Selected Issues

Abstract

Selected Issues

Closer to Best Practice—Tax Reform in Norway1

A tax reform, underpinned by work of the Tax Commission in late 2014, has begun being implemented from 2016. It entails scaling back the overall tax burden and adjusting the tax structure away from income taxes, which are high by OECD standards. The reform is timely as the Norwegian economy is looking to rebalance from many years of an oil and gas-related growth model to achieve sustained long term growth. The key reform measures, including lowering corporate income and ordinary personal income taxes, raising reduced VAT rates and introducing financial activity taxes, and better aligning taxable housing wealth with market values, are welcome steps to help stimulate innovation, boost productivity, improve labor supply, and promote business investments in line with the objectives in the government’s Long-Term Perspectives white paper (2016–2017). This Selected Issues Paper evaluates the key reform measures and identifies remaining gaps in the current tax system relative to the best practice.

A. Introduction

1. Norway’s mainland economy has taken a hit from the oil shock. Oil and oil-related investment and exports have dropped significantly. Despite the recent pick-up, global oil prices are likely to stay low due to oversupply and slowing demand. Oil-related investments are projected to recover over the medium term, but not to the level seen in the past as oil-related investment was expected to fall irrespective of oil prices. Hence, the oil-driven growth has come to an end. The journey ahead calls for reforms in support of economic transition.

2. Tax revenue in recent years reflected the oil sector downturn, but the level is still high compared with that of peers. Like other Nordic countries, tax revenue-to-GDP ratio in Norway was around 10 percent higher than the OECD-average prior to the oil shock. The margin narrowed by half in the recent years as tax collection from corporate income and profits fell sharply, driven largely by oil sector companies. Excluding taxes from the oil activities, Norway’s tax revenue has been growing in pace with economic growth.

3. The tax burden lies mostly on income taxes. Close to 70 percent of overall tax revenues are from income taxes, of which 58 percent is in the form of individual taxes and social security contributions. Taxes on corporate income, profits and gains account for the rest including from the oil industry, which accounts for about half2 of total corporate income tax. Compared with other OECD countries, Norway’s tax structure is characterized by higher taxes on personal and corporate income, profits and gains and lower taxes on property. This suggests some room to shift the tax burden from direct to indirect taxes.

Figure 1:
Figure 1:

Recent Trend of Tax Revenue and Tax Structure

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

4. The tax reform could help mitigate the erosion of the tax base and facilitate the economic transition away from oil dependence. Following many years of strong growth driven by the oil-related industries, the Norwegian economy is looking to rebalance and diversify in support of sustained longer term growth. The non-oil-related mainland economy will need to make larger contributions to growth and public finances considering growing financing needs for old age pensions and health care services. In this context, the Tax Commission proposed a tax reform in [late 2014], which laid the basis for the tax reforms that started implementation in 2016. The reform aims at securing the tax base, and strengthening incentives to save, invest, and work.

B. An Overview of the Tax Reform

5. The reform proposals entail scaling back the overall tax burden and adjusting the tax mix more towards indirect taxes. Since the reform, the corporate income tax rate has been reduced from 27 to 25 percent in 2016, and is planned to decline further to 23 percent by 2018. This brings Norway’s effective tax rates closer to the levels in the comparator countries. To avoid tax planning, the reform will lower the ordinary personal income tax rate in parallel with the corporate tax rates to 23 percent by 2018. To compensate for the revenue loss, a new progressive tax on gross personal income has been introduced to replace the current surtax on higher incomes. The new progressive gross tax incorporates four brackets (the bracket tax), where the upper two brackets correspond to the previous surtax. This will reduce the top marginal tax rate for most personal tax payers. And to prevent income shifting from labor income to dividends because of the reduction of CIT rate, an adjustment on dividends, which increased the effective tax rate was introduced in 2016. In addition, one of the reduced VAT rates increased from 8 to 10 percent in 2016; a new tax on the financial activities was introduced in 2017; rules on depreciation, interest deduction limitation and other measures to counter profits shifting and base erosion will be phased in over the coming years. The Tax Commission also proposed a revenue neutral reform of the net wealth tax to bring the allow more equal tax treatment across different types of assets and debts; so far some minor changes have been made. For example, the 2017 budget introduced a 10 percent valuation discount for shares and operating assets and associated debt. Secondary dwellings and associated debt will be valued at 90 percent, narrowing the preferential tax treatment for real estate. The reform has also introduced a scheme for the deferred payment of net wealth tax for business owners. There has also been a clear shift towards environmentally-related taxes, in line with the Long-Term Perspectives White Paper.

