Tax reform: squaring of the circle? Not necessarily!

The Government is planning to introduce a major tax reform that is set to take effect on 1 January 2017. Such an ambitious and far-reaching reform needs to be prepared meticulously given that taxation, directly or indirectly, affects all aspects of a country’s economic and social life – and this is particularly true in Luxembourg. A well-designed and fully coherent tax reform requires a constructive dialogue between the main “movers and shakers” of our economy and it is only through such dialogue that all the relevant information can be taken into account. It is with this in mind that I would like to shed light on a number of broad principles of Luxembourg taxation and to highlight a number of safety barriers for tax reform.

“Too much tax kills tax”

First of all, I should stress that the primary objective of the tax reform must not be to increase the tax burden. That would be highly dangerous and counter-productive. According to the saying “too much tax kills tax”, an increase in the general level of our taxation would produce a short-term surplus in tax revenue but the loss of attractiveness and competitiveness would damage economic activity and would decrease the tax base in the medium and long term (see Laffer Curve).

To balance our public finances, we must not increase the tax burden, which is already substantial in Luxembourg as I will mention further below, but we must control the trend of public expenditure while optimising its efficiency.

The reason for this is that our country has witnessed an enormous increase in public expenditure. Between 2008 and 2014, total public administration expenditure increased by 41% whereas revenues increased over the same period by only 32% (which, during a crisis period, is in itself impressive). Our expenditure per inhabitant is now double the average in the eurozone. This scissors effect reflects numerous factors of expenditure rigidity and the numerous automatic adjustments existing in Luxembourg (indexation, link between pensions and real wages and others that cannot be discussed here).

In such a context, budgetary responsibility must be based not on an increased tax burden but on achieving greater expenditure efficiency and on limiting its “automaticity” and its inherent growth. In the same vein, an increased selectivity of social benefits is also required.

Luxembourg is a tax haven only on the front pages of foreign newspapers…

Efforts focussed principally on expenditure are all the more necessary given that taxation on labour or on companies is anything but anecdotal in Luxembourg, where tax revenues and social contributions increased in 2013 to around 18 billion euros. Again in 2013, direct taxes on companies alone reached around 5% of GDP in Luxembourg, compared with an average of 2.5% in the eurozone. In its most recent annual report [1], the National Bank of Belgium (NBB) published a chart on taxation of capital as a whole, comprising, inter alia, corporation tax, taxes paid by the self-employed, inheritance duties and gift taxes, savings taxes and real property taxes. According to this chart, Luxembourg has the highest rate of “capital taxation” in the eurozone, at around 11% of GDP in 2012. Luxembourg even outstrips France and Belgium (taxation in the region of 10% of GDP in both cases). Ireland, Germany and the Netherlands come in around 6% of GDP, i.e. just over half of the figure for Luxembourg.

Another very revealing indicator concerns the taxation of individuals: according to the OECD, the “tax wedge” (social contributions and direct taxes) for a single person without dependants earning the average salary is 37.0% in Luxembourg compared with 35.9% for the OECD as a whole. I note in passing the much lower rates observed in “competitor” countries such as the United Kingdom (31.5%), Ireland (26.6%) and Switzerland (22.0%).

The average level of Luxembourg taxation is patently not as favourable as the foreign media make out. The overall tax burden should not therefore increase following the implementation of the tax reform.

What is needed instead is to have the ambition, as the government programme states, “to do better with less”.

I would even say that by exploiting currently unused margins on the revenues side, it would be possible, without causing any budgetary “damage”, to decrease the total amount of two taxes that have a high level of potential to attract and incentivise economic players (individuals and companies). These are the tax on wages and salaries (and the like) and direct taxes on companies. I will give just one example where there is potential for adjustment: property tax, the proceeds from which in 2013 amounted to 0.1% of GDP, compared with 1.2% in the eurozone. Not to mention other possible “opportunities” (certain rebates and other tax expenses).

The tax reform must increase Luxembourg’s appeal to businesses

The least that we can say is that Luxembourg has been given something of a rough ride in recent years on the international scene. These often sterile controversies highlight the need to immunise our tax legislation against any biased or malicious criticism. Luxembourg’s reputation and appeal – our goodwill – depend on this. The national authorities have already expended considerable efforts in this regard, particularly with regard to banking secrecy or a more precise definition of the famous “rulings”.

However, taxation plays an important role in encouraging and stimulating (or discouraging) economic activity in an open economy greatly exposed to international competition. Although they help to improve our international reputation, the aforementioned adjustments cause us to “lose” traditional advantages in terms of economic incentive and localisation of businesses, lost advantages that need to be compensated by new gains. It is therefore essential and even imperative to introduce new provisions which are simple, transparent and sufficiently “sellable” to enable Luxembourg to continue to retain new businesses or attract them to its soil. The international trend seems to be heading towards harmonisation of the tax base or, at least, towards one that is defined more transparently, i.e. more simply. In practice, that means that tax bases will doubtless be broadened. If the taxable bases are broadened – which is highly likely in the context of the discussions around the famous “BEPS” [2] – in order to remain competitive, it will be absolutely essential to reduce the tax rate accordingly, or to reduce it even further in order to have a product that appeals to potential investors, with a view to ensuring that these changes are at least neutral from a budgetary and financial point of view.

