Taxing Labor versus Taxing Consumption?
Europe’s welfare systems face substantial demographic headwinds. Increasing life expectancy and the approaching retirement of “Baby Boomers” will increase public expenditures for years to come. Rightfully, much attention is focused on containing additional spending needs for pensions, health and long term care. But how is all this being paid for?
Currently, the majority of social spending, including most importantly pension benefits, in most countries in Europe and Central Asia is financed through social security contributions, which are essentially taxes on labor. This has two important implications. First, in terms of fiscal sustainability, the growth in spending is only a concern if expenditures grow faster than the corresponding revenues. Since labor taxes are the predominant source of financing for most welfare systems in both EU and transition countries, aging will not only increase spending, but simultaneously exert pressure on revenues. With the exception of countries in Central Asia and Turkey, the labor force, and hence the number of taxpayers that pay labor taxes will decline by about 20 percent on average across the region. Second, already today, labor taxes, including both personal income taxes and social security contributions account on average for about 40 percent of total gross labor costs in Europe and Central Asia (including EU member states), compared to an average of 34 percent in the OECD.  This means that for every US$ 1 received in net earnings, employers on average incur a labor cost of US$ 1.67. And out of the 67 cents that are paid in labor taxes, 43 cents (or 65 percent) are directly used to finance social security benefits. By increasing the cost of labor, the high tax burden potentially harms competitiveness, job creation, and growth in countries in the region.
So what does this mean for the tax systems of the future? One response has been to explore other sources of financing for social welfare spending. Some countries, most notably Georgia and Denmark, have moved towards a system that finances pension benefits from the general government revenue pool. While retaining social security contributions, Germany introduced a 3 percent increase in the standard VAT rate (from 16 percent to 19 percent) and a simultaneous reduction of 1.8 percent in employer social security contributions in 2007. Hungary decided a simultaneous 5 percent reduction in employer social security contributions and a 5 percent increase in VAT in 2009.
Shifting the tax burden from direct labor taxes to indirect taxes, especially VAT, offers several advantages. First, income taxes, including social security contributions are origin based, meaning that they are levied on domestic production while imports are excluded from the tax base. In contrast, consumption taxes are destination based, meaning consumption of both domestic and imported goods are included in the tax base, while exports are zero-rated (and as such excluded from the tax base). As a result, a shift from labor taxes to VAT lowers the cost of exports while increasing the cost of imports. This is especially relevant for countries in need of increased export competitiveness. Second, relying more on consumption taxes may help balancing intergenerational distribution of the fiscal impact of demographic change. This is because taxpayers receiving income from sources other than labor and those financing consumption out of savings, including pensioners, will carry part of the additional financing burden. Finally, while aging will have important implications for the composition of consumption, for example increasing consumption of health services, the overall level of consumption will be less affected by demographic change than labor income.
However, there are drawbacks as well. Consumption taxes tend to be regressive because poorer households spend a higher share of their income on current consumption while the saving rate increases with higher incomes. Tax shifts to consumption taxes will therefore need to be assessed carefully in terms of equity and possibly accompanied by offsetting measures to achieve desirable fiscal redistribution. Moreover, as with any taxes, VAT rate increases cause behavioral responses by taxpayers and may encourage evasion. Rate increases beyond a certain level may therefore harm rather than increase revenue yield. Some estimates have placed the revenue-maximizing VAT at below 25 percent. Room for future rate increases may therefore be limited. Finally and most importantly, shifts of social security financing to general government revenue will need to be embedded in wider reforms of the welfare system. Since shifting the financing burden to general government revenue eliminates the link between individual contributions and benefits, changes on the revenue side will most likely need to be accompanied by changes to the determination of benefits. For example, public pension schemes that are largely financed from general taxation will most likely concentrate on the provision of basic income support rather than paying earning related pension benefits while relying on private savings for additional income support. This is the case both in Georgia and Denmark. Of course, this would fundamentally alter the philosophy underlying most current welfare systems, but the alternative of increasing cross-subsidization from the general budget of rising deficits in contributory welfare schemes is likely to involve greater inequities and higher fiscal costs.