Tax policy and growth in OECD countries

82. Although theories differ as to the magnitude of the impact of taxes and welfare benefits on employment and growth, there seems to be a general presumption that higher average tax burdens have an adverse impact. However, there is no clear empirical evidence from cross-country comparisons to support this general proposition (Gerson, 1998; Disney, 2000). In the end, the specific effect of taxes on employment and growth may be an empirical issue in each individual country and for each tax and benefit system.

83. Some authors find that tax policy plays a fundamental role in affecting the long-run growth performance of countries but others disagree. Prescott (2002) and Lucas (2003) find a large negative impact of taxes on economic activity, suggesting for example that heavy labor and consumption taxation is responsible for the low output per working-age person in France, which is estimated to be 30 percent lower than in the United States.⁴⁸ In general, policies that improve the neutrality of taxation and promote the accumulation of human capital may have the potential to enhance growth. In this regard, the structure of taxation could have important implications for growth (Tanzi and Zee, 1997). Not all authors agree, however. Harberger conjectured in 1964 that in practice tax policy is ineffective to influence growth, after observing that the tax mix did not produce significant effects on savings and investment rates in the United States. Stokey and Rebelo (1995) and Mendoza, Milesi-Ferretti, and Asea (1997) similarly find that tax reform has little impact on long-term growth, although the latter acknowledge that altering the tax mix may yield welfare gains induced by efficiency gains on the levels of consumption and output.⁴⁹

84. Studies generally assume a negative relation between taxes on labor, and employment and growth in OECD countries. Social security contributions, payroll taxes, and personal income taxes may adversely affect the cost of labor (if industrial relations or regulatory constraints prevent the labor tax wedge to be fully borne by workers) and, thus, reduce labor demand by firms, employment and, eventually, economic growth. To the extent that part of the burden of labor taxes and social security contributions is shifted to workers, these taxes may also generate disincentives to seek work or raise work effort (OECD, 1995; OECD, 2001b). High labor taxation may also induce a drift into the informal economy, if tax enforcement is weak (OECD, 2001b). In reviewing the evidence, Zee (1997) and others point to several stylized facts:

• High employers’ social security contributions and payroll taxes, which usually bear heavily on low-income workers, tend to be reflected in higher labor costs (because of labor market rigidities) and to reduce labor demand (this effect is usually reflected in high average tax wedges on labor).

• High marginal effective tax rates (due to the combination of tax and benefit systems) can have a significant impact on labor supply by affecting the choice between additional work and leisure, entailing a disincentive to job search and increased work effort. Very high marginal rates (close or above 100 percent) may create so-called poverty or inactivity traps.⁵⁰

• Several groups of individuals are most likely to be negatively affected by high marginal effective tax rates: low-income workers eligible for in-work benefits; high-income workers, which face high tax rates and may be more mobile; individuals considering entering the labor force (e.g., young people, and married women); and workers nearing retirement. For these groups facing complex budget constraints with high effective tax rates over certain segments, empirical studies find a significant labor supply response to policy changes (Disney, 2000).

• Regarding unemployment benefits, high replacement ratios associated with these benefits may reduce the incentive to seek work.

• Taxes and benefits, however, are not the only factor explaining employment and growth. Taxation may exacerbate the impact of existing distortions, labor market rigidities, and union-employers bargaining processes.

85. Recently, the negative impact of labor taxation on employment and growth was emphasized by Daveri and Tabellini (2000) who attributed the slowdown in growth in Europe, associated with persistent unemployment, to the rapid growth in labor costs, particularly due to taxes on labor. With strong and decentralized trade unions, labor taxes are shifted into real wages thus reducing labor demand; this, in turn, leads to substitution away from labor and downward pressure on the marginal product of capital, reducing investment and growth. The authors estimate that the observed rise in labor tax rates (by 14 percentage points) between 1965-1995 in the European Union (EU) accounts for a decline in the rate of growth by 0.4 percentage points per year and a rise in unemployment of about 4 percentage points.

86. Consumption taxes are deemed to create fewer distortions. They do not affect savings and investment decisions (since current and future consumption are treated equally) and remain neutral with respect to various sources of income (labor, transfer, and capital income) and with respect to international trade. Daveri and Tabellini (2000) find that consumption taxes have no impact on employment (and growth), because they do not create a wedge between labor income and unemployment benefits—both being taxed the same way and absorbed by the labor factor.⁵¹ Milesi-Ferretti and Roubini (1995) show that while consumption taxes as well as income taxes have a negative impact on growth through their distortion of the choice between labor and leisure, the latter involve additional distortions in the production function (raising the capital/labor ratio, thus reducing the return on capital) that further reduce capital accumulation and growth. Kneller, Bleaney, and Gemmell (1999) validate empirically for OECD countries that consumption taxes have a non-distortionary effect on growth, suggesting that reducing distortionary taxes by 1 percent of GDP could raise the growth rate by 0.1-0.2 percent per year. Tanzi and Zee (2000) find that consumption taxes have a smaller negative impact on savings than income taxes (and confirm empirically that the interest elasticity of savings is positive).

87. The value-added tax (VAT), as a general tax on consumption, is regarded as relatively non-distortionary—and has indeed been adopted by most OECD countries. In practice, however, it still suffers from an imperfect implementation. Differentiated rates, product and sector-related exemptions, and significant problems with cross-country trade in the EU tend to distort competition and consumption patterns while increasing compliance costs. Complexities also reduce the capacity to detect tax evasion and fraud, thus further distorting competition (Joumard, 2002).

88. In addition to raising the required rate of return on investment and depressing investment, corporate taxes in OECD countries tend to favor debt financing over equity financing or retained earnings, which may lead to an inefficient allocation of resources (in addition to raising insolvency risks and potentially discriminating against small companies that have more difficulties borrowing). These distortions arise because tax systems provide a more favorable tax treatment to interest payments than to distributed or retained profits, or because they maintain double taxation of dividends (once at the corporate level and once at the shareholders’ level). Corporate taxes are also non-neutral given the widespread use of rebates, exemptions, and special regimes for specific sectors or regions (OECD, 2001b; Joumard, 2002). Imperfectly coordinated tax regimes in the OECD may affect location decisions, which, as a result, may not be efficient, and give firms ample opportunities for tax avoidance (Bond et al, 2000). Empirical studies in the EU have documented significant distortions: tax systems tend to favor debt financing and investment in intangibles and machinery. There are also considerable differences across countries in the treatment of subsidiary companies of a parent company, depending on their location (European Commission, 2001). Empirical studies also suggest that large companies bear a smaller tax burden than small enterprises, suggesting that the former are more successful in avoiding taxes, possibly through tax planning and fiscal engineering (Nicodéme, 2002).

