Economic surveys and country surveillance

Economic Survey of the Czech Republic 2010: Further advancing pro growth tax and benefit reform

 

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The following OECD assessment and recommendations summarise chapter 2 of the Economic Survey of the Czech Republic published on 6 April 2010.

 

Contents

More can be done to make the tax system less distortive…

While fiscal consolidation efforts should focus more on the expenditure side than hitherto, it is likely that further revenue measures will also be required as part of the adjustment. It will be important, therefore, to identify the revenue sources that are least distorting and least damaging to growth. Setting out a clear path for tax policy, with well defined goals, would enhance the transparency and predictability of policy during this period. Given that the labour tax wedge is still relatively large and that the tax system overall still relies very heavily on the direct taxation of labour and capital income, new revenue measures should focus on indirect taxes, particularly the taxation of consumption and property rather than income.

  • The Czech Republic relies less on the taxation of real property than any other OECD member. Yet property taxes are among the least distorting revenue sources available. They are also relatively difficult to evade and less cyclical than income taxes. The real estate tax should be increased by raising tax rates and linking the tax base to actual market prices.

  • The two tier VAT should also be reviewed. It creates market distortions and complicates administration. Yet as a means of helping those on low incomes it is extremely inefficient: households with median income or higher receive around 60% of the tax benefits of the two rate system. VAT should be levied at a unified rate, with exceptions and exemptions reduced to a minimum. Distributional concerns should be addressed by direct transfers.

  • Finally, although the recent tax reform package marked a first step in environmental tax reform in the Czech Republic, considerable scope remains for more progress in this direction. The next government should follow through with plans for further environmental tax reform, including the introduction of a greenhouse gas emissions tax and a transition from free allocation to auctioning emissions permits under the Emissions Trading Scheme.

 

Distortions in capital taxation should be reduced

The steady reduction in the statutory rate of corporate income tax (CIT) has itself helped to reduce some of the distortions that exist in the system of capital taxation. However, the Czech CIT is still less neutral between forms of investment finance and asset types than many in the OECD. Specifically, it tends to favour debt financed investment very heavily, as compared with investment financed by new equity, and the effective taxation of investment in new machinery tends to be unusually low compared to investments in most other assets. The CIT and/or the dividend tax should be revised to reduce, if not eliminate, the disparities between the tax treatment of different sources of investment finance. At the same time, the neutrality of the CIT with respect to investment in different types of assets should also be increased. This may require revision of depreciation schedules and of targeted investment incentives now written into tax legislation.

 

Effective corporate tax rates are low but should be more neutral

%

Note: The marginal effective tax rate (METR) is defined as the difference between cost of capital and post tax real rate of return. The average effective tax rate (AETR) is a measure of the present value of taxes paid, expressed as a proportion of the net present value of the income stream. For further details see Devereux et al. (2008). The METR applies to a marginal investment which earns zero economic rent, whereas the AETR applies to a discrete investment with economic rent. The graph shows effective rates based on the assumption of a non qualified zero rate shareholder. Rates are simple averages over the different types of assets. Simulations refer to the system in 2009 and 2007 (symbol X) for the Czech Republic and 2007 otherwise. Ranking is by retained earnings.


Source: Project for the EU Commission, TAXUD/2005/DE/3 10, Centre for European Economic Research (ZEW).

 

Interactions between the tax and benefit systems still create perverse incentives for some groups

While the tax changes of 2008 increased work incentives, the interaction of tax and benefit systems remains an issue. An analysis of tax benefit interactions suggests that the Czech Republic has made considerable progress in addressing inactivity traps since 2006. However, some groups still face very high average effective rates of taxation, which discourage activation, or very high marginal effective rates, which reduce the incentives for individuals to increase their labour supply. Where possible, the remaining spikes in marginal effective tax rates should be reduced or eliminated, by smoothing the withdrawal of some benefits as income rises, particularly unemployment benefit and living allowance, and by gradually withdrawing the spousal tax credit as the second earner increases earnings. Family benefits are the area where tax benefit interactions create the largest – and, in recent years, increasing – disincentives to work. Parental allowances and other benefits available to families with young children reflect the Czech authorities’ preference for family based childcare and are therefore heavily tilted towards de activating parents for relatively long periods. A comprehensive review of the tax and benefit system provisions as they apply to families with dependent children should be undertaken with a view to making it easier to combine work and family life and making the system more neutral with respect to parents’ choices about how to do this. Problematic tax benefit interactions partly reflect the fragmentation of policymaking, with different ministries handling taxes and benefits. At a minimum, tax and benefit policies should be systematically co ordinated with one another. The government may want to consider using a tax benefit model to analyse systematically the tax benefit interactions that arise when policies change.


Tax reform has increase incentives to work for most but not all household types

Percentage points, AETR in 2008 minus AETR in 2006

 

Note: In a two earner household the second spouse is assumed to have full time earnings equal to 67% of the average wage (AW). The graph shows the average effective tax rate (AETR) when an individual moves to full time employment at the minimum wage, 67% of AW and 100% of AW. Simulations refer to the systems in 2006 and 2008.


Source: Ministry of Finance; Ministry of Labour and Social Affairs; and OECD, Tax and Benefit Model. 

 

Remaining distortions in labour taxation should be addressed

Some distortions in labour taxation still need to be addressed. Perhaps the most important concern the tax privileges enjoyed by self employed persons. These create incentives for employers to declare many de facto dependent employees to be self employed contractors. Steps should be taken to reduce the disparities in the tax treatment of dependent workers and the self employed. Secondly, given that the fiscal situation limits the scope for further reductions in the labour tax wedge at present, priority should be given to reducing the tax wedge on the low paid, where the evidence suggests the employment effects of a reduction would be greatest. Targeted reductions in social security contributions for low wage jobs should be considered. These could be financed in part by eliminating the current anomaly whereby individuals with earnings above the cap on social security contributions face steadily declining average effective rates of tax on personal income. This could be done either by eliminating the cap on social security contributions for very high earners or by introducing a higher rate income tax bracket for earnings above the cap. Although such a change would affect only a small number of people, it would eliminate an arrangement that is troubling in terms of equity and unlikely to have any impact on labour supply.

 

How to obtain this publication

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations

Czech version

 

The complete edition of the Economic Survey of the Czech Republic is available from:

 

Additional information

For further information please contact the Czech Republic Desk at the OECD Economics Department at eco.survey@oecd.org.

The OECD Secretariat's report was prepared by William Tompson, Zuzana Šmídová, Laura Vartia, Zdeněk Hrdlička and David Prušvic under the supervision of Andreas Wörgötter. Research assistance was provided by Margaret Morgan.

 

 

 

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