I. Background
Any modern tax system is grounded on a compromise of reciprocal exchanges between the State and its citizens. To this extent, taxes are levied and paid as a form of consideration for the provision of public goods and services or, at least, due to a legitimate expectation of such provision by the State. While the most apparent purpose of most taxes is to raise revenue to finance public expenditures, taxes could also be employed to regulate social and economic behavior and to shape the distribution of economic resources, being a key player in economic growth.
Taxes and their specific configuration and weight in the tax mix are essential for the preceding functions.
However, sources of revenue previously deemed stable may need help to rise to the challenge ahead. Trends associated with population dynamics, climate change, globalisation and digitalisation have already impacted – and will continue to do so – the way we live, work, and do business, hence on taxation.
It is very noticeable how our economies and societies are being and will be shaped by such significant trends in the coming years, which will most likely constrain and shape the tax mix of the future:
Digitalisation
Tax rules have traditionally been based on a physical presence (brick-and-mortar), namely the permanent establishment principle. Therefore, taxation has traditionally been linked to where all or part of business activities are physically carried out. This framework of understanding economic activity subject to tax needs to be revised against the background of the digital economy.
Firstly, the fact that a business can be virtually conducted without any physical presence (so-called ‘nexus’) poses one of the leading tax policy challenges, notably establishing the jurisdiction eligible for taxation, which, under the existing rules, is increasingly difficult. On the one hand, digital business models allow for the provision of digital services with a minimal physical presence in a given tax jurisdiction (so-called ‘scale without mass’). On the other hand, assets and activities of digital businesses can easily and quickly move across jurisdictions to avoid a taxable presence in a high-tax jurisdiction. Secondly, the expansion of e-commerce poses difficulties in determining the competent jurisdiction for taxation, with many sellers avoiding registration in third states, where they conclude transactions via platforms. Finally, the role of data and users and the reliance on intangible assets that characterise new digital business models bring into question how and where value is created.
Population dynamics
Two dimensions must be considered: ageing and high mobility.
An ageing society with a shrinking working population faces the inevitable challenge of how the latter can support the expanding group of retirees. The heavy reliance on labour taxes is increasingly unsustainable since revenue from these will inevitably decrease.
Moreover, the widespread practice of remote work, digitalisation of the economy and the gig economy entail changes and challenges to the labour market, posing a threat to the Personal Incoming Tax (PIT) framework. In fact, contrary to what was once the norm, remote working raises the possibility of cases where the jurisdiction in which the employees reside and pay PIT and the jurisdiction in which the employer pays Corporate Income Tax (CIT) are no longer the same. Employees can increasingly choose where to reside, regardless of the employer’s location. This change in the labour market is set to have significant consequences for tax systems, particularly PIT, not only because it might induce a displacement effect on tax revenues, affecting its ability to be a stable source of revenue for national budgets, but also because it could foster tax competition, with countries competing for the same tax base, with consequences beyond tax revenue, namely economic and social ones. In addition, digital nomads are at risk of being tax residents nowhere and may not enjoy the same tax regimes as regularly settled employees.
Globalisation
New digital technologies and intangible assets make factors of production more mobile, moving across borders more freely, and it is, therefore, harder to sustain taxes where the production factors are. Therefore, a significant side effect of globalisation and technological advancement is the erosion of the tax base due to the growing mobility of capital and the consequent international tax competition via policies that reduce tax rates or introduce tax incentives to attract investors and mobile skilled high-income labour.
These trends and the potential loss of revenues they cause merit serious consideration, as taxes are the principal source of revenue that governments use to finance public expenditures that promote economic growth, stability and equitable income distribution. Especially when demand for public goods has risen in the last couple of years, governments face the challenge of financing more significant public expenditures with lower tax revenues. Therefore, governments need to balance goals such as increased revenue mobilisation, sustainable growth, and reduced compliance costs with ensuring that the tax system is fair and equitable.
II. Changing the tax mix
The aforementioned trends have boosted a debate about whether tax rules and the tax mix are fit for purpose. As a result, tax policy options currently on the table involve a change in the tax mix aimed at delivering at least the same amount of tax revenue to the governments. Preferably, one that could be more conducive to economic growth, fairer to those less affluent, more difficult to avoid and easier to understand, hence to comply with and administer.
