This Selected Issues paper examines implications of capital account liberalization in Iceland. Capital controls were critical in 2008 to avoid a more severe collapse of the Icelandic economy. Six years later, capital inflows have been liberalized, but most outflows remain restricted. Iceland has used the breathing room to reduce flow and stock vulnerabilities, strengthen institutions, and prepare for the lifting of capital controls. Simulations using the central bank’s Quarterly Macroeconomic Model (QMM) suggest that, compared with the 2008 crisis episode, the economy can better withstand the impact of an abrupt removal of capital controls. However, the outcome would be dependent on a number of factors, including resident depositor behavior.

Abstract

This Selected Issues paper examines implications of capital account liberalization in Iceland. Capital controls were critical in 2008 to avoid a more severe collapse of the Icelandic economy. Six years later, capital inflows have been liberalized, but most outflows remain restricted. Iceland has used the breathing room to reduce flow and stock vulnerabilities, strengthen institutions, and prepare for the lifting of capital controls. Simulations using the central bank’s Quarterly Macroeconomic Model (QMM) suggest that, compared with the 2008 crisis episode, the economy can better withstand the impact of an abrupt removal of capital controls. However, the outcome would be dependent on a number of factors, including resident depositor behavior.

Fiscal Policy Reform Options to Boost Potential Growth and Strengthen the External Position1

This chapter focuses on how fiscal policy reforms could boost the long term growth rate while maintaining continued debt reduction and supporting the external position. A Global Integrated Monetary and Fiscal Model (GIMF) is calibrated on Icelandic data and used to consider the following budget neutral scenarios: a) boosting public investment which has bourne the brunt of the fiscal adjustment with off-setting savings in current expenditures; b) shifting the tax burden from direct to indirect taxes; c) improving the incentives for private sector investment by reducing corporate income tax to its pre-crisis levels with offsetting changes in indirect taxes, and d) reducing the size of the government by reducing both direct taxation and government consumption. The paper finds that a comprensive package of fiscal reforms could boost GDP over the medium term by 2 to 2.5 percent of GDP, increasing the annual growth rate by 0.5 percent, while strengthening, to varying degrees, the external position.

A. Introduction

1. The last seven years have been a difficult time for fiscal policy management in Iceland. The global financial crisis in late 2008 exposed serious vulnerabilities, leading to a disintegration of the domestic banking system and a deep recession. The domestic currency depreciated sharply and inflation increased. The crisis had a profound impact on Iceland’s fiscal position. Between 2008 and 2013, tax revenues fell by 4.2 percentage points of GDP as domestic demand, output and imports all collapsed. A combination of financial sector clean up costs, central bank losses and higher crisis-related social expenditures pushed the public expenditures above 50 percent of GDP. The general government deficit reached double digits in terms of GDP. Public investment bore the brunt of the post-crisis adjustment. In real terms, public investment fell by 40 percent. Allowing for capital depreciation, public investment has been close to zero in net terms since 2010.

2. Nevertheless, the post-crisis consolidation efforts, which began in 2009, yielded important results. The general government deficit was reduced from almost 11 percent of GDP to a projected surplus of almost 2 percent in 2014, while the primary balance has been in surplus since 2012. Public debt peaked in 2011 at 95 percent of GDP and has fallen over 12 percentage points since then. The revenue decline has been reversed, with the revenue-to-GDP ratio increasing by 3.2 percentage points since 2009. Expenditure restraint has yielded a 5 percentage point improvement in the total expenditures to GDP ratio between 2009 and 2013.

3. With the post-crisis fiscal legacies contained, there is now an opportunity to reconsider the fiscal reform strategy. Looking beyond the crisis, Iceland faces serious fiscal challenges, which need to be addressed. The tax regime – particularly VAT and personal income tax – suffer from serious structural weaknesses. Unfavorable demographic trends will lead to growing pension and health expenditures. Social sector expenditures are significantly higher than they were prior to the crisis. Fiscal space needs to increase in order to provide resources for higher public investment, particularly in the health sector, which needs urgent infrastructure-related expenditures.

