effects of personal income tax on income distribution: example from bulgaria

EFFECTS OF PERSONAL INCOME TAX ON INCOME DISTRIBUTION: EXAMPLE FROM BULGARIA

FAREED M. A. HASSAN and ZEWKO BOGETIk+

This study utilizes the 2992 Bulgarian household budget survey to analyze the distribution qf income and income tax burden. Results indicate that the coun ty is characterized by low income inequality, though this is changing rapidly. Thefindings also show that the present income tax system is progressive and that the urban sector pays much more relative to its income. Despite a steeply graduated statutory tax rate schedule, e c t i v e progression is rather modest, indicating signjScant tax evasion. However, one must view the results 4 progressivity and urban bias cautiously. As in-kind income becomes monetized and as the economy becomes more market-oriented, both progressivity and urbanlrural differences will wane over time.

I. INTRODUCTION

Under the previous centrally planned system in Bulgaria, taxes were but one- and perhaps not the main-instrument of massive redistribution. Indeed, non-market pricing and extensive explicit and im- plicit subsidies were equally important mechanisms for creating and maintaining an economy based on the principle of ex- treme egalitarianism. The shift to a market economy, which in Bulgaria accelerated in 1991, changed all that. Market-based relative prices now guide most economic activity, private sector is a significant part of the economy, and taxes increasingly are becoming similar in form and effects to those in market economies (for recent sur-

'Economic Consultant and Country Economist, The World Bank, Europe and Central Asia Country Department 1. This is a revised version of a paper pre- sented at the Western Economic Association Interna- tional 70th Annual Conference San Diego, California, July 7, 1995, in a session organized by Lisa M. Grobar, California State University, Long Beach. The authors thank Ayre Hillman and anonymous referees for their useful comments. The views expressed in this paper are the authors' own and should not be attributed to the World Bank.

H a ~ a n : 202-473-5095, Fax 202-47-8518 E-mail [email protected]

E-mail [email protected] Bogetid: 202-473-5095, Fax 202-477-8518

17

veys of Bulgaria's market reforms see, for example, chapter two in Bogetic' and Hill- man, 1995; World Bank, 1994a, 1994b; Eu- ropean Commission, 1994).

Furthermore, taxes are becoming an important characteristic of the overall economic environment, determining incentives for economic activity and the level and composition of incomes. But empirical analysis of the effects of taxes during the economic transition is lacking. Coulter et al. (1993) and Milanovic' (1992) provide ex- ceptions. But the lack of research partly is due to the fact that isolating factors that influence a particular phenomenon is dif- ficult in a rapidly changing environment. Nevertheless, as more reliable data emerge, they provide a basis for assessing tangible economic issues of the transition. In particular, household budget survey data, with all their shortcomings, can serve multiple purposes for analyzing a host of distributional issues.

The analysis here uses data on household income, expenditure, and taxes from the most recent Bulgarian household bud-

ABBREVIATIONS CMEA: Council of Mutual Economic

NSI: National Statistical Institute Assistance

Contemporary Economic Policy (ISSN 10743529) Vol. X N , October 1996 @Western Economic Association International

18 CONTEMPORARY ECONOMIC POLICY

get survey to analyze the impact of personal income tax on household income. The present income tax system with marginal rates ranging from 20% to 52% is the most important tax affecting the individual and household financial positions. Furthermore, the analysis addresses ques- tions such as: Who pays income tax in Bul- garia? What proportion of households are paying most of this tax, and how progressive is the income tax? Does the current income tax system contribute to achieving economic equality? The analysis also ex- amines the effective tax rates paid by households in rural and urban areas, as well as their distributional impacts.

1 1 . TAX STRUCTURE AND TAX PERFORMANCE:

Bulgarian tax structure and tax revenue performance have undergone profound changes over the past several years (see Bogetic‘ and Hillman, 1994, 1995; Bogetic‘ and Hassan, 1996; World Bank, 1994a; Tax Notes International, 1993). Much of this change is associated with the unique cir- cumstances of the economic transition from a centrally planned to a market economy. The transition causes an explosion of new private activity and the implosion or stagnation of many state enterprises facing restructuring and privatization. This poses formidable challenges to tax policy and tax administration. High taxes on a heav- ily controlled, small number of state enterprises become unsustainable and are replaced with more moderate taxes on con- siderably larger number of private and state enterprises. Given the scarce tax administration resources, this results in a general policy shift toward a simpler tax structure with lower rates. Tax revenues inevitably fall.

