorenz curve as the ratio of the area between the diagonal line and the Lorenz curve (area X) to the area below the diagonal line (area X + Y + Z), or

View Full Size

Lorenz and Tax Liability Concentration Curves

Citation: IMF Working Papers 2005, 087; 10.5089/9781451861068.001.A001

• Download Figure
• Download figure as PowerPoint slide

$\begin{array}{ccc}G=X/(X+Y+Z)=1-2·(Y+Z).& & (9)\end{array}$

G, therefore, varies between zero (complete equality) and unity (maximum inequality).

The concentration curve for tax liability is a construct similar to the Lorenz curve, except that the variable on the vertical axis is now the cumulative share of tax liability. An example of this curve is also shown in Figure 1 as the curve T. Analogous to the Gini coefficient, a concentration coefficient of tax liability, N, can be derived as one minus twice the area under the concentration curve for tax liability, that is,

$\begin{array}{ccc}N=1-2\cdot Z.& & (10)\end{array}$

It is clear that N also varies from zero (maximum tax regressivity—the T curve coincides with the diagonal line) and unity (maximum tax progressivity).

The Kakwani index is then defined as

$\begin{array}{ccc}K=N-G=2\cdot Y,& & (11)\end{array}$

which is twice the area between the Lorenz curve and the tax liability concentration curve. The higher the K, the more globally progressive is the tax. For a given G, the value of K varies from (– G) to (1 – G), a negative K being an indication that the tax is regressive. The T curve would coincide with the L curve (i.e., K = 0) if the tax is proportional.

There are two important relationships among K, the earlier definition of a globally progressive tax, and the LP measure of tax progressivity at the local level. First, the tax liability concentration curve would lie entirely below (above) the Lorenz curve if the tax is globally progressive (regressive) as defined by condition (4). This is intuitively obvious, since such a progressive (regressive) tax would necessarily give rise to a distribution of tax burden that is more (less) unequal than the distribution of pretax income. Second, given two taxes, A and B, and their respective tax liability concentration curves, T^A and T^B, T^A would lie entirely below (above) T^B if LP^A is greater (less) than LP^B at all pretax income levels. In this case, it is clear that tax A is more (less) progressive globally than tax B, as the Kakwani index associated with A would be higher (lower) than that associated with B.

In real world comparisons, however, the tax liability concentration curves for any two given taxes may well cross each other (or, equivalently, the relative magnitudes of their LP measures get reversed) at some pretax income level(s). Under such circumstances, the relative global progressivity of the two taxes is no longer readily ascertainable by comparing the positions of their tax liability concentration curves or the magnitudes of their LP measures. Nevertheless, the Kakwani index for each tax can still be computed and compared to produce an unique answer to the question regarding which tax is more globally progressive.

F. Social Welfare and Optimal Shape of the PIT Rate Schedule

The tradeoff between efficiency and vertical equity considerations is, of course, the most fundamental policy issue confronting any PIT reform. Broadly speaking, the problem is one of maximizing social welfare—as given by a particular social welfare function that embodies the policymaker’s notion of distributive justice—subject to both the behavioral responses of individuals (e.g., how the tax would affect their savings and labor supply decisions) and the economy’s technological constraint (e.g., how the supplied capital and labor could be combined to produce income). Whether anything useful can be said about the shape of the PIT rate schedule from solving the above optimization problem has been the subject of a large number of both theoretical and simulation investigations.

Overall, theoretical studies have succeeded in producing only limited insights on the optimal shape of a PIT rate schedule. Based on one-period models where only wages are taxed, the most important results are (provided that certain technical conditions are satisfied): (1) the optimal marginal tax rates are nonnegative and less than unity at all pretax income levels, that is, 1 > m(y) ≥ 0 (which is exactly what was assumed in earlier discussions); and (2) the optimal marginal tax rates at both ends of the income scale are zero. Theory alone imparts few additional insights, however, about the optimal shape of the rate schedule between the income end points.¹⁹

In view of the limited insights that can be gleamed from theoretical studies on the optimal rate schedule, researchers have turned to simulations based on specific assumptions about the structure of individual preferences for consumption and leisure, the dispersion of skills (and therefore wages), and the policymaker’s notion of distributive justice. As expected, the simulation results tend to be sensitive to model specifications, with findings of both relatively flat and progressive optimal rate schedules.²⁰ On the whole, these findings provide little practical guidance for determining the level and structure of PIT rates.

A. Number of Rates

While there is no scientific basis for determining the optimal number of PIT rates, a multiplicity of such rates is not necessary for rendering the PIT progressive. This can be most dramatically illustrated by considering the case of a single positive rate (τ), coupled with an exemption threshold (e) below which pretax income (y) is not taxed.²¹ Total tax payment (t) is then

Dividing equation (12) through by y thus yields the average tax rate a:

With only one positive tax rate, τ is, of course, also the marginal rate (for income above the exemption threshold). From equation (13), it is cleared that τ > a as long as e > 0, which satisfies the definition of progressivity given by condition (4). It is true that the difference between τ and a is reduced by an increase in y, and for this reason a compelling case could perhaps be made for introducing one or two additional higher marginal rates on the well-off to ensure that the degree of progressivity would not fade too rapidly with rising income, should vertical equity be an important concern. Nevertheless, the point remains that an adequate degree of progressivity could usually be delivered by only a few positive rates. Moreover, keeping the number of rates low would also ease administration.

B. Range of Rates

The possibly significant efficiency costs, as well as evasion risks, of high marginal rates usually argue for setting the top PIT rate at a reasonable level—commonly perceived to be below 50 percent. Another important consideration in setting this rate concerns the differential between the top PIT rate and the corporate income tax (CIT) rate. When the former exceeds the latter, an incentive is created for high-income individuals to incorporate themselves to take advantage of the lower CIT rate. Such behavior has indeed been observed in countries where such an incentive exists and is large enough to overcome the transaction costs of artificial incorporation for tax reasons. Hence, it is generally considered good policy the keep the gap between the two rates to a minimum, unless the tax system is explicitly designed to be of the dual-income type (see Section VI).

The bottom PIT rate could be either zero or some positive rate. A zero rate over an income range would be an alternative way for specifying an exemption threshold—if such a threshold is designed to apply to the same set of taxpayers to whom the rate schedule applies. If an exemption threshold is separately specified, then the choice of the level of the (positive) bottom PIT rate would depend on a number of considerations, including the desired revenue yield and the degree of curvature of the entire rate schedule (which is, in turn, dependent on the desired range and number of rates).

C. Incorporation of Social Security Taxes

Social security taxes (SST), which are typically imposed on wages of the employee, or payroll of the employer, or both more commonly, could contribute to a significant increase in the tax burden on personal income and should, therefore, be taken into account when deciding on the PIT rate schedule. To see the interactions between the SST and the PIT, assume for simplicity that there is a single SST rate on the employee, s₁; a single SST rate on the employer, s₂; and a single PIT rate, τ.

If s₂ is deductible against the employer’s CIT, as is common, the gross labor cost (l) to the employer would be

where δ is the CIT rate. Similarly, if s₁ is deductible against the employee’s PIT, the net-of-tax wages (w) of the employee would be

The total effective tax burden on wages is the difference between the gross labor cost to the employer and the net-of-tax wages of the employee, that is,

Hence, depending on s₁ and s₂, SST could raise the tax burden on wages quite significantly. In some countries, this burden is mitigated somewhat by the application of a ceiling on wages subject to either s₁ or s₂ (or both), which primarily benefit, of course, high wage earners. Wage ceilings under the SST are thus regressive.