4. Iceland’s Economic Program – published in February 2014 – was an important step towards the normalization of fiscal policy. It outlined an economic strategy that aimed to “increase the economy’s growth potential” through increased investment and higher exports. The main pillars of the reform strategy were the removal of capital controls, household deleveraging, prudent budgetary policies that both reduced public sector indebtedness while boosting investment and productivity.

5. The program includes a number of broad fiscal policy objectives and proposals.

  • On the revenue side, the government would like to establish “a simple and efficient tax system which encourages investment and increases household disposable incomes” (Ministry of Economic and Financial Affairs, 2014). To prepare the groundwork for meeting this objective, government is committed to a review of tax policy.

  • The government reaffirmed Iceland’s medium term objective of reducing the ratio of public expenditure to GDP. The main instruments for achieving this goal will be continued restraint on current expenditures and debt service savings as a result of prudent debt management practices and ongoing debt reduction.

  • The program also argues in favor of higher public investment, which was curtailed severely during the crisis. This implies a significant reordering of expenditure priorities given the commitment to simultaneously reduce the tax-to-GDP ratio and maintain a downward path of the debt-to-GDP ratio.

6. This paper seeks to complement the objectives of the Economic Program by quantifying fiscal reforms within a macroeconomic model. It will identify package of measures consistent with the Program that could play a decisive role in promoting strong, sustainable and equitable growth in Iceland during the next five years. To achieve this objective, we use the Global Integrated Monetary and Fiscal Framework – calibrated on Icelandic data - to model tax and expenditure reforms that could be implemented in the near term and which could both have a permanent positive impact on Icelandic potential growth without jeopardizing ongoing efforts to reestablish fiscal sustainability.

B. Fiscal Policy, Growth and the External Position

7. The need for a more effective growth strategy has been a long standing and recurring feature of the policy debate in Iceland. This debate is now more pressing since the crisis has resulted in a sizeable and permanent loss in potential GDP (see text chart).

A06ufig01

Real Medium-term Potential Growth 1/

(Index, 2008=100)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Sources: Ministry of Finance ; and IMF staff projections.1/ Data before 2008 is based on actual otturns.

8. The Icelandic economy faces the challenges in identifying new sources of growth. This task is made difficult by the unique structure of the Icelandic economy. It has a narrow structure of exports, dominated by fisheries, tourism, and aluminum. The low population places limits on the creation of new industries catering for domestic demand. The supply side of the economy, particularly the labor market, is comparatively rigid by international standards, making it vulnerable to global shocks. Furthermore, Iceland’s growth strategy will need to be placed in the context of its most pressing policy challenge; the need to exit from its current regime of capital controls.

9. A well-designed package of tax and expenditure policies can strengthen both potential growth and the external position by improving allocative efficiency and building human and physical capital. Some taxes are more distortionary than others and therefore shifting the revenue mix to less distortionary taxes will reduce the deadweight loss of taxes and increase potential output (Mendoza et al, 1997). The empirical literature indicates that corporate taxes are the most distortionary, followed by labor taxes, while consumption and property taxes are regarded as being comparatively less distortionary (Fiscal Monitor, 2013; Norregaard, 2013). Limiting distortionary tax expenditures and preferential rates can create a “level playing field” for consumers and producers. The public expenditure mix can also have a powerful impact – both positive and negative – on potential output. Public investments in human and physical capital will also enhance potential growth, while abolishing untargeted subsidies, and restraining public sector wages can also improve allocative efficiency.

C. The Current Fiscal Policy Mix

10. Fiscal policy since 2008 has largely been driven by the need to contain debt accumulation in the context of a financial crisis and a large output shock. This has often involved taking short-term and politically viable measures that have addressed government financing need. Understandably, in the context the crisis, the long term growth consequences of the fiscal policy mix have been of secondary importance. For example, reductions in public investment between 2008 and 2010 contributed to a 1.3 percentage point reduction in the overall deficit. However, this measure cumulatively reduced gross public sector capital accumulation by almost ISK40 billion or about 2.4 percent of GDP.

