the relationship between tax rates and budgetary...

The relationship between tax rates and budgetary

income. Adaptability of the Laffer curve in

budgetary planning

MASTER THESIS

Authors Academic Advisor

Sarunas Cerekas Erik Strøjer Madsen

MSc in Finance and International Business Department of Economics and

Business

Arturas Gumuliauskas

MSc in Finance and International Business

June 2012

Table of Contents

1. INTRODUCTION ................................................................................................................. 3

2. THEORY OF TAXES .......................................................................................................... 5

2.1. Tax history ...................................................................................................................... 5

2.2. Concept of taxes ............................................................................................................. 7

2.3. Classification of taxes ..................................................................................................... 8

2.4. Laffer Curve .................................................................................................................... 9

2.5. Personal Income Tax ..................................................................................................... 15

2.6. Value Added Tax ........................................................................................................... 17

3. TAX ANALYSIS ................................................................................................................. 21

3.1. GDP dynamics .............................................................................................................. 21

3.2. Budgetary dynamics ..................................................................................................... 26

3.3. Revenue composition ................................................................................................... 33

3.4. Income tax overview .................................................................................................... 35

3.5. VAT overview ............................................................................................................... 47

4. LABOR TAX REVENUE ESTIMATION ........................................................................... 56

4.1. Labor tax ratio determination ....................................................................................... 56

4.2. Labor tax revenue determination ................................................................................. 58

4.3. The Data ....................................................................................................................... 61

4.4. Model ........................................................................................................................... 62

4.5. Results .......................................................................................................................... 69

5. VAT REVENUE ESTIMATION ......................................................................................... 71

5.1. VAT Revenue Determination......................................................................................... 72

5.2. The Data ....................................................................................................................... 76

5.3. Model ........................................................................................................................... 78

5.3.1. Linear-Linear Model .................................................................................................. 79

5.3.2. Log- Log Model ......................................................................................................... 83

5.4. Results .......................................................................................................................... 86

6. CONCLUSION ................................................................................................................... 89

7. REFERENCES .................................................................................................................. 91

1. INTRODUCTION

"In this world nothing is certain but death and taxes."

--Benjamin Franklin, in a letter to M. Leroy, 1789.

Relying on these words of wisdom we should not fight taxes but learn to live

with them. History shows that changes in tax systems were common practice and

one can assume that the present system will continue to adopt changes based on

the state of public finances and extent of international trade, making the topic of

anticipating shift in taxation highly relevant. Taxes are the backbone of general

government revenue for countries across the globe and the imbalances between

revenue and expenditure often are the sources of political quarrels and economic

swings.

Due to the effects of globalization and free capital movement, which are

especially evident in economic and political unions, market participants are free to

choose the country of activity. Generally market participants are concerned with

the overall fiscal stability and tend to favor more stable countries. Countries with

the most significant or unexpected fiscal policy adjustments tend to be regarded as

slightly unstable and unpredictable, transforming them into risky markets with an

unattractive environment thus evoking the negative effect of capital flight from the

country.

Unsustainable levels of debt to GDP and budgetary deficits constitute a lethal

combination and have become a material topic for policy makers. Recent events

including the Greek debt restructuring deal, that was executed in March 2012 and

huge concerns aimed at similarly indebted South European countries of Portugal,

Italy and Spain raise the topic of austerity measures. Generally three ways of

budgetary balancing are used in practice: cuts in expenditures, increases in

revenues and borrowing, with the third option being the preferred choice of most

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governments. However an initiative of fiscal austerity measures1 for most of the

European Union member states has been enacted on May 2012; it severely

curtailed the use of borrowing by general government, especially in the case of

member states that have and excessive and hardly sustainable debt to GDP ratio

of 60 %.

Since it is difficult to argue against the use of any of the two remaining

budgetary balancing measures, we will focus our thesis on the revenue maximising

measures that are at the disposal of individual countries. We identified the two

dominating taxes used by EU member states – labor tax and value added tax.

Each of the taxes will be estimated based on the Laffer theory of revenue

maximization. In theory Laffer Curve explains the parabolic relationship between

tax revenue and tax rate. The objective is to define the model for tax revenue to

see if the model is robust and fits with the theory of Laffer Curve. As a final result,

the revenue maximizing labor tax and value added tax rates will be computed and

compared to existing tax rates in different European countries.

The first section explores the basic theory of the taxes, including the concept of

the Laffer Curve. The second section presents the macroeconomic situation of the

sample countries and analyses labor tax and value added tax in more depth.

Finally, the models and estimations for both labor tax revenue and value added tax

revenue are estimated with the conclusions along with a summary presented at the

end of the paper.