D. Indexing for Inflation

If the rate bands of the PIT rate schedule stay invariant over time, taxpayers with unchanged real income would find themselves facing higher marginal tax rates as their nominal income rises with inflation, which is clearly an inequitable outcome. In some countries where high inflation is a chronic problem, extensive indexation of the tax system is implemented to minimize inflation-induced tax consequences. One extreme form of indexation (e.g., as practiced in some Latin American countries) could be to specify all nominal quantities in the PIT in some artificial tax units rather than in units of the local currency. The exchange rate between the tax and currency units could then be adjusted in line with changes in a chosen price index (such as the CPI). In a majority of countries with moderate inflation, however, such an indexation scheme is probably unnecessary. Under most circumstances, adjusting the PIT rate bands, as well as some personal allowances (see below), based on changes in the CPI (or even periodically on an ad hoc basis) would be adequate for alleviating much of the undesirable tax impact from inflation.²²

A. Unit of Taxation

If the PIT has a single rate, it would be immaterial whether the unit of taxation is the individual or the family. Under a progressive rate structure, however, the chosen unit of taxation could confer substantial benefit or penalty when individuals change their marital status. If the tax unit is the family, for example, whether the total tax liability of two individuals would increase or decrease after marriage would depend on the discrepancy between their individual earnings in conjunction with the extent to which income splitting is allowed under the PIT.²³ Of course, differences, if any, in personal allowances granted to single individuals and families would also matter.

On efficiency grounds, there is a rather strong argument that joint filing by husbands and wives with full income splitting—which effectively results in equalizing the marginal PIT rates between the two—is sub-optimal, since their labor supply elasticities are not necessarily the same.²⁴ Yet, adopting the individual unit of taxation seems inequitable, since families with the same income could now vary greatly in tax liabilities. Thus, neither alternative emerges as the superior choice on all counts. The trend in country practices in developed countries over the past few decades has been a steady shift towards the individual as the tax unit, so much so that the PITs in the majority of OECD countries are now implemented on this basis (the most notable exception being France).²⁵

B. Personal Allowances

Personal allowances of various kinds can be found in every PIT. While a proliferation of such allowances will surely narrow the tax base and complicate tax administration, it is not always correct to argue, as some are inclined to do, that all such allowances should be eschewed in favor of lower tax rates. Some allowances could serve useful purpose, while others could be expressedly designed for altering certain behavior to achieve possibly compelling social or economic objectives. An assessment of their merits and limitations is ultimately a matter of balancing their costs (in terms of revenue forgone) and benefits (in terms of achieving their stated objectives).

Personal allowances fall broadly into two categories: general (basic) and targeted. There is also the question of whether allowances should be granted as deductions to income or as tax credits: they are equivalent under some circumstances but could entail different equity implications under others.

Deductions vs. tax credits

All allowances, whether general or targeted, could be given either as deductions to income, or as credits against the tax liabilities. If the PIT has a single rate τ, it is easy to see that a given deduction d would be equivalent to a tax credit c, where c = τ·d. If the PIT has multiple rates, the value of a given d, i.e., the amount of tax saving the deduction would confer, would clearly depend on the taxpayer’s applicable rate band: the higher the rate band, the more valuable the given deduction. In contrast, the value of a given c would remain the same irrespective of the taxpayer’s applicable rate band. This is illustrated below assuming the rate schedule consists of two rates: 10 percent on income of 1,000 and below, and 20 percent on income above 1,000.

Income	Marginal tax rate (In percent)	Tax liability
		No allowance	Deduction d = 200	Tax credit c = 10
1,000	10	100	80	90
10,000	20	1,900	1,860	1,890

View Table

Income	Marginal tax rate (In percent)	Tax liability
		No allowance	Deduction d = 200	Tax credit c = 10
1,000	10	100	80	90
10,000	20	1,900	1,860	1,890

The deduction of 200 is seen to worth 20 to a taxpayer with income of 1,000, but 40 to a taxpayer with income of 10,000. By comparison, the tax credit of 10 is worth exactly 10 to all taxpayers irrespective of the income level. Hence, for a given tax schedule with rising marginal rates, replacing a deduction with a tax credit would enhance the vertical equity of the PIT, as well as reduce the revenue cost of the allowance.

It is possible, however, to reproduce the outcome of a deduction with a tax credit by modifying the rate schedule. The modification involves inserting a new first rate band that is equal in size to deduction, at the rate of θ = c/d. Continuing with our numerical example, the new rate would be 5 percent on income of 200 and below. The old rate bands would be stacked on top of this new rate, i.e., 10 percent on income of 201 up to 1,200, and 20 percent on income above 1,200. The new rate schedule would produce the following result.

Income	Marginal tax rate (In percent)	Tax liability with tax credit c = 10
200	5	0
1,000	10	80
10,000	20	1,860

View Table

Income	Marginal tax rate (In percent)	Tax liability with tax credit c = 10
200	5	0
1,000	10	80
10,000	20	1,860

As is evident, the tax liabilities at various income levels match exactly those under the earlier two-rate schedule with a deduction of 200.²⁷ In this sense, there is a fundamental equivalence between a deduction and a tax credit. The insertion of the new rate band together with the tax credit essentially duplicates the effect of the deduction.²⁸

It is worth noting that the above equivalence result is predicated on neither the number of rates in the original rate schedule nor the income of the taxpayer. This can be readily illustrated graphically in Figure 2, where OA is the deduction and ABC is the original two-rate schedule. The elimination of the deduction shifts the rate schedule horizontally to the left until it emanates from the origin, as denoted by OEF. The introduction of a new first rate band at the rate θ = PA/OA, in conjunction with stacking the original rate bands on top of it, results in the tax schedule OPQR. Finally, a tax credit equal to PA shifts OPQR vertically down so that the segment PQR coincides with the segment ABC on the original tax schedule. Clearly, the number of rates in the original schedule or the income of the taxpayer is immaterial to this demonstration.

View Full Size

Equivalence Between a Deduction and a Tax Credit

Citation: IMF Working Papers 2005, 087; 10.5089/9781451861068.001.A001

• Download Figure
• Download figure as PowerPoint slide

The equivalence result is illuminating, but its validity is limited to handling a single personal allowance. In reality, where multiple allowances and multiple rates are the norm, the choice between deductions and tax credits remains an important one. While there is no consensus in the literature on this issue, most would agree that the case for deduction is the strongest with respect to the general (basic) allowance, while tax credits are more equitable when it comes to targeted allowances.

C. Negative Income Tax

If the subsistence justification for granting a general (basic) allowance noted earlier is accepted, then it would seem logical to argue that an individual whose pretax income is below some minimum level should obtain a subsidy from the income tax system (i.e., a negative income tax). Of course, direct welfare payments are an alternative means of delivering financial assistance to the poor, but such payments have long been criticized for their work-disincentive effects, as they are usually discontinued when recipients find work. Many economists have argued that the adverse incentive effects of direct welfare payments could be overcome if they are replaced by a negative income tax.