89. Taxation of capital income (interest income, dividends, and capital gains), although relatively low in the EU, remains distortionary. While there is little evidence in the literature that taxes affect the aggregate level of savings, they may affect its composition and location. Many EU countries tend to grant favorable treatment to specific savings instruments, such as retirement schemes and housing investment. Moreover, they generally apply a preferential treatment to non-residents, thus distorting savings flows and potentially enhancing tax evasion possibilities associated with cross-border investment (OECD, 2001b; Joumard, 2002). The EU recently adopted a tax directive to exchange information between tax administrations on interest income paid to non-resident individuals (three countries will impose withholding taxes instead), aimed at reducing these distortions and tax evasion possibilities.

Broad reform options in the literature

90. Studies generally point to two complementary directions for reform to increase employment and growth. First, direct reforms to reduce institutional labor market rigidities (such as improving skill mismatches, increasing labor mobility, reducing high minimum wages, and widening wage differentials); and second, reforms of tax and benefit systems, especially with less than fully flexible labor markets (Zee, 1997; IMF, 2003).

91. In general, lowering the tax burden on labor while also reducing labor market rigidities may lead to increases in both labor supply and demand, thus boosting employment and growth (Joumard, 2002). However, for tax cuts to be seen as permanent and, thus, to have their desired effects on agent’s behavior, reductions in the overall tax burden should—in cases where fiscal sustainability is in question—be matched with corresponding reductions in public expenditure. If the latter cannot be achieved, shifting the tax burden away from labor to other tax bases, such as consumption, in a revenue-neutral manner may in itself have positive employment effects (OECD, 1995; Zee, 1997; Tanzi and Zee, 1997 and 2000; Daveri and Tabellini, 2000; and European Commission, 2000). Specifically, key reform options include:

• Shifting the tax burden from payroll taxes to broader-based taxes, such as consumption taxes. This would broaden tax bases, since the consumption out of other income (capital, property, income transfers) would be taxed; remove the pressure on labor costs stemming from payroll taxes and contributions; reduce disincentives to work effort, to the extent that marginal rates are reduced; and indirectly reduce the taxation of savings, thus potentially encouraging capital accumulation;

• Introducing tax relief for employers of low-skilled and low-income workers to reduce labor costs for those categories, mainly through targeted reductions in employers’ payroll taxes so as to reduce the high tax wedge faced by these categories of workers; and

• Addressing poverty and inactivity traps for low-income earners by reducing effective marginal tax rates. This can be done by directly lowering marginal tax rates for these income categories, increasing general deductions, or introducing income support schemes such as an earned income tax credit.

92. Some studies suggest that shifting taxes from labor to consumption (such as the VAT) could have a positive impact on growth, employment, and investment. Using a general equilibrium macroeconomic model (QUEST), the European commission (2000) estimated that such tax reform, with the shifting of 1 percent of GDP from labor taxes to the VAT, could increase the level of GDP by 0.4 percent after 10 years.⁵² Other studies, however, suggest that the impact on employment and growth of such reform is likely to be moderate, especially if wages and social benefits are increased to compensate for the rise in consumption taxes (OECD, 1995).

93. Streamlining the VAT structure by minimizing exemptions and the scope for reduced rates is generally suggested as a way to reduce distortions. Using reduced VAT rates for social and redistributive purposes is an ineffective and costly instrument. Consumption patterns are not very differentiated across income classes, which means that high income consumers generally benefit as much as low-income ones from reduced rates, and even more so in absolute terms since they consume more. This makes such policies extremely untargeted and, consequently, costly to the budget. A more effective policy would be to target specific income or social groups with cash transfers (Ebrill, Keen, Bodin, and Summers, 2001).⁵³ Moreover, reducing VAT rates selectively to boost employment in labor-intensive sectors is also likely to be costly to the budget and moderately effective.⁵⁴ Finally, simplifying cross-border trade regimes for the VAT in the EU would reduce distortions, increase trade, and cut compliance costs.⁵⁵

94. To improve the neutrality of capital income taxation with respect to different sources of income, several Nordic countries⁵⁶ moved toward a so-called dual income tax system in the early 1990s. Under this system, all capital income (interest income, dividends, and capital gains) and corporate profits are taxed at a low uniform, proportional rate, while labor income is taxed at higher, progressive rates. This is in contrast to a system of a global income tax, which taxes the sum of all types of income according to a single, progressive schedule, but taxes corporate income separately at lower rates. Thus, the dual income tax is deemed to ensure greater neutrality between capital and corporate incomes and reduce the opportunities for tax arbitrage between those types of income and across borders (Keen, 2003; and Cnossen, 1999).”⁵⁷

95. In the area of corporate taxation, reform options include improving the neutrality of taxation regarding various forms of corporate financing, in particular by reducing the tax advantage given to debt financing; eliminating double taxation of dividends; and streamlining special corporate tax regimes and relief to “level the playing field.” A general lowering of corporate tax rates (possibly associated with a broadening of the base by reducing depreciation allowances, as done recently in Germany—see Keen, 2002) may contribute to minimizing the impact of existing distortions. In addition, simplifying administrative requirements and tax filing obligations for business may increase compliance and reduce costs, especially for small and medium-size enterprises.

Tax burden

98. The tax burden in France is among the highest in the OECD, After dropping to 42.7 percent of GDP in 1992, the tax ratio increased sharply during the second half of the 1990s, buoyed by economic growth, tax measures in the run-up to the third stage of the EMU, and the need to finance rising social security benefits and transfers, reaching an all-time high of 45.5 percent of GDP in 1999 (Figure III.1). Although it was reduced in 2000-02, the tax ratio remained much higher than the OECD average of 37 percent of GDP and even than the EU average of 42 percent of GDP in 2001 (Figure III.2).⁵⁸ To address this issue, the authorities engaged in several rounds of tax cuts over the period 2000-2003.

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France; General Government Total Tax Revenue, 2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 335; 10.5089/9781451813548.002.A003

Source: OECD, Revenue Statistics.

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Tax structure or tax mix

99. The tax structure in France is dominated by social security contributions and, to a lesser extent, indirect taxes. These account for about 40 percent and 34 percent of total tax revenues, respectively (Table III.2).⁵⁹ In contrast, the share of direct taxes on households and businesses (20 percent and 6 percent of total, respectively) is relatively low compared to other OECD countries.

Table III.2.

France: Structure of General Government Revenue in Selected OECD Countries, 2003 (Projections)

(In percent of total)

Source: OECD, Analytical database (December 2002).

Table III.2.