The decline in the revenue-to-GDP ratio reflects the decline in state involvement in the economy. In Bulgaria, revenues de- clined from 42% of GDP in 1991 to approximately 35% in 1993. Tax revenues, particularly profits tax revenues, were the main

A BRIEF OVERVIEW

driving force of this decline. The new set of market based relative prices uncovered many enterprises’ financial inviability. Furthermore, many enterprises faced an abrupt loss of external markets when the former Eastern European trading block- Council of Mutual Economic Assistance (CMEA)-collapsed. At the same time, state control over state enterprises weak- ened. This led to perverse incentives of state enterprise managers and contributed to a dramatic deterioration in the financial position of many state enterprises. As a result, the profits tax base-surpluses of state enterprises-and the associated government revenues plummeted. The percentage of revenues from profits tax, the key tax instrument, dropped from over 17% of GDP in 1991 to about 5% in 1993 (table 1).

Tax reform necessitated by the move to a market economy resulted in significant changes in the tax structure. Dominating the pre-reform Bulgarian tax structure was the extremely high rate of 50% on ”accounting profits” of state enterprises, an archaic final-sale turnover tax structure with many rates, and non-transparent social security contributions. The base for the tax on accounting profits of state enterprises had little to do with economic profits. Subsidies were counted as revenues while important expenditure items including wages and salaries, interest payments and insurance were not counted as costs. Therefore, ”accounting profits” were much higher than economic profits. Addi- tionally, both input and output prices typ- ically were controlled, thus further distort- ing the picture of these enterprises’ true financial position. (For more thorough dis- cussions of the pre-reform tax system in Bulgaria, see Bogetic‘ and Hillman, 1994; World Bank, 1991, chapter one.) The pre- reform Bulgarian taxes were the main sources of government revenues under the planned regime. Administrative effort re- quired to collect those revenues was modest. Non-compliance costs were high for

HASSAN LQ BOGETIC: EFFECTS OF INCOME TAX ON INCOME DISTRIBUTION-BULGARIA l9

TABLE 1 Tax Structure and Government Revenues in Bulgaria, 1991-1993

__________

Type of Tax Rates Base Revenue (70 of GDP) 1991 1992 1993

Profits Tax

Social Security contributions

Income Tax

Turnover Tax / VAT

Excises and customs

Non-tax revenue

40%) standard rate for non-financial enterprises.

50%) rate for banks and insurance companies

30% for private corn anies with

1 million leva

pension: 40% unemployment: 7%

Marginal rates from 20% to 52%

Standard rate: 22% (lower rates: 270, 10%)

pro P its below

VAT (1994) Single rate: 18%

Ad valorem excise rates vary from 35% (diesel fuel) to 70% (alcohol, jewelry)

Various fees, charges on services

Profits of all SEs, 17.3 8.3 MEs , and private enterprises

Gross wage 7.8 9.1

Individual income 3.8 5.4

Retail turnover of 3.8 3.5 all enterprises; lower rates ap ly

sectors (construction)

Value added of goods and services

Turnover of select 4.8 4.6 goods

to food and se P ect

select public services 4.8 7.5

Total Total 42.3 38.3

5.2

8.4

4.8

3.8

6.2

6.2

Total 34.6

5 E s denotes state enterprises; MEs denotes municipal enterprises. Municipal enterprises and state enterprises with more than 50% municipal participation in ownership were liable for an additional 10% tax on profits payable to their municipalities.

Source: Bogetid and Hillman (1994), World Bank (1994a), and Tax Notes International (1993).

the managers of a relatively small number of state enterprises (around 6,000) that the state-party apparatus directly controlled.

The 1991 comprehensive price liberal- ization occurred at a time when the economy suffered a series of severe external shocks. These include the loss of tradi- tional external markets of the former CMEA countries, the impact of the Gulf War, the severed trade routes to the West

due to the disintegration of the former Yu- goslavia, and the subsequent U.N. sanc- tions against Federal Republic of Yugosla- via (Serbia and Montenegro). The mirage of ”accounting profits” disappeared, leav- ing many state enterprises in the red. By 1993, the revenue significance of profits tax, levied at a reduced 30% rate, fell be- hind social security tax, excises and customs, and non-tax revenues. After con-