1 Treaty on Stability, Coordination and Governance in the Economic and Monetary Union

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2. THEORY OF TAXES

The Oxford dictionary states that a tax (Latin taxare: ‘to censure, charge,

compute‘) is a compulsory contribution to state revenue, levied by the government

on workers' income and business profits, or added to the cost of some goods,

services , and transactions. Taxes are not voluntary payments or donations in their

essence, but rather enforced contributions with failures to comply resulting in state

prosecution and punishment by law.

According to Meidūnas V., Puzinauskas (2001), no services or goods are

granted directly to the individual taxpayer for the payment of taxes. Funds are

accumulated and later dispensed through the budgetary mechanism according to

current National priorities. Budgetary expenditures exceeding revenue can only be

offset by borrowing or increasing tax rates, meaning that budgetary sustainability is

an essential element for the existence of a sovereign nation.

History shows that changes in tax systems were common practice and one can

assume that the present system will continue to adopt changes based on the state

of public finances and extent of international trade, making the topic of anticipating

shift in taxation highly relevant.

2.1. Tax history

Taxation can be considered as an integral part of society. With the evolution of

states came changes in the means of raising funds for military activities, expansion

and common social affairs (Meidūnas V., Puzinauskas, P, 2001). Taxes in all its

forms played a crucial role in the development of the modern state. The first

documented tax system was recorded in Ancient Egypt around 3000 BC, when

during a biennial event the Pharaoh would appear before his people and collect

taxes. Along with taxation came immunity from taxation to the privileged groups

with the first documented occurrence around 2600 BC for temple staff and the

property of temples and foundations.

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Ancient Mesopotamian records provide more insight to the extent and methods

used in the primitive taxation systems. Due to the lack of a unified measure of

value, currently played by currency, taxes were paid in kind. Some periods saw

excessive taxation with a poll tax requiring each man to deliver a cow or a sheep to

the authorities, tolls and duties levied on the merchants required a portion of

transported goods to be paid. The most burdensome obligation frequently recorded

in history is the labor obligation, meaning that households were required to perform

certain deeds, including military service, for the state or local powers. A form of

labor obligation- serfdom- was common in Europe until its cancellation in late XIX

century, with obligations reaching 6 days of labor per week for every employable

household member.

Taxation levels varied depending on the state of public finance and in certain

countries displayed high levels of flexibility. In 167 BC due to successful expansion

and income generated from recently captured provinces, the Roman Empire

revoked the tax against land owned by its citizens in Italy. The Roman Empire also

practiced a novel approach to tax collection by introducing the model of private tax

collectors called ‘publicani’ at the expense of tax payers resulting in excess tax

rates.

As stated by Meidūnas V., Puzinauskas, (2001), the process of centralization of

political power in Europe that started in XV-XVI century caused serious financial

problems due to increased military, administrative and other expenses and was a

catalyst for change in taxation. The new movement, called mercantilism, focused

on enriching the state from international trade by decreasing taxation on exports

and increasing taxation on imports and laid the foundation of the basic principles of

modern customs and duty policies. Successive years saw growing concerns on the

topic of taxes with numerous proposals offered, from the Physiocratic position of a

single tax based on land ownership, since all the goods produced stem from land,

to the classical finance school position of minimizing taxes and the role of the state

altogether.

Two major schools of the modern economic thought on taxation are the ones of

Neo-Keynesian and Neo-classicists. The first movement envisions taxes as a

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regulatory mechanism for manufacturing and industry and the tax system as an

anti-inflation and anti-recession model aimed at countering economic cycles and

thus smoothening economic swings. This is theoretically achieved by increasing

the tax burden and imposing additional constraints during the growth cycle and

contrary - decreasing the tax burden and increasing public expenditure during the

contraction cycle in the economy. The opposing economic school – the Neo-

classicists – holds a contradicting approach to taxes and believes in the self

regulating capabilities of the free market. According to them competition itself holds

the necessary regulatory power and the role of taxes and government in general

should be limited to warranting an effective balance of supply and demand and

ensuring local and national security (Stačiokas, R.,Rimas, J., 2003)

However taxation systems are constantly changing and the current model is

most likely simply a stage of the ongoing transition.

2.2. Concept of taxes

According to Stačiokas, R.,Rimas, J., (2003), taxes are the primary means of

funding public services such as security from external threats, internal policing and

sustaining public order, health care, social care, education, major infrastructure

projects, etc. Global practice shows that most of the public services cannot be

successfully outsourced through private businesses, since in many instances

projects might have negative net present value or the service might generate

insufficient return on investment. In the case of policing functions, privately owned

subjects might not be trustworthy with extremely fertile ground for corruption.

