Taxation and Inequality: Empirical Developments 1980-2013
In the following we present some empirical evidence to gauge how the liberalization of capital markets has affected economic inequality. We first look at overall OECD developments and show how tax rates, tax revenues and the tax mix changed with the start of tax competition at the end of the 1980s. We then turn to four case studies—Britain, France, Denmark and Ireland—to point out what the literature to date has often ignored: the diversity in tax policy reactions and associated inequality developments across advanced democracies.
Common OECD Developments 1980-2013
Figure 5.2 illustrates that taxation in advanced democracies has undergone some considerable changes since the 1980s. The average OECD top corporate income tax rate dropped by about half from 43 to 25 per cent, and the top personal income tax rate was reduced from 58 to 40 per cent. This finding is in line with the efficiency school, which argues that governments engage in competitive tax cuts for capital owners and high-income earners while they increase taxes for less mobile tax bases through such mechanisms as the value added tax (VAT). In fact, the VAT rate almost doubled from 10 to 18 per cent in the period under investigation. Thus, Fig. 5.2 provides the evidence protagonists of the efficiency school often cite: tax competition has circumscribed the capacity of the nation-state to adhere to the principles of vertical equity. Accordingly, the tax burden has shifted: low- and middle-income classes are paying more while capital owners and high-income earners are taxed less. Inequality is
Fig. 5.2 Development of average OECD top tax rates since 1980. Source: OECD Tax Database (2014)
growing. However, looking at the tax mix rather than the tax rates makes the picture more complex.
Figure 5.2 suggests that globalization has affected vertical equity as it shows that, on the one hand, the top tax rates for corporate and personal income taxes, which are the most progressive forms of taxation, have continuously been cut since the 1980s. On the other hand, VAT, which is a more regressive form of taxation, has been on the rise. While the development of top tax rates suggests that globalization has increased inequality, Fig. 5.3 provides mixed support for this finding. With regards to consumption taxes, we find that the amount of revenue generated from VAT has steadily increased since the 1980s. Yet, this rise has been accompanied by a revenue drop from other goods and services taxes such as the general consumption tax and excises. Therefore, we cannot observe a general increase in the significance of regressive consumption
Fig. 5.3 Average OECD revenue mix since the 1980s. Source: OECD Tax Revenue Database (2014)
taxes in the OECD. Yet, there has been a shift in the revenue contribution from income taxes and social security. While the revenue from personal income taxes has decreased by about 6 percentage points, corporate income tax and SSCs have gained slightly in importance by about 1 and 5 percentage points, respectively. The steady revenue from corporate income taxes despite the reduction in the top tax rate is due to a number of factors. First, corporate tax rate reductions were generally compensated with base broadening (Ganghof 2000, 2006). Second, higher corporate incomes as well as an increase in investments can offset the lost revenue from tax rate cuts (Ganghof and Genschel 2008). Third, governments have tried to combat international tax avoidance and evasion with legal and administrative measures, potentially shutting out tax competition (Ganghof 2000).
The most significant change in the period under observation is the shift from personal income taxes to social security contributions. While revenue from personal incomes has decreased from about 30 to 25 per cent, average revenue from SSCs has increased by about 5 percentage points. Generally, the personal income tax is the most progressive tax in the OECD despite significant cross-country variations, while in most countries SSCs tend to be regressive (Joumard et al. 2012). The progressivity of SSCs has increased in the majority of OECD countries as they have been cut for low-income earners or for groups at high unemployment risk (Joumard et al. 2012). Yet, the main characteristic of SSCs has remained, that is, they redistribute over the lifetime of one individual rather than across individuals. In short, Fig. 5.3 cannot confirm that a shift has taken place from direct to indirect sources of tax revenue but illustrates instead a shift from tax- to contribution-financed revenue systems.
Our evidence from the development of tax revenues and tax rates since the 1980s provides a mixed picture of the effect of tax competition on vertical equity and inequality. While tax rates for capital and high-i ncome earners have dropped and VAT rates have increased, the revenue mix across direct and indirect taxes has not changed. Moreover, merely looking at the overall revenue from personal income tax obscures whether the tax burden has changed for low-, middle- or high-income earners. Considering statistics for the tax wedge of average production workers in the OECD (2014), we find that the tax burden has even been reduced by a few percentage points. As such, the often-discussed effect of tax competition on inequality between the poor and the rich is less obvious than the literature often implies.
Although the scholarly literature gives utmost attention to vertical equity in the context of tax competition, it also seems crucial to consider the effects of tax competition on horizontal and international equity. With regard to horizontal equity, we find that most governments taxed corporate and personal incomes under the same law until the mid-twentieth century. Yet, with the beginnings of tax competition, competitive capital tax rate cuts brought about a gap between the two. Most governments today apply a lower tax rate for capital than for labour income.
For instance, in 1985 the Danish government introduced a dual income tax, with capital income being subjected to a uniform proportional tax rate of 50 per cent, while wage income was taxed progressively at a higher top rate of 68 per cent (Ganghof 2005). Recently, some governments, particularly in Eastern Europe, have reversed this trend by introducing a flat income tax, which provides a uniform rate for capital and labour income. However, this reversal was done at the cost of abolishing the progressivity of the personal income tax and thus with potential negative redistributive effects (Appel 2014, 2011). Moreover, some countries, such as the Netherlands, introduced certain tax incentives to attract high-skilled workers from abroad by providing considerable tax reductions. Hence, the opening of capital markets has not only led to potential redistributive implications between different levels of income, it has also done so between different sources of income. Horizontal equity has increasingly been breached.
Finally, tax competition almost by definition breaches international equity and affects the international distribution of income, particularly between small and large countries. Models of asymmetric tax competition suggest that small countries have an advantage over large ones (see the literature review). By having lower capital taxes than their large neighbours, small states such as Switzerland or Ireland can lure international investments. Figure 5.2 illustrates this phenomenon by drawing the tax rates weighted and unweighted by population. It shows that once we weigh the average OECD tax rates by population size, thus giving more weight to the big countries, the downward trend is slower. In other words, small countries tend to have lower capital tax rates. International capital flows lead to a more flourishing economy from which people without capital income also gain via increased employment opportunities and higher wages. This finding suggests that tax competition has an effect on world income distribution—even pre-taxes. Whether it lowers or increases income inequality depends on the distribution of income before tax competition.
In sum, our discussion of average OECD trends reveals a complex and mixed picture: we find that, while they have increased indirect tax rates, governments have lowered their top income tax rates and introduced a different and often lower tax rate for capital than for labour. In line with this trend, we find that the revenue share from income taxes has declined since the 1980s, while the importance of SSCs has increased. These changes have had a regressive effect. Yet, despite an increased VAT rate, the income from consumption taxes has remained stable, which suggests that, instead of a general shift towards this form of revenue, a shift within the category has taken place. Moreover, we could not find evidence that the tax burden for the average production worker has increased since the
1980s. In fact, the data show a slight downward trend. Although low- income earners today have a lower tax burden than they did in the 1980s, it is possible that the tax burden on high-income earners has dropped by even more. In summary, the data show that the effect of tax competition on inequality is much more nuanced than is often assumed. Some tax reforms might lead to more vertical equality while simultaneously hurting horizontal or international equality. At the same time, the international dimension already points to an important distinction: even within advanced democracies, countries are very heterogeneous when it comes to tax policy and inequality. We will discuss this national diversity in the remaining part of the chapter.
-  The reader will note that minor changes can always be due to changes in the business cycle ratherthan active policy changes.
-  The tax burden has decreased not only for the average production worker but also for those earning 67 per cent and those earning 167 per cent of the average worker—with and withoutchildren.