The income taxes people really pay
When comparing different tax systems, most people tend to look at top rates of personal income taxes imposed by central government. However, concentrating on these ‘headline’ rates can be misleading. In the first of a two part series, Flip de Kam and Chiara Bronchi explain why.
In all OECD countries central government levies a tax on personal income. The rate structure of these income taxes shows wide variation. Our focus here is on top marginal rates, that is the highest percentage of tax imposed on every additional dollar, yen, deutsche mark or franc earned above standard taxable income levels. Most studies compare only the top rates of personal income tax imposed by -central government. However, 22 out of the 29 OECD countries also levy other taxes on personal income. Consequently, any cross-country study of tax systems that does not take into account the combined rate of all taxes on personal income will not grasp how top income taxes in the OECD area really look.
The fundamental structure of personal income tax systems imposed by central governments is very similar in every OECD country. A certain amount of income may be exempted from tax. That’s the ‘personal exemption’ – also known as personal allowance. In some countries, the first slice of income is not exempted, but is taxed at zero per cent instead. This zero band has the same effect as a personal exemption. An alternative system is to tax all income, and give all taxpayers a reduction in their tax bill in the form of a ‘basic tax credit’.
Even if the fundamental structure of income taxes from country to country is broadly the same, the tax bill for taxpayers in more or less the same position may be quite different. One major reason is that different countries provide different tax relief to their citizens. Expressed as a percentage of the gross wage of an average production worker, Greece exempts only 3% of the average worker’s wage, Korea 7%, the Netherlands 14%, France 20%, and the United Kingdom and the United States offer relief to the tune of 24% of the average wage. The average production worker in Sweden pays no income tax at all to the central government. This is because the tax allowance is a tenth higher than his or her wage.
With the exception of Germany, which applies several tax formulae, income in excess of the personal exemption or zero-rated band is divided up into brackets. The number of brackets -varies significantly; Sweden has one tax bracket, Iceland and Ireland have two, while Luxembourg, Mexico, Spain and Switzerland each have eight or more. All of the taxable income within a bracket is taxed at the same rate. The rate applied to the income in successive brackets increases. The result is a progressive tax: as total taxable income rises, a growing share of it goes – at least in principle – to the taxman.
Under a progressive system, tax relief is determined by the marginal rate applicable to the highest unit of income. So, as earners move into higher tax brackets, their tax relief actually rises in value. In other words, personal allowances and the value of the zero band go up, rather than down. In contrast, the value of tax credits is independent of the taxpayer’s income level (see box). In 1998, nine countries used -basic tax credits: Austria, Canada, Hungary, Iceland, Italy, Mexico, New Zealand, -Poland and Portugal.
How progressive a given rate sche-dule depends not only on the amount of basic tax relief, but also on the width (or length) of the tax brackets, and the marginal rates applied to the income in each bracket. And income tax brackets certainly vary in size, while income taxes exhibit a remarkable -variety of marginal rates, reflecting national views on what constitutes an equitable distribution of the tax -burden.
Top marginal rates of personal income tax levied by central government range from 25% in Sweden and 33% in New Zealand to as much as 60% in the Netherlands. In Ireland and New Zealand, taxpayers at the income level of an average production worker are -already exposed to the top marginal rate of 48% and 33% respectively. In Austria, Belgium, Canada, Finland, France, Germany, the Netherlands and the United Kingdom workers must earn about twice the average before they start paying the top rate.
On the other hand, Swiss and US employees are not confronted by the top rate unless their salaries reach ten times the average production worker’s wage. In Turkey the top rate does not kick in until taxable income is 29 times the average wage and more. The table summarises the rate structure of the personal income tax levied by central governments in all OECD countries.
Before drawing any firm conclusions from this panoply of income tax sche-dules, three points should be borne in mind. First, the actual tax bill of individual taxpayers also reflects the impact of various deductions – for example, for mortgage interest and employee contributions to occupational pension plans – and exemptions – for example for capital gains or interest received.
That means that effective tax rates in countries with lower statutory rates but little in the way of basic relief, deductions and exemptions, could well be higher than effective rates in countries which combine higher statutory rates with much more generous exemptions and deduct-ions. The second point is one we made at the start, namely that in most OECD countries there are other taxes to pay on income, beyond that owed to central government. Finally, tax systems are often characterised by minor peculiarities, which while perhaps complicating matters slightly, do not have a major bearing on the general picture we have outlined here.