Generally it is difficult to evaluate the extent of public services consumed by

separate individuals, therefore common practice is taxation based on capability by

the subject.

In modern economics, fiscal policy and taxation rates can be a distortive

element. A lag factor exists in the administrative and functional level as well as in

the identification of economic cycles. This means that fiscal policy adjustments and

taxation rate changes require extensive discussion in the government level prior to

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the decision. Substantial lag is also evident between the moment of resolution and

the actual effect that the resolution produces. Economic cycles are judged by major

macroeconomic rates such as inflation rates and Gross Domestic Product (GDP)

rates which by themselves are lagging indicators. Therefore reacting to economic

cycles through fiscal changes presents significant challenges and has the power to

trigger severe budgetary constraints.

2.3. Classification of taxes

In modern times individual taxes are composed of five essential elements

(classification supplied by Meidūnas V., Puzinauskas, P, 2001):

• A tax subject is a person who is assigned the obligation to pay taxes.

Commonly the tax subject and the actual tax payer are congruous, but in

certain cases they might not coincide (in the case of value added tax, the tax

subject is the consumer of the product, but the payer is the seller of the

product).

• A tax object is the actual object that is being taxed like income, services,

goods, assets, etc.

• The unit of taxation is a unit of measurement that is required for the estimation

of the amount of tax payable, like a currency unit for income tax, a hectare for

land taxes, capacity for excise duties.

• The tax rate is amount of tax required per unit of taxation. Usually the tax rate

is expressed in a percentage value (income tax, goods and services tax), it can

also be expressed as a fixed amount (diesel, tobacco).

• A tax exemption is a special tax rate reduction for certain tax subjects. Tax

exemptions may be temporary or permanent, compulsory or allowable. A tax

credit (a delay of payments) and tax holiday (a waiver of taxes for a certain

period of time) are both forms of tax exemption.

In modern tax theory, taxes are broadly categorized into two branches- direct

and indirect taxes. The distinction is made based on tax object and the relation

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between the tax subject and state- directly from income and assets or indirectly

from the price system (added to the price of goods sold within a state). Classifying

individual taxes into these major branches is a fairly subjective matter because

most direct taxes like corporate revenue taxes can be argued to be transferable to

the consumer in the pricing process, but the dominant classification is common and

based on best practice.

The most widespread direct tax is the income tax, levied on personal income

and corporate revenue. Other examples of direct taxes are property taxes, land

taxes, inheritance taxes, capital, capital gains taxes and other. The most common

indirect taxes are levied on goods and services, like the Value Added Tax, the

Goods and Sales Tax and other taxes that actually fall on the consumer but are

paid by the seller, like excise duties on oil products, alcohol, tobacco and other

goods that are generally regulated by the government or belong to monopolist

industries.

A different type of tax is the Ecological tax, the subject of which is the

consumption of polluting materials like most oil products. The tax revenue is not

directed to the national or municipal budgets but is rather accumulated for dealing

with prevention and consequences of pollution. Another specific tax exists in the

European Union and is levied on the imports of agricultural products, the proceeds

of which are directed to the EU budget.

In our thesis we will focus on two major taxes- one from each branch- personal

income tax and Value Added Tax. The particular taxes were chosen based on their

prevalence globally and the extent of budgetary income they generate.

2.4. Laffer Curve

As the stagflation, high unemployment and high inflation appeared in the 1970s,

demand side policies were unable to solve such type of the problems (van Duijn,

1982). However, supply-side economists believed that the reason for stagflation is

an excessive tax burden and an economical over-regulation by the government. In

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order to solve stagflation problem, the policy of a tax reduction and a deregulation

of the economy must be pursued (Burda, Wyplosz, 1993). Supply

expressed in the Laffer curve which depicts the expected rel

revenue and tax rate.

The Laffer curve is named after economist Art Laffer, who is said to have drawn

this curve on a napkin in a Washington restaurant in 1974. The Laffer curve states

that there is parabolic relationship between tax

noted, “there are always two tax rates that yield the same revenues” (Laffer, 1986).

That means that taxable income changes when tax rate is altered, but there is a

point where reduction in taxable income from higher ta

enough to completely offset the higher tax rate. This point is called “revenue

maximizing” point.

Laffer curve is the illustration of a dynamic scoring model (Fig

scoring model (Figure 1a) assumes that the higher the ta

revenue is collected. One can contradict that if tax rate was 100 per cent, no one

would work and thus no tax revenue would be collected. Also, if tax rate was 0 per

cent, obviously no tax revenue would be collected as well. This lead

that relationship between tax rate and tax revenue must be parabolic.