In affluent countries, the principal sources of government revenues tend to be social contributions made directly by or on behalf of employees, taxes on Income (personal or corporate, for example) and consumption. Although the answer to what could be an optimal tax mix has yet to be settled, there are good reasons for the coexistence of different forms of taxation, as they address the economic policy objectives of efficiency and redistribution in different ways.
The current debate tends to lean towards shifting taxes from income to consumption, such as the Value Added Tax (VAT). However, the general idea and specific examples for moving the tax mix from income to consumption have been around for many decades, in both the academic literature and in reports and recommendations from international organisations, including the OECD, the IMF and the European Commission. Moreover, shifting taxes from income to consumption has been accompanied by the recommendation to do so in a revenue-neutral way, meaning by increasing revenues for an equal amount from other tax bases.
The merits of a heavier reliance on consumption taxes can be underpinned by different perspectives: economic growth, labour and revenue.
The role of tax policy as a means for fostering growth has regained attention in the last few years. Although the role of taxation, namely on economic growth, should not be overemphasised, economic theory and literature delivered some indications for why a shift from income to consumption taxation might be favourable in efficiency terms (promoting growth and employment): because of higher incentives to participate in the labour market due to lower marginal tax rates on labour income. On this basis, shifting from income taxes and social contributions towards consumption taxes could release new and unused productive capability by stimulating labour supply and demand since the burden to employees and employers would be lower.
On the other hand, tax-wise, the consumption tax base is broader, as it includes, among others, pensioners, beneficiaries, and capital-income earners. As such, it is tendentially non-discriminatory, as virtually everyone (workers or non-workers) pays consumption taxes. Moreover, as more elderly people retire and the working population shrinks, which will place increasing demands on government spending, the tax burden will have to shift to consumption taxes, which are a more robust revenue source in an ageing society. Therefore, by broadening the tax base, consumption taxes may allow for obtaining the same revenue by applying a lower rate.
On top, relying on the consumption tax is a robust option for a stable source of income in a globalised and highly mobilised environment since consumption taxes are levied where products are consumed. The rates applied are those of the country of final consumption, and the entire revenue accrues to that country’s budget. Presumably, for a consumption tax, the tax residence of the consumer is irrelevant. Therefore, contrary to origin-based taxes, such as income tax, destination-based taxes, such as consumption taxes, will be less affected by the degree of factor mobility.
Lastly, lower income tax rates could mean, in theory, an increase in the real disposable income of households, which could lead to more willingness to spend more money on products and services, which, in turn, produces more revenue.
However, switching from income tax to consumption tax can also have non-neglectable disadvantages. For example, higher consumption taxes are often associated with reduced tax progressivity and increased inequality.
In contrast to a progressive income tax, which levies more taxes on the wealthy, a consumption tax such as VAT is charged equally on every purchase, regardless of the consumer’s wealth. VAT is, therefore, considered regressive if it is measured in relation to current income and if it is introduced without other policy adjustments, as lower-income individuals spend a more significant fraction of their income in VAT than higher-income individuals. Moreover, taxing a more substantial percentage of the income of lower-income households might place an undue burden on lower-income taxpayers, missing any social and distributional aim. Therefore, low-income groups, the unemployed, and pensioners are typically worse off from a tax shift.
Economic and tax literature, theoretical models and empirical analysis do not offer irrefutable and undisputed evidence of the merits of higher reliance on consumption taxes, as they leave out many distortions created by taxation and struggle to encompass variables that fully reflect all aspects of taxes.
In conclusion, a shift like the one mentioned would always cause resistance and uncertainty for any government. This is because labour usually constitutes the major base for generating revenues in most countries. On top, there might be budgetary constraints and redistribution and competitiveness concerns for reducing taxes on labour, and there can be limits to which taxes can be increased to compensate for tax cuts.
However, the positive indicators towards a shift like the one under analysis encourage reflecting on this option.