France: Structure of General Government Revenue in Selected OECD Countries, 2003 (Projections)

(In percent of total)

	Social security contributions	Indirect taxes	Direct taxes on business	Direct taxes on households	Total
France	39.7	33.7	6.4	20.2	100.0
Austria	37.0	32.1	5.1	25.8	100.0
Belgium	34.2	28.0	7.6	30.3	100.0
Canada	15.0	39.0	10.1	36.0	100.0
Czech Republic	42.5	31.1	12.5	14.0	100.0
Denmark	5.4	35.0	4.7	54.9	100.0
Finland	29.0	29.9	8.2	32.9	100.0
Germany	45.0	28.4	1.6	25.0	100.0
Iceland	8.9	45.7	3.4	42.0	100.0
Ireland	17.9	42.5	14.0	25.5	100.0
Italy	30.7	34.8	5.8	28.7	100.0
Japan	41.0	30.1	11.6	17.3	100.0
Korea	17.4	53.2	12.6	16.8	100.0
Netherlands	36.0	33.3	10.7	20.0	100.0
New Zealand	4.6	37.5	16.0	42.0	100.0
Norway	22.1	31.6	18.9	27.3	100.0
Poland	40.6	39.2	6.4	13.8	100.0
Portugal	33.0	40.8	10.5	15.7	100.0
Slovak Republic	38.3	41.7	10.6	9.4	100.0
Spain	38.8	32.1	9.2	19.9	100.0
Sweden	31.2	29.6	5.5	33.6	100.0
United Kingdom	21.1	36.4	8.5	34.0	100.0
United States	25.9	27.8	7.6	38.7	100.0
Turkey	0.0	64.8	7.0	28.2	100.0
Average OECD (unweighted)	27.3	36.6	8.9	27.2	100.0
Euro Area	38.3	32.1	5.7	23.9	100.0

Source: OECD, Analytical database (December 2002).

View Table

Table III.2.

France: Structure of General Government Revenue in Selected OECD Countries, 2003 (Projections)

(In percent of total)

	Social security contributions	Indirect taxes	Direct taxes on business	Direct taxes on households	Total
France	39.7	33.7	6.4	20.2	100.0
Austria	37.0	32.1	5.1	25.8	100.0
Belgium	34.2	28.0	7.6	30.3	100.0
Canada	15.0	39.0	10.1	36.0	100.0
Czech Republic	42.5	31.1	12.5	14.0	100.0
Denmark	5.4	35.0	4.7	54.9	100.0
Finland	29.0	29.9	8.2	32.9	100.0
Germany	45.0	28.4	1.6	25.0	100.0
Iceland	8.9	45.7	3.4	42.0	100.0
Ireland	17.9	42.5	14.0	25.5	100.0
Italy	30.7	34.8	5.8	28.7	100.0
Japan	41.0	30.1	11.6	17.3	100.0
Korea	17.4	53.2	12.6	16.8	100.0
Netherlands	36.0	33.3	10.7	20.0	100.0
New Zealand	4.6	37.5	16.0	42.0	100.0
Norway	22.1	31.6	18.9	27.3	100.0
Poland	40.6	39.2	6.4	13.8	100.0
Portugal	33.0	40.8	10.5	15.7	100.0
Slovak Republic	38.3	41.7	10.6	9.4	100.0
Spain	38.8	32.1	9.2	19.9	100.0
Sweden	31.2	29.6	5.5	33.6	100.0
United Kingdom	21.1	36.4	8.5	34.0	100.0
United States	25.9	27.8	7.6	38.7	100.0
Turkey	0.0	64.8	7.0	28.2	100.0
Average OECD (unweighted)	27.3	36.6	8.9	27.2	100.0
Euro Area	38.3	32.1	5.7	23.9	100.0

Source: OECD, Analytical database (December 2002).

Taxation of labor, capital, and consumption⁶⁰

100. The French tax system is characterized by the high taxation of labor. France’s effective tax rate on labor (LETR) is estimated by the European Commission at close to 42 percent in 2001, much higher than in the EU (36 percent) and in the United States and Japan (24 percent and 21 percent, respectively).⁶¹ Although these rates declined in 2000-01, the differential between France and other countries remained. About 68 percent of the LETR is due to non-wage labor costs (social security contributions and other payroll taxes) and the remaining 32 percent to personal income taxes. As a result, while non-wage labor costs are as high as 32 percent of total labor costs in France, they are only 24 percent on average in the EU and as low as 11 percent in the United States in 2001 (Table III.3). Alternative calculations by the OECD Secretariat for the overall period 1990-2000 yield broadly similar conclusions (Table III.4). At 40½ percent, the effective taxation of labor in France was higher than on average in the EU (38 percent) and much higher than in the OECD (32 percent).⁶²

Table III.3.

France: Effective Tax Rates in the European Union, 2001

(In percent)

Sources: Martinez-Mongay (2000), European Commission (2000).

Table III.3.

France: Effective Tax Rates in the European Union, 2001

(In percent)

		Non-wage labor costs paid by employers	Non-wage labor costs	Effective tax rate on labor (LETR)	Effective tax rate on capital (KETR)	Tax rate on consumotion (CITR)	Total tax wedge on labor
	European Union
France		22.5	31.9	41.8	21.8	23.9	55.7
Austria		13.2	26.2	39.3	17.3	24.1	54.0
Belgium		19.0	25.5	43.6	23.5	20.8	55.3
Denmark		1.1	6.1	43.0	29.0	29.6	59.9
Finland		20.7	23.4	42.8	24.3	24.9	57.0
Germany		17.4	31.1	42.0	14.8	18.4	52.7
Greece		18.1	23.5	29.3	17.8	20.8	44.1
Ireland		7.7	11.2	22.6	19.5	24.7	41.7
Italy		22.4	23.1	35.1	25.4	22.9	50.0
Luxembourg		9.8	20.9	30.4	32.2	26.7	49.0
Netherlands		5.2	25.0	32.9	23.3	20.2	46.5
Portugal		15.5	20.5	28.7	26.0	23.8	45.7
Spain		17.7	21.9	30.0	18.5	18.3	42.8
Sweden		20.2	28.4	50.6	27.3	24.2	62.5
United Kingdom		7.1	11.9	24.7	34.0	18.4	38.6
Euro Area (EU-11)		18.5	27.5	38.5	20.0	21.2	51.5
European Union (EU-15)		16.1	24.2	36.2	23.0	20.9	49.5
	Other countries
Japan		10.4	17.4	21.3	17.6	13.8	32.1
United States		6.3	11.3	23.9	22.9	9.1	30.8

Sources: Martinez-Mongay (2000), European Commission (2000).

View Table

Table III.3.

