Macroeconomic Effects: Shift To Indirect Tax

Macroeconomic Effects Of A Shift From Direct To Indirect Taxation: A Simulation For 15 Eu Member States

Note presented by the European Commission services (DG TAXUD) at the 72nd meeting of the OECD Working Party No. 2 on Tax Policy Analysis and Tax Statistics, Paris, 14-16 November 2006.

This paper presents a contribution to the discussion on the macroeconomic effects of a shift in taxation from direct to indirect taxes, at an unchanged overall revenue level. Such shift has been receiving increasing attention in policymaking circles, as highlighted not only by a number of proposals but also by the recent decision of the German government to increase VAT by three percentage points and attribute some of the revenue raised to offset cuts in direct taxation and social security contributions.

The paper is organised as follows: section 1 gives an overview of the current situation and trends in the structure of taxation in the EU; section 2 contains a theoretical discussion of the merits of a shift from direct to indirect taxation, on the basis of a survey of some recent economic literature; section 3 contains a scenario analysis, based on the European Commission QUEST model, of what might be the macroeconomic effects from the simultaneous introduction of various tax shift measures in the EU 15; it also discusses whether, amongst OECD members, there is evidence of faster growth in countries having a greater reliance on indirect taxation.

Conclusions

65. The tax shift policy proposals reflect the desire to boost Europe's growth and employment performance. Given the difficulty encountered in many EU countries in financing a cut in the tax burden on labour through an overall expenditure reduction policy, it is currently being debated whether a shift in taxation from direct to indirect taxes might exert a beneficial effect on employment levels and GDP even at unchanged overall revenue levels.

66. Some of the existing economic literature and the simulation presented in this paper, carried out by the services of the Commission services on the QUEST model seem to suggest that such a taxation shift might indeed strengthen economic growth and increase employment. A number of studies examined in this note give similar results, pointing at an order of magnitude of around one quarter of a point in additional annual growth. The paper presents also results from growth regressions cautiously supporting the hypothesis that countries with a higher share of indirect taxation have tended to grow faster in the last decades.

67. It has nevertheless to be pointed out that no consensus exists in the economic profession on the usefulness of tax shifts. A strand of the literature represented notably by Layard-Nickell consider that the burden of indirect taxation is ultimately borne entirely by workers, so that the labour market reaction to the measure would render the shift ineffective in the long term. The reason for the ineffectiveness is directly linked to the unchanged real level of tax burden for workers.

68. Although it is impossible to summarise in a few lines the subtle differences in the models yielding the different results, this highlights the essential nature of the conundrum: whether hiking indirect taxation would be effective in shifting at least partly the tax burden on other taxpayers, i.e. benefit recipients, pensioners, but in particular recipients of capital income. It seems likely that the distribution of national income, the degree of tax avoidance and the specificities in capital taxation play a role in this respect.

69. Another area where country specificities may play a role is the fact that the specific institutional characteristics of the labour market, such as the degree of centralisation of wage bargaining, influence –most likely in the short term but possibly even in the long term- the labour market reaction to a hike or decline in taxes (degree of so-called real wage resistance).

70. Finally, the effect of increasing indirect taxes, particularly in the short term, varies according to the specific tax being increased. This is true in particular with regards to the effect on growth. Therefore, it would be useful to define more precisely what combination of increases would be optimal. In this paper it has been assumed that a VAT hike would constitute the bulk of the increase.

71. Another important issue, which is found to have an important bearing on the effects on growth and employment, is the choice of what direct taxes would be cut (personal income tax, corporate income tax or social contributions) and in which combination. The paper argues that a cut in employers' social security contributions financed by an increase in VAT, possibly complemented by other measures, may be one of the most attractive options in light of the stronger effects on employment and of a more direct impact on production costs, which should lead to more limited increases in the Consumer Price Index.

72. One problematic aspect of the tax shift proposal is that, in practice, it is likely to have substantial redistributive effects. Taxpayers with high incomes would probably benefit substantially, particularly when capital income is taxed within the personal income tax, while medium and low incomes might well face an increase in the tax burden. On the other hand, for the shift to be effective in increasing employment, it must have some positive redistributive effects particularly at the lower end of the wage distribution.

73. Another somewhat problematic consequence of a tax shift is that it would result in a one-off increase in the price level. This could lead to a wage-price spiral, particularly in countries with extensive price and wage indexation, or to negative effects on consumer and saver confidence. Earners of non-indexed income streams such as (long-term non-indexed) bond holders would lose out from the price increase, as would recipients of social security payments in the (not very realistic) hypotheses that these were not fully indexed to the price level. The simulations show clearly that in the case of non-indexation of social security payments, the resulting decline in the overall real burden of taxation would yield a strong positive effect in terms of employment and growth.

74. Finally, a shift to indirect taxation would –while introducing a one-off capital tax on bondholders- implicitly reduce taxation of future savings (assuming that the capital income is taxed within the personal income tax system). This would lead to greater capital accumulation and thereby to a series of effects on productivity; a part of the literature suggests that the effects from this would be dynamic, not static yielding large gains in the long run.

75. Summing up, the proposal to rebalance fiscal policy towards indirect taxation seems unlikely to constitute a panacea, but may in some countries represent a useful element in an overall strategy to improve growth performance, by means of a reduction of the fiscal charge on labour.