III. New ingredient
To overcome the challenges posed by the major trends identified, namely, to avoid loss of revenue and find a path to collect at least the same amount of it, the tax mix could be shifted/ adjusted in three ways: by (i) creating new revenue sources, meaning new taxes; by (ii) adjusting the weight that existing taxes have in the tax mix, yet facing some drawbacks as mentioned above (e.g. regressivity); or by (iii) adjusting the weight existing taxes have in the tax mix, with some fine-tuning to avoid/limit such drawbacks.
This third option could avoid the costs of designing and implementing a new revenue source by using an existing and well-proven one with some tweaks.
For this, as the most knowledgeable and proven consumption tax, VAT should be considered.
Apart from other considerations, a reflection towards a shift to consumption taxes must address the major criticism levelled against consumption taxes: their regressive nature.
The traditional response has been excluding certain products from full taxation, achieved primarily through exemptions or reduced rates.
The application of reduced rates is one of the two methods used to address regressivity, either by diminishing the regressivity of VAT or increasing the consumption of perceived merit goods. Unfortunately, however, it tends to result in precisely the opposite result. This is because to achieve distributional and social aims, fighting regressivity, the decrease in the tax rate, or even the exemption, must be passed on to consumers through price reductions. Yet, even assuming that reduced rates will indeed affect prices, there is still no guarantee that the envisaged distributional and social aims will be achieved.
On the other hand, even for essential items, consumption is mostly done by the wealthiest. So, even assuming that reduced rates will indeed be reflected in lower prices, it would be those consumers (and not the poorest), therefore, who benefit the most from that. This, in turn, means that contrary to common assumption, reduced VAT rates, as with any other exclusions from the base, do not necessarily reduce the tax’s regressivity, but can, on the contrary, increase it.
Moreover, applying more than one rate of VAT gives rise to significant legal difficulties (e.g. qualification and interpretation problems) and might create economic distortions.
Finally, such methods could represent high costs for State budgets with several implications without achieving, in return, none of the wanted objectives. Any impact on revenues might take a toll on providing high-standard public services, once again affecting lower-income households.
Alternatively, a way forward may be an adequately designed progressive consumption tax such as VAT, helping reduce inequality by shifting the tax burden from the non-affluent to the affluent without losing overall tax revenue.
The VAT should complement, not substitute, existing direct and indirect taxes. Moreover, the VAT should be coupled with adjustments to ensure the policy change is progressive.
An adequately designed progressive VAT should be based on: a broad tax base, including essentially all consumption that is associated with direct payments; no exclusions from the base; no exemptions; with a standard rate that applies to all taxable purchases; and a real-time refundable credit available to all households to make the tax progressive. Instead of using an exclusion for low-income households, the system can achieve progressivity by providing a direct real-time tax refund/rebate of the VAT amount at stake.
It could even encompass items not traditionally subject to VAT to extend the already broad tax base further.
Therefore, progressivity would result from the partial or total refund, depending on the case, of the amount of VAT individually paid, according to the level of consumption or income determined, to be carried out by the tax administration, to those who, when buying goods or services, request the issue of an invoice with their tax registration number.
Although on a smaller scale, the Portuguese tax authority already implements a similar mechanism by deducting a small part of the VAT paid by taxpayers in the PIT (which was implemented as an incentive to request an invoice).
There would be several percentage levels of VAT refund, applied (in an option to be taken by governments) either in (i) accordance with the amount, in the last year or half year, of the total consumption value ascertained through the taxpayers’ invoices of goods or services acquired, according to the amount calculated by the Tax Administration, or in (ii) accordance with the individual annual income calculated by the Tax Administration.
These levels of refund would be staggered: from a VAT refund which, for lower-income/ consumption individuals, could be total, up to a threshold of individual income/ consumption from which there would be no refund, with mid brackets for a partial refund with marginal rates, as already happens in the PIT.
It would be a simple process for taxpayers: when buying any good or service, they would ask for the invoice with their tax number. Then, they would need only a personal bank account to receive the refund.
A progressive VAT would mean fewer administrative and economic costs, namely for those countries with lookalike Portuguese software solutions in place.
All things considered, there are enough shreds of evidence to build a case supporting a reflection and consideration of a progressive consumption tax (a progressive VAT) as a revenue-neutral outcome for a tax shift from income to consumption. A recipe to be tested.
Gonçalo Grade
May 2023