France: Effective Tax Rates in the European Union, 2001

(In percent)

		Non-wage labor costs paid by employers	Non-wage labor costs	Effective tax rate on labor (LETR)	Effective tax rate on capital (KETR)	Tax rate on consumotion (CITR)	Total tax wedge on labor
	European Union
France		22.5	31.9	41.8	21.8	23.9	55.7
Austria		13.2	26.2	39.3	17.3	24.1	54.0
Belgium		19.0	25.5	43.6	23.5	20.8	55.3
Denmark		1.1	6.1	43.0	29.0	29.6	59.9
Finland		20.7	23.4	42.8	24.3	24.9	57.0
Germany		17.4	31.1	42.0	14.8	18.4	52.7
Greece		18.1	23.5	29.3	17.8	20.8	44.1
Ireland		7.7	11.2	22.6	19.5	24.7	41.7
Italy		22.4	23.1	35.1	25.4	22.9	50.0
Luxembourg		9.8	20.9	30.4	32.2	26.7	49.0
Netherlands		5.2	25.0	32.9	23.3	20.2	46.5
Portugal		15.5	20.5	28.7	26.0	23.8	45.7
Spain		17.7	21.9	30.0	18.5	18.3	42.8
Sweden		20.2	28.4	50.6	27.3	24.2	62.5
United Kingdom		7.1	11.9	24.7	34.0	18.4	38.6
Euro Area (EU-11)		18.5	27.5	38.5	20.0	21.2	51.5
European Union (EU-15)		16.1	24.2	36.2	23.0	20.9	49.5
	Other countries
Japan		10.4	17.4	21.3	17.6	13.8	32.1
United States		6.3	11.3	23.9	22.9	9.1	30.8

Sources: Martinez-Mongay (2000), European Commission (2000).

101. Estimates of effective taxation of consumption vary. It is estimated by the European Commission at 24 percent in 2001, much higher than the EU average of 21 percent (Table III.3).⁶³ In contrast, the OECD estimates this tax to be only 15 percent on average over 1990-2000, lower than the EU average of 18 percent, but close to the average in the OECD of about 16 percent (Table III.4). The OECD data suggests that there is room for increasing taxes on consumption.

Table III.4.

France: Effective Tax Rates in Selected OECD Countries, Average 1990-2000

(In percent)

Source: OECD, Carey and Rabesona (2002).

¹Unweighted average.

Table III.4.

France: Effective Tax Rates in Selected OECD Countries, Average 1990-2000

(In percent)

		Capital	Labor	Consumption	Labor and Consumption
	European Union
France		33.2	40.5	15.1	51.3
Austria		24.3	39.6	16.2	51.2
Belgium		32.7	41.3	15.0	51.7
Denmark		39.5	39.9	20.6	56.0
Finland		26.0	45.0	18.7	58.0
Germany		21.2	35.0	13.4	44.9
Greece		12.9	34.9	15.5	46.5
Ireland		…	26.3	21.2	41.9
Italy		31.0	37.7	13.9	47.9
Netherlands		32.7	36.4	18.0	47.9
Portugal		17.6	23.9	19.9	39.0
Spain		20.0	30.7	14.5	40.8
Sweden		35.7	49.6	19.8	59.6
United Kingdom		34.0	22.6	15.7	34.8
European Union (EU-15) 1		28.7	38.0	17.8	48.9
	Other countries
Japan		27.9	24.1	6.4	29.4
Norway		24.7	36.2	25.7	52.5
United States		27.3	23.4	6.4	28.3
OECD Total 1		28.1	32.3	15.7	42.6

Source: OECD, Carey and Rabesona (2002).

¹Unweighted average.

View Table

Table III.4.

France: Effective Tax Rates in Selected OECD Countries, Average 1990-2000

(In percent)

		Capital	Labor	Consumption	Labor and Consumption
	European Union
France		33.2	40.5	15.1	51.3
Austria		24.3	39.6	16.2	51.2
Belgium		32.7	41.3	15.0	51.7
Denmark		39.5	39.9	20.6	56.0
Finland		26.0	45.0	18.7	58.0
Germany		21.2	35.0	13.4	44.9
Greece		12.9	34.9	15.5	46.5
Ireland		…	26.3	21.2	41.9
Italy		31.0	37.7	13.9	47.9
Netherlands		32.7	36.4	18.0	47.9
Portugal		17.6	23.9	19.9	39.0
Spain		20.0	30.7	14.5	40.8
Sweden		35.7	49.6	19.8	59.6
United Kingdom		34.0	22.6	15.7	34.8
European Union (EU-15) 1		28.7	38.0	17.8	48.9
	Other countries
Japan		27.9	24.1	6.4	29.4
Norway		24.7	36.2	25.7	52.5
United States		27.3	23.4	6.4	28.3
OECD Total 1		28.1	32.3	15.7	42.6

Source: OECD, Carey and Rabesona (2002).

¹Unweighted average.

102. Capital taxation in France is estimated to be at or above the EU average. While the European Commission estimates the effective tax rate on capital in France at 22 percent, slightly lower than the average in the EU and in the United States (23 percent) (Table III.3),⁶⁴ the OECD finds higher values for France (33 percent) than on average in the EU (29 percent) (Table III.4). This would suggest that there may be room for reducing taxes on capital income.

103. The combination of high taxes on labor and consumption leads to a large total tax wedge on labor income. The total tax wedge on labor income, resulting from wages being taxed directly and indirectly (through consumption), is estimated by the European Commission to reach close to 56 percent in 2001—much higher than the EU average of 50 percent, and than the United States at 31 percent. In fact, France has among the highest labor tax wedges in the EU, topped only by Sweden, Denmark, and Finland (Table III.3). Similar results are found by the OECD with total labor and consumption taxation reaching 51 percent in France, against 49 percent on average in the EU and 43 percent in the OECD (Table III.4).

104. Employers face very high non-wage costs on labor. Non-wage labor costs (social security contributions and other payroll taxes) paid by employers represent 22.5 percent of total compensation of employees, the highest rate in the EU with an average of 16 percent (Table III.3).

105. Micro-simulations of the tax wedge on labor income suggest broadly similar conclusions. Table III.5 presents average and marginal tax wedges on labor income calculated for an average worker in the manufacturing sector earning the average gross wage (OECD, 2003a). The average labor tax wedge is much higher in France than on average in EU and OECD countries for single as well as for married wage earners (48 percent of gross labor costs in France against 41 percent in the EU for a single worker; 39 percent against 29 percent in the EU for a married couple with two children and one wage earner; and 40 percent against 34 percent for a married couple with two children and two wage earners). The difference with the EU is less striking, however, with respect to the marginal labor tax wedge (it is even lower in France than in the EU for a married couple with two children and one income earner).

Table III.5.

France: Average and Marginal Tax Wedge in Selected OECD Countries, 2002¹

(In percent of labor costs)

Source: OECD (2003).

¹Income tax plus employee and employer contributions less cash benefits, for wage earners at the income level of the average production worker.

²167 percent of the average production wage.

³The second earner’s income level is two-thirds of that of the average production worker.

⁴Unweighted average.

Table III.5.