siderably simplifying the turnover tax rate structure and broadening its base, policymakers replaced it in 1994 with a Value Added Tax having a single 18% rate. While the profit tax base was eroding, a progressive income tax with marginal' rates ranging from 20 to 5270 gained more promi- nence. Revenues from income tax as a share of GDP rose by 25% between 1991 and 1993, compared with about a 70% decline in profit tax revenues. This illustrates the increasing relative importance of the personal income tax, particularly when compared with the collapse of the corporate income tax revenues associated with the decline in the profits tax base as well as in the rates. On the other hand, social security contributions-with an average share of 9% of GDP-remains the most sta- ble revenue instrument. Unfortunately, lack of data on social security payments on the household budget survey prevents analyzing their effect on income distribution. Social security contributions do con- stitute a larger part of the tax burden on households, but they are proportional, whereas income tax is becoming very progressive. However, the actual develop- ments since 1992 have moved Bulgaria to a more progressive income tax. In particular, the 1993 amendments to the 1992 personal income tax have complicated the system in two major ways. First, while the 1992 marginal income tax rates had not been low by international standards, the rates implemented in the 1993 amendment were even higher, with top rate rising from 40% to 52%. Second, the number of tax brackets has been increased from 7 to 10, with three additional brackets having higher rates of 44%, 48%, and 52%, respec- tively.

Against this background, distributional effects of the emerging tax system in Bul- garia are far from clear and have not been systematically analyzed. Yet, in the emerging market economy, understanding distributional effects of taxation may be of particular interest for policy. This paper

uses the available household budget survey data to provide a preliminary analysis of the effects of income tax on income distribution. As more data emerge, future analyses should examine the whole tax system rather than a specific tax in order to provide the basis for better tax policy and tax design in Bulgaria as well as in other economies in transition.

111. DATA AND METHODOLOGY

The basis for the analysis is the most recent household budget survey: the 1992 Individual Budgets of Households com- piled by Bulgaria's National Statistical In- stitute (NSI). The two-tier random sample involves 2,202 households (less than 1% of households)-l,386 (or 63%) are urban; the remaining are rural. A sample frame developed from the 1985 Population Cen- sus provided the basis for constructing a sample from 418 sectors or Census dis- tricts. Six of the approximately 90 households in each district were sampled. The sample of 418 sectors are from a "control" sample of 4,000 sectors, which in turn are from the 1985 Population Census of 40,000 sectors including approximately 3.2 million households. According to NSI offi- cials, the sample is "random" and adequately represents the Bulgarian population's incomes and expenditures. Nevertheless, some minorities, particularly gypsies, probably are under-repre- sented.

Whether the effective tax rates are progressive, regressive, or proportionate depends not only on the distribution of tax burdens, but also on the concept of income used to determine the underlying pattern of income distribution. The concept employed in the NSI survey includes seven major sources of pre-tax income-earned income, property income, social insurance, social benefits, income from sales, other sources of income (mainly in-kind income), and income from loans, credits, and savings. Some sources such as income from property sales, borrowing, and sav-

HASSAN & BOGETIk: E F F E C E OF INCOME TAX ON INCOME DISTRIBUTION-BULGARIA ’’ ing withdrawals do not belong to the usual definition of income. Including these sources can alter Bulgaria’s income distribution due to the concentration of as- sets (real and financial) among the richest group. However, even including these sources does not significantly affect the overall income distribution picture (Hassan and Peters, 1996). Although in- kind income accounts for about 24% of household income and was counted as part of income, only cash income was subject to taxation. Ultimately, total consumption is a more reliable indicator of household well-being than is annual income. As Nissen (1984) notes, total consumption reflects not only current total household income but also past savings, windfalls, and expectations of future income. That is, expenditure is a better proxy of lifetime income. More important, when Poterba (1991) examined the regressiveness of the U.S. gasoline tax using both household expenditure and income data, he concluded that the tax appears far less regressive when expenditure rather than income is the basis for analysis. Of course, year-to- year fluctuations in income among poor households may exaggerate the regressiveness of taxes. Following Poterba’s warning regarding the use of income, the analysis here uses both income and expenditure approaches and finds that the results are not substantially different with either approach. To avoid duplication, sec- tion V reports only the results based on income.

