New SSE Riga/BICEPS occasional paper by Alf Vanags (BICEPS).
The recently published guidelines for the medium term development of Latvia’s tax system (NodokĜu un nodevu sistēmas attīstības pamatnostādĦes 2011-2015” have for the first time introduced social fairness (socialais taisnīgums) as an explicit goal of Latvian tax policy. Social fairness is further explained in the guidelines as “a more progressive tax system” and a “lower tax burden on lower wage workers and a higher tax burden on exclusive properties”. The challenge for policy-makers is how to realise this goal in combination with the other goals, in particular the goal of improving the competitiveness of the Latvian economy. The aim of this paper is to operationalise the concept of fairness of a tax system by developing quantitative indicators of tax fairness. We take ‘progressivity’ of a tax or a tax system to be the fundamental indicator of fairness, where progressivity means that the tax liability of higher income groups is higher than their share of income and that the tax liability of poorer people is less than their share of income. This approach leads naturally to the use of the Kakwani index (developed by Kakwani (1976)) which provides a summary measure of the progressivity of a tax or a set of taxes defined in this way. A positive value of the Kakwani index indicates that a tax is progressive and a negative one that it is regressive and a zero value indicates that the share of tax liabilities of different income groups is exactly proportional to their share of income. This methodology is applied to Latvian experience in three ways: i) the recent changes in taxes between 2006 and 2010, ii) the proposals made in the government guidelines – removing the current reduced rate of VAT, 1.5% real estate tax, 21% income tax rate and 95LVL untaxed personal allowance, iii) as a comparator we consider the introduction of a 10% reduced rate of VAT on food. The main results are as follows:
- direct taxes are overall progressive but indirect taxes are overall regressive;
- the overall tax system is mildly progressive;
- international comparisons suggest that the Latvian tax system is towards the less progressive end of the spectrum;
- the tax measures implemented since 2006 have overall been regressive;
- the measures proposed in the guidelines are overall marginally regressive, especially removing the reduced rate of VAT and reducing the income tax rate to 21%;
- increasing the untaxed income allowance and introducing a higher property tax are both progressive;
- a reduced (10%) rate of VAT on food is quite strongly progressive even if it is used to substitute for the current reduced rate regime.
The revenue impact of the various tax changes suggests that the removal of the reduced rate of VAT and the extension of the property tax would result in more revenue but not by enough to compensate for the loss of revenue from the proposed income tax changes. The net effect would be a total tax revenue loss of 3.9% as compared with planned 2010 tax revenues. Thus, the policy paper measures are both regressive overall and would lose revenue. The comparator proposal of a reduced rate of VAT on food is clearly progressive and even if uncompensated by removing the existing reduced rate of VAT would result in an overall loss of 3.3% of planned 2010 revenues.
It is hoped that these results throw a new light on Latvia’s tax system and can inform the debate on tax policy in the election campaign and beyond.