France: Average and Marginal Tax Wedge in Selected OECD Countries, 2002¹

(In percent of labor costs)

		Average Labor Tax Wedge				Marginal Labor Tax Wedge
		Single, no children	Single, no children2	Married, 2 children 1 income earner	Married, 2 children 2 income earners3	Single, no children2	Single, no children2	Married, 2 children 1 income earner	Married, 2 children 2 income earners3
	European Union
France		47.9	50.5	39.2	39.9	52.5	54.0	43.9	50.0
Austria		44.8	50.0	29.6	34.4	55.6	61.1	55.6	55.6
Belgium		55.3	61.1	40.1	48.5	66.4	70.1	63.4	66.7
Denmark		43.4	51.2	30.9	38.4	62.9	62.9	57.4	62.9
Finland		45.4	51.2	38.5	39.3	56.6	61.1	56.6	56.6
Germany		51.3	55.8	32.5	43.0	64.5	49.6	58.7	61.7
Greece		34.7	40.2	35.1	34.8	44.1	54.0	44.1	44.1
Ireland		24.5	34.4	9.0	16.9	33.2	50.0	33.2	33.2
Italy		46.0	49.9	34.0	41.8	54.2	59.0	54.2	54.2
Luxembourg		31.5	39.0	9.0	15.4	44.8	52.6	24.4	38.5
Netherlands		35.6	40.4	25.2	32.6	50.9	52.0	50.9	50.9
Portugal		32.5	38.0	23.4	27.1	39.4	47.5	37.8	37.8
Spain		38.2	41.9	31.4	34.7	45.8	48.9	41.2	45.8
Sweden		47.6	52.0	40.5	42.7	49.5	62.7	49.5	49.5
United Kingdom		29.7	32.9	18.2	22.4	39.2	30.2	72.6	39.2
European Union (EU-15)4		40.6	45.9	29.1	34.1	50.6	54.4	49.6	49.8
	Other countries
Japan		24.2	27.1	20.3	22.6	29.0	37.4	26.3	26.3
Norway		36.9	43.5	27.2	31.4	43.1	55.1	43.1	43.1
United States		29.6	35.2	17.6	25.0	34.3	45.4	53.9	34.3
Total OECD4		35.9	40.8	25.9	30.8	44.6	49.6	45.9	44.1

Source: OECD (2003).

¹Income tax plus employee and employer contributions less cash benefits, for wage earners at the income level of the average production worker.

²167 percent of the average production wage.

³The second earner’s income level is two-thirds of that of the average production worker.

⁴Unweighted average.

View Table

Table III.5.

France: Average and Marginal Tax Wedge in Selected OECD Countries, 2002¹

(In percent of labor costs)

		Average Labor Tax Wedge				Marginal Labor Tax Wedge
		Single, no children	Single, no children2	Married, 2 children 1 income earner	Married, 2 children 2 income earners3	Single, no children2	Single, no children2	Married, 2 children 1 income earner	Married, 2 children 2 income earners3
	European Union
France		47.9	50.5	39.2	39.9	52.5	54.0	43.9	50.0
Austria		44.8	50.0	29.6	34.4	55.6	61.1	55.6	55.6
Belgium		55.3	61.1	40.1	48.5	66.4	70.1	63.4	66.7
Denmark		43.4	51.2	30.9	38.4	62.9	62.9	57.4	62.9
Finland		45.4	51.2	38.5	39.3	56.6	61.1	56.6	56.6
Germany		51.3	55.8	32.5	43.0	64.5	49.6	58.7	61.7
Greece		34.7	40.2	35.1	34.8	44.1	54.0	44.1	44.1
Ireland		24.5	34.4	9.0	16.9	33.2	50.0	33.2	33.2
Italy		46.0	49.9	34.0	41.8	54.2	59.0	54.2	54.2
Luxembourg		31.5	39.0	9.0	15.4	44.8	52.6	24.4	38.5
Netherlands		35.6	40.4	25.2	32.6	50.9	52.0	50.9	50.9
Portugal		32.5	38.0	23.4	27.1	39.4	47.5	37.8	37.8
Spain		38.2	41.9	31.4	34.7	45.8	48.9	41.2	45.8
Sweden		47.6	52.0	40.5	42.7	49.5	62.7	49.5	49.5
United Kingdom		29.7	32.9	18.2	22.4	39.2	30.2	72.6	39.2
European Union (EU-15)4		40.6	45.9	29.1	34.1	50.6	54.4	49.6	49.8
	Other countries
Japan		24.2	27.1	20.3	22.6	29.0	37.4	26.3	26.3
Norway		36.9	43.5	27.2	31.4	43.1	55.1	43.1	43.1
United States		29.6	35.2	17.6	25.0	34.3	45.4	53.9	34.3
Total OECD4		35.9	40.8	25.9	30.8	44.6	49.6	45.9	44.1

Source: OECD (2003).

¹Income tax plus employee and employer contributions less cash benefits, for wage earners at the income level of the average production worker.

²167 percent of the average production wage.

³The second earner’s income level is two-thirds of that of the average production worker.

⁴Unweighted average.

Marginal effective tax rates

106. France’s marginal tax rates on labor income are close to the EU average (about 50 percent of total labor costs for revenues up to 167 percent of the average production wage, Table III.5). High income earners, however, face higher marginal rates, mainly due to the sharp progressivity of the personal income tax, which has a maximum rate of close to 50 percent (plus 8 percent for the CGS and the CRDS), and the absence of ceilings on health insurance contributions (Debonneuil and Fontagné, 2003; OECD, 2001c and 2003b). These high marginal tax rates may induce a reduced labor supply, in addition to tax avoidance or relocation decisions.⁶⁵ In addition, wealthy individuals face an annual tax on their net wealth.

107. Certain combinations of taxes and benefits induce high marginal effective rates of taxation for low-income households. High METRs may lead to strong disincentives to work and “inactivity traps” for certain groups, in particular low-wage and older workers, as well as spouses of low-income earners.⁶⁶ Although several reforms implemented before 2000 (in particular, reductions in the CSG for low-income workers) have reduced some cases of high METRs, they have not succeeded in eliminating all of them (Mahfouz, 2000).

108. Reforms in benefits, as well as the introduction of the earned-income tax credit (primepour l’emploi) in 2001 have contributed to reducing high METRs for low-income earners. Successive reforms to the minimum income support scheme (RM1) and to the housing subsidy have succeeded in removing a great deal of inactivity traps. In particular, METRs of 100 percent and over seem to have disappeared, although METRs remain high in some cases and time horizons, particularly for benefit recipients seeking part-time employment (Hagnere and Trannoy, 2001). incentives to work remain low for some categories, such as single mothers with children, because their benefits are high and their potential wages are low (Gurgand and Margolis, 2001). Nevertheless, by supplementing the income of low-wage workers, recent reforms may have potentially stimulated labor supply and, by moderating wage pressures, stimulated labor demand as well (OECD, 2001c).⁶⁷

Corporate taxation

109. Corporate income taxation is high. Estimates by the European Commission (2001) suggest that France, with a rate of 33 percent, had the highest effective marginal rate in the EU in 1999, and, at over 37 percent, the second-highest average rate after Germany (Table III.6). High corporate tax rates may have powerful negative effects on incentives to invest and, thus, on growth.⁶⁸ Other calculations by Devreux, Griffith, and Klemm (2002), however, suggest that marginal and average effective tax rates in France are broadly in line with the major EU and OECD countries (Table III.7). These results may reflect, in part, the reductions in the statutory corporate tax rate implemented in France in 2001.