Figure 1. Comparison of the static scoring and dynamic scoring.


of the economy must be pursued (Burda, Wyplosz, 1993). Supply

expressed in the Laffer curve which depicts the expected relationship between tax



that there is parabolic relationship between tax rates and tax revenue. As Art Laffer



point where reduction in taxable income from higher tax rates becomes large

enough to completely offset the higher tax rate. This point is called “revenue

Laffer curve is the illustration of a dynamic scoring model (Fig

igure 1a) assumes that the higher the tax rate the higher tax



cent, obviously no tax revenue would be collected as well. This lead


. Comparison of the static scoring and dynamic scoring.


of the economy must be pursued (Burda, Wyplosz, 1993). Supply-side ideas are

ationship between tax



rates and tax revenue. As Art Laffer



x rates becomes large

enough to completely offset the higher tax rate. This point is called “revenue-

Laffer curve is the illustration of a dynamic scoring model (Figure 1b). Static

x rate the higher tax



cent, obviously no tax revenue would be collected as well. This leads to a notion


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Laffer assumes that too high tax rates make people to be inactive

Figure 2 illustrates extreme occasion when tax rate is 100 per cent. High taxation

rate leads to low production, low incomes and, consequently, to low tax revenues

(Heijman, van Ophem, 2005). Additionally, people may become active in the black

labor economy. As Friedman et al

are generally correlated with a higher share of the unofficial economy. Lower tax

rates, conversely, make people to withdraw from the black economy and become

officially active. Point B in Figure 2 shows “reve

government can reach optimum tax rate and collect maximum possible tax

revenue.

Figure 2. Laffer Curve

As Mitchell (2009) argues revenue maximizing point is not the best for whole

economy. Ideal policy is reached in growth max

somewhere on upward sloping section of the Laffer curve. Growth maximizing

point is greater than zero, because there is a need for tax revenue to ensure

market economy function. Society needs such things as public safety,

courts, and healthcare.

The Laffer curve explains relationship between tax rate and tax revenue.

However, in the real world tax rate changes are not made in isolation with other

economic aspects. Beczi (2000) analyses what happens if the government

Laffer assumes that too high tax rates make people to be inactive

extreme occasion when tax rate is 100 per cent. High taxation



labor economy. As Friedman et al (Friedman et al, 2000) shows, higher tax rates



officially active. Point B in Figure 2 shows “revenue-maximizing” level where



economy. Ideal policy is reached in growth maximizing point (Figure 2), which is



market economy function. Society needs such things as public safety,



economic aspects. Beczi (2000) analyses what happens if the government

Laffer assumes that too high tax rates make people to be inactive – Point C in

extreme occasion when tax rate is 100 per cent. High taxation



(Friedman et al, 2000) shows, higher tax rates



maximizing” level where



imizing point (Figure 2), which is



market economy function. Society needs such things as public safety, honest



economic aspects. Beczi (2000) analyses what happens if the government actively

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spend its revenues, as it is obvious in the real world. If the government spends

more revenues on taxed goods, it will increase the demand for good. This action

will offset the decrease in tax revenue caused by tax increase. Therefore, revenue

maximizing tax rate will rise. In Figure 3 one can see that because of demand

curve shift, revenue-maximizing tax rate moves from Point A to Point E. Finally

Beczi (2000) concludes that if government cuts taxes and at the same time rises

government consumption and decreases public investments, it increases the

likelihood that optimal tax revenues are lost. Tax policy must be related to both

public investment and public spending.

Figure 3. The impact on tax rate due to demand curve shift.

Furthermore, Henderson (1981) points out interesting idea that real

curve is more complex. It looks like in Figure 4, because, as Henderson argues,

tax rate cut would not necessarily cause people to work more.



will offset the decrease in tax revenue caused by tax increase. Therefore, revenue

ximizing tax rate will rise. In Figure 3 one can see that because of demand

maximizing tax rate moves from Point A to Point E. Finally

) concludes that if government cuts taxes and at the same time rises

on and decreases public investments, it increases the


public investment and public spending.

The impact on tax rate due to demand curve shift.

Furthermore, Henderson (1981) points out interesting idea that real


tax rate cut would not necessarily cause people to work more.



will offset the decrease in tax revenue caused by tax increase. Therefore, revenue-

ximizing tax rate will rise. In Figure 3 one can see that because of demand

maximizing tax rate moves from Point A to Point E. Finally

) concludes that if government cuts taxes and at the same time rises

on and decreases public investments, it increases the


Furthermore, Henderson (1981) points out interesting idea that real-life Laffer


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Figure 4. Complex shape of the

If the government cuts tax rate, tax revenues move from point A to point B.

