Personal income tax

3. In common with many countries, Poland’s personal income tax is based on a definition of global personal income, though some income sources (such as dividends and interest income) are taxed under separate schedules. In addition, agriculture, forestry, and inheritances are taxed under separate laws. Spouses can file jointly and split their incomes. The tax schedule has three rates: 19 percent, 30 percent, and 40 percent. There is a basic credit that all taxpayers can claim, adding to the progressivity of the tax schedule. The tax brackets and basic credit are indexed to previous wage growth. The income taxes on some sources of income (e.g., dividends) are flat rate taxes in the range of 10-20 percent. There are many exemptions, deductions, and credits. Interest income from bank deposits and government securities, and capital gains from sales of publicly traded stocks are exempt from tax. There are deductions for presumed employment-related expenses, social security contributions, charitable contributions, and a variety of other purposes. In addition, there are significant credits for housing, education, and medical expenditures. These tax preferences are designed to encourage socially desirable activities and to adjust tax liabilities for perceived differences in ability to pay. Taxes on wages are collected through withholding, though all individuals (or their employers on their behalf) must file a final reconciliation. Self-employed individuals calculate net income largely on the basis of rules that apply to corporate income and then pay tax on a self-assessed basis. Two types of presumptive taxes apply to small self-employed taxpayers with turnover below Zl 400,000 in 1999.

Social insurance taxes

4. Starting in 1999, both employers and employees are required to pay a contribution to the pension and disability fund (until 1999, only employers were liable for paying this tax). For the purposes of the social insurance taxes, employees’ wages are grossed up by the amount of tax employees pay to the social insurance funds.² Employers pay a tax of 22 percent of gross wages and employees pay a tax of 23 percent. (The effective rates on grossed up income are 17.9 percent and 18.7 percent, respectively). Social insurance fund contributions are withheld from wages. Self-employed individuals pay these taxes on a self-assessed basis that is slightly different from that applying to wage earners. Employers pay an additional tax of 2.6 percent on grossed up wages to the Labor Fund, which administers unemployment compensation and job training programs.

Corporate income tax

5. Poland has a standard corporate income tax. The tax rate on profits was 36 percent in 1998, but has been lowered to 34 percent in 1999. All interest income and capital gains and losses are taxable as ordinary income at the standard rate. Depreciation is straight line, with accelerated depreciation allowed for some assets. Inventory accounting is based on standard principles. There are special investment incentives and a number of Special Economic Zones, which provide significant tax breaks. These tax incentives have complex qualifying conditions. Some cost deductions, such as for motor vehicles, advertising, and representation, are subject to limits. There is a 20 percent withholding tax on dividends paid to individuals.

Value-added tax (VAT)

6. Poland’s VAT is an invoice-style, consumption- and destination-based tax, as is commonly found in the EU. The tax base includes excise duties and customs fees. The standard rate is 22 percent. A 7 percent rate applies to most processed foodstuffs, building materials, certain construction materials, articles for children, musical instruments, and intercity passenger transport. A temporary 4 percent rate applies to most medicines. Exports, agricultural inputs, some medical and veterinary supplies, and books and magazines are zero-rated. Unprocessed agricultural produce, financial services (except currency exchange), insurance, education, health services, art and culture, municipal (except heat, gas, and electricity) and postal services, apartment rental, and sales of land are exempt from VAT. Taxpayers with annual turnover below Zl 80,000 are not obligated, but have the option, to register for VAT.

Excises

7. The tax applies to a wide range of domestically produced and imported goods and services, including alcoholic beverages, tobacco, fuels, passenger cars, luxury electronic equipment, gambling, salt, plastic packaging, furs, cosmetics, luxury yachts, and sailboats. Taxes are not levied on exports.

Revenue structure compared to other OECD countries

8. Unlike many transition economies, Poland has maintained a high level of revenue collections. Tax revenues (excluding social insurance contributions and local taxes) are estimated to be about 24 percent of GDP in 1998. Total general government tax revenues are estimated at about 37 percent of GDP in 1998. This level of collection places Poland on a par with Western European nations. The strong performance of indirect taxation is notable—the combination of revenues from the VAT and excise taxes is estimated to amount to almost 13 percent of GDP in 1998. Nonetheless, the yield from personal and corporate income taxes is also significant—an estimated 9 percent of GDP in 1998 with about 6¼ percentage points of GDP from the personal income tax and 2¾ percentage points of GDP from the corporate income tax. Setting this performance in an international context, Poland’s direct tax yield is broadly in line with OECD experience—within the OECD, during 1990-95 income taxation averaged 9 percent of GDP. Moreover, the decomposition between personal and corporate income taxes mirrors that in the OECD generally—for example, during 1990-95, the average corporate tax yield for OECD countries was 2½ percent.

