Social security contributions and progressive personal income taxes are associated with higher labor costs and tend to discourage job creation. But the solution is not as straightforward as simply reducing employment taxes and increasing tax on capital income.
Distortionary impact of taxes on employment
Taxes on employment have been heavily criticized for their distortionary impact on labor markets. Social security contributions and progressive personal income taxes are known to drive a wedge between the labor costs for employers and the take-home pay for employees. To the extent that these tax wedges are associated with higher labor costs, they discourage job creation; and as far as they reduce the take-home pay for workers, tax wedges discourage labor supply. The wedges can be large, often in the range of 40 to 60 percent of labor costs — especially in Europe and Latin America. Empirical studies consistently find that large tax wedges reduce countries’ employment levels and increase involuntary unemployment. In addition, tax wedges tend to reduce the quality of employment (productivity), for instance, by discouraging education and training, inducing people to work informally and causing skilled workers to migrate abroad.
Would it therefore not be better to shift the tax burden away from employment, and, if so, where to? This article discusses the desirability of shifting the tax burden from labor and toward capital income. The latter can be taxed either at the individual level (taxes on interest, dividends, capital gains) or at the corporate level.
The argument for tax on capital
Capital income in most countries is earned disproportionately by the better off. High taxes on capital income (or on the underlying wealth) are therefore often viewed as a good way to address inequality. But theory offers several perspectives on this issue. Because capital income enables the purchase of consumption in the future, taxing it corresponds to imposing a tax on that future consumption. Prudent individuals who prefer to postpone consumption (or transfer it to their heirs) will be taxed more than those who do not. Some see this as unfair as time preference is not a good basis to differentiate tax liabilities. Moreover, a tax on capital may also create relatively large economic distortions. Since income first needs to be earned by working before it can be saved, taxes on capital discourage labor supply in the same way as labor income taxes do. But in addition, they also distort saving behavior, thereby magnifying the overall economic distortion of the tax.
What all this implies is intensely debated among public finance economists. At one extreme is the view that, because it distorts behavior so much, the optimal tax on capital income is zero with redistribution better achieved by progressive labor taxes alone (including the personal income tax on employment income). At the opposite extreme is the view that labor and capital income should be taxed identically — for many years the most popular view. This, it is argued, best complies with the ability to-pay principle. Moreover, it might also be efficient, as it can be hard to distinguish labor income from capital income, for instance, of self-employed entrepreneurs. Neither view stands on entirely firm theoretical grounds. What has become clear is that the desirable tax on capital income, even if not zero, may well differ from that on labor income — not least because capital is more mobile internationally, making it harder to tax without driving the base abroad. Many countries now employ some form of dual income tax: taxing capital income separately from labor income, and at a lower rate than the highest personal tax rate on employment income.
While capital income taxes clearly have their limitations, most countries have them in place. Often, governments have several opportunities to strengthen them. For example, taxes on capital income are very often a leaky bucket due to a myriad of exemptions and reliefs for certain types of income. These create major distortions in asset portfolios and ample tax avoidance. A more neutral treatment of all personal capital income at a reasonable, uniform rate could then boost revenue — enabling a revenue-neutral tax shift away from labor.
A shift towards corporate income taxes
Countries might also consider shifting toward corporate income taxes. Here, the notion of tax incidence — who ultimately bears the real burden of a tax — is key. Corporations themselves cannot bear the incidence of tax — only people can. To the extent that corporate income generates personal capital income (in the form of dividends or capital gains), the arguments of the previous paragraph apply: the corporate tax is then merely a withholding mechanism for such taxes to facilitate collection. Yet, when it comes to business taxation, part of the incidence might actually fall directly on workers. To see this, take an economy that is small in world capital markets, and so must take as given the after-tax rate of return on investment: investors will move their capital abroad if they earn less than this. If a country now taxes the returns that investors earn there, the before-tax rate of return will have to rise enough to leave the after-tax return unchanged. Consequently, an outflow of capital will then occur. But that outflow leads to a lower domestic capital-labor ratio, which reduces labor productivity — and, in turn, wages. So workers, not shareholders, bear the real incidence of the corporate income tax; and it is more efficient to tax workers directly through employment taxes than indirectly through corporate taxes.
The corporate income tax still plays an important role in taxing economic rents — the profit over and above the minimum required return to compensate investors. The traditional corporate income tax is not a rent tax because it taxes all returns to equity, including the minimum required return. It could quite easily be transformed into a rent tax, however, either by allowing companies to reduce their taxable income through a deduction for normal capital returns (interest and equity returns) or by allowing immediate expensing of the cost of investment. This would eliminate its distortionary impact on investment and the incidence would fall on capital. When keeping a reasonably high tax rate, the corporate tax could then be an important and efficient revenue source.
Where does this leave us regarding options to shift taxation away from employment?
A major shift in the tax burden away from labor toward capital income is unlikely to be the silver bullet that could enable big relief for employment. Yet, more efficient design of existing capital income tax systems offers some opportunities in many countries as a more buoyant source of public revenue — and provides relief for employment.
Download the full "What to Tax?' publication here.
by Ruud de Mooij
Before joining the IMF, he was Professor of Public Economics at Erasmus University in Rotterdam. He has published extensively on tax issues, including in the American Economic Review and the Journal of Public Economics. His current research focuses on income taxation, international tax issues, and the corrective role of tax.