People get higher income because of tax cut, but they might work less and spend

more time for leisure. Therefore, tax revenues decrease.

Another aspect, discussed by

which is also a tax. If tax rate cut does not cause immediate rise of tax revenue

and government does not decrease spending, the increase in budget deficit will

appear. Therefore, in countries, which have

would increase. Also increase in tax revenues might appear simpl

population growth.

Feige, Edgar L., and Robert T. McGee (1982) developed a simple model for

Laffer curve. The model shows that the shape and

Sweden depend on the power supply, the progressivity of the tax system and the

size of the observed economy.

Jonas Agell and Mats Persson (2000) analyze the government budget balance

in a simple endogenous growth model, by

transfer-adjusted tax rates in OECD countries to determine if countries apply

theoretically optimal tax rates. Jesús Alfonso Novales and Ruiz (2002) analyze

Complex shape of the Laffer Curve.



more time for leisure. Therefore, tax revenues decrease.

Another aspect, discussed by Henderson, is that tax cut can increase inflation,



appear. Therefore, in countries, which have the power of currency issue, inflation

would increase. Also increase in tax revenues might appear simpl


Laffer curve. The model shows that the shape and position of the Laffer curve for


size of the observed economy.


in a simple endogenous growth model, by conducting an empirical study of

adjusted tax rates in OECD countries to determine if countries apply




Henderson, is that tax cut can increase inflation,



the power of currency issue, inflation

would increase. Also increase in tax revenues might appear simply because of


position of the Laffer curve for



conducting an empirical study of

adjusted tax rates in OECD countries to determine if countries apply


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how to manage deficit by substituting debt with taxes. They find that tax cuts on

labor and capital income have a positive effect on growth rate of the economy.

Trabandt Mathias and Harald Uhlig (2006) used a neoclassical growth model,

calibrated with constant Frisch elasticity for the US, and EU-14 economy. The

results show that both US and EU-14 economies can increase tax rates on labor

and capital income and gain higher tax revenues. However the Laffer curve in

consumption taxes does not have a peak.

The discussion about implementation of the Laffer curve in practice spread

widely in the USA in 1970’s. At that time top federal tax rate was 70 per cent and

encouraged people from that tax bracket to withdraw from official economy.

Proponents of the Laffer curve suggested politicians to cut tax rate and collect

higher tax revenues. Finally in 1988 top tax rate dropped to 28 per cent leading to

the increase of tax revenue five times as much revenue as was collected when top

tax rate was 70 per cent2. Table 1 shows that the number of tax payers (who’s

income was over $200 000) was nearly 117 000 and tax paid was more than $19

billion. After tax cut the number of the taxpayers in that bracket jumped to nearly

724 000 and the government collected more than $99 billion of taxes. However one

needs take into account the facts that population grew over this period as well as

inflation increased about 44 per cent. Still this example illustrates strong effect of

the Laffer curve.

Taxes paid on income over $200 000 in 1980

Tax bracket Number of

taxpayers

Taxable

income Income tax paid

$200 000 - $500 000 99 971 $22 696 007 $11 089 114

$500 000 - $1 000 000 12 379 $6 512 424 $3 613 195

$1 000 000 and more 4 389 $7 013 225 $4 301 111

Total 116 757 $36 221 656 $19 003 420

Taxes paid on income over $200 000 in 1988

Tax bracket Number of Taxable Income tax paid

2 http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html

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$200 000 - $500 000

$500 000 - $1 000 000

$1 000 000 and more

Total

Table 1. Labor tax statistics in the USA

Another example is Ireland. In 1985 with corporate tax rate of 50 per cent

Ireland collected tax revenues equal to 1.1 per cent of GDP

steadily decreased corporate tax rate until it was 12.5 per cent in 2000. As shown

in Figure 5, corporate tax revenues increased about three times and reached 3.6

percent of GDP. It must be noted that GDP figures are corrected for inflatio

Laffer curve effect is obvious in this case.

Figure 5. Corporate Tax Rate and Corporate Tax Revenue dynamics in Ireland.

2.5. Personal Income Tax

Personal Income Tax is a direct tax levied on income of a person. A person

means an individual, an

Generally, a person pay tax calendar year basis.

3 http://www.oecd.org.dataoecd/48/27/41498733.pdf

taxpayers income

547 239 $134 655 949

114 562 $67 552 225

61 896 $150 744 777

723 697 $352 952 951

Labor tax statistics in the USA


Ireland collected tax revenues equal to 1.1 per cent of GDP3. The government


, corporate tax revenues increased about three times and reached 3.6

percent of GDP. It must be noted that GDP figures are corrected for inflatio

Laffer curve effect is obvious in this case.