A household’s living standard depends on factors beyond total income/expenditure-e.g., household size and composition. The income unit that corresponds with the income concept in the Bulgarian survey is the household. The household concept adopted in the survey includes a one-person household, one family household, and a multi-family household that makes common provision for food or other essentials. This definition corresponds closely to that of the 1980 World

Population Census Program (United Na- tions, 1978). To account for variation in the household size, the analysis here uses the annual household income per capita. Sur- prisingly, the budget survey results show that Bulgarian household size is not a cor- relate of poverty (Hassan and Peters, 1996). This distinguishes Bulgaria from de- veloping countries, where households with lower income per person tend to be larger with more children (Lipton and Ravallion, 1993; Van de Walle and Ravall- ion, 1993). In contrast, poor Bulgarian households (defined as the lowest two income decile) average three members, ex- actly the same size as all sample households (Hassan and Peters, 1996). Further- more, they show that middle-to-higher-income households have slightly larger household size (with virtually equal number of children) than do low-income households. Apparently, adjusting income to an adult equivalent scale is unnecessary since the number of children seems to be evenly distributed across Bulgarian households and not highly concentrated in any income group. Also note that a number of conceptual and practical difficulties influence the construction of such a scale. The literature on the best procedures is contro- versial (e.g., Deaton and Muellbauer, 1986; Ravallion 1992; Van de Walle and Ravall- ion, 1993). Hence, the analysis here does not attempt to calculate such a scale.

The analysis uses a partial equilibrium method for estimating the distribution of tax burdens. That is, taxes on factor income such as the income tax are taken to affect household positions from the sources side only (the burden being distributed in line with earnings subject to tax). The analysis does not consider further effects from the uses side resulting from changes in relative prices. However, disregarding the uses side does not alter the results if each income group spends the same proportion of its income on taxed and untaxed commodities. Analysts have used this partial equilibrium approach for

22 CONTEMPOKARY ECONOMIC POLICY

policy analysis and for assessing the qual- i ty of the tax structure in distributional terms tor many countries including the United States (Musgrave et al., 1951; Musgrave et al., 19651, Colombia (McLure, 1971), Greece (Karageorgas, 1973), and Tanzania (Huang, 1976).

A more complete analysis of the effects of taxation that takes into account second- ary effects requires a general equilibrium approach. Due to the difficulties involved, only a few studies (e.g., Harberger, 1962; McLure, 1975; Fullerton et al., 1979; Devarajan et al., 1980) attempt to combine the uses (demand for goods and services) and sources (of income) sides of tax burden within the standard general equilibrium framework. In their comparison of different approaches, Devarajan et al. (1980) develop a simple, two-sector, two- consumer model and compare its implica- tions with the Musgrave et al. (1965) partial equilibrium estimation of the distribution of tax burdens for the United States. Even for this simple general equilibrium model, the general expression for the changes in the distribution of tax burden is fairly complex, and a wide range of results are possible. Nevertheless, Devarajan et al. identify two parameters that might reverse the typical partial equilibrium pattern: the capital-labor ratio of the taxed industry and the capital-intensity of a consumer’s factor endowments. However, the two-sector, two-factor model oversim- plifies the process of substitution that affects both sources and uses sides. Finally, Devarajan et al. in comparing the results of the Fullerton et al. (1979) model with estimates of the partial procedure for four tax changes and three tax substitutions in the United States, conclude that the two approaches yield strikingly similar results in the case of the income tax. In other cases, the similarity is greater for taxes on products whose capital-labor ratios are close to the average. Note that models of general equilibrium tax burden tend to make simpler assumptions of the Arrow-

Debreu type. These include, inter a h , the assumptions that perfectly competitive markets with no externalities exist, that factors of production are perfectly mobile between different industries, and that the total supplies of all factors are perfectly inelastic for the economy as a whole.

A crucial assumption of the partial equilibrium method here is that the distribution of a tax burden that initially affects household income from the sources (uses) side will be determined fully by the sources (uses) side effects. Furthermore, the analysis does not capture other fea- tures that are especially relevant to the analysis of tax burden, such as variations in capital-labor ratios in production activ- ities, variations in ratios of consumer factor endowments, and longer-term effects of tax policy through changes in the level of capital formation and growth. More so- phisticated future analyses could modify these simplifying assumptions. At the same time, one must weigh the difficulties involved in working with more complex models against the pitfalls of over-empha- sizing a single dimension of tax burden problems. Nevertheless, an important start involves focusing on the analysis and in- terpretation of the available data using a simple analytical framework, such as the one in this study.