9. In the past decade there has been a trend toward lowering the top marginal income tax rates in OECD countries.³ Poland’s top marginal rate of 40 percent is consistent with OECD practice, though in combination with Poland’s high social insurance contributions the rate on labor income is higher than in most OECD countries. Poland’s current three brackets are fewer than is typical of OECD countries.

10. In OECD countries, there has also been a trend toward lower corporate income tax rates. In contrast to the personal income tax, there are a significant number of OECD countries with lower corporate income tax rates than in Poland. Moreover, unlike Poland, many OECD countries have some form of integrated corporate and personal income tax systems that alleviate the double taxation of corporate profits.⁴

11. The level of taxes on labor in Poland is among the highest in the OECD—taking the case of a one-earner married couple where the worker earns the average production wage, the OECD estimates that the combination of employers’ social security contributions and personal income tax less transfer payments amounted to almost 40 percent of gross labor costs in 1996.

Principles underlying tax reform

12. The key objectives of tax reform are to have a tax system that is efficient, fair, and simple. To accomplish these goals, a tax system should rely heavily on broad-based taxes, such as the personal income tax and VAT, and should levy as low marginal tax rates as are consistent with achieving fiscal revenue targets and the desired degree of progression.

A critique of the current tax system

13. The Polish tax system has some notable strengths and weaknesses. The personal and corporate income taxes are the weakest elements. The main weakness of the personal income tax is that the definition of the base is very narrow. A considerable share of income is exempt from tax, and deductions and credits are given for an extensive range of activities. The broad range of tax preferences has serious implications for a personal income tax. First, tax preferences distort economic decisions, which are overly influenced by such preferences rather than by underlying economic values. The Polish tax system endeavors to achieve many social objectives through the tax system. Tax incentives for housing, education, medical care, and charitable contributions seek to encourage these activities. Nevertheless, typically there are more cost effective ways than the tax system for achieving important social objectives. First, direct spending programs are often more transparent and efficient in subsidizing worthwhile social activities. Second, the erosion of the tax base by tax reliefs and privileges means that marginal tax rates must be higher to achieve a given revenue objective. Third, because higher income taxpayers typically benefit most from tax preferences, the tax system is less progressive overall than might be indicated by progressivity in marginal tax rates.⁵

14. The personal income tax includes a standard credit, which is a desirable feature in that it enhances the progressivity of the tax. Although this progression could also be achieved with a standard deduction or exemption, the benefit of a credit is that the tax saving is the same for all taxpayers, unlike a deduction or an exemption where the value is proportional to the marginal tax rate of the taxpayer and hence benefits higher income taxpayers disproportionately.

15. Another weakness of the Polish tax system is that social insurance taxes are very high. Since these taxes are levied only on wage income, combining their effects with those of personal income taxes results in a very high tax burden on labor income. These high social insurance tax rates, as well as the weak link between the rates and subsequent pension entitlements, has resulted in strong incentives to under report wage income and work in the grey market, which impairs collections of social insurance taxes and personal income tax. The new pension system, which takes effect in 1999, strengthens the link between contributions and benefits, and is thus likely to encourage more accurate reporting of wages and greater compliance with the tax laws.⁶

16. Similarly, the current corporate income tax code also has serious deficiencies, particularly in the definition of deductible costs of business, and the system of depreciation allowances, investment allowances, and tax holidays. Some legitimate business expenses, such as those for advertising, are arbitrarily limited. Tax incentives for investments in capital goods and in Special Economic Zones seek to increase the level of domestic and foreign investment, but are excessively complex and poorly structured.

17. The treatment of some forms of interest payments is asymmetric under the personal and corporate income taxes. Individuals do not pay income tax on capital gains arising from the trade of listed stocks and bonds or on some types of interest received; in contrast, such returns are taxable if they are a component of company income. In addition, there are advantages for the self-employed to choose the noncorporate form of organization rather than to incorporate and pay tax under the personal income tax.

18. The income taxes are excessively complex, making it difficult to administer the tax system effectively. As a result, the tax system collects less revenues than it should, and the fairness of the tax system is undermined. Tax officials, struggling to cope with the complexities, do not have the time or the staff resources to determine the extent to which taxpayers make a reasonably proper declaration of income and expenses.

Personal income tax

19. The personal income tax would be significantly improved if many of the exemptions, deductions, and credits currently in the tax code were eliminated. These reforms would simplify the tax code and make it easier to administer. At the same time, they would enhance the efficiency of the income tax. By broadening the tax base and allowing a lowering of marginal tax rates, they would reduce distortions affecting decisions to work and invest.

20. An excessive number of reliefs in the tax system, including those for housing, education, and medical expenses, should be eliminated or reduced. As regards housing preferences, the repeal could be introduced in parallel with a well-designed expenditure program to expand the supply of housing for low-income groups, in an amount commensurate to the tax savings. Or the nominal amount of the tax preference could be capped. A few targeted deductions, such as a rationalized deduction for charitable donations, may be warranted and would be consistent with international practice.