6. Some revenue loss resulting from the reform in the short term is acceptable given ample fiscal space. Overall, the reform was estimated to cost around 11 billion krone in net, equivalent to about 0.4 percent of mainland GDP in 2016. A bulk of the costs resulting from the reduction of CIT and PIT rate (2 percent of mainland GDP in 2016) will be partially offset by other tax changes. The newly introduced bracket tax in replacement of the surtax offset over 65 percent of the revenue loss from the reduction of PIT tax rate. Other indirect taxes such as financial activity tax, increase in reduced VAT rate, and changes of depreciation rules, interest deduction limitations and other measures to counter profits shifting are also expected to mitigate the remaining of the revenue loss. Norway has ample fiscal space given the fiscal surplus, small gross debt, and very large GPFG and other financial assets. Hence some revenue loss in the short term is justifiable.

7. Over the longer term, the reform can help improve productivity, stimulate labor supply and support longer term growth, which would at least partially offset any short-term revenue loss. The tax structure would be improved by shifting the tax burden away from income taxes to more growth-friendly indirect taxes. Lowering PIT rates along with better design of labor taxes and social benefits can strengthen work incentives and induce a positive labor supply response. Lowering the CIT rate supported by well-targeted tax incentives can help stimulate private investment, encourage entrepreneurship, and improve productivity growth. Reducing tax preferences for housing investment frees up capital for other business and industrial investment, generating more sustained long term growth.

8. Further tax reforms would be warranted to bring Norway’s tax system closer to the best practice. The following sections will discuss the remaining gaps in the current system and how further tax reforms could help the economy achieve the objectives highlighted in the Long-Term Perspectives White Paper.

C. Boosting Productivity and Promoting Investments

9. Norway’s effective corporate tax rate is moving closer to the average among advanced European economies owing to the ongoing tax reform. Effective tax rates account for both statutory rates as well as depreciation rules and tax exemptions; hence they are considered more relevant for investment decisions. Norway’s statutory and effective tax rates are both higher than an average advanced European country. The tax reform, which lowered the statutory tax rate and adjusted the depreciation rule has brought Norway’s effective tax rate closer to its peers, and will lower the rates further next year (Figure 2).

Figure 2:
Figure 2:

Statutory and Effective Corporate Income Taxes

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

Table 1.

Revenue Effects of Tax Reform 2/

(in million NOK)

article image
Source: Ministry of Finance, Tax Commission, and staff calculationsNotes:

Revenue effect of Budget 2017 is measured in 2017 NOK, while other revenue effects are in 2016 NOK

Only includes revenue effects of agreed upon tax reform, which is not equivalent to aggregate revenue effects of implemented tax programmes.

10. The lower CIT rate should help improve firms’ cost competitiveness, though the productivity impulse can sometimes be modest. In theory, reducing the effective tax rates lowers firms’ investment costs, and hence should encourage higher investments. Empirical analyses for the advanced economies (De Mooij and Edervenn (2008), IMF Fiscal Monitor (April 2016)) show that lower CIT rates attract inbound FDI. Innovation is a key driver of long term productivity growth. To boost innovation, research and development (R&D), technology spillovers, and entrepreneurial innovation play key roles. The IMF Fiscal Monitor (April 2016) finds that lowering the average effective tax rates on business income by 1 percentage point, would increase new business entry rate by between 0.1 and 0.3 percentage points; the impact is relatively modest.

