APPENDIX III: III. Employment and Taxation in Finland: Empirical Estimation
1. The aim of this appendix is to estimate the impact of labor taxation, as measured by the real tax wedge (see Section D) on labor market equilibrium in Finland, and to compare the results with those reported in the studies by Tyrväinen (1995 b, c). While the model is similar to Tyrväinen (1995 b, c), the sample period was extended to the most recent years, so as to evaluate possible changes in the parameters that might have occurred since the beginning of the nineties. The appendix is organized as follows: the first part describes the theoretical model of labor market behavior; the second part describes the data set and variables used in the estimations; the third part presents the econometric techniques in the estimation, and, the final section presents and interprets the econometric results.
Agel, J., P., Englund and J. Sodersten (1996), “Tax Reform of the Century—the Swedish Experiment,” National Tax Journal, Vol., No., pp. 643–64.
Cnossen, S., (1996), “Company Taxes in the European Union: Criteria and Options for Reform,” Fiscal Studies, Vol. 17, No. 4, pp. 67–97.
International Bureau of Fiscal Documentation, (1996), “Finland: Taxation of Corporations, and Taxation of Individuals,” in European Taxation.
Lodin, S., (1994), “The Nordic Reforms of Company and Shareholder Taxation - A Comparison,” Stockholm Federation of Swedish Industries.
Sorensen, P. (1994), “From the global Income Tax to the Dual Income Tax: Recent Tax Reforms in the Nordic Countries,” International Tax and Public Finance, Vol. 1, No. 1, pp. 57–79.
The real tax wedge is defined by (1+s)/(1-t)Pc/P, where s is the employers social security contribution rate, the tax rate on income, Pc the consumer price index and P the producer price index. The wedge represents the ratio of real gross labor costs to real after tax take-home pay of the employee.
The variables included were, real producer wages, employment, output, real wedge and productivity.
Prepared by Russell Krelove.
In EU-15, general consumption tax revenue rose by about 1 percent of GDP since 1985, while specific consumption tax revenue fell marginally as a share of GDP.
The tax replaced a number of more specific and complex property-type and other taxes.
Specifically, municipal income tax, real estate tax and the municipal shares of corporate tax are equalized. For each municipality and for each tax base, the average tax rate over all communities is applied to the municipality’s measured tax base. If the per capita revenue from this calculation is less than 90 percent of the realized average per capita revenue from that source over all municipalities, the community is entitled to a grant on account of this tax base to bring it up to the 90 percent level. When the per capita revenue from the calculation exceeds 90 percent of the average realized per capita revenue, the municipality’s overall subsidy is reduced by an amount that is 40 percent of the amount exceeding the equalization limit, up to a ceiling of 15 percent of the municipality’s calculated tax revenue.
Current transfers totaled Fmk 32.5 billion in 1996. The breakdown was Fmk 11.8 billion for education and culture, Fmk 16.1 billion for social welfare and health services, and Fmk 4.6 billion for others, including general subsidy and equalization.
State subsidies for education are paid to organizations maintaining private educational institutions, as well as to municipalities and joint municipal boards. In addition, bilingual education needs of municipalities are recognized in the grants paid where appropriate.
The central government share will be reduced to 24 percent in 1998. This sharing is achieved by defining a per capita local contribution amount that municipalities are expected to cover, which is subtracted from the total calculated per capita expenditure in all categories.
Specifically, for social welfare, approximately 93 percent of calculated expenditure is based on the age structure, while the unemployment factor (based in a nonintuitive manner partly on the municipal unemployment rate and its relation to the national rate, partly on the relative municipal and national employment rates, and partly on the number of unemployed in the municipality) receives approximately 7 percent weight. For the health care grant, the age structure is weighted approximately 75 percent, and the morbidity factor by about 25 percent, determined using a “sickness factor.”
In fact, calculations for several countries with similar tax treatment have indicated that there was a net revenue loss from the taxation of capital income. See Sorensen (1994).
Some such treatment was necessary because most domestic taxable interest income is subject to final withholding at source.
As already noted, the rate was raised to 28 percent in 1996.
In the 1993 reform in particular, the system of tax-deductible transfers to reserves was substantially abolished, subject to some transitional measures. At the same time the share of entertainment expenditures that could be deducted was reduced from 100 percent to 50 percent, and restrictions were placed on deductibility of voluntary contributions to pension plans. Losses were allowed to be carried forward for ten years, without interest, but could not be carried backwards. This provision created an asymmetry in the treatment of profits and losses.
See Farrar and Pointon (1996). Farrar and Pointon calculate that, under certain assumptions, the required before-tax rate of return on investment is the lowest in Finland among eleven European countries. For plant and machinery the required rate of return was calculated to be 13.3 percent in Finland, compared to an average of 17 percent; for industrial buildings the required rate in Finland is 14 percent, compared to an average of 19 percent; and for commercial buildings the required rate of return in Finland is 14 percent, compared to an average of 20 percent. In general in the calculations of Farrar and Pointon, Luxembourg, Finland and Greece have low effective corporate tax rates, whereas the Netherlands and Germany have higher rates. The magnitudes of the required returns, but not the thrust of the argument, needs to be modified on account of the increase in the tax rate to 28 percent in 1996. Note that the calculations show that there is no strong bias toward a particular asset category in the current system in Finland.
Since nominal interest is usually deductible, the interaction of this tax provision with inflation can have a significant effect on the after tax cost of borrowing. Even for moderate rates of inflation, the after-tax cost can become negative for those facing higher marginal tax rates.
The capital gain on a dwelling is, tax free if the taxpayer has simultaneously lived in and owned the dwelling continuously for at least two years.
At the same time some special additional tax reliefs were introduced for those households having difficulty with mortgage payments and those with negative equity, and extra tax credit for interest was granted for those who purchased their first house. The revenue cost of these and similar additional measures was Fmk 1.6 billion in 1993, and had fallen to an estimated Fmk 0.5 billion by 1996 (Table 20).
The increases in the effective VAT tax rate on new construction enacted in 1993 and 1994 would be expected to make existing (untaxed) housing relatively more attractive and have a positive impact on prices.
The fall in volume may be associated with a lock-in effect for existing owners arising from negative equity, as well as because of a lack of demand on account of expectations of further price decreases.
As indicated, the revenue cost qf the deduction of mortgage interest payments was estimated to be Fmk 2.2 billion (0.4 percent of GDP) in 1996. In addition, the cost of the exclusion of imputed rent and of capital gains on owner-occupied housing is estimated to have totaled Fmk 7.2 billion (1.5 percent of GDP) in 1993 (OECD (1996b)).
Of course, as the proportion of the return to housing that is made taxable is increased, nondistortionary treatment requires that a corresponding proportion of mortgage interest expense be allowed as a deduction.
In principle, the credit against earned income tax is limited to Fmk 8,000–12,000 (i.e., approximately Fmk 28,600–42,900 in interest expense), depending on the number of dependents of the taxpayer, but there are a number of qualifications and transition provisions that increase the ceiling (Finland, Ministry of Finance, 1995, pp. 23–24). Any excess interest expense can be carried forward for up to ten years.
This tax treatment applies to both active and passive shareholders in closely held companies.