IV. INCOME LEVELS AND INCOME DISTRIBUTION

Ideally, the basis for tax policy analysis and reform proposals are estimates of the income distribution and of the burden of existing taxes. Knowing how equally (or unequally) income is distributed is essen- tial to determining the tax system’s de- sired degree of progressiveness (or regressiveness). If the income distribution al- ready is extremely unequal, a regressive tax system would impose even higher burden on the poor and lower income classes, while a mildly progressive tax system would not tap the tax revenue potential of those in the top income classes. The classic

HASSAN & BocETlk: E F F E C E OF INCOME TAX O N INCOME DISTRIBUTION-BULGARIA 23

TABLE 2 Distribution of Annual Household Income Per Capita (%, Leva)

Income Share Average Share Average Share Average Decile (%I Leva) (%) (Leva) (70) (Leva)

National Urban Rural

Bottom Second Third Fourth Fifth Sixth Seventh Eight Ninth

Average Gini Coefficiei Decile Ratio

TOP

4.2 5.6 6.5 7.4 8.3 9.3

10.6 12.1 14.3 21.8

nt 25.8 66.0

6,941 9,361

10,900 12,387 13,928 15,643 17,778 20,380 24,121 36,653 16,809

4.5 5.9 6.7 7.6 8.4 9.4

10.5 12.1 14.4 20.7

24.6 70.0

6,816 8,882

10,101 11,359 12,654 14,095 15,844 18,192 21,598 31,357 15,090

3.8 5.6 6.6 7.5 8.5 9.5

10.5 12.0 14.2 21.8

26.5 65.0

7,507 11,020 13,037 14,789 16,622 18,663 20,856 23,608 28,265 42,784 19,151

~~

Source: Authors’ estimates from the 1992 Individual Budgets of Households Survey, NSI.

study by Kaldor (1963) makes a similar ar- gument for progressive taxation in the context of the Latin American countries. Moreover, without knowing the effective tax rates, knowing whether and how taxation corresponds with a country’s views of the concept of equity is impossible.

In Bulgaria, household incomes have fallen significantly in real terms during the transition. GDP has fallen by nearly 30% since 1989 when the political transition began (World Bank, 1994a; Rose, 1993). A recent UNICEF (1994) study indicates that household incomes probably have fallen by roughly the same amount. One should exercise caution in comparing household incomes since the onset of the transition, however, because dramatic changes have occurred in the structure of income and taxation over the past few years. Never- theless, most households have suffered significant income losses, and many face increased uncertainty about their future incomes.

Using the 1992 household survey, the analysis estimates average household income per capita at 16,809 leva, or about US$709 (see table 2). The average house-

hold income per capita in the rural sector is 19,151 leva (about US$808) and is 26% higher than the urban average (15,090 leva or about US$637). Furthermore, for each income decile, rural household income is higher than urban household income (see table 2). The difference in income levels between the two sectors is statistically significant.

Income distribution measurement is by groups (decile, quintiles, etc.), ranking households by their income/consumption expenditure. Table 2 shows the distribution of household income per capita by income decile. The Gini coefficient is 25.8%. While the Gini index in a typical middle- income country had ranged between 40 and 5470, in Central and Eastern Europe, it oscillated between 20 and 29%-at val- ues even lower than those prevailing in Western market economies (Hassan and Peters, 1996.) This comparatively low income inequality, although changing rapidly, still is an important characteristic of most economies in transition.

Table 2 shows that the rich (top decile) receive nearly 22% of total income, a share that exceeds their population share by


TABLE 3 Effective Income Tax Rates (70)

Income Decile National Urban Rural

Bottom Second Third Fourth Fifth Sixth Seventh Eight Ninth

Average Poor (lowest 2 decile)

TOP

1.35 1.36 1.74 2.03 2.53 3.56 4.32 4.86 5.62 5.82 4.06 1.35

1.51 1.64 2.29 2.59 3.51 5.28 5.96 6.01 7.28 7.82 5.31 1.57

0.96 1.03 1.03 1.15 1.53 1.80 2.46 3.02 3.28 3.63 2.42 0.99

Source Authors' estimates using 1992 Individual Budget of Households Survey, "3.

more than 100%. In contrast, the poor (the bottom 20?0) receive less than 10% of total income, a share that falls short of their population share by about 50%. Another way of viewing the concentration of income in the upper income groups involve calculating the decile distribution ratio- that is, the share of the bottom 40% in re- lation to the share of the top 20%. Table 2 indicates that the decile distribution ratio is 0.66, indicating that the poorest 40% of households earn only two thirds of the earnings of the top quintile. While income levels vary significantly between urban and rural areas, both the analysis of income shares by decile and Gini coefficients indicate that no significant difference ex- ists between them in terms of income distribution (see table 2). Note that the fact that income inequality is not significantly different between urban and rural areas is unusual for countries at Bulgaria's income level.