Table III.6.

France: Statutory and Effective Tax Rates on Corporations in the EU, 1999¹

(In percent)

Sources: European Commission, 2001, Tables 7 and 8; Thakur, Keen, Horvath, and Cerra (2003). EMTR: Effective tax rate on a marginal investment earning a normal after-tax real rate of return of 5 percent. EATR: Effective tax rate on a profitable (infra-marginal) investment with a pre-tax real rate of return of 20 percent.

¹Only corporation taxes, including surcharges and local taxes.

Table III.6.

France: Statutory and Effective Tax Rates on Corporations in the EU, 1999¹

(In percent)

	Statutory corporate tax rate	Effective marginal tax rate (EMTR)	Effective average tax rate (EATR)
			EC (2001)	TKHC (2003)
France	40.0	33.2	37.5	47.5
Austria	34.0	20.9	29.8	38.4
Belgium	40.2	22.4	34.5	44.5
Denmark	32.0	21.9	28.8	36.8
Finland	28.0	19.9	25.5	32.4
Germany	52.4	31.0	39.1	57.7
Greece	40.0	18.2	29.6	43.3
Ireland	10.0	11.7	10.5	13.0
Italy	41.3	-4.1	29.8	34.0
Luxembourg	37.5	20.7	32.2	38.3
Netherlands	35.0	22.6	31.0	40.0
Portugal	37.4	22.5	32.6	42.0
Spain	35.0	22.8	31.0	40.0
Sweden	28.0	14.3	22.9	31.0
United Kingdom	30.0	24.7	28.2	35.7
European Union (EU-15)	34.7	20.2	29.5	38.3

Sources: European Commission, 2001, Tables 7 and 8; Thakur, Keen, Horvath, and Cerra (2003). EMTR: Effective tax rate on a marginal investment earning a normal after-tax real rate of return of 5 percent. EATR: Effective tax rate on a profitable (infra-marginal) investment with a pre-tax real rate of return of 20 percent.

¹Only corporation taxes, including surcharges and local taxes.

View Table

Table III.6.

France: Statutory and Effective Tax Rates on Corporations in the EU, 1999¹

(In percent)

	Statutory corporate tax rate	Effective marginal tax rate (EMTR)	Effective average tax rate (EATR)
			EC (2001)	TKHC (2003)
France	40.0	33.2	37.5	47.5
Austria	34.0	20.9	29.8	38.4
Belgium	40.2	22.4	34.5	44.5
Denmark	32.0	21.9	28.8	36.8
Finland	28.0	19.9	25.5	32.4
Germany	52.4	31.0	39.1	57.7
Greece	40.0	18.2	29.6	43.3
Ireland	10.0	11.7	10.5	13.0
Italy	41.3	-4.1	29.8	34.0
Luxembourg	37.5	20.7	32.2	38.3
Netherlands	35.0	22.6	31.0	40.0
Portugal	37.4	22.5	32.6	42.0
Spain	35.0	22.8	31.0	40.0
Sweden	28.0	14.3	22.9	31.0
United Kingdom	30.0	24.7	28.2	35.7
European Union (EU-15)	34.7	20.2	29.5	38.3

Sources: European Commission, 2001, Tables 7 and 8; Thakur, Keen, Horvath, and Cerra (2003). EMTR: Effective tax rate on a marginal investment earning a normal after-tax real rate of return of 5 percent. EATR: Effective tax rate on a profitable (infra-marginal) investment with a pre-tax real rate of return of 20 percent.

¹Only corporation taxes, including surcharges and local taxes.

Table III.7.

France: Statutory and Effective Tax Rates on Corporations in Selected OECD Countries, 2001¹

(In percent)

Source: Institute for Fiscal Studies; Devereux, Griffith, and Klemm (2002). EMTR: Based on an investment in plant and machinery, financed by equity or retained earnings. No economic rent. Real discount rate 10 percent. EATR: Economic rent and real discout rate 10 percent.

¹Only corporation taxes, including local taxes.

Table III.7.

France: Statutory and Effective Tax Rates on Corporations in Selected OECD Countries, 2001¹

(In percent)

	Statutory corporate tax rate	Effective marginal tax rate (EMTR)	Effective average tax rate (EATR)
France	36.4	20.8	29.9
Austria	34.0	17.4	27.0
Belgium	40.2	25.6	34.0
Canada	34.6	24.0	30.0
Finland	29.0	19.5	24.8
Germany	38.3	28.3	33.9
Greece	37.5	27.7	33.2
Ireland	10.0	6.6	8.4
Italy	40.3	9.2	28.6
Japan	40.9	31.8	36.9
Netherlands	35.0	24.3	30.3
Portugal	35.2	20.3	28.9
Spain	35.0	29.5	32.5
Sweden	28.0	16.1	22.8
United Kingdom	30.0	20.3	25.7
United States	39.3	23.8	32.8
Average (unweighted)	34.0	21.6	28.7
EU countries (unweighted)	33.0	20.4	27.7

Source: Institute for Fiscal Studies; Devereux, Griffith, and Klemm (2002). EMTR: Based on an investment in plant and machinery, financed by equity or retained earnings. No economic rent. Real discount rate 10 percent. EATR: Economic rent and real discout rate 10 percent.

¹Only corporation taxes, including local taxes.

View Table

Table III.7.

France: Statutory and Effective Tax Rates on Corporations in Selected OECD Countries, 2001¹

(In percent)

	Statutory corporate tax rate	Effective marginal tax rate (EMTR)	Effective average tax rate (EATR)
France	36.4	20.8	29.9
Austria	34.0	17.4	27.0
Belgium	40.2	25.6	34.0
Canada	34.6	24.0	30.0
Finland	29.0	19.5	24.8
Germany	38.3	28.3	33.9
Greece	37.5	27.7	33.2
Ireland	10.0	6.6	8.4
Italy	40.3	9.2	28.6
Japan	40.9	31.8	36.9
Netherlands	35.0	24.3	30.3
Portugal	35.2	20.3	28.9
Spain	35.0	29.5	32.5
Sweden	28.0	16.1	22.8
United Kingdom	30.0	20.3	25.7
United States	39.3	23.8	32.8
Average (unweighted)	34.0	21.6	28.7
EU countries (unweighted)	33.0	20.4	27.7

Source: Institute for Fiscal Studies; Devereux, Griffith, and Klemm (2002). EMTR: Based on an investment in plant and machinery, financed by equity or retained earnings. No economic rent. Real discount rate 10 percent. EATR: Economic rent and real discout rate 10 percent.

¹Only corporation taxes, including local taxes.