11. Tax incentives could enhance productivity by stimulating R&D and entrepreneurial innovation. The positive externalities imply that private companies would underinvest in R&D compared with the socially-optimal level. The underinvestment can be addressed by corrective fiscal instruments that lower the costs of private R&D and encourage firms to invest. The fiscal support can take the form of direct provision of grants, contracts and loans (direct subsidies), or preferential tax treatments such as tax credits, enhanced allowances, accelerated depreciation, and special deductions for labor taxes or social security contributions (tax incentives). Tax incentives provide broader incentives to all firms investing in R&D, which complement direct subsidies that are more targeted and especially useful to support research in the early phase of innovation (Fiscal Monitor April 2016). The analysis in the Fiscal Monitor (April 2016) found that both direct subsidies and indirect tax incentives increase firms’ productivity, but tax incentives have a large effect in high R&D industries and for small firms. Tax allowances to venture capitalists or start-ups also help promote entrepreneurial activities. Increasing private R&D could generate a significant growth dividend. Donselaar and Koopmans (2016) found that by boosting the productivity, an increase of 10 percent in private R&D for a representative advanced economy could boost the level of GDP by 1.3 percent over the long term.

12. The tax incentives should be properly designed and effectively administered to yield the most value. 29 out of 35 OECD members and 22 out of 28 EU member states gave preferential tax treatment to R&D expenditures in 2016. The wider use of tax incentives in recent years has highlighted the importance of design to maximize the overall effectiveness. The Fiscal Monitor (April 2016) summarized a few key lessons. First, targeting new firms is more effective in promoting entrepreneurship than size-based incentives. Second, loss-making start-ups would benefit from refundable tax credits, and relief from labor taxes rather than tax credit before making profits. Third, measures targeting incremental R&D can be cheaper than broad-based tax incentives, but they are more complex and have higher compliance costs. Fourth, intellectual property (IP) box regimes have been proven less cost-effective to promote innovation. Fifth, a gradual phase-in of tax incentives in pace with educational advancement is preferable to prevent wage inflation led by excess demand for high-specialty labor. Lastly, a well-designed tax incentive system should be supported by effective administration to ensure compliance rates.

13. The Norwegian government expanded the R&D tax incentives in recent years. Norway’s tax incentives compared favorably to other Nordic countries, but much less so as a percentage of GDP than major advanced OECD countries, such as US, Canada, Netherlands, and the UK (Figure 3). The Skattefunn research and development (R&D) tax incentive scheme, a government policy tool to offer tax deductions to all Norwegian companies or branches with R&D projects, has expanded the tax incentives in recent years.

Figure 3:
Figure 3:

Government Support for R&D

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

Note: B-Index = before-tax income needed to break even on one dollar of R&D outlay; BERD = business expenditures on research and development

14. While Norway’s tax incentives are generally well-designed, further adjustment may help improve their effectiveness. Empirical studies find that tax incentives targeting new firms and start-ups are more effective in raising R&D investment, whereas size-differentiated tax incentives could restrain firms from growing. Norway’s overall fiscal support on R&D is not high by international standard, but the preferential tax treatment to SMEs is more generous than the peers. Like Norway, France, Canada, the UK, Chile, Netherlands, Australia, and Japan also give a more generous rate of tax credit to smaller firms; while in other countries (Belgium, France, Italy, the Netherlands and Portugal), preferential tax treatments are given to the young and start-ups. Tax allowances to venture capitalists or start-ups may be considered to help encourage entrepreneurial activities.