The simplest form of a negative income tax would be to let t in equation (12) to go negative when y < e. In essence, the taxpayer is subject to the regular PIT (equaling τ·y) less a tax credit (equaling τ·e), with any excess tax credit refunded. Under such a scheme, e should now be interpreted as the break-even level of income (i.e., no subsidy is paid when y = e) and τ·e the guaranteed level of income (i.e., it is the subsidy amount when y = 0). This scheme preserves work incentives because the post-tax income (z) of an individual—inclusive of any subsidy—necessarily rises with pretax income, since

Hence, in theory, replacing direct welfare payments with a negative income tax should enhance the supply of labor.²⁹ The downside of the negative income tax is that the nonpoor may well receive a significant share of its benefit (depending on the tax rate, the level of break-even income could be substantially higher than that of the guaranteed income³⁰), thus imposing a large budgetary cost.

The PIT in the United States contains a limited negative income tax element known as the earned income tax credit, which operates by providing a refundable tax credit as a fixed percentage of earned income up to a given income threshold.³¹ It has grown over the years into a very costly program. In FY 2001, it led to a reduction of about US $4.2 billion in PIT revenue and incurred an outlay of about US $25.8 billion in expenditure, for a total cost of about US $30 billion (0.3 percent of GDP).³²

D. Treatment of Pension Schemes³³

Funds flowing through a pension scheme can be broken down typically into three stages: (1) the contributory stage, when funds enter the scheme as contributions from participants: (2) the investment stage, where contributions are invested in income-generating assets within the scheme; and (3) the payout stage, where pensions are withdrawn by retirees. Tax issues can arise, therefore, at each of these stages. Specifically, whether (1) contributions are deductible under the PIT; (2) investment income within the pension scheme is taxable; and (3) pensions are taxed under the PIT.

To see the tax implications of the interactions among the stages, consider the simple example of an individual making a contribution p to the pension scheme at the beginning of a year and withdraws his pension at the end of the year in the amount of his initial contribution plus whatever returns (say, at the pretax rate r) it has earned within the scheme. All transaction costs are assumed to be nil for simplicity. Suppose the individual faces a PIT rate of τ₁ at the time of his contribution. If the contribution is tax deductible, it would yield a tax saving of τ₁·p, thus reducing the cost of the contribution to (1 – τ₁)·p. Should the returns earned within the scheme be taxable (say, at the rate τ₂), then the pension payout would be [1 + r·(1 – τ₂)]·p. Finally, the pension itself could be subject to the PIT (say, at the rate τ₃) at the time of the payout, in which case the individual’s after-tax pension would be [1 + r·(1 – τ₂)]·(1 – τ₃)·p. The rate of return (ρ) to the individual from participating in the pension scheme is, therefore, the ratio of his after-tax pension to the cost of contribution minus one, or

Several important implications can be drawn from equation (18). First, if τ₃ = τ₁ (i.e., pension is taxed at the same rate as the relief given to the contribution), then ρ = r·(1 – τ₂), so that only the tax rate on the return earned within the pension scheme matters. The benefit of the deductibility of the contribution is offset completely in this case by taxing the pension at the same rate. Second, if, in addition to τ₃ = τ₁, τ₂ = 0 (i.e., the returns earned within the pension scheme is tax exempt), then ρ = r, so that the net effect is that savings channeled through the pension scheme escapes taxation altogether. Hence, participation in the scheme would confer substantial tax benefit if the returns from regular savings (i.e., outside the scheme) are subject to tax (as is usual under a typical PIT).

Finally, if τ₂ = τ₃ = 0 (i.e., returns earned within the pension scheme as well as pension payout are tax exempt), then ρ = (1 + r)/(1 – τ₁) – 1 > r. In other words, the tax treatment of the pension scheme in this case actually results in an effective subsidy to savings channeled through the scheme.

The decision on how pension schemes should be treated under the PIT should be based on a clearly articulated public policy objective regarding savings, as well as on a well thought-through role for tax policy to play to achieve that objective, after taking due consideration of all the associated costs and benefits. A tax policy that favors one saving vehicle, such as pension schemes, over others (such as life insurance) need to be carefully justified, especially if the policy involves not only a reduction in taxation, but actually granting a subsidy. If pension schemes are tax-favored, penalties would need to be imposed on early withdrawals.

The PIT treatment of pension schemes in most OECD countries follow broadly the model of setting τ₃ = τ₁ and τ₂ = 0 (although limitations are typically imposed on the extent to which contributions are deductible). As noted earlier, this model results in exempting savings channeled through pension schemes from tax.³⁴ To the extent that such savings constitute a major share of total savings, this treatment effectively transforms, to a significant degree, the PIT into a consumption-based tax (see further discussion in Section VI below).

E. Treatment of Capital Income

Arguments for and against aggregating capital income with labor income for PIT purposes have already been reviewed earlier in Section II. Here, the focus is on some structural aspects of the tax treatment of the three main forms of capital income (interest, dividends, and capital gains), assuming the policy decision has been made to subject them to tax on either a schedular or aggregative basis.

F. Treatment of Perquisites

In principle, there is no basis for treating perquisites (fringe benefits), in cash or in kind, received by employees differently from their wage income under the PIT. Indeed, any differential tax treatment between the two could lead to serious abuse, as has been borne out the experiences of several countries that had at one time or another exempted certain perquisites from tax.⁵³ In practice, not all perquisites—especially those paid in kind—can always be adequately brought to tax even if the tax legislation explicitly provides for their taxation. The best one can hope for would be to ensure that the more common and significant ones (e.g., employer-provided accommodations; employer-provided vehicles and other transportation allowances; food discounts; employer contributions to medical insurance; education assistance; and subsidized loans) do not escape the tax net.

Perquisites can be taxed in essentially three different ways: (1) in the hands of the employee—this approach requires the proper valuation (when paid in kind) and declaration of perquisites received, and is thus administratively the most difficult approach to enforce (although it is ironically the most widely-used); (2) in the hands of the employer by denying the tax deductibility of perquisites paid—this approach effectively taxes the perquisites at the CIT rate and is easier to enforce than the first approach (since the cost of perquisites to the employer is more readily ascertainable); and (3) through the adoption of a separate fringe benefits tax to be paid by the employer—this approach is capable of overcoming the limitation of the second approach when the perquisite-paying employer is CIT-exempt, and has the added flexibility of taxing the perquisites at a rate different from the CIT rate. The third approach has been adopted by Australia and New Zealand (in both countries, the fringe benefits tax rate is higher than the CIT rate).⁵⁴

G. Treatment of the Self-Employed

In most developed countries, business income of the self-employed is determined according to the same rules that are used to determine corporate profits, although in a number of countries the accounts of the self-employed are allowed to be kept on a simplified basis. Personal allowances and other deductions available under the PIT are then applied to the business income so determined to arrive at the taxable income—and taxed in accordance with the PIT rate schedule. In some countries, special tax arrangements (e.g., flat-rate schemes) are available for the self-employed meeting certain qualifying conditions.⁵⁵

An important issue related to taxing the self-employed is that the income of this class of taxpayers is really an amalgamation of wages and profits. This would present no problem to a PIT that makes no attempt to separate the two. Some PITs do, however, as in dual income tax systems (Chapter VI). The associated complications are discussed there in that context.