Value-added taxation

110. The standard VAT rate in France (19.6 percent) corresponds exactly to the average in the EU, but is higher than the average in the OECD (17.6 percent). The reduced rates (2.1 percent and 5.5 percent) are lower, however, than in most EU countries, and the difference with the standard rate is rather large, implying significant losses for the budget (Table III.8).

Table III.8.

France: VAT Rates in the EU and OECD Countries, 2002

(In percent)

Source: European Commission, OECD, and IMF Staff.

Table III.8.

France: VAT Rates in the EU and OECD Countries, 2002

(In percent)

		Standard Rate	Other Rates
European Union
France		19.6	2.1; 5.5
Austria		20	10; 12
Belgium		21	6; 12
Denmark		25	--
Finland		22	8; 17
Germany		16	7
Greece		18	4; 8
Ireland		21	4.3; 12.5
Italy		20	4; 10
Luxembourg		15	3; 6; 12
Netherlands		19	6
Portugal		17	5; 12
Spain		16	4; 7
Sweden		25	6; 12
United Kingdom		17.5	5
European Union (EU-15)		19.5	--
Euro Area (EU-12)		18.7	--
	Selected OECD countries
Australia		10	--
Canada		7	--
Czech Republic		22	5
Hungary		25	12
Japan		5	--
New Zealand		12.5	--
Norway		24	7; 12
Poland		22	3; 7
Switzerland		7.6	2.4; 3.6
Turkey		18	1; 8; 26; 40
Total OECD		17.6	--

Source: European Commission, OECD, and IMF Staff.

View Table

Table III.8.

France: VAT Rates in the EU and OECD Countries, 2002

(In percent)

		Standard Rate	Other Rates
European Union
France		19.6	2.1; 5.5
Austria		20	10; 12
Belgium		21	6; 12
Denmark		25	--
Finland		22	8; 17
Germany		16	7
Greece		18	4; 8
Ireland		21	4.3; 12.5
Italy		20	4; 10
Luxembourg		15	3; 6; 12
Netherlands		19	6
Portugal		17	5; 12
Spain		16	4; 7
Sweden		25	6; 12
United Kingdom		17.5	5
European Union (EU-15)		19.5	--
Euro Area (EU-12)		18.7	--
	Selected OECD countries
Australia		10	--
Canada		7	--
Czech Republic		22	5
Hungary		25	12
Japan		5	--
New Zealand		12.5	--
Norway		24	7; 12
Poland		22	3; 7
Switzerland		7.6	2.4; 3.6
Turkey		18	1; 8; 26; 40
Total OECD		17.6	--

Source: European Commission, OECD, and IMF Staff.

111. While still high, the yield of the VAT has steadily eroded over time. With VAT revenues at 7.4 percent of GDP in 2001, France is only slightly above the average in the EU and the European countries of the OECD (6.8 and 7.0 percent of GDP, respectively), and many OECD countries have higher yields, up to 10 percent of GDP in Denmark (Figure III.3). Revenue from the VAT fell further to 7.1 percent of GDP in 2002. Moreover, the efficiency ratio of the French VAT is not exceptionally high at about 38 percent, indicating the widespread use of reduced rates, exemptions and, possibly, collection inefficiencies (Figure IV.4).⁶⁹ Finally, France is one of the few EU countries to have seen its VAT revenue-to-GDP ratio decline since 1980 (Figure IV.5). This was the result of successive rate cuts, the elimination of the augmented rates, and the extension of exemptions. In particular, the standard rate was reduced by 1 percentage point in 2000 and the coverage of the reduced rate was extended to renovations and repairs of private dwellings, domestic care services, and cleaning services in private households (at a budgetary cost estimated at about 0.6 percent of GDP).

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France: VAT Revenue, 2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 335; 10.5089/9781451813548.002.A003

Source: OECD, Revenue Statistics.

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France: VAT Efficiency Ratio, 2001

(In percent)

Citation: IMF Staff Country Reports 2003, 335; 10.5089/9781451813548.002.A003

Source: OECD, Revenue Statistics; and staff calculations.

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France: VAT Revenue in Selected OECD Countries, 1980-2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 335; 10.5089/9781451813548.002.A003

Source: OECD Revenue Statistics, 2002

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Local taxes

112. France levies two unusually-designed local taxes which yield low revenues (1.8 percent of GDP in 2002). First, local governments levy a tax on businesses (taxe professionnelle) based on the rental value of commercial and industrial buildings and equipments and, until 2003, part of the payroll of the company. Rates vary between municipalities, and the tax is levied regardless of the actual turnover or profits of the enterprise. Because this tax is capped, increasing amounts have been covered by the central government (over 60 percent of total revenue of the tax). Second, local governments levy a housing tax (taxe d’habitation), which is due by individuals based on the notional rental value of the occupied dwelling, with numerous deductions depending on the family situation and varying rates between municipalities.

113. Real estate taxation is moderate but on the high side of the OECD average. Real estate taxes (taxe fonciere), which are collected by local governments, yielded only 1.1 percent of GDP in 2002. In contrast, real estate taxes represented 3.3 percent of GDP in the United Kingdom and 2.6 percent of GDP in the United States, while the average in the OECD was below 1 percent of GDP.

Tax administration

114. The tax system is managed by several administrations and entails heavy administrative requirements for taxpayers. Direct taxes and social contributions are assessed and collected through various administrations and channels. Social security contributions (including the CGS on wages) are collected from employers by a specialized semi-public agency (URSSAF); personal and (until 2003) corporate income taxes are assessed by the tax administration (DGI) but collected by a separate unit, the public accounting administration (DGCP); and the VAT is managed entirely by the DGI. Taxable bases, procedures, and filing periods vary across taxes. Unlike most EU countries which withhold most personal income taxes at source, in France only the CSG and social contributions are withheld at source. Filing under the PIT is mandatory for every resident, even if there is no tax liability, making this tax costly to administer, while being subject to considerable collection lags. Finally, the tax code is complex and difficult to understand for both taxpayers and the tax administration (Conseil des Impôts, 2002).

Progressivity of the tax system

115. The French tax system is considered fairly progressive. While this paper does not deal with the equity of the tax system, this remains an important consideration. In this regard, the VAT and social security contributions are considered more or less proportional, while direct income taxes are somewhat progressive (Bourguignon and Bureau, 1999), although the small yield of the personal income tax limits its redistributive impact.

Rebalancing the tax burden from labor to consumption

121. Rebalancing the tax structure away from taxes on labor and toward taxes on consumption may have the potential to raise the level of output in the medium term. A shift in the tax mix may alleviate pressures on labor costs (to the extent that firms are unable to resist wage pressures associated with taxes on wages) and, thus, increase labor demand, employment, investment and growth. Reducing the marginal labor tax wedge may improve incentives to work and participate in the labor market, eventually increasing labor supply. Finally, taxing consumption may broaden the tax base, since income from other sources than labor (i.e., capital, property, pension benefits and other income transfers) would be taxed through consumption, thus reducing distortions against labor (despite the equivalence, in an inter-temporal setting, between taxing wages and taxing consumption).