Corporate Tax Rate and Corporate Tax Revenue dynamics in Ireland.

Personal Income Tax


means an individual, an ordinary partnership, a non-juristic body of person.

Generally, a person pay tax calendar year basis.

http://www.oecd.org.dataoecd/48/27/41498733.pdf

$38 446 620

$19 040 602

$42 254 821

$99 742 043


. The government


, corporate tax revenues increased about three times and reached 3.6

percent of GDP. It must be noted that GDP figures are corrected for inflation. So

Corporate Tax Rate and Corporate Tax Revenue dynamics in Ireland.


juristic body of person.

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Taxpayers are classified into residents and non-residents. The definition of a

concept “resident” differs from country to country. Basically, “resident” means any

person residing in certain country for a certain period of time. A resident of certain

country is liable to pay tax on income from sources both in the country he/she

resides and in foreign countries. A non-resident is a person who does not reside in

certain country but still earns income in that country.

Income can be in cash and in kind. Both of these income types are chargeable

to the personal income tax. The income which is subject to income taxation is

called assessable income. Certain deductions and allowances are allowed in the

calculation of the taxable income. Taxpayer shall make deductions from

assessable income before the allowances are granted. Therefore, taxable income

is calculated by the following formula:

Taxable income = Assessable Income - deductions - allowances

Taxes can have a significant effect on income distribution in an economy. As

Adam Smith (1904) noted tax should be linked to ability to pay. Therefore, tax

systems can be distinguished as follows:

• Progressive tax system – a system in which tax represents a greater proportion

of a person's income as their income rises. In other words, the average rate of

taxation rises.

• Regressive tax system – a system in which tax represents a smaller proportion

of a person's income as their income rises. In other words, the average rate of

taxation falls.

• Proportional tax system – a system in which tax is paid as the percentage if the

income. The percentage remains the same despite the level of income. In this

system the average rate of taxation is constant.

There is always an open discussion about the difficulties in administering the

tax and maintaining a sense of fairness of who is paying and how much. Proposals

to modify the income tax system to make it “flat” (fewer tax rates and fewer

deductions) arise more often (Kiefer, 2010). Still, income tax is an important source

of budgetary income. However, each country has its own specifics on personal

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income tax. The review of personal income tax along with labor taxes are depicted

in Section 3.4.

2.6. Value Added Tax

Value added tax (VAT) is one of the most widespread indirect taxes in the world

with increasingly more countries adopting it for taxation of consumption. According

to the Organization of Economic Cooperation and Development (OECD), over 150

countries have implemented a VAT/GST and there is a need for a global platform

where the economic, social and cross border issues of operating a VAT/GST can

be discussed. A VAT is levied on the difference between a business’s sales and

its purchases of goods and services. Typically, a business calculates the tax due

on its sales, subtracts a credit for taxes paid on its purchases, and remits the

difference to the government (United States Accountability Office Report to

Congressional Requests, Value Added Taxes, 2008.)

The Lithuanian Ministry of Finance proposes the following definition of the VAT

subject: ‘the subject of VAT is the supply of goods and services by a taxable

person in the performance of his/its economic activities within the territory of the

country that are affected for consideration’. The value added tax system is

designed to address various problems associated with the conventional sales tax

system such as cascading- the term describing a situation when the end consumer

of a product is obliged to pay taxes on an input that has already been taxed earlier

in the production chain. The clarity and transparency of the VAT system enables

effective elimination of the cascade problem and the associated tax evasion

problem. In regard of International trade, VAT is seen by some countries as

discriminatory. The American Manufacturing Trade Action Coalition (AMTAC)

express concerns that the rebate of taxes upon export normally is prohibited under

the World Trade Organization trading regime, but within the Value Added Tax

system, taxes are rebated on exports and assessed on imports, triggering

International imbalances and providing certain countries with a competitive

advantage. According to the OECD, research suggests that the current

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international environment for consumption taxes, especially with respect to trade in

services and intangibles, is hindering business activity and economic growth and

distorts competition. The US Government Accountability Office also discusses

initiatives of introducing a VAT equivalent in the US. The creation of a global

framework for applying VAT/GST on international trade is therefore a key priority

for the OECD.