V. OVERALL AND SECTORAL INCOME TAX BURDEN

Table 3 shows the effective rate of income tax-the ratio of income taken by income tax-for each income decile. Whether this ratio rises or falls (or is con- stant) as income rises determines whether

the tax system is progressive or regressive (or proportionate). Table 3 shows that low- income households display markedly lower income tax-to-income ratios than do higher-income households. For the bottom income decile, this ratio is as small as 1.4%. Additionally, the poor (lowest two deciles) pay a similar ratio. The tabIe shows a relatively smooth rise in the share of income devoted to income tax, to 2.5% at the fifth income decile. For the higher-income households (7 to 10 decile), the percentage of per capita income paid in income tax rises sharply with income. For instance, the rich (top income decile) pay a more than four times higher effective income tax rate than do the poor. These results sug- gest that the 1992 income tax system with marginal rates ranging from 20% to 40% is progressive. Furthermore, excluding in- kind income (expenditure), which accounting for about 24% of household income, eliminates much of the income of the poor from taxation, thereby increasing progressivity.

Despite a steeply graduated statutory tax-rate schedule, effective income tax rates are low, indicating a significant income tax gap (i.e., the ratio of potential income tax revenue to actual revenue). The analysis shows that, on the average, poten-

HASSAN & BOGETI~: EFFECTS OF INCOME TAX ON INCOME DISTRIBUTION-BULGARIA 25

FIGURE 1 Potential, Effective, and Tax Gap by Income Decile (as percent of income)

tial income tax revenue is at least twice the amount actually collected. Obtaining potential income tax revenue involves apply- ing the statutory tax rates/brackets to the household per capita income derived from the survey. The tax gap rises with the income level. For instance, the effective tax rate for the top income class is only 5.8%, while the potential rate is 17.7%, giving a tax gap of 304% (see figure 1). This reflects poor design of tax rates/brackets and incentives for tax evasion inherent to the present income tax system (see Hassan and Bogetic', 1996). Tax brackets are extremely narrow and do not adequately tap the revenue potential of their respective income groups. The highest income tax rates of 36 and 40% are irrelevant (i.e., have no significant revenue effects). That is, in designing the 1992 tax rates/brackets, policymakers have not adequately taken into account the underlying income distribution. Hassan and Bogetic' (1996) show that a flat tax with a rate that is ap-

rate

10

proximately half the lowest 1992 statutory rate could generate approximately the same revenue as does the current system. Furthermore, the rapidly growing number of self-employed individual resulting from the surge in small-scale retail establish- ments amplifies incentives for tax evasion. The private sector expansion created po- tentially taxable entities that previously had no tax files. To include this group in the tax base, the tax administration must identify, locate, monitor, and enforce col- lection of tax obligations. Given the slowly improving tax administration, a consider- ably larger number of potential taxpayers probably will reduce detection of noncom- pliance, making tax evasion less costly.

Table 3 also gives the urban and rural effective income tax rates for each income decile. Urban households pay 5.3% of their per capita income in income tax whereas the rural sector pays less than half that amount. The table shows that the percentage of per capita income devoted to in-


TABLE 4 Percentage of Income Tax Paid by Income Decile

Income decile National Urban Rural

Bottom Second Third Fourth Fifth Sixth Seventh Eighth Ninth Tenth

Poor (lowest 2 decile) Total

1.38 1.86 2.79 3.69 5.20 8.16

11.26 14.53 19.86 31.27

100 3.24

1.40 1.67 2.89 3.68 5.52 9.31

11.83 13.57 19.68 30.46

100 3.07

1.51 2.35 2.82 3.53 6.30 6.01

10.65 14.96 19.24 32.63

100 3.86

Soirrcs: Authors’ tabulations using 1992 Individual Budget of Households, NSI

come tax is much higher for the urban sector than for the rural one. This urban-rural disparity in income tax burden cuts across income classes. The disparity mainly is due to the exclusion of in-kind income/expenditure from taxation. Such exclusion greatly reduces tax burden estimates, particularly in the rural sector where in-hnd income/expenditure is more common. Huang’s (1976) study of the distribution of the tax burden in Tanzania concludes that the role of in-kind consumption is extremely important and partially explains why the tax system is both progressive and urban-biased. Other reasons are con- nected with the type of items taxed. For instance, many taxed commodities such as motor vehicles, entertainment, and dura- bles are more commonly available in urban areas. Furthermore, the existence of non-monetized sectors limits the scope of taxation and also permits tax-induced movements into non-taxable activity-a form of tax avoidance that the more ad- vanced industrial nations can eliminate.

