A tax policy for both insiders and outsiders

The objective of this report is to evaluate the long-term effects of a few different tax reforms on public finances, employment and the income distribution. The model that is used is a model that analyses how changes in regulatory systems change households’ disposable income and thus affect people’s decisions on work and consumption.

A summary of the conclusions of the report
THE EARNED INCOME TAX DEDUCTION LEADS TO AN INCREASE IN EMPLOYMENT. The evaluation indicates that in the long run, the earned income tax deduction will increase the number of employed by 72 000 in terms of full-time employed. Since the tax deduction makes it more profitable to work and encourages a greater effort, this leads to a larger tax revenue from more hours worked and higher hourly wages. From a government budget perspective, this means that the reform is 30% self-financed. This is somewhat lower than the estimates from the Ministry of Finance that the degree of self-financing is 40–50 percent.

LESS TAX REVENUE WITH THE PROPOSAL FROM THE RED-GREEN PARTIES. The proposal from the red-green parties of decreasing the earned income tax deduction step by step for monthly incomes exceeding SEK 40 000 would lead to a long-run decrease in employment by 3 000 people in terms of full-time employed per year as compared to the current earned income tax deduction. The reform might deteriorate the public finances by SEK 0.7 billion per year if taking into account the negative effects due to the fact that it becomes slightly less profitable to work for high-income earners. The shadow budget of the red and green parties estimates that a de-escalation will create an increase in the tax revenue amounting to SEK 2 billion per year. The difference is likely to be due to different estimates of the dynamic effects. A de-escalation of the earned income tax deduction has very limited effects on the income distribution, according to the model. For those 10 percent of the wage earners with the highest income, disposable income will decrease by about 1 percent.

HIGHER LIMITS BETWEEN LAYERS WILL CREATE 28 000 ADDITIONAL JOBS IN THE LONG RUN. The report analyses the effects of a tax reform with higher limits between layers which means that no more than 15 percent of the wage earners would pay state tax (as compared to 19 percent today). Such a tax reform would increase employment by another 28 000 individuals, calculated as full-time employed, by its becoming even more profitable to work for those with higher incomes. The reform is 78 percent self-financed if the effects on household behaviour of the change in the regulation are taken into account.

A FLAT TAX RATE IS 90 PERCENT SELF-FINANCED. Finally, the report evaluates the effects of a so-called flat tax rate, consisting of 25 percent tax on labour income, notwithstanding the level and the same 25 percent tax rate on capital income and 25 percent uniform VAT. The analysis shows that such a reform would generate less tax revenue, but would, at the same time, have considerable dynamic effects. Since it becomes so much more profitable for many medium and high income earners to work, employment would increase by 100 000 jobs besides the 72 000 created by the earned income tax deduction (in terms of full-time employed). Accordingly, such a reform is 90 percent self-financed.

RESULTS OF THE MODEL WITH A FOCUS ON THE LONG-TERM PERSPECTIVE. The results build on an evaluation model which analyses how the earned income tax deduction affects the choice of working hours and the effort of individuals and households. It is a so-called micro simulation model which takes into account possible changes in their behaviour by individuals and households due to the earned income tax deduction. This means that the results are affected by how the relationships between different economic variables are described.

The analysis is limited to the supply-side of the labour market, i.e. how much individuals and households choose to work. But since the model has been adjusted to what the actual relationships have been on the Swedish labour market in the twenty-first century, many of those effects that come via the supply side might be included in the analysis. In contrast, the effect on the supply side cannot be presented separately.

Finally, the model is a tool for evaluating the long-term effects of regulatory changes. Those figures that are presented here are not measures of the actual effect in the short run, which is affected by business-cycle factors such as, for example, that the demand for labour has decreased during the business cycle downturn. Instead, the analysis focuses on the long-term perspective and how the tax policy affects employment in the long run.