11. Notwithstanding the impact of the crisis, the structure of revenue mobilization and expenditures have a number of important structural weaknesses which should now be addressed:

A06ufig02

Gross Public Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Sources: Statistics Office of Iceland; and IMF staff projections.

Public investment ratios are low relative to historical trends and to other OECD countries.

12. Capital expenditure contracted sharply during the crisis. Prior to the crisis, public investment as a ratio of GDP, averaged around 4 percent a year. Since, 2010, the ratio has averaged just over 2 percent a year. As such, the gross investment rate has barely kept pace with the rate of capital depreciation. While there may be a case that there was an element of over-investment during the pre-crisis period, this stock of over-investment has now almost certainly evaporated. Within Iceland, there is growing concern about a lack of investment in key social sectors such as health as well as a deteriorating quality of the road network.

A06ufig03

Gross Public Fixed Capital Formation

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: OECD

13. International comparisons of investment rates suggest that Iceland has, in recent years, underinvested in the public capital stock. In terms of gross public capital formation, Iceland sits towards the lower end of the range for OECD countries. Moreover, it has the lowest rate of capital formation among its key comparator group—the Nordic Countries.

A06ufig04

Iceland - Composition of Expenditures 2013

(Percent)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: Ministry of Finance.

The composition of expenditure is unbalanced

14. The composition of expenditures is heavily geared towards current rather than capital expenditures (see text chart). Public investment only accounts for 5 percent of total investment, while a third of expenditures are devoted to public sector wages. Expenditures on subsidies are almost as large as those on public investment.

15. The crisis resulted in a sharp increase in social benefits expenditures, which have not yet been unwound. Reflecting the social consequences of the crisis, expenditures on social security benefits increased by 1.7 percentage points of GDP between 2007 and 2011. Over the same period, other transfers increased by almost one percentage point. As the crisis has subsided, social benefits expenditure has declined somewhat. Nevertheless, social benefits expenditures in 2014 were almost 2 percentage points higher than in 2007.

The current VAT system suffers from serious weaknesses

16. Iceland’s VAT system combines an extremely high standard rate, a very low reduced rate for socially sensitive products and large number of exemptions (Matheson and Swistak, 2014). The current VAT system was reformed as part of the 2015 budget. Nevertheless, the main VAT rate – which is now 24 percent – is well above European and OECD averages and even above that of other Scandinavian countries. The lower rate, which is charged on essential products such as food was raised from 7 to 11 percent. Notwithstanding this important reform, the rate is comparatively low by OECD stands. Furthermore, there continue to be a significant number of exemptions that undermine the revenue base and distort competition.

A06ufig05

VAT revenues

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Sources: Ministry of Finance, and Statistics Iceland..

17. As a consequence of these longstanding design weaknesses, the share of VAT in both total revenues and as a percent of GDP has been declining in recent years. Prior to the crisis, VAT revenues amounted to 11.3 percent of GDP, although this figure was boosted by cyclical factors. Just prior to the crisis, the VAT rate on socially sensitive items was cut from 12 to 7 percent. Since the crisis, VAT revenues have settled at an average of around 8 percent of GDP. Despite the high standard rate, Iceland’s VAT revenue performance compares unfavorably with its Nordic peer group. In 2013, the VAT collections were considerably lower than Sweden, Finland and Denmark (see text chart).

A06ufig06

Tax Burden

(Percent of total revenues)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Sources: Ministry of Finance; and Statistics Iceland.