H. Residence Rules and Foreign Tax Credits

Residence rules are necessary in any tax system. For the PIT, they determine how an individual is treated for tax purposes regardless of his nationality or citizenship. Residence rules may also help determine the source of an income (e.g., it may be sourced in a country if it is paid by a resident of that country). While rules vary in detail, most countries employ a domicile test in conjunction with a physical presence test: an individual is considered a resident in a given tax year if he has a domicile in the country or is physically present in the country for more than a given number of days (typically 183 days) over a given period of time (typically the current tax year).⁵⁶ In a residence-based tax system, as a rule residents are taxed on their worldwide income, with credits given for foreign taxes paid (further discussed below), while nonresidents are taxed only on their domestically sourced income. In a source-based tax system, it is, of course, only the source taxes matter. However, as noted earlier, the tax systems of most countries are hybrids, and may treat different types of income differently. For example, employment income may be accorded a different tax treatment from capital income, and, within capital income, a distinction may be drawn between interest and dividends.

For income received by a resident derived from employment in a foreign country, the OECD model tax convention awards the rights to tax that income to the resident’s home country if the resident’s presence in the foreign country does not exceed an aggregate of 183 days. Such a rule is broadly followed by most countries. Any foreign taxes paid on employment income are almost without exception creditable against any domestic taxes on such income. In contrast, the tax rights to interest and dividends under the convention are shared between the host (where the income is paid) and the home (where it is received) countries, albeit with limitations on the rights assigned to the former (in the form of withholding ceilings, as noted earlier). The home countries face no such restrictions under the convention, and in practice typically elect to treat foreign-source interest differently from foreign-source dividends.

While foreign-source interest is typically taxed on a residence basis in most countries (as noted earlier)—with credits granted for foreign withholding taxes, the treatment of foreign-source dividends could vary depending on a number of considerations, e.g., the ownership share of the resident in the foreign corporation paying the dividends. For example, if this share exceeds a certain threshold, a country could elect to tax the dividends on either the source basis (no further domestic taxes are imposed) or the residence basis (credits against the domestic taxes are given for both the underlying foreign CIT and the foreign withholding tax). However, if the ownership share falls below the specified threshold, tax credits for foreign-source dividends could be limited to foreign withholding taxes only.

As a rule, the maximum foreign tax credits available are limited to the domestic tax liability on foreign-source income, i.e., foreign taxes paid in excess of this amount are not refundable (for otherwise domestic tax collections would be dependent on the tax policies in foreign countries). This raises two further issues: (1) whether foreign tax credits should be segregated on a country-by-country and/or income-by income basis (i.e., no cross-crediting is allowed); and (2) whether excess foreign taxes in one period can be carried forward to subsequent periods (and for how long). How a country decides on these issues is largely a matter of balancing the objective of minimizing the double tax burden with that of safeguarding revenue.

A. Targeting Consumption

By definition, the tax object of an income tax is income. In what sense, then, can a tax on personal income be regarded as a tax on consumption? It is in the sense that taxing labor income is equivalent to taxing consumption over the life cycle of a taxpayer. This outcome can be achieved through two alternative, but equivalent, reforms to a conventional PIT: (1) shifting the base of the PIT to wages only (the wage tax); and (2) allowing a deduction for savings (the expenditure tax). The well-known “flat tax” and “USA tax” proposals correspond to the wage tax and expenditure tax ideas, respectively, although each also includes a proposal to convert the conventional CIT into a consumption-based tax as well.

B. Addressing Global Capital Mobility

For a variety of policy and administrative reasons, schedular elements are present in the tax systems in most countries, despite their formal adherence to the global income approach to taxation. However, around the early 1990s, a group of Nordic countries (Denmark, Finland, Norway, and Sweden), concerned with high global capital mobility but faced with the need to retain high PIT rates for revenue reasons, decided explicitly to tax capital income separately from labor income. While the extent of this separation varies across individual members of the group, collectively their approach to income taxation has come to be known as the dual income tax (DIT).⁷⁴

In its pure form, the DIT has the following main characteristics:⁷⁵ (1) capital income includes interest, dividends, capital gains, rents, royalties (from acquired assets), and business profits; (2) labor income includes wages and salaries (including the value of imputed labor services of the self-employed—see further discussion below), pensions and social security benefits, perquisites, and royalties not classified as capital income; (3) the rate of tax on capital income is uniform (to prevent tax arbitrage) and moderate (on account of high capital mobility); and (4) the rates on labor income are progressive (for equity reasons) and generally higher than the rate on capital income (on account of low labor mobility), but not so high as to provide a strong incentive to the self-employed to disguise labor income as capital income.

In general, the income tax systems in Finland and Norway come closest to the DIT as described above, while Denmark’s has strayed from it the furthest. Table 1 provides a comparative picture of the main features of the income tax systems in the four Nordic countries. Several notable aspects emerge from the comparison: (1) the separate taxation of capital income and labor income is largely achieved in Finland, Norway, and Sweden, while Denmark only manages the separate taxation of dividends; (2) the CIT rate is set at or close to the bottom PIT rate on labor income in each of the four countries; (3) taxing capital income at a uniform rate is not always achieved even in those countries that have largely separated capital income from labor income: in Sweden, for example, the 30 percent rate on personal capital income is slightly higher than the CIT, and dividends are double taxed in the same way as under a classical system;⁷⁶ and (4) Norway has gone so far as to eliminate the double taxation of corporate retained earnings through adjusting the cost basis of shares from which taxable capital gains are to be determined.

Table 1.

Comparative Features of the Income Tax Systems in the Nordic Countries, 2002

Source: Zee (2002).

^1/Inclusive of local taxes but exclusive of social security contributions (rates shown are rounded). There could be some imprecision in the indicated ranges due to variations in local tax rates by locality.

^2/In addition to the CIT.

^3/On adjusted gains: the cost basis of shares is stepped up by new retained earnings (net of the CIT) and down by losses and distributions from previously accumulated earnings.

^4/Long-term gains are taxed as dividends, but such gains from quoted shares are tax exempt if the total holding of such shares is below a stipulated threshold.

^5/On resident individuals; on nonresidents, in general, withholding taxes on interest are nil and on dividends are governed by tax treaties.

Table 1.

Comparative Features of the Income Tax Systems in the Nordic Countries, 2002

	Strong DIT features		Weak DIT features
	Finland	Norway	Denmark	Sweden
Year of reform	1993	1992	1994	1991
CIT rate (percent)	29	28	30	28
PIT rates (percent)
Wages and salaries 1/	30 - 59	28 - 48	33 - 59	28 - 56
Interest	29	28	Aggregated with wages and salaries.	30
Dividends 2/	--	--	28 - 43	30
Capital gains on shares	29	28 3/	Aggregated with wages and salaries for short-term gains (< 3 years). 4/	30
Other capital income	29	28	Aggregated with wages and salaries.	30
Withholding tax rates (percent) 5/
Interest	29	--	--	30
Dividends	--	--	28	30
Integration of PIT and CIT	Full imputation.	Full imputation.	No.	No.

Source: Zee (2002).

^1/Inclusive of local taxes but exclusive of social security contributions (rates shown are rounded). There could be some imprecision in the indicated ranges due to variations in local tax rates by locality.

^2/In addition to the CIT.

^3/On adjusted gains: the cost basis of shares is stepped up by new retained earnings (net of the CIT) and down by losses and distributions from previously accumulated earnings.