15. Lowering the net wealth tax and reducing tax preferences on housing assets could help stimulate savings and reallocate investments to the business sector. The net wealth tax implies a very high effective tax rate for savings. Based on the latest calculation by the Ministry of Finance, a 0.85 percent tax on the household net wealth suggests the effective tax rate on real income from interest-bearing assets and shares of 87%. The net wealth tax also distorts investments away from business activity to residential property due to the discounted valuation on primary residences (25%). The government has been gradually lowering the net wealth taxes in recent years. The rate has been reduced from 1.1 per cent in 2013 to 0.85 percent, and the tax-free allowance has been increased from NOK 870,000 in 2013 to NOK 1.48 million. The taxable values of second dwellings have been increased from 50 to 90 percent3 of estimated market value, and the taxable values of recreational properties have been increased by 10 percent to ensure more equal treatment across investment types. A valuation discount of 10 percent on shares and operating assets and associated debt was introduced in 2017. This is to be increased to 20 percent in 2018, in line with the Parliamentary agreement on tax reforms. Continued reduction of the net wealth tax and more equal valuation discounts applied for different investment assets, for example lowering valuation discounts for primary dwellings, would further improve savings and channel more investments to the productive investment.

16. Protecting the tax base against profit shifting practices is vital. Norway has adopted key anti-avoidance measures, but there is room for improvement. In 2014, Norway adopted an anti-avoidance rule to address earning stripping by means of intra-company loans by denying interest deductibility if the ratio of interest payments to EBITDA exceeds 25 percent. The design of this rule, however, is not ideal and its application is complex as it applies only to intra-company loans. The rule could be improved by applying it to all net interest payments in line with the OECD BEPS project and the recent EU directive on anti-tax avoidance.4 Further, Norway does not impose withholding taxes on interest payment, royalties, and lease payments in its domestic law. It could consider introducing withholding taxes on cross-border royalties and interest5.

D. Improving Labor Supply

17. The tax reform has narrowed the labor tax wedge further, which should stimulate labor supply. Norway’s average labor tax wedge was comparable to other OECD countries prior to the reform (Figure 4). The government decided to lower ordinary personal income taxes in line with corporate income taxes to prevent the shifting of tax base from labor to capital income, which also contributed to further narrowing the labor tax wedge.

Figure 4:
Figure 4:

Labor Tax Wedge: By Family Type and Over Time

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

18. However, the average tax wedge for certain groups remains high, undermining work incentives. While single workers’ tax wedges are close to OECD averages, regardless of the income levels, one-income-earner-families with children are subject to higher tax wedges6 than similar families in an average OECD country. While the tax wedge on one-income-families with children is falling in other Nordic countries and many OECD countries, it has risen in Norway. Higher wedges can be attributed to both higher income tax rates and more generous benefit systems7. Indeed, Norway’s social security and unemployment benefits are found to be more generous than an average OECD or EU country. This is true for all family types, but more so for family with children. For example, the marginal effective tax rate to transition from being unemployed while receiving social security benefits to full employment was as high as 98 percent of gross labor income for one-income family with children, much higher than the OECD and EU averages around 70 percent (Figure 5).

Figure 5:
Figure 5:

Marginal Effective Tax Rates to Transition to Full Time Employment

(Percent, 2014)

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

Source: OECD Database

19. Income tax policies need to be complemented by well-targeted reform of the benefit system to reactivate the work incentive for certain groups. Norway’s disability rate is one of the highest among the Nordics thanks to the generous disability system. Some changes have been made on the calculation of disability benefit, but further reforms to increased employment rate among disabled are pending. The tax system does not explicitly penalize two-earner households, but its progressiveness can nonetheless create disincentive for women to work given wage gaps relative to male workers8. Providing alternative child care options for children under age two could increase caregivers’ availability to work.9

E. Broadening the VAT Tax Base

20. Norway has one of the highest standard VAT rates in the EU, but collection performance is somewhat lower. At 25 percent, Norway’s standard VAT rate is the second highest in the EU, the same as Sweden and Denmark. But the C-efficiency10, an indicator of the departure of the VAT from a perfectly enforced tax levied at a uniform rate on all consumption, is somewhat lower than some other Nordic countries (Figure 6). This can be due to a relatively more complex VAT system with multiple reduced rates11 and exemptions, and efficiency of the tax administration system.