Jacking up the tax bill
For several reasons, taxpayers in most OECD countries are often confronted by higher marginal rates than suggested by regularly cited headline or ‘standard’ rates of the personal income tax shown in the table. Central govern-ments sometimes impose temporary increases on the income tax, such as the austerity surcharge in Belgium and the German solidarity tax. Such surcharges jack up the total income tax bill.
Also, income earners may have to pay local, regional, provincial or state income taxes on top of the central government income tax. This is the case in Belgium, Canada, Iceland, Japan, Korea, the Nordic countries, Spain, Switzerland and the United States. In a few OECD countries local and regional income taxes are quite significant. In Sweden the typical top rate of provincial and local income taxes is 31.7%, which means it exceeds the 25% income tax rate levied by central government. In some countries, state, regional or local income taxes paid constitute a deductible item, inasmuch as the amount paid in such taxes may be deducted when calcula-ting taxable income for the central government income tax. For the pre-sentation of -‘all-in’ tax rates in the graph, the deductibility of non-central government income taxes has been taken into account.
Is it all tax?
Another feature to watch out for, particularly in Europe, is the tax some national governments impose on income on behalf of the state church. Austria, Germany, the Nordic countries and Switzerland all have such a church tax, though in the chart it is included only in the cases of Denmark and Switzerland. One may ask whether the church tax really is a ‘tax’ as defined by international organisations: a compulsory, unrequited payment to general government. Here, ‘unrequited’ means that benefits provided by government to taxpayers are not normally in proportion to their payments.
Likewise, it is sometimes difficult to define the status of social security contributions – are they really taxes or are they payments for some form of -social protection? In part, the answer depends on the degree to which these payments are directly linked to the value of the benefits they offer. Social security programmes come in two -basic forms. In some the revenue is earmarked to finance programmes that essentially cover the whole population. Here, the tax base may be identical to – or closely resemble – that for personal income tax. However, in contrast to the rate structure of the income tax, a ceiling or ‘cap’ often applies and income above that ceiling is not subject to further contributions.
In addition to programmes covering the whole population, most European countries run social insurance programmes which only protect workers, or at least sections of them. The tax base to finance such employee social insurances is wage income, usually up to a ceiling, which in turn is related to the maximum amount of wages insured against the risks of unemployment and disability. Furthermore, in a few instances such payments can be made into individual accounts, such as pension plans, the relatively strong tie between contributions and benefits making them even less ‘tax-like’.
Of course, when considering top marginal rates, social security contributions are only relevant if they are not capped. Contributions – where they are imposed – are usually deductible for personal income tax purposes, though this is not the case, for ex-ample, in Hungary, Norway and the United Kingdom. When calculating marginal ‘all-in’ rates, the OECD takes the deductibility of social security contributions into account.
Since the income tax and social contributions are quite similar in terms of the tax base they use and of their economic impacts, both are included in the calculations underlying the chart which compares the ‘standard’ top rate of central government personal income tax with ‘all-in’ top rates. These include the combined effect of temporary increases of the central government income tax, income taxes at -local, regional and state levels, the church tax and employee social security contributions.
Not included here are social security contributions directly paid by employers, even though these may eventually be borne by -labour through tighter wage deals. Conversely, when labour is much in demand, employees may be able to shift part of their income taxes and employee contributions back onto employers by successfully demanding additional wage increases. That said, this article only considers statutory rates of taxes, which the law requires employees to pay.
Closer than you think
So where does our analysis of ‘all-in’ tax rates lead? One lesson is that the gaps at the margin between top income earners domiciled in various OECD countries are narrower than often imagined and certainly not as wide as the headline rates show. In fact, the marginal top rate in most countries rises substantially when considering the all-in rate of taxes on income, to 61% in France and Turkey, 62% in Denmark and Sweden, 65% in Japan and 66% in Belgium. The highest all-in rates for taxpayers in the United States fall in the 40–48% range, depending on the State where they are resident.
That puts the gap with their counterparts in Sweden, which most people would see as the quintessential welfare state, in some cases at as low as nine percentage points. But before European countries gain too much confidence from this, US income earners can point out that taxpayers in Sweden and most other OECD countries in Europe move into top rate brackets at much lower income levels than they do.
©OECD Observer No 216, March 1999
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