122. Switching part of the tax burden from labor to consumption could be implemented by reducing social security contributions while simultaneously increasing the VAT or the CSG in a revenue-neutral way. As noted in Section B, there may be some room for moderate increases in the VAT rate, which currently is not above the average in the EU. The financing of social security could be decoupled from exclusive reliance on wage contributions, and instead would be financed in part by general taxation.⁷⁵ If a tight budget constraint on social security spending is of order, contributions could be replaced by a fixed number of points of VAT, specifically allocated to social security.⁷⁶ An alternative would consist in increasing the CSG while lowering regular social security contributions, since the former has a broader taxable base that includes non-wage incomes.

Reforming direct income taxation

123. Continuing to selectively reduce marginal rates of income taxes or social contributions would improve incentives to increase labor supply, especially if the cuts are targeted in favor of low- and high-income earners which have a relatively high income-elasticity in their labor supply. The policy of targeted rebates on social security contributions for low-skilled workers, which may have reduced labor costs for these categories, could be maintained though its cost-effectiveness from a budgetary perspective should be established.

124. The wide difference between marginal and average effective tax rates of the PIT points to the need for a comprehensive overhaul of this tax. As noted earlier, the top marginal rate is as high as 50 percent but the average rate for the top decile is only 12 percent, suggesting a large disincentive effect accompanied by small tax collections. While the authorities have cut PIT rates considerably over the past few years, more could be done to reduce marginal rates while broadening the tax base—which would involve restructuring the tax schedule and reducing deductions. Lowering PIT rates, by reducing the taxation of capital income, would also increase savings incentives.

125. Consideration should be given to integrating the PIT and the CSG into a unified personal income tax. In principle, both taxes share broadly the same income base—although the PIT base is significantly reduced by various deductions and is based on the previous year’s income—and unification would simplify the tax system. The PIT and the CSG could be integrated into a single tax comprising a unified tax schedule, with a proportional base rate and a progressive component, and a unified tax base—preferably the broad base of the CSG. The integrated tax could be based on the current year’s income, and withheld at source. However, because the CSG is currently earmarked to financing social security, its integration with the PIT would require an overhaul of the relations between the government budget and the various social security institutions.

Improving the yield and efficiency of the VAT

126. Streamlining the VAT would greatly reduce distortions, cut compliance costs, and facilitate international trade. The French VAT is not particularly buoyant because of its reduced rates and exemptions. Best practices suggest that the VAT should be used primarily as a financing instrument and not as a means to pursue sectoral or redistributive objectives (Ebrill, Keen, Bodin, and Summers, 2001). The following measures, which would contribute to improving the yield and efficiency of the tax, should be considered:

• Eliminating the 2.1 percent super-reduced rate;

• Increasing the 5.5 percent reduced rate to a level closer to the standard rate (19.6 percent) while limiting its scope;

• Narrowing the extent of exemptions;

• Increasing the standard 19.6 percent rate, which currently is not above the average in the EU; and

• A simplification of the cross-border VAT regime, which, however, requires agreement at the EU level.

127. Reduced rates are costly ways to achieve sectoral policy objectives, miss the mark as they are often regressive, and create additional distortions. Alternative policies such as a reduction in labor costs would be much more effective and less costly. Appropriate compensation, in the form of targeted social transfers, could mitigate the impact of the proposed measures on low-income households.

Reducing corporate and capital taxation, and improving its neutrality

128. There is scope for further reducing corporate income tax rates (e.g., from 33 percent to 25-30 percent) to align them with major economic partners and competitors, especially considering the relatively low yield of the CIT (2.8 percent of GDP in 2001). The German tax reform may be instructive in this regard, and may also prompt a review of the French imputation system to achieve greater neutrality with respect to cross-border investment flows (Keen, 2002).

129. Consideration might be given to moving toward a Nordic dual income tax system, so as to improve neutrality with respect to various incomes from capital or corporations. The dual income tax is characterized by a low tax on all capital income accompanied by a progressive tax on labor income, instead of taxing all personal income (from labor and from capital) under a unified tax (and taxing corporate income separately). To the extent that it reduces the taxation of capital income, such reform may improve incentives toward savings and promote growth. It could be considered along with the reform of the PIT mentioned earlier.

Simplifying local taxes

130. Low yielding and costly local taxes should be eliminated—specifically the local business tax and the local housing tax. The resulting revenue loss for subnational government should be compensated by other taxes in a revenue-neutral way (see below). The local business tax, since it is levied independently of actual turnover and profits, may constitute an impediment to entrepreneurship, in particular for small firms and new companies.⁷⁷ The local housing tax serves no defined purpose and has become somewhat of a nuisance tax, following its gradual erosion by numerous deductions, exemptions, and reductions designed to bring its base closer to taxpayers’ ability-to-pay. Consequently, it would be better integrated with the PIT or with local property taxes.⁷⁸

131. Subnational governments should be assigned simple and buoyant taxes. There are various options for local taxation, which go beyond the scope of this paper.⁷⁹ To replace the eliminated local direct taxes, consideration could be given to introducing a low rate but broadly-based local surcharge on personal and corporate income taxes (or a surcharge on the CSG) specifically allocated to local governments. It could be redistributed to local governments according to the origin principle, or according to needs or equalization objectives. Rates could be set by each local government according to its own needs or preferences. Another potential source of local revenues lies in real estate taxation. Developing this source may improve the redistributive characteristics of the tax system, although it would necessitate updating real estate values and harmonizing valuation rules and rates. Finally, a local tax on businesses’ value-added, along the lines of the Italian IRAP, could be considered—although its base, which includes wages, may cause a direct increase in labor costs.⁸⁰

132. Gains from a reform of local taxation may be substantial in the long run, despite the almost certain short-term political economy costs. There may be large efficiency gains to be reaped from designing local taxes on a sound and economic basis. Moreover, this may improve the transparency and simplicity of the overall tax system—possibly improving economic conditions for businesses—as well as the fiscal accountability of local governments. The political economy cost of a reform of local taxes maybe large, however, given the large number of parties involved and the complexity of the existing financing arrangements among various levels of local governments and with the central government.

Simplifying income taxes and reducing tax administration costs

133. The compliance costs for taxpayers and the tax administration could be reduced significantly by introducing withholding at source for the PIT and by rationalizing tax administration. Introducing generalized withholding of income taxes at source, following the successful model of the CSG, would greatly simplify the collection of direct taxes, reduce costs for taxpayers and for the tax administration, and improve compliance, eventually increasing revenues. Furthermore, the necessity of mandatory filing for all taxpayers under the PIT should be reconsidered. At the very least, systematic advance payment of taxes would reduce the burden of the tax administration in verifying millions of annual declarations. Finally, rationalizing the various administrations dealing with assessment and collection of taxes and social security contributions would entail significant savings for the public sector and for taxpayers.