18. Iceland has traditionally supplemented its indirect tax system with a wide range of ad valorem commodity taxes.2 In addition to the revenue objective, these taxes had the goal of making the tax system more progressive since the incidence falls heavily on luxury goods. However, this type of tax was not effective means of achieving this type of policy objective. Often, wealthier individuals could acquire these items overseas while on vacation. These excises often fell on business inputs which distorted production as well as consumption decisions. Moreover, businesses did not receive credit for excises paid on their inputs, in contrast to taxes paid on VAT. These taxes were significantly reformed as part of the 2015 budget.

The burden of taxation has shifted from indirect to direct taxes

19. Since the late 1990s, the burden of taxes has shifted decisively towards direct taxation. In 1998, indirect taxation accounted for 60 percent of the revenue base. Since then this figure has declined steadily. As of 2013, indirect taxes account for just under half of all revenues. This decline has been mirrored by a fall in VAT revenues as a proportion of total revenues.

A06ufig07

Personal Income Tax Revenues by Tax Bracket

(Billions of ISK)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: Ministry of Finance

The labor tax regime has serious design weaknesses

20. By OCED standard’s Iceland’s personal income tax system is comparatively complex. The personal income allowance is high, which means that over a third of wage earners do not pay directly any personal income tax3. However, the entry personal income tax rate is 23 percent - one of the highest in the OECD, while the highest tax rate is comparatively low – at 32 percent. Moreover, the upper level PIT tax rates generate only minimal levels of additional revenue.

21. The personal income tax regime is further weakened by the comparatively large number of closely held businesses, where owners contribute both capital and labor. The advantageous tax regime for corporate profits and partnership income relative to labor income has resulted in increase in the number of incorporated small businesses, which has weakened the personal income tax regime (Escolano et al, 2010).

22. The government’s economic program has an objective of simplifying the regime. Specifically, the government has stated its long term objective of reducing the current three rate regime and move to a two rate regime.

A06ufig08

Number of Personal Income Tax Payers

(Thousands)

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: Ministry of Finance.

D. Estimating the Potential Gains from Growth-Friendly Fiscal Policy

23. The Global Integrated Macroeconomic Model (GIMF) provides a useful framework for quantifying the potential gains from a package of growth-enhancing tax and expenditure policies, as well as their impact on Iceland’s external position (Anderson et al 2013,. GIMF has the ability to analyze a wide range of fiscal issues. It includes seven fiscal policy instruments – government consumption and investment, lump-sum transfers to all households or targeted transfers to liquidity-constrained households, taxes on labor and corporate income, and consumption taxes – which impact macroeconomic variables through a number of transmission channels:

  • Productivity. Firms utilize the public sector capital stock as an input. Therefore, higher public investment increases private sector productivity.

  • Finite planning horizons. GIMF assumes OLG households with age-specific productivity. A tax-financed fiscal stimulus pushes the profile of consumption towards current periods and therefore increases aggregate demand.

  • Liquidity constraints. A fraction of households consume their entire current income in each time period so that government transfers imply high fiscal multipliers;

  • Tax policy. The growth effect of lower consumption and labor income taxes transmits most strongly via liquidity-constrained households while a cut in corporate taxes increases the return to capital, induces higher investment and stimulates labor demand; and

  • Risk premium. The economy-wide risk premium increases with public debt, raising the real interest rate and reducing private investment and output.

24. These channels imply that fiscal policy can stimulate growth – potentially with significant persistence – but sustained fiscal deficits and higher debt will crowd out private investment. GIMF also enables a steady state where countries can be long-run debtors or creditors. In this way, fiscal policy and private savings play a key role in macroeconomic dynamics.

25. This paper considers four reform scenarios. These scenarios are broadly consistent with the policy objectives outlined in the government’s economic program. Furthermore, each scenario is constructed in a budget neutral manner. Changes in revenues and expenditures are matched by other fiscal measures that leave the overall balance unchanged.