21. With a simpler income tax, greater use should be made of final with holding on labor income, which greatly facilitates tax administration. The number of taxpayers who must file tax returns either themselves or through their employers should be sharply reduced by greater recourse to final withholding of income taxes. In many countries, for example, taxpayers who have only wage income or interest income do not need to file a return. To facilitate final with holding and in line with recent international trends, joint filing for married taxpayers could be eliminated while accommodating differing family circumstances through allowances for spouses and dependents rather than through income splitting. In addition, spending programs can also take family circumstances into account.

22. The coverage of the personal income tax should be extended. As regards capital gains, the most significant gains are likely to arise from the sale of financial assets—apart from residential real estate gains that are already covered by the personal income tax. Given the incipient development of capital markets in Poland and the difficulty in administering capital gains taxation, it may be wise for Poland to move cautiously in this area. An area where Poland may find it easier to collect tax is on interest on bank deposits and government securities, which is currently exempt. Final withholding is one way to ease the administration of income tax on interest. For example, in addition to the role of final withholding on labor income, some industrial countries (the Nordic countries) are now using final withholding on interest income.

23. The schedule of marginal tax rates, in combination with the definition of the base, determines taxpayers’ liabilities under the tax. Although a progressive marginal tax rate schedule is most typically found in income tax systems, any degree of progression is potentially consistent with a society’s definition of fairness. In a country, such as Poland, which is accustomed to a high degree of redistribution from the wealthier to the poorer, a schedule with greater progression may be more consistent with prevailing notions of fairness than one with little or no progression. In combination with a basic credit (or a high tax-free threshold), even a single, positive marginal tax bracket would yield a progressive income tax. Nevertheless, it may not be possible to satisfy the revenue needs from the personal income tax while simultaneously meeting demands for a fair system of taxation with a single, positive marginal tax bracket.

Corporate income tax

24. Paralleling the recommendations for the personal income tax, the priority should be to simplify the corporate income tax and broaden the tax base. Poland’s highest priority is to ensure that the reformed tax system can accommodate the new challenges arising from EU membership and globalization pressures.

25. The tax treatment of investment is a critical area for reform. The present provisions for depreciation of most capital investments are too complex and too ungenerous, while those for investment incentives are too complex, in some ways too restrictive and in other respects ill-targeted. Corporate tax reform presents the opportunity to simplify the present corporate income tax, for both taxpayers and the tax administration, to reduce the scope for abuse, to make the corporate income tax more attractive to investors, and to reduce the extent to which it distorts business investment in unproductive ways.

26. There is also scope for improvement in other areas of the corporate income tax, including the taxation of debt interest and bad debt, the taxation of mutual and other collective investment vehicles/funds, the taxation of company reconstructions and leasing, the taxation of foreign exchange gains and losses, and capital gains and losses, and transfer pricing and thin capitalization.

27. It is desirable that the income tax regime maintain an alignment of the corporate income tax rate with the top marginal tax rate under the personal income tax in order to ensure that the tax rate will not be a determining factor in decisions whether to adopt a corporate or a noncorporate form. Along with revenue considerations, this consideration limits the extent to which the corporate income tax rate should ultimately be lowered.

28. Clarity is an important objective for a tax system. Any reform should include a complete rewriting of the income tax. This should be combined with establishing a capability in the Ministry of Finance to give guidance on the law and regulations.

VAT and excises

29. Poland must continue to adjust indirect taxes to meet directives of the EU. The most important changes to the VAT are changes in the rate of tax on unprocessed agricultural produce and means of agricultural production, building materials and apartments in multi-family construction, articles for children, municipal services and services of culture, books and magazines, and legal services. Poland must also increase the excise tax rates on cigarettes and engine fuels to meet minimum levels set out in EU directives. In addition to these reforms, it may also be desirable to raise the threshold under the VAT to remove more small taxpayers from the obligation to pay tax. Even if this threshold is left in place, it would be desirable to use the same threshold for VAT as is used for presumptive income taxation, though the appropriate threshold probably lies closer to the existing VAT threshold of Zl 80,000 than the presumptive income tax threshold of Zl 400,000. Ultimately, the presumptive income tax should be phased out and taxpayers brought into the standard tax system.

Revenue implications of tax reform

30. Although the goal of the government is to gradually reduce the burden of the government on the economy, given the important budgetary needs of the government in the short run associated with structural reforms and the goal of EU accession, any reforms should be designed with a view to being revenue neutral. Although it is always tempting for a government to project that reducing marginal tax rates and tax simplification will lead to better compliance and large revenue gains, this is likely to be unrealistic. It usually takes a long time and sustained efforts to improve tax compliance.