Figure 6:
Figure 6:

VAT Rates and Collection Efficiency

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

21. The government has taken steps to broaden the tax base. A new tax on financial activities—which are currently exempt from value added tax—was introduced on January 1, 2017. The value added consists of the sum of wages and profits. The tax on wages will be set at 5 per cent of gross salaries paid; and the corporate tax rate for financial undertakings will be kept at the 2016 level. Accordingly, financial undertakings will not be included in the general reduction in tax on ordinary income. Profits from financial undertakings will then be taxed 1 percent higher than others. The 2016 budget also incorporates an increase of the low rate from 8 percent to 10 percent.

22. To broaden the tax base further, the government could consider reducing the exemptions and unifying the reduced rates. The government may reconsider the previous proposal by the Tax Commission for a dual-rate value added tax system, in which the standard rate of 25 per cent can be retained but the current zero rate on domestic sales and the lowest rate of 10 percent increased to 15 per cent, corresponding to the current rate on food.

F. Lowering Household Debt Bias and Housing Market Vulnerability

23. Various tax instruments have important implications for household leverage and housing market stability. While the tax deductibility of mortgage interest provides incentives for higher household leverage (IMF Policy Paper, 2016), taxes on imputed rent or capital gains, transaction taxes, or recurrent property taxes are designed to reduce bias towards home-ownership and risks of excessive house price appreciation. While the effectiveness of using transactions taxes to reduce the risk of erratic house-price developments shows mixed success, new evidence finds that recurrent property taxes curb house-price volatility, adding to their attractiveness as a fair and efficient revenue source. A fully neutral taxation of owner-occupied housing would require full taxation of imputed rents and capital gains on housing, combined with mortgage interest deductibility. In practice, however, imputed rents and capital gains on primary residences are rarely taxed, creating a general bias toward housing, which is reinforced by the mortgage interest relief where it exists.

24. Mortgage interest deductibility in Norway favors household leverage. Tax deductibility of mortgage interest is widespread among AEs and EMs. But the design and coverage differs across countries. The design in Norway is more generous than the peers. While Sweden applies deduction of 30 % of interest up until 100 000 SEK (€10,438), and 21 % over that amount, Norway considers any interest paid, for a home mortgage as a deductible expense (Table 2). In recent years, several countries have taken steps to put restrictions on this deductibility: Ireland and Spain have eliminated mortgage interest deductibility on new loans, while Denmark and the Netherlands are gradually reducing them (IMF Cross-Country Report, 2015).

Table 2.

Current Mortgage Interest Deductibility from Personal Income Taxes

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Sources: National tax and other authorities; Bourassa et al. (2013); Smidova (2016).

25. Low property taxes provide an additional incentive for house ownership. Compared to peer countries, recurring tax on housing ownership is relatively low in Norway. There are two types of recurrent taxes on residential property: net wealth tax and property tax. A wealth tax is imposed on real estate property at the national and municipal levels. A flat rate of 0.85 percent is levied on the assessed value of the property, which is much lower than the market value, especially for the primary residence (75 percent discount)12. With the tax being levied only on net wealth exceeding a certain threshold NOK 1.48 million (€158,000), only 11 percent of the tax payers are paying the net wealth tax. Property tax rates range from 0.2 percent to 0.7 percent, depending on the municipalities. The rate is not necessarily low by international comparison (Table 3), but the collection rate is low, which can be attributed to discounted assessed value, basic allowances, and partial participation from municipalities13.

Table 3.

Residential Recurrent Property Taxes

article image
Sources: National Authorities, Deloitte
uA02fig01

Recurrant taxes on residential property

(in percent of GDP)

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

Sources: OECD Revenue Database

26. The recent change to the net wealth tax is welcome, but further reform is needed to reduce tax preferences on housing. Norway may consider reassessing policy tools such as mortgage interest deductibility, imputed rents on owner-occupied housing, and property taxes, for example by lowering the cap on mortgage interest deduction, applying deductibility only to first mortgages on primary residences, increasing property tax rates, better aligning tax charges with market values of properties, updating assessed value more frequently, etc. Reforming mortgage interest deductibility requires a cautious and gradual approach as house prices can respond rapidly with consequent risks to macroeconomic stability. The current low interest rate environment is a great opportunity for Norway to act ahead of curve before higher interest rates pose additional debt burden on mortgage holders.