We could in this respect follow the approach adopted by countries such as Switzerland or Ireland. In the latter case, since the introduction of new tax rules in January 2003, GDP has recorded an increase of 23% (compared with 10% in the eurozone) despite the (brutal) impact of the crisis in that country. In Luxembourg, the taxation of businesses should in any case back up the diversification strategy by supporting technology-intensive companies for example. Let’s not forget that the creation of new activities represents an opportunity for particularly substantial tax revenues (and is one of the reasons for our tax windfall in recent years).

As well as attracting and promoting new economic activities, the tax reform must consolidate and strengthen existing activities and contribute towards the continual growth of the financial centre. In 2014, financial and insurance activities alone accounted for more than 70% of the total proceeds from corporate income tax, in an amount exceeding one billion euros. Various foreign studies show that the decision of financial companies to establish themselves in a given country is particularly sensitive to the tax burden.

The tax reform must be an incentive to households and employees

Continuing with a systemic approach, the incentivising aspect of taxation on households and workers must also be considered. Direct taxes on household income – primarily tax on wages and salaries (ITS) – accounted for a total of around 4 billion euros in 2003. One must not believe, however, that these levies do not concern the employers of the workers concerned. An increase in ITS normally tends to bring about a corresponding rise in wage claims from employees in terms of their “take home” pay. So it is hardly surprising that over these recent years of crisis we have observed an increase in the proportion of government revenue corresponding to ITS compared with corporation tax (IRC) and communal business tax (ICC) since this is the result of employees becoming richer and businesses becoming poorer.

In addition, personal income tax (IRPP) does not only concern households in the strict sense but also more than 5,000 individual entrepreneurs as well as partnerships. For these two reasons, assuming a certain interaction between direct taxes on households and on companies, the tax reform must ensure better articulation between these two forms of taxes, by avoiding a “balancing act” between these two levies. The large number of bands on the IRPP scale is a major drawback.

We need more generally to avoid “confiscatory” tax rates, even if the precise definition and calculation of these rates is still the subject of bitter discussion.

Any “intelligent” reform of taxation must also ensure a good connection between household taxation (including social contributions) on the one hand and social transfer schemes on the other. “Unemployment traps” should merit our full attention: we must avoid the situation whereby a person who has found a job after a period out of work ends up earning less because of an inappropriate interaction between the tax system and social benefits (guaranteed minimum income (RMG), unemployment benefit, etc.). According to the European Commission’s departments [3], the marginal effective tax rate for a single-earner couple with two children resuming work after unemployment at two thirds of the average wage is more than 100% in Luxembourg. In other words, unemployment benefits bring in as much as paid work in this case. The corresponding rate is “just” 78% for the whole of the European Union.

Such a confiscatory marginal effective tax rate is perilous from a social perspective. This powerful “unemployment trap” captures many inactive households and serves to depreciate their “human capital” (experience, school knowledge, fitness to work).

According to a recent Swiss study [4], households facing underemployment are likely to have much greater social vulnerability, both in terms of relative poverty (at-risk-of-poverty rate) and absolute poverty (poverty or material deprivation rate). This is the case not only in Switzerland, according to this study, but also in Luxembourg. For example, the at-risk-of-poverty rate in Luxembourg was 10.1% in 2002 for the actively employed compared with 15.1% for the total population. This difference can be attributed to an at-risk-of-poverty rate among the unemployed of around 52% in 2012 (STATEC).

The question of household incentives also poses the question of tax expenses, a general term for all sorts of deductions and rebates. The tax expenses identified and calculated in the draft 2015 multiannual budget (there are many others) already amount to around 800 million euros. There may be justification for using taxation in order to stimulate certain economic behaviours that are “desirable” for the community, particularly in the area of retirement prevention or the environment. However, I would emphasise the need to properly identify these tax expenses for budgetary cost reasons and in order not to cause economic distortions – for example, in terms of housing prices.[5]

The tax reform must target a perfect fairness

The tax reform cannot avoid the important question of fairness. Firstly, the tax burden on a company should reflect the economic reality of the business rather than its legal status. Secondly, matrimonial or family status should not have a disproportionate effect on the tax payable by employees in comparable socio-economic situations. Finally, taxation must ensure a reasonably balanced division of the “whole cake” of the economy.

The tax reform should ideally be designed on a “cost/benefit” analysis incorporating economic efficiency and fairness and avoiding microeconomic distortions. We must stimulate work and innovation, which are the drivers of our economy.