^4/Long-term gains are taxed as dividends, but such gains from quoted shares are tax exempt if the total holding of such shares is below a stipulated threshold.

^5/On resident individuals; on nonresidents, in general, withholding taxes on interest are nil and on dividends are governed by tax treaties.

View Table

Table 1.

Comparative Features of the Income Tax Systems in the Nordic Countries, 2002

	Strong DIT features		Weak DIT features
	Finland	Norway	Denmark	Sweden
Year of reform	1993	1992	1994	1991
CIT rate (percent)	29	28	30	28
PIT rates (percent)
Wages and salaries 1/	30 - 59	28 - 48	33 - 59	28 - 56
Interest	29	28	Aggregated with wages and salaries.	30
Dividends 2/	--	--	28 - 43	30
Capital gains on shares	29	28 3/	Aggregated with wages and salaries for short-term gains (< 3 years). 4/	30
Other capital income	29	28	Aggregated with wages and salaries.	30
Withholding tax rates (percent) 5/
Interest	29	--	--	30
Dividends	--	--	28	30
Integration of PIT and CIT	Full imputation.	Full imputation.	No.	No.

Source: Zee (2002).

^1/Inclusive of local taxes but exclusive of social security contributions (rates shown are rounded). There could be some imprecision in the indicated ranges due to variations in local tax rates by locality.

^2/In addition to the CIT.

^3/On adjusted gains: the cost basis of shares is stepped up by new retained earnings (net of the CIT) and down by losses and distributions from previously accumulated earnings.

^4/Long-term gains are taxed as dividends, but such gains from quoted shares are tax exempt if the total holding of such shares is below a stipulated threshold.

^5/On resident individuals; on nonresidents, in general, withholding taxes on interest are nil and on dividends are governed by tax treaties.

Under a DIT, the treatment of the self-employed is the most problematic, since its income contains both a return to capital and a remuneration for labor services. In each of the four countries, a specific procedure is used to separate these two elements.⁷⁷ In Finland and Norway, a presumptive rate of return on capital is used to determine the fraction of total current-period business profits (whether withdrawn or retained) that should be taxed as capital income;⁷⁸ the remaining fraction is then taxed as labor income. This approach is based on the concept that underpins the DIT: all income is classifiable as either capital or labor income. In contrast, In Denmark and Sweden (and Finland for unlisted companies), all retained profits are taxed as capital income; the presumptive splitting between capital and labor income only applies to withdrawn profits. This approach views the self-employed/closely-held companies as if they were corporations, and confers a tax advantage (relative to wage earners) to the returns to labor services of the self-employed when such returns are retained.

A common criticism against the DIT is that the above splitting of the business profits of the self-employed is arbitrary and entails administrative complexity.⁷⁹ However, these limitations do not appear to be excessively severe compared to many other arbitrary and complex administrative rules that typically exist in any tax system. On the whole, the DIT seems to be a compelling alternative to a conventional PIT in balancing efficiency and equity concerns on the one hand, and addressing global capital mobility consequences on the other. By retaining a tax on capital, albeit at a relatively moderate level, it is also a much less radical reform than a full switch from income to consumption taxation.

A. Revenue Developments

As Table 2 indicates, PIT revenue has remained, on average, relatively stable over the past decade in the selected OECD countries, as a share of either GDP (about 11 percent) or total tax revenue (about 28 percent). This relative stability was broadly observed in all regional groups in terms of GDP shares, but less so in terms of total tax revenue shares.

Table 2.

Selected OECD Countries: PIT Revenue, ^1/ 1986-2002

Source: Revenue Statistics Database (OECD).

^1/General government.

Table 2.

Selected OECD Countries: PIT Revenue, ^1/ 1986-2002

	Period average
	1986-1990	1991-1995	1996-2000	2001-2002
	(In percent of GDP)
North America	11.6	11.8	12.5	11.8
Canada	13.2	13.7	13.6	12.5
United States	10.0	9.8	11.5	11.2
Asia and Pacific	10.4	9.6	9.2	8.8
Australia	13.3	11.5	12.6	12.1
Japan	7.2	6.9	5.4	5.1
Korea	2.8	3.6	3.9	3.3
New Zealand	18.3	16.5	15.0	14.6
Europe (West)	8.9	9.2	8.7	9.2
France	4.8	5.2	6.9	7.8
Germany	10.5	10.3	9.3	9.5
Italy	9.9	10.9	10.9	11.0
Netherlands	9.4	10.3	6.5	6.9
United Kingdom	9.9	9.5	9.8	10.9
Europe (East)	…	6.2	6.8	6.9
Czech Republic	…	4.5	5.2	5.0
Hungary	…	6.9	6.9	7.7
Poland	…	7.2	8.3	7.5
Nordic	18.3	17.8	17.7	16.8
Denmark	24.9	26.0	26.1	26.2
Finland	16.8	17.3	15.3	14.4
Norway	11.4	10.6	11.1	10.7
Sweden	20.3	17.4	18.3	15.9
Average	12.2	11.0	10.9	10.7
	(In percent of total tax revenue)
North America	38.0	37.3	38.6	38.2
Canada	38.5	38.4	37.7	36.3
United States	37.5	36.2	39.5	40.0
Asia and Pacific	34.1	32.1	30.4	28.6
Australia	44.9	40.9	42.3	39.1
Japan	24.8	24.5	19.6	19.3
Korea	16.1	18.2	17.2	13.5
New Zealand	50.5	44.7	42.6	42.6
Europe (West)	22.9	23.3	21.5	23.3
France	11.2	11.9	14.6	17.5
Germany	28.7	27.4	24.7	26.1
Italy	26.8	26.3	25.4	25.6
Netherlands	21.3	23.2	16.0	17.3
United Kingdom	26.7	27.6	26.7	30.0
Europe (East)	…	14.8	17.7	18.7
Czech Republic	…	10.9	13.7	12.8
Hungary	…	15.5	17.1	20.0
Poland	…	18.0	22.2	23.3
Nordic	38.8	38.2	36.8	35.0
Denmark	50.6	53.6	52.1	53.0
Finland	39.7	37.9	33.3	31.4
Norway	26.4	25.9	26.7	24.5
Sweden	38.5	35.5	35.3	31.1
Average	32.1	28.7	28.1	27.9

Source: Revenue Statistics Database (OECD).

^1/General government.

View Table

Table 2.