G. Other Considerations

Corporate Debt Bias

27. Corporate debt bias remains a financial stability concern for many countries. A common corporate income tax system allows deduction on interest expense from debt financing while the same allowance for equity financing is not granted, which leads to preference for debt financing, called “debt bias”. This debt bias raised concerns for financial stability as financial and non-financial firms with higher corporate leverage are vulnerable to credit crunch or business cycle downturns (IMF Policy Paper, 2016). This effect can be partially offset by the personal income taxes. However, a significant share of investment is sheltered from PIT, such as those by institutional investors who mainly pay CITs, and foreign investors who are usually not subject to PITs in the host country.

Figure 7:
Figure 7:

Effective Marginal Tax Rates for Debt vs. Equity

Citation: IMF Staff Country Reports 2017, 181; 10.5089/9781484306659.002.A002

28. An allowance for corporate equity (ACE) is one option to address the corporate debt bias. Under a well-designed ACE system, debt bias is eliminated as a notional return on equity is deducted from taxable income. This implies that the “normal” return to investment is not taxed; only abnormal returns (“economic rent”) are taxed. Several advanced economies, including Belgium and Italy, have used variants of this scheme without major implementation problems. The evidence suggests that the ACE has considerably lowered corporate debt (Hebous and Ruf, 2017; De Mooij and Keen, 2016). Some studies found a positive impact on private investment in Belgium (e.g., Ausdem Moore, 2014). The budgetary cost of the ACE can be mitigated by granting the allowance for only incremental equity (i.e., only to new equity compared to a reference year).

Environmental Taxes

29. The government has carried out a shift more towards environmentally-friendly taxes. Energy and environmentally-related taxes have increased in real terms by 5.5 NOK billion since 2013. The 2017 budget included a green tax shift as a part of the follow-up on the Green Tax Commission with higher taxes on greenhouse gas emissions and fuel use, and tax relief to low/zero emission motorists and transport providers (e.g. reduced motor vehicle taxes, reduced road tolls, and increased travel allowances). Norway’s environmental tax collection is currently higher than the OECD average, but the shift towards more ambitious target is welcome as it helps lower the social costs and broaden the tax base to compensate the revenue loss from the income tax reductions.

References

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1

Prepared by Yuanyan Sophia Zhang

2

Subject to large fluctuation due to volatile oil prices.

3

The parliament modified the Government’s 2017 tax proposal in the revised budget by increasing the valuation of secondary dwellings and associated debt for net wealth tax to 90 percent (from 80 percent).

4

The Ministry of Finance issued a discussion paper with an amendment to the 2014 interest deduction limitation rule in May 2017. The proposed new rules include limitation also on third party interest and a debt-to-equity ratio escape clause. The new rules are proposed to be implemented in 2018.

5

Such withholding taxes has been proposed by the government as part of the 2016–2018 tax reform, but implementation of such taxes has not yet been proposed in the annual budgets.

6

Average wage tax wedge.

7

Introduced higher tax allowance for married taxpayers that provide for a spouse that has no or little income.

8

There is a higher tax allowance for married couples where second earner has no or little income.

9

It could also underpin women’s participation in professional activities, where longer absences can carry implicit penalties with regards to career progression.

10

C-Efficiency is calculated as the VAT rate times the ratio of VAT revenue to Final Consumption minus VAT Revenue

11

15 percent on food stuffs, 10 percent on transport and zero percent on magazines, cultural activities.

12

No primary dwelling has a taxable value higher than the market value. Secondary dwellings and commercial properties have valuation discounts of 10 percent and 20 percent respectively.

13

Discounts on assessed value (either follow estimated value from the wealth tax system or own assessment) and basic allowances (0–4 million NOK) vary by municipalities. As of 2016, 270 of 428 the municipalities had introduced recurrent tax on residential properties.

Norway: Selected Issues
Author: International Monetary Fund. European Dept.