The tax system plays a crucial role in modern economies: it impacts on a range of macro and microeconomic variables by means of many different effects (direct and indirect via incentives) and has far-reaching socio-political implications. That is why there has always been a constant debate on how to configure taxes, although in the last few years this had been relegated to the background behind the financial crisis and monetary and fiscal policy. Now, as the crisis gradually abates, the need to revise the tax system is becoming evident in several countries, although the key points in this discussion vary according to the circumstances of each state.
In the USA, where the recovery seems to be firmly on track, the main issue is to what extent taxation should help to redistribute personal income, followed by how corporate tax should treat the profits made by large multinationals abroad. In Japan, whose level of public debt is very high, the crux of the discussion centres on indirect tax hikes as the best way to increase revenue. Across Europe, the key issues are the harmonisation of bases for certain taxes (such as VAT and corporate tax), coordinating the fight against tax evasion (tax havens), as well as the implementation of taxes to correct certain market faults (such as those related to energy and financial transactions). In Spain, a comprehensive in-depth reform of the tax system is required given the serious dysfunctions that have become evident during the crisis, as well as needs resulting from growing European integration and Spain's territorial structure (organized into autonomous communities and local administrations). The European Commission has identified this need, urging the government to present a reform proposal early in 2014. The challenge is considerable given the trade-offs between the different objectives such a reform must pursue. In particular, it is highly appropriate to ensure that the traditional long-term objectives (regarding the efficiency and fairness of the system as a whole, potentially conflictive per se) are compatible with the short-term objectives (increasing revenue at the same time as stimulating economic growth). A brief review of the main conclusions provided by tax theory and the experience of other countries could provide useful points of reference in this case.
As in many other areas of economics, tax theory is not without controversy, especially when the analysis shifts towards the normative («what it should be») from the merely positive («what it is»). However, a conventional consensus that has gradually taken shape offers valuable conclusions.(1) The starting point is to identify the tax system's justifications and basic propositions: collecting enough funds for the state to pay for public services and meet other costs, to correct market faults (such as externalities) and redistribute income and wealth according to collective preferences regarding social fairness. Given this approach, the theory provides some recommendations to be borne in mind when designing the tax system (in the broad sense of including social security contributions, duties, etc.) for a developed, open economy such as Spain's. First: to adopt a comprehensive view of the system with a general strategy aimed at the long term while also leaving space for occasional short-term adjustments; the design must take into account not only how different taxes interact with each other but also how they interact with public spending programmes (for example, unemployment benefit) to make them complementary and avoid inconsistencies. Second: to avoid uncertainty, insecurity, arbitrariness and unnecessary complexity. Third: to anticipate agents' reactions (shifting, avoidance, evasion, etc.), such as realizing that the free movement of capital affects the possibilities for taxation at a national level. Fourth: to preserve neutrality regarding agents' decisions, unless there are justified and explicit reasons for the contrary. In this respect, indirect taxes are more neutral than direct taxes. Fifth: to aim to (gradually) redistribute wealth while encroaching as little as possible on efficiency. To this end it is preferable, in general terms, for taxation to work via personal income tax rates together with social spending programmes and not via deductions, exemptions or distortions to the taxable base. It is crucial, on the other hand, to suitably adjust income tax so as not to discourage work or business initiative.
Although the tax systems of the main developed countries have notable differences, it is quite remarkable that the reforms carried out over the last three decades have been in line with the guidelines of optimum tax theory. One notable milestone was the Reagan Administration's Tax Reform Act in the USA in 1986, which simplified the US tax system, broadened taxable bases by eliminating exemptions and lowered tax rates. Several developed countries have followed suit and implemented reforms along these lines, as is the case of the member states of the euro area. As can be seen in the graph above, direct tax rates for euro area countries have fallen significantly. Between 1995 and 2010, both the highest bracket for personal income tax and particularly the statutory corporate tax rate fell significantly (by 5.9 and 11.4 percentage points respectively). This has partly been offset by an increase in indirect taxation, principally on consumption by raising the standard VAT rate. In turn, this higher tax on consumption has been accompanied by broader taxable bases and the simplification of the system as a whole (for example, in Spain the number of income tax brackets fell from 34 in 1983 to 4 in 2006). However, the recent outbreak of the economic crisis has temporarily brought this trend to a halt. The need to sort out national accounts has forced a large number of European countries, and more specifically those on the periphery, to increase fiscal pressure with almost widespread hikes in all tax areas (although, once again, with a greater relative impact on indirect taxes). The Spanish case is no exception. These different fiscal consolidation measures helped to boost tax revenue by 1.4 percentage points between 2009 and 2012, to 33.5% of GDP. But this is not enough and the whole system needs to be revised. The reform being developed provides, therefore, the opportunity to advance towards a tax system that ensures national accounts are efficient and fair but also sustainable in the medium and long term. In the short term, moreover, it would also be useful for the new system to help reactivate economic growth.
There are two lines of action that could be used to achieve this dual aim: the so-called «fiscal devaluation» and by increasing the taxable bases for the main taxes. The former includes tax measures that reduce labour costs (generally by cutting social security contributions) in exchange for increasing taxation on consumption. Implementing this measure stimulates economic growth due to its positive effect on external competitiveness. Moreover, given that Spain is one of the euro area countries that taxes consumption the least, there is room for further tax hikes. But such an increase in tax revenue should not be achieved through tax hikes, with the consequent negative impact on incentives for economic activity. In fact, the second aspect to be treated by tax reform is the broadening of taxable bases by eliminating a large number of the tax deductions and exemptions existing in the current system. Spain's budget calculates that tax benefits will amount to almost 4.0% of GDP in 2013, concentrated mainly in the areas of income tax, VAT and corporate tax. A reduction in such breaks would boost Spain's tax revenue, even with cuts in some relatively high tax rates. This would be the case of the highest income tax bracket which, in some jurisdictions, reaches 56%, one of the highest in the world.
Introducing these aspects into Spain's fiscal reform would boost short-term growth at the same time as making the tax system more efficient. We therefore have an unrivalled opportunity that should not be missed.
Joan Daniel Pina and Avelino Hernández
Research Department, "la Caixa"
(1) See Mirrlees J.A., S. Adam, T. Besley, R. Blundell, S. Bon, R. Chote, M. Gammie, P. Johnson, G. Myles and J. Poterba (eds.) (2011) Tax By Design: The Mirrlees Review. Oxford University Press.