Selected OECD Countries: PIT Revenue, ^1/ 1986-2002

	Period average
	1986-1990	1991-1995	1996-2000	2001-2002
	(In percent of GDP)
North America	11.6	11.8	12.5	11.8
Canada	13.2	13.7	13.6	12.5
United States	10.0	9.8	11.5	11.2
Asia and Pacific	10.4	9.6	9.2	8.8
Australia	13.3	11.5	12.6	12.1
Japan	7.2	6.9	5.4	5.1
Korea	2.8	3.6	3.9	3.3
New Zealand	18.3	16.5	15.0	14.6
Europe (West)	8.9	9.2	8.7	9.2
France	4.8	5.2	6.9	7.8
Germany	10.5	10.3	9.3	9.5
Italy	9.9	10.9	10.9	11.0
Netherlands	9.4	10.3	6.5	6.9
United Kingdom	9.9	9.5	9.8	10.9
Europe (East)	…	6.2	6.8	6.9
Czech Republic	…	4.5	5.2	5.0
Hungary	…	6.9	6.9	7.7
Poland	…	7.2	8.3	7.5
Nordic	18.3	17.8	17.7	16.8
Denmark	24.9	26.0	26.1	26.2
Finland	16.8	17.3	15.3	14.4
Norway	11.4	10.6	11.1	10.7
Sweden	20.3	17.4	18.3	15.9
Average	12.2	11.0	10.9	10.7
	(In percent of total tax revenue)
North America	38.0	37.3	38.6	38.2
Canada	38.5	38.4	37.7	36.3
United States	37.5	36.2	39.5	40.0
Asia and Pacific	34.1	32.1	30.4	28.6
Australia	44.9	40.9	42.3	39.1
Japan	24.8	24.5	19.6	19.3
Korea	16.1	18.2	17.2	13.5
New Zealand	50.5	44.7	42.6	42.6
Europe (West)	22.9	23.3	21.5	23.3
France	11.2	11.9	14.6	17.5
Germany	28.7	27.4	24.7	26.1
Italy	26.8	26.3	25.4	25.6
Netherlands	21.3	23.2	16.0	17.3
United Kingdom	26.7	27.6	26.7	30.0
Europe (East)	…	14.8	17.7	18.7
Czech Republic	…	10.9	13.7	12.8
Hungary	…	15.5	17.1	20.0
Poland	…	18.0	22.2	23.3
Nordic	38.8	38.2	36.8	35.0
Denmark	50.6	53.6	52.1	53.0
Finland	39.7	37.9	33.3	31.4
Norway	26.4	25.9	26.7	24.5
Sweden	38.5	35.5	35.3	31.1
Average	32.1	28.7	28.1	27.9

Source: Revenue Statistics Database (OECD).

^1/General government.

There are large differences in the level of PIT revenue among the regional groups, with the Nordic countries having the highest (reaching almost 18 percent of GDP) and the Eastern European countries having the lowest (a little below 7 percent of GDP). North American countries’ average PIT revenue level (about 12 percent of GDP) exceeded all others except the Nordic countries, while Asian and Pacific countries’ is more or less on par with that of the Western European countries. The importance of the PIT as a revenue source among the country groups exhibits, however, a different pattern of relativities. Since the average total tax revenue in the North American countries is significantly below that in the Nordic countries, the former’s reliance on PIT revenue (over 39 percent of total tax revenue in 2001) actually surpassed the latter’s (about 36 percent). Similarly, Asian and Pacific countries’ traditionally low total tax revenue levels imply that they rely much more heavily on PIT revenue than do the Western European countries (by about 6 percentage points of total tax revenue in 2001).

The distribution of the PIT revenue between the central and sub-central levels of government in most of the selected OECD countries is in the former’s favor, with the Nordic countries being the sole exception, where the central government on average claimed only a 38 percent share of the total in 2000 (Table 3). Elsewhere, the central government’s share ranges from over 60 percent (Eastern Europe) to over 88 percent (Asia and Pacific as well as Western Europe). In a number of countries (Australia, France, Italy, Netherlands, New Zealand, and the United Kingdom), all PIT revenue accrues to the central government.

Table 3.

Selected OECD Countries: PIT Revenue by Level of Government, 2000

Source: Revenue Statistics Database (OECD).

^1/Excluding social security taxes.

^2/The division of PIT revenue between central and sub-central governments incorporates the part of the PIT revenue that is shared between the two.

^3/Data pertain to 1999.

4/Data pertain to 2001.

Table 3.

Selected OECD Countries: PIT Revenue by Level of Government, 2000

	As share of total tax revenue of respective government 1/		PIT revenue of central government as share of total PIT revenue 2/
	Central 2/	Sub-central 2/
	(In percent)
North America	65.4	27.8	72.6
Canada	55.2	31.3	62.7
United States	75.5	24.4	82.5
Asia and Pacific	36.1	19.5	88.5
Australia	44.2	--	100.0
Japan	35.6	27.8	65.5
Korea	19.0	11.1	88.5
New Zealand	45.4	--	100.0
Europe (West)	32.6	48.4	88.6
France	20.6	--	100.0
Germany	35.4	48.4	42.9
Italy	43.0	--	100.0
Netherlands	26.4	--	100.0
United Kingdom	37.5	--	100.0
Europe (East)	19.3	47.7	60.6
Czech Republic	10.3	66.3	35.4
Hungary	28.3	0.8	99.8
Poland 3/	19.4	76.0	46.7
Nordic	22.9	89.0	38.0
Denmark	36.3	91.6	42.9
Finland	27.3	74.4	49.0
Norway	17.5	89.9	42.6
Sweden	10.5	100.0	17.3
Average	32.6	53.5	70.9

Source: Revenue Statistics Database (OECD).

^1/Excluding social security taxes.

^2/The division of PIT revenue between central and sub-central governments incorporates the part of the PIT revenue that is shared between the two.

^3/Data pertain to 1999.

4/Data pertain to 2001.

View Table

Table 3.

Selected OECD Countries: PIT Revenue by Level of Government, 2000

	As share of total tax revenue of respective government 1/		PIT revenue of central government as share of total PIT revenue 2/
	Central 2/	Sub-central 2/
	(In percent)
North America	65.4	27.8	72.6
Canada	55.2	31.3	62.7
United States	75.5	24.4	82.5
Asia and Pacific	36.1	19.5	88.5
Australia	44.2	--	100.0
Japan	35.6	27.8	65.5
Korea	19.0	11.1	88.5
New Zealand	45.4	--	100.0
Europe (West)	32.6	48.4	88.6
France	20.6	--	100.0
Germany	35.4	48.4	42.9
Italy	43.0	--	100.0
Netherlands	26.4	--	100.0
United Kingdom	37.5	--	100.0
Europe (East)	19.3	47.7	60.6
Czech Republic	10.3	66.3	35.4
Hungary	28.3	0.8	99.8
Poland 3/	19.4	76.0	46.7
Nordic	22.9	89.0	38.0
Denmark	36.3	91.6	42.9
Finland	27.3	74.4	49.0
Norway	17.5	89.9	42.6
Sweden	10.5	100.0	17.3
Average	32.6	53.5	70.9

Source: Revenue Statistics Database (OECD).

^1/Excluding social security taxes.

^2/The division of PIT revenue between central and sub-central governments incorporates the part of the PIT revenue that is shared between the two.

^3/Data pertain to 1999.

4/Data pertain to 2001.

Table 4 provides a broad picture of the revenue structure and its trend over the past decade in the same countries. The average ratio of income to consumption taxes has remained unchanged at 2.6 for these countries over the past decade, with the North American countries showing a rising trend, countered by the declining trend observed in the Asian and Pacific countries. Indeed, at 4.2 in 2001, the North American countries had the highest ratio among all the regional groups—and more than twice that of the Eastern European countries (whose ratio was slightly less than 2).

Table 4.

Selected OECD Countries: Structure of Tax Revenue, ^1/ 1986-2002

Source: Revenue Statistics Database (OECD).

^1/General government.

^2/Income taxes include all direct taxes and taxes on properties; and consumption taxes include all indirect taxes.

Table 4.