Our Master thesis will be primarily focused on members of the European Union

therefore the European VAT systems will be addressed in more depth. VAT was

invented in 1954 by a French economist and introduced by Maurice Laure, the joint

director of the French tax authority. It was introduced for large businesses but later

expanded to remaining sectors of the economy. On 11 April 1967 the first two VAT

Directives were adopted, establishing a general, multi-stage but non-cumulative

turnover tax to replace all other turnover taxes in the Member States. The first two

VAT Directives laid down only the general structures of the system with Member

States being free to determine the VAT coverage. In May 1977 the Sixth VAT

Directive was adopted and established a uniform VAT coverage. On 1 January

2007, the Sixth Directive was replaced by the VAT Directive which guarantees that

the VAT contributed by each of the Member States to the Community's own

resources can be calculated. It still however, allows Member States many possible

exceptions and derogations from the standard VAT coverage. Moreover, it does

not set out the rates of VAT to be applied in Member States, only a minimum rate

of 15%. For transactions between taxable persons it is still a destination based

VAT system, but it is a Transitional VAT System, and the intention is eventually to

have a common system of VAT where VAT is charged by the seller of goods - an

origin based VAT system with VAT being charged at the rate in force where the

supplier is established4.

The European e-Justice portal under the European Commission provides the

following explanation of a VAT system: ‘The common system of VAT applies to the

production and distribution of goods and services bought and sold for consumption

4 European Commission on the history of value added taxes in Europe

19 | P a g e

within the European Union and the actual tax burden is visible at each stage in the

production and distribution chain. To ensure that the tax is neutral in impact,

irrespective of the number of transactions, taxable persons for VAT may deduct

from their VAT account the amount of tax which they have paid to other taxable

persons. VAT is finally borne by the final consumer in the form of a percentage

addition to the final price of the goods or services’. Double taxation is avoided and

tax is paid only on the value added at each stage of production and distribution. In

this way, as the final price of the product is equal to the sum of the values added at

each preceding stage, the final VAT paid is made up of the sum of the VAT paid at

each stage. The tax is paid to the revenue authorities by the seller of the goods,

who is the taxable person, but it is actually paid by the buyer to the seller as part of

the price thus making it an indirect tax.

For VAT purposes, a taxable person is any individual, partnership, company or

any other subject which supplies taxable goods and services in the course of

business. However, if the annual turnover of this person is less than a certain limit

(the threshold), which differs according to the Member State, the person does not

have to register as a payer and charge VAT on their sales. EU Member States

have freedom of choice setting the values of thresholds for VAT registration and for

the minimum standard and reduced rates as long as they comply with the minimum

requirements. Supplies of goods and services subject to VAT are normally subject

to a standard rate of at least 15% but Member States may apply one or two

reduced rates of not less than 5% to goods and services enumerated in a restricted

list. However, these rules are complicated by a multitude of derogations granted to

certain Member States which were granted during the negotiations preceding the

adoption of the VAT rates Directive of 1992 and in the Acts of Accession to the

European Union. Such derogations prevent a coherent system of VAT rates in the

EU from being applied.

In order to eliminate any competitive disadvantages stemming from tax rate

differences between Member states and for the purpose of exports between the

Community and non-member countries, no VAT is charged on the transaction and

the VAT already paid on the inputs of the good for export is deducted - this is an

20 | P a g e

exemption with the right to deduct the input VAT. There is thus no residual VAT

contained in the export price. However, as far as imports are concerned, VAT must

be paid at the moment the goods are imported so they are immediately placed on

the same footing as equivalent goods produced in the Community. Taxable people

registered for VAT will be allowed to deduct this VAT in their next VAT return5 The

significance of value added tax proceeds in European Union member states both in

its nominal form and as a proportion of total tax revenue with associated

implications will be discussed in a later chapter of the thesis.

5 The European e-Justice Portal under the European Commission,

http://ec.europa.eu/taxation_customs/index_en.htm

21 | P a g e

3. TAX ANALYSIS

Differing taxation policies and trends, as well as the political and business

environment, are basic factors affecting the level of competitiveness of countries.

As was already mentioned, consistency in countries‘ economic and taxation policy

is of vital importance to the subjects pursuing business objectives both in their

home markets and abroad. Specific data on the dynamics of national budgetary

revenue, the composition of the revenue depending on specific taxes, levels of

expenditure and borrowing should be addressed in order to substantiate the

problem of possible tax changes Europe-wide.

We will present a basic overview of the present-day European Union member

states Gross Domestic Product (GDP) dynamics, revenue and expenditure levels

of the general government and analyze the composition of revenue and its trends.

General government data will be used as an aggregate proxy allowing us to

perform country level comparison and bypass the variations in the extent of

centralization, municipal taxation and compulsory social welfare charges.