But how do we choose an appropriate measure of fairness? The at-risk-of-poverty rate is the indicator most often favoured in Luxembourg. However, that is a relative measure of fairness: households earning less than 60% of the median available income are considered to be at risk of poverty. That raises the bar to a particularly high level in the case of Luxembourg, a country where the median salary is very high when compared internationally.

The Swiss study mentioned above illustrates the importance of this aspect: the material deprivation rate – i.e. a measure of poverty based on absolute thresholds reflecting the ability to afford housing, decent food and heating and to own various domestic appliances – was barely 1.3% in 2012 in Luxembourg, i.e. the lowest rate in Europe after Switzerland and Sweden. As for the EU, the material deprivation rate in the whole of the European Union was 9.9% (5.6% for the average of the three countries bordering Luxembourg).

According to the “Sozialalmanach 2014” published by Caritas, 5% of households bear half of direct taxes on households, whereas 40% of households pay no income tax at all. The origin of such an obvious anomaly must be analysed. Is this the legitimate effect of progressivity or the reflection of an excessive tendency to rely on a small group of supposedly “privileged” individuals to feed the public coffers? Is it fair that a huge number of citizens are excluded from financing the nation (even symbolically) when everyone should normally contribute according to their means? This situation causes the notion of “tax citizenship” to lose all meaning. We should rectify that situation. In my eyes, all households, even those on a modest income, should pay a minimum level of tax (like companies) while compensating, where necessary through targeted social transfers, for the impact of any measures aimed at ending “tax exclusion” on individuals who are genuinely disadvantaged.

The tax reform should promote stable, predictable and attractive taxation

Another advantage of a well-considered and fully coherent tax reform is the avoidance of “latent defects”, disruptive elements or nasty surprises for investors by the creation of a new stable and predictable tax system. Stability is essential for an economy as open as ours and has played a substantial role in the past, contributing greatly to the economic success of our country’s business model.

We need to cherish this stability. Let’s not forgot that tax stability requires healthy public finances that ensure that our economy can better withstand shocks. Hence the need, as mentioned at the beginning, for real control over public expenses.

The tax reform must create a simple, transparent and modern system

Another essential consideration that is often forgotten is the need for simplification and modernisation of the tax system, as these two elements are a guarantee of transparency. So I must emphasise that it is absolutely necessary to “cleanse” the tax system, for example by cutting away those dead branches that many tax expenses represent. Although these expenses may have appeared to have been justified at the time they were decided, they now cause distortions or conflict with current political priorities.

Following the introduction of one-off “mini reforms”, our taxation has become a complex set of rules lacking in transparency. This complexity does nothing to promote economic calculations and tax predictability. It sometimes exposes us to distorted or even malicious uses of the tax system, dealing fresh blows to the essential “business fuel” that is Luxembourg’s international reputation. Furthermore, for our businesses, households and public authorities, complexity represents a “dead loss” because it requires resources of time or “money” which end up being expended on complicated returns, costly controls or other onerous administrative tasks. These resources could be used in another way.

In conclusion:

  • A far-reaching reform must come hand in hand with a simple and transparent tax system. We need to recreate a genuine level playing field, preventing any attempt at fraud or tax evasion that might cause harm to Luxembourg’s image once again.
  • An ambitious reform that harmoniously blends these various ingredients is a necessity for Luxembourg in the current circumstances characterised by the loss of major tax sovereignty niches. In order to merit its name, a reform must represent a genuine “quantum leap” in terms of Luxembourg’s appeal.
  • We need to embark upon this considerable task as soon as possible by following a strategic and systemic approach. The tax reform must be prepared methodically, by studying the long-term consequences of the ideas for reform being considered. A partial, minimal or patchwork tax reform that aims to reconcile various opposing interests and adds a layer of complexity would not be a viable option.

Finally, the architects of the reform must constantly keep in mind one obvious fact: tax is not a goal in itself but a means of financing public choices. We must avoid having a discussion about “revenues” behind closed doors, without considering how they fit in with public expenses and ignoring the relevance, efficiency or long-term trend of those expenses.

[1]  Doc. pdf. See, in particular, page 164.

[2] The concept of Base Erosion and Profit Shifting [BEPS] refers to tax planning strategies that aim to “erode” or make profits disappear or to shift them to countries or territories where the taxes are low. These strategies are most often legal and involve “optimising” existing rules rather than breaching them. The OECD has adopted a BEPS Action Plan, which lists 15 actions to address base erosion and profit shifting in a comprehensive and coordinated way. These actions should result in fundamental changes to international tax standards.

[3]  Doc. pdf.

[4] Poverty in Switzerland – Results for the years 2007 to 2012, OFS (Federal Statistics Office) News, July 2014.

[5] Numerous tax expenses are capable of increasing the tension between supply and demand for housing in Luxembourg, the latter being more dynamic in trend. These include the housing tax credit (“Bëllegen Akt”) or the deductibility of debit interest on a bank loan in order to finance the purchase of a home.

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