Selected OECD Countries: Structure of Tax Revenue, ^1/ 1986-2002

	Period average
	1986-1990	1991-1995	1996-2000	2002
	(Ratio of income to consumption taxes) 2/
North America	3.6	3.7	4.1	3.8
Canada	2.5	2.8	3.0	2.8
United States	4.7	4.6	5.1	4.8
Asia and Pacific	3.1	2.9	2.6	2.4
Australia	2.4	2.5	2.7	2.3
Japan	6.7	5.9	4.6	4.0
Korea	0.9	1.2	1.4	1.5
New Zealand	2.2	1.9	1.8	1.8
Europe (West)	2.6	2.5	2.4	2.4
France	2.3	2.6	2.6	2.8
Germany	2.9	2.6	2.6	2.4
Italy	2.7	2.7	2.7	2.5
Netherlands	2.8	2.9	2.5	2.2
United Kingdom	2.2	1.8	2.0	2.0
Europe (East)	…	1.9	1.8	1.9
Czech Republic	…	2.0	2.1	2.4
Hungary	…	1.7	1.5	1.7
Poland	…	2.1	1.8	1.7
Nordic	2.1	2.2	2.4	2.3
Denmark	2.0	2.1	2.1	2.0
Finland	1.9	2.2	2.3	2.3
Norway	1.7	1.7	1.7	2.2
Sweden	3.1	2.9	3.6	2.8
Average	2.7	2.6	2.6	2.4
	(Ratio of PIT to CIT)
North America	4.7	5.3	4.1	4.6
Canada	4.8	6.2	3.8	3.5
United States	4.6	4.3	4.5	5.6
Asia and Pacific	3.3	2.6	2.3	2.1
Australia	4.1	2.9	2.6	2.3
Japan	1.1	1.5	1.4	1.5
Korea	1.2	1.5	1.5	1.0
New Zealand	6.7	4.7	3.9	3.5
Europe (West)	3.1	4.0	3.1	4.1
France	2.1	2.6	2.5	2.6
Germany	5.4	8.0	5.7	8.7
Italy	2.6	2.8	3.2	3.4
Netherlands	2.9	3.3	1.5	2.1
United Kingdom	2.4	3.3	2.6	3.7
Europe (East)	…	2.0	2.6	2.7
Czech Republic	…	0.8	1.4	1.1
Hungary	…	3.2	3.3	3.3
Poland	…	2.0	3.0	3.6
Nordic	9.0	13.5	5.6	5.0
Denmark	12.1	14.3	10.1	9.2
Finland	10.5	28.1	3.9	3.4
Norway	3.7	3.0	2.5	1.3
Sweden	9.4	8.5	5.8	6.3
Average	4.9	5.6	3.5	3.7

Source: Revenue Statistics Database (OECD).

^1/General government.

^2/Income taxes include all direct taxes and taxes on properties; and consumption taxes include all indirect taxes.

View Table

Table 4.

Selected OECD Countries: Structure of Tax Revenue, ^1/ 1986-2002

	Period average
	1986-1990	1991-1995	1996-2000	2002
	(Ratio of income to consumption taxes) 2/
North America	3.6	3.7	4.1	3.8
Canada	2.5	2.8	3.0	2.8
United States	4.7	4.6	5.1	4.8
Asia and Pacific	3.1	2.9	2.6	2.4
Australia	2.4	2.5	2.7	2.3
Japan	6.7	5.9	4.6	4.0
Korea	0.9	1.2	1.4	1.5
New Zealand	2.2	1.9	1.8	1.8
Europe (West)	2.6	2.5	2.4	2.4
France	2.3	2.6	2.6	2.8
Germany	2.9	2.6	2.6	2.4
Italy	2.7	2.7	2.7	2.5
Netherlands	2.8	2.9	2.5	2.2
United Kingdom	2.2	1.8	2.0	2.0
Europe (East)	…	1.9	1.8	1.9
Czech Republic	…	2.0	2.1	2.4
Hungary	…	1.7	1.5	1.7
Poland	…	2.1	1.8	1.7
Nordic	2.1	2.2	2.4	2.3
Denmark	2.0	2.1	2.1	2.0
Finland	1.9	2.2	2.3	2.3
Norway	1.7	1.7	1.7	2.2
Sweden	3.1	2.9	3.6	2.8
Average	2.7	2.6	2.6	2.4
	(Ratio of PIT to CIT)
North America	4.7	5.3	4.1	4.6
Canada	4.8	6.2	3.8	3.5
United States	4.6	4.3	4.5	5.6
Asia and Pacific	3.3	2.6	2.3	2.1
Australia	4.1	2.9	2.6	2.3
Japan	1.1	1.5	1.4	1.5
Korea	1.2	1.5	1.5	1.0
New Zealand	6.7	4.7	3.9	3.5
Europe (West)	3.1	4.0	3.1	4.1
France	2.1	2.6	2.5	2.6
Germany	5.4	8.0	5.7	8.7
Italy	2.6	2.8	3.2	3.4
Netherlands	2.9	3.3	1.5	2.1
United Kingdom	2.4	3.3	2.6	3.7
Europe (East)	…	2.0	2.6	2.7
Czech Republic	…	0.8	1.4	1.1
Hungary	…	3.2	3.3	3.3
Poland	…	2.0	3.0	3.6
Nordic	9.0	13.5	5.6	5.0
Denmark	12.1	14.3	10.1	9.2
Finland	10.5	28.1	3.9	3.4
Norway	3.7	3.0	2.5	1.3
Sweden	9.4	8.5	5.8	6.3
Average	4.9	5.6	3.5	3.7

Source: Revenue Statistics Database (OECD).

^1/General government.

^2/Income taxes include all direct taxes and taxes on properties; and consumption taxes include all indirect taxes.

Much more variability was observed in the ratio of PIT to CIT revenue among the same country groups over the same period. In general, the Nordic countries historically have by far the highest ratio, followed by North America. Both of these regional groups tended, however, to converge in recent years, and were observed to have an average ratio around 4.5 in 2001— being exceeded in the event by Western Europe’s average ratio of 5.5. The average ratios of countries in the Asia and Pacific and Eastern Europe regions were traditionally much lower by comparison—by roughly half in 2001.

B. Structural Aspects

Rate schedule and basic allowance

Several important changes to the structure of the PIT rate schedules in the selected OECD countries between 1986 and 2002 are highlighted in Table 5. They include, at the central/federal government level, an average reduction in: (1) the maximum PIT marginal rate from about 55 percent to about 38 percent; (2) the minimum PIT marginal positive rate from about 19 percent to about 14 percent; (3) the number of PIT rates from eight to four; and (4) the excess of the maximum PIT marginal rate over the standard CIT rate from about 15 to about 8 percentage points. Furthermore, reductions in the maximum PIT marginal rate, minimum PIT marginal positive rate, and the number of PIT rates hold for all regional country groups during the period (except for the Eastern European countries, for which meaningful comparative information in 1986 did not exist). In short, the PIT rate schedules have gotten significantly flatter, lower, and simpler over the past one and a half decade.

Table 5.

Selected OECD Countries: PIT Rate Schedules and Basic Allowance, ^1/ 1986 and 2002

Sources: European Tax Handbook (IBFD), various issues; Taxes and Investment in Asia and the Pacific (IBFD), various issues; and Individual Taxes—A Worldwide Summary (PriceWaterhouseCoopers), various issues.

^1/At the central/federal level, inclusive of surcharges.

^2/If multiple rate schedules apply, the schedule applicable to wage income for a single resident taxpayer is shown.