Scenario One: Lower current expenditure, higher public investment

26. This scenario models a reform strategy where current expenditures are reduced to provide fiscal space for an increase in public expenditures (See Figure 1). The objective would be to restore capital expenditures to their pre-crisis level as a percent of GDP. This would require raising the ratio from its current level of about 2 percent of GDP to something in the range of 3.5 to 4 percent of GDP. In terms of current expenditure measures, the scenario assumes:

  • Wage restraint. The objective would be to reduce expenditures by around 0.2 percent of GDP relative to the 2014 baseline.

  • Subsidies reform. For the last ten years, subsidies expenditures have remained remarkably stable at 1.8 percent of GDP despite the financial crisis and efforts to contain expenditures. The scenario would assume that these expenditures were permanently reduced to 1 percent of GDP.

  • More effective targeting of social benefits. The objective would be to identify permanent savings of around 0.5 percentage point of GDP per year. This would bring expenditures closer to its pre-crisis level.

Figure 1.
Figure 1.

Iceland: Scenario One Increased public investment, lower current expenditures

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: IMF staff projections.

27. Switching the composition of expenditure from current to capital expenditure generates a sizable growth impact, as well as a more uncertain impact on the external position. Over the medium term, the level of real GDP is higher by around one percentage point, adding about 0.2 percent a year. In the short run, the trade balance deteriorates, as higher public investments leads to an increase in imports. The exchange rate also depreciates gradually and over the medium term, adds about 0.2 percent inflation. This prompts an increase in the policy rate, based on the model assumptions regarding the central bank response function. Over time, imports decline as investment demand subsides and exports start to adjust to the lower exchange rate. Eventually, the trade balance returns to balance.

Scenario Two: A shift away from personal income tax to indirect taxation

28. This scenario examines the implications of changing the relative weights of direct and indirect taxes in total taxes (see Figure 2). Specifically, the model looks at a reduction of personal income tax revenues by one percentage points of GDP and an equal compensating increase of VAT revenues. On the revenue side, personal income tax rates are assumed to be harmonized with the lower rate being reduced to enhance labor force participation. On the VAT side, the scenario seeks to approximate a reform where the two VAT rates are harmonized, while exemptions are eliminated. In principle this would raise revenues, alleviate economic distortions, and simplify administration.

Figure 2.
Figure 2.

Iceland: Scenario Two Lower personal income tax, higher indirect taxes

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: IMF staff projections.

29. Under this scenario, the level of real GDP increases by almost 0.5 percentage points relative to the baseline over the medium term; just slightly less than 0.1 percent per annum, while the external position improves. On a net basis, private consumption declines slightly over the short term, as the impact of the higher VAT rate on consumption is greater than the higher post-tax real wage. Subsequently, consumption returns to the baseline over the medium term. This results in a reduction of imports. Exports increase as both the real and nominal exchange rate depreciates. As a result, the trade balance improves relative to the baseline. The model projects a minimal impact on inflation over the medium term.

Scenario three: Reducing corporate income tax by increasing VAT

30. This scenario examines the implications of returning to the pre-crisis corporate tax regime. In 2011, Iceland corporate income tax rates were increased from 18 to 20 percent as part of the ongoing effort to reducing the crisis-related fiscal financing gap. As a consequence, the tax burden on the corporate sector has increased by around 0.5 percentage points of GDP.

31. Under this scenario, the shortfall in revenues, which would result a reduction in corporate income tax, will be made up by a modest increase in VAT taxes (see Figure 3). This latter assumption can be thought of as a more limited reform of the VAT system, whereby the lower tax rate is increased, but where the lower and higher VAT rates are not harmonized. Therefore, the indirect revenue improvement would broadly match the reduced revenues from lower corporate tax rates.

Figure 3.
Figure 3.

Iceland: Scenario Three Lower corporate income tax, higher VAT

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: IMF staff projections.