Finally, the analysis here assesses the distributional impact of income tax at the national, urban, and rural levels, by questioning whether the poor and other lower income classes pay a smaller share of total

income tax than their share of national income. If that is the case, the income tax system is pro-poor, as it reduces income inequality. Table 4 presents information on the percentage of income tax paid by each income decile at the national, urban, and rural levels. Combining the information in tables 2 and 4 indicates that the poor as well as the lower middle income groups (up to the 6th income decile) pay a smaller share of income tax than their share of national income. For instance, while the poor (bottom two deciles) pay about 3.2% of total income tax (or less than one third of their income share), the top income class share of tax is 31.3% (or more than 50% of their income share).

The following Gini coefficients further confirm the redistributional effect of the personal income tax. The Gini Coefficient, before the allocation of the personal income tax burden, is 25.870 (see table 2). Personal income tax reduces the inequality of income distribution as the Gini coefficient decreases from 25.8% before tax to 24.3% after the allocation of the tax burden. This positive distributive effect of income tax applies to both the urban and rural sector (see tables 2 and 4.) Similarly, the Gini coefficient drops from 24.6 to

HASSAN & BOGETIC: EFFECTS OF INCOME TAX O N INCOME DISTRIBUTION-BULGARIA 27

22.8% for the urban sector and from 26.5 to 25.1% for the rural one.

Interestingly, urban households overall pay a smaller share of total taxes paid than do rural households. However, the difference is not significant. This result applies to the rural poor (the lowest two deciles) and urban poor as well. This conclusion confirms the insignificant difference in the income distribution between the urban and rural sector.

In sum, the 1992 personal income tax system seems to be progressive and urban- biased. Furthermore, it contributes to re- ducing the overall and sectoral (urban- rural) income inequality.

VI. CONCLUSIONS

This study utilizes the 1992 household budget survey to determine the distribution of the overall and sectoral (urban- rural) income and income tax burden in Bulgaria. The paper also analyzed the distributional impact of the present income tax at the national, urban and rural levels.

Bulgaria is characterized by low income inequality, though this is changing rapidly. Income levels vary significantly between urban and rural areas, but analyses of income shares by decile and by Gini coefficients indicate no significant difference between urban and rural areas in terms of income distribution.

The personal income tax system is progressive, with the poor (the lowest two income deciles) paying 1.4% of their per capita income to the government in personal income taxes and the rich (top decile) paying nearly 6%. This progressiveness tax mainly is due to a progressive statutory tax schedule with marginal tax rates ranging from 20% to 40%. Excluding in-kind income/expenditure from taxation accen- tuates this. Although the 1992 income tax

system shows a steeply graduated statutory tax-rate schedule, effective progression is rather modest, indicating a significant income tax gap/evasion.

The present income tax system has an obvious "urban bias." For example, urban households pay 5.3% of their per capita income in income tax whereas the rural sector pays 2.4%. This urban-rural disparity in income tax burden cuts across income classes. The exclusion of in-kind income/expenditure from taxation reduces tax burden estimates, particularly in rural areas where in-kind income/expenditure is more common. This implies that rural households may bear an even smaller tax burden relative to urban households. However, one can justify the urban bias on equity grounds. To the extent that urban households are enjoying more government services per capita, this higher tax burden at least may partially offset the urban bias of the public services favoring urban resi- dents.

One must view the findings of progressivity and urban bias in Bulgaria cautiously. Obviously, as in-kind income becomes monetized and as the economy becomes more market-oriented, both progressivity and urban/rural difference will substantially wane over time.

One also can assess the distributional effects of income tax by questioning whether the poor and other lower income groups pay a smaller share of income tax than their share of national income. Re- sults show that the 1992 personal income tax system contributes positively to reduc- ing income inequality at both the national and sectoral level: the poor (as well as the lower middle income groups up to the 6th decile) pay a share of taxes that is smaller than their share of national income.


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effects of personal income tax on income distribution: example from bulgaria

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