^3/If multiple basic allowances apply, the maximum allowance related to wage income for a single resident taxpayer is shown. The basic allowance does not include any standard deduction in lieu of itemized deductions.

Table 5.

Selected OECD Countries: PIT Rate Schedules and Basic Allowance, ^1/ 1986 and 2002

	Maximum marginal rate 2/		Minimum marginal positive rate 2/		Number of positive marginal rates 2/		Maximum marginal rate less standard CIT rate		Annual basic allowance 3/
	1986	2002	1986	2002	1986	2002	1986	2002	1986	2002
	(In percent)						(In percent)		(In percent of per capita income)
North America	43.7	33.8	23.8	13.0	8	5	-0.7	3.2	13.8	15.7
Canada	37.4	29.0	27.5	16.0	3	4	-0.4	2.88	21.3	22.8
United States	50.0	38.6	20.0	10.0	12	6	-1.0	3.6	6.2	8.6
Asia and Pacific	62.8	39.8	20.3	13.9	9	4	24.2	9.8	18.5	10.4
Australia	60.0	47.0	25.0	17.0	5	4	14.0	17.0	25.9	16.5
Japan	70.0	37.0	30.0	10.0	9	4	36.7	7.0	15.3	8.4
Korea	55.0	36.0	6.0	9.0	16	4	25.0	9.0	14.4	8.5
New Zealand	66.0	39.0	20.0	19.5	6	3	21.0	6.0	…	8.2
Europe (West)	62.5	48.5	20.0	12.0	8	5	23.8	15.8	18.0	32.8
France	…	52.75	…	7.5	…	6	…	17.32	…	17.1
Germany	56.0	51.17	…	21.06	…	…	20.0	24.79	1.8	28.7
Italy	62.0	46.4	12.0	18.25	9	5	26.0	9.63	3.9	30.1
Netherlands	72.0	52.0	18.0	2.95	9	4	29.0	17.5	29.9	60.0
United Kingdom	60.0	40.0	30.0	10.0	6	3	20.0	10.0	36.5	28.2
Europe (East)	…	37.3	…	18.0	…	3	…	11.7	…	42.5
Czech Republic	…	32.0	…	15.0	…	4	…	1.0	…	63.3
Hungary	…	40.0	…	20.0	…	3	…	22.0	…	48.5
Poland	…	40.0	…	19.0	…	3	…	12.0	…	15.7
Nordic	45.2	23.9	14.9	12.9	5	3	4.5	-4.9	46.7	70.7
Denmark	39.6	15.0	14.4	5.5	3	3	-10.4	-15.0	74.9	14.0
Finland	51.0	36.0	38.0	13.0	4	5	18.0	7.0	18.5	45.2
Norway	40.0	19.5	3.0	13.5	8	2	12.2	-8.5	…	112.8
Sweden	50.0	25.0	4.0	20.0	…	2	-2.0	-3.0	…	110.7
Average	54.9	37.6	19.1	13.7	8	4	14.9	7.8	22.6	36.0

Sources: European Tax Handbook (IBFD), various issues; Taxes and Investment in Asia and the Pacific (IBFD), various issues; and Individual Taxes—A Worldwide Summary (PriceWaterhouseCoopers), various issues.

^1/At the central/federal level, inclusive of surcharges.

^2/If multiple rate schedules apply, the schedule applicable to wage income for a single resident taxpayer is shown.

^3/If multiple basic allowances apply, the maximum allowance related to wage income for a single resident taxpayer is shown. The basic allowance does not include any standard deduction in lieu of itemized deductions.

View Table

Table 5.

Selected OECD Countries: PIT Rate Schedules and Basic Allowance, ^1/ 1986 and 2002

	Maximum marginal rate 2/		Minimum marginal positive rate 2/		Number of positive marginal rates 2/		Maximum marginal rate less standard CIT rate		Annual basic allowance 3/
	1986	2002	1986	2002	1986	2002	1986	2002	1986	2002
	(In percent)						(In percent)		(In percent of per capita income)
North America	43.7	33.8	23.8	13.0	8	5	-0.7	3.2	13.8	15.7
Canada	37.4	29.0	27.5	16.0	3	4	-0.4	2.88	21.3	22.8
United States	50.0	38.6	20.0	10.0	12	6	-1.0	3.6	6.2	8.6
Asia and Pacific	62.8	39.8	20.3	13.9	9	4	24.2	9.8	18.5	10.4
Australia	60.0	47.0	25.0	17.0	5	4	14.0	17.0	25.9	16.5
Japan	70.0	37.0	30.0	10.0	9	4	36.7	7.0	15.3	8.4
Korea	55.0	36.0	6.0	9.0	16	4	25.0	9.0	14.4	8.5
New Zealand	66.0	39.0	20.0	19.5	6	3	21.0	6.0	…	8.2
Europe (West)	62.5	48.5	20.0	12.0	8	5	23.8	15.8	18.0	32.8
France	…	52.75	…	7.5	…	6	…	17.32	…	17.1
Germany	56.0	51.17	…	21.06	…	…	20.0	24.79	1.8	28.7
Italy	62.0	46.4	12.0	18.25	9	5	26.0	9.63	3.9	30.1
Netherlands	72.0	52.0	18.0	2.95	9	4	29.0	17.5	29.9	60.0
United Kingdom	60.0	40.0	30.0	10.0	6	3	20.0	10.0	36.5	28.2
Europe (East)	…	37.3	…	18.0	…	3	…	11.7	…	42.5
Czech Republic	…	32.0	…	15.0	…	4	…	1.0	…	63.3
Hungary	…	40.0	…	20.0	…	3	…	22.0	…	48.5
Poland	…	40.0	…	19.0	…	3	…	12.0	…	15.7
Nordic	45.2	23.9	14.9	12.9	5	3	4.5	-4.9	46.7	70.7
Denmark	39.6	15.0	14.4	5.5	3	3	-10.4	-15.0	74.9	14.0
Finland	51.0	36.0	38.0	13.0	4	5	18.0	7.0	18.5	45.2
Norway	40.0	19.5	3.0	13.5	8	2	12.2	-8.5	…	112.8
Sweden	50.0	25.0	4.0	20.0	…	2	-2.0	-3.0	…	110.7
Average	54.9	37.6	19.1	13.7	8	4	14.9	7.8	22.6	36.0

Sources: European Tax Handbook (IBFD), various issues; Taxes and Investment in Asia and the Pacific (IBFD), various issues; and Individual Taxes—A Worldwide Summary (PriceWaterhouseCoopers), various issues.

^1/At the central/federal level, inclusive of surcharges.

^2/If multiple rate schedules apply, the schedule applicable to wage income for a single resident taxpayer is shown.

^3/If multiple basic allowances apply, the maximum allowance related to wage income for a single resident taxpayer is shown. The basic allowance does not include any standard deduction in lieu of itemized deductions.

Also of interest and significance is the change in the level of basic allowance under the PIT, which had risen, on average, from about 23 percent of per capita income to about 36 percent of per capital income for the same countries between 1986 and 2002, although this rise was not observed across all country groups (countries in the Asia and Pacific region saw a decline). As noted earlier, a higher level of basic allowance raises, all other things equal, the average progressivity of the PIT. This would tend to compensate, at least in part, any adverse equity effects of the lowering and flattening of the PIT rate schedules.