32. The scenario suggests that there is a medium term improvement in the level of GDP of around 0.4 percent, while the external position deteriorates in the short-run. As one would expect, there is a sizable increase in private sector investment. Interestingly, consumption remains broadly unchanged. The downward pressure on consumption of higher VAT is compensated by higher consumption due to increased GDP. The exchange rate appreciates in the short run, pushing downward pressure on exports and leading to a deteriorating trade balance. Over time, the exchange rate adjusts downward, creating recovery in exports, reducing imports, leading to medium term improvement in the trade balance over the medium term.

Scenario four: Lowering the tax and expenditure to GDP ratios

33. The final scenario examines the growth impact of a combined package of measures aimed at reducing both the revenue and expenditure to GDP ratios (see Figure 4). The 2014 economic program has outlined a long term goal of reducing the relative size of the government. To approximate this policy objective, the scenario examines the implications of reducing direct income tax revenues by one percent and matching this reduction by a one percent of GDP reduction in public sector wages and expenditures on goods and services.

Figure 4.
Figure 4.

Iceland: Scenario Four Lower personal income tax, lower government consumption

Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A006

Source: IMF staff projections.

34. Under this scenario, real GDP is higher and the external position improves. There is a strong labor supply response as the reduction in personal income tax acts as a positive real wage shock. In contrast to scenario two, there is no countervailing increase in indirect taxes to suppress consumption. Over the medium term, the level of GDP is about around 0.4 percent higher relative to the baseline. The positive real wage shock also generates a real exchange rate depreciation. In turn, exports increase.

E. Concluding Remarks

35. The fiscal policy challenges in Iceland are rapidly evolving. The crisis related issues - in particular, the imperative to bridge the fiscal financing gap - have now subsided. The fiscal position has moved decisively into balance and the public debt ratio is now firmly on a downward trajectory.

36. However, deep structural fiscal issues, which often pre-date the crisis, are now returning into focus. The VAT system is comparatively inefficient in terms of raising revenues, despite very high tax rates. The personal income tax is complicated, and in some key respects, lacks progressivity. On the expenditure side, there are also important crisis legacy issues. Public investment is at historically low levels, while social sector expenditures need to return to their pre-crisis levels. Indeed, many key elements of this post crisis reform agenda are articulated in the government’s February 2014 Economic Program.

37. This chapter has sought to identify the magnitude of the “growth premium” that could be gained by addressing Iceland’s key fiscal policy challenges. In this respect, it is important to distinguish between the growth impact resulting from fiscal consolidation with those from reforms aimed at boosting growth from changing the revenue and expenditure mix. The overall conclusion is that addressing Iceland’s structural fiscal problems, while maintaining the current fiscal stance of broadly balanced budgets, could offer an increase in the level of GDP in the range of 2 to 2.5 percent of GDP over the medium term, boosting the growth rate by around 0.4-0.5 percent of GDP.

38. Any fiscal reform package must take place against the backdrop of capital account liberalization. Liberalization can only take place when the risks to the external sector are sufficiently mitigated. Each fiscal reform strategy has different implications for the current account, particularly in the short run. Reforms that aim to increase the proportion of indirect taxes support external balance both in the short and medium term, largely through constraining consumption expenditures. Other reforms, particularly those that aim to boost public investment, may result in a short-term deterioration in the external accounts. Therefore, the sequencing of these fiscal reforms, particularly in the context of their impact on the external position and capital account liberalization, must be carefully considered. Nevertheless, over longer time horizons, the fiscal reforms highlighted in this chapter will serve to increase potential GDP, and through the interest rate-growth differential, reduce public indebtedness and contribute to the resolution of Iceland’s remaining crisis legacy issues.

References

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1

Prepared by Jimmy McHugh.

2

For example, there is a 15 percent duty on various building materials and automotive spare parts; a 20 percent duty on various large household appliances and a 25 percent excise on various electronic goods.

3

All taxpayers are required to pay municipal income tax, which is formally levied on all income. However, individuals with income less than the lowest personal income tax threshold receive a full tax credit from the central government for municipal taxes.

Iceland: Selected Issues Paper
Author: International Monetary Fund. European Dept.