3.1. GDP dynamics

Gross domestic product is a measure of the economic activity, defined as the

value of all goods and services produced less the value of any goods or services

used in their creation. It is important to review the extent of and dynamics of

economic activity in all the EU member states and grasp the underlying differences

between them. Due to limited availability of valid statistical data for the full sample,

only the period of 1996-2011 will be reviewed in this section.

Table 2 demonstrates the significant disparity of nominal GDP growth in the EU

member states from year 1996 to 2011 with 1996 as the base year. As visible in

the table, the greatest growth was displayed by member states that were admitted

during the final two enlargement stages with exceptionally high figures

demonstrated by the former states of the Soviet Union and its satellites of the

Warsaw Pact. The economies of these highly dynamic countries are extremely

22 | P a g e

sensitive to economic and fiscal policy changes and represent a potential obstacle

in the homogenization of the tax environment. The column depicting nominal GDP

change in national currency for the Euro Zone countries is calculated as Euro-fixed

series by applying the Euro fixed rate on the national currencies data with

discrepancies of the GDP change data compared to nominal GDP change in Euros

stemming from the pre-Euro exchange rate fluctuations. The column is intended to

display the heterogeneity of the economies of the member states with Romania

and Bulgaria having recently experienced a period of significant inflation, and

Czech Republic, Slovakia and Lithuania appreciating the value of their currencies

during the period of 1996-2011. Furthermore, while Czech Republic and Slovakia

(Slovakia joined the Euro Zone in January 1st 1999) have evolved from a pegged

currency rate to a managed and eventually floating exchange rate with its positive

effects on the economy and trade, Lithuania achieved the depreciation by merely

swapping the base currency used for the peg from US Dollar to the Euro. This

means that even in this respect the three countries are not readily comparable.

Country

Nominal GDP

Change, EUR

Nominal GDP

Change, National currency Country

Nominal GDP

Change, EUR

Nominal GDP

Change, National currency

Belgium 69,81% 74,00% Luxembourg 157,65% 171,08%

Bulgaria 386,28% 4173,53% Hungary 178,51% 301,56% Czech Republic 203,02% 116,24% Malta 121,08% 107,37% Denmark 65,23% 67,04% Netherlands 82,84% 88,30% Germany 33,86% 37,11% Austria 62,92% 66,87% Estonia 328,82% 339,11% Poland 199,36% 260,92% Ireland 165,47% 163,50% Portugal 79,24% 83,46% Greece 96,01% 118,59% Romania 370,21% 4982,06% Spain 118,85% 126,52% Slovenia 113,84% 198,32% France 60,40% 62,05% Slovakia 314,47% 220,79% Italy 58,42% 56,59% Finland 89,43% 93,25% Cyprus 143,22% 140,49% Sweden 77,77% 88,52%

Latvia 348,25% 352,54% United Kingdom 81,08% 92,85%

Lithuania 362,62% 214,54% Table 2. Nominal GDP growth in 1996-2011

23 | P a g e

Figures 6 and 7 have intentionally been projected on a uniform vertical axis

range to depict the real GDP growth rate for year 1996 to 2011 for two groups of

countries based on the years of accession to the European Union. The duration of

membership is likely to reflect the qualitative effect resulting from prolonged

exposure to the unified market conditions, broader experience in the competitive

market setting and the inveteracy of democratic rule and correspondent values.

The first group consists of the EU – 15 countries that have been member states

during the whole sample period and the second group is comprised of countries

admitted during the latest stages of EU enlargement most of which have

experienced a transition to the competitive market setting during the sample

period. The calculation of the annual growth rate of GDP volume is intended to

allow comparisons of the dynamics of economic development both over time and

between economies of different sizes. For measuring the growth rate of GDP in

terms of volumes, the GDP at current prices are valued in the prices of the

previous year and the thus computed volume changes are imposed on the level of

a reference year. This type of measurement eliminates the effects of price changes

during the period and allows for adequate comparison. Among the EU – 15

member states Ireland and Luxembourg initially demonstrated a higher growth rate

in and Greece experienced significant contraction in the end of the period. The 12

EU member states that have joined the Union during the last stages of

enlargement are depicted individually with the bold line representing the average

arithmetical real GDP growth rate for the 15 EU countries. The three newly

independent Baltic states of Lithuania, Latvia and Estonia have experienced the

greatest fluctuations in the growth rate with Malta and Cyprus showing generally

milder deviations and Poland demonstrating a sustainably higher growth rate with

increased resilience to significant changes.

24 | P a g e

Figure 6. Real GDP growth rate in 1996-2011 for EU – 15 states

Figure 7. Real GDP growth rate in 1996-2011 for new Member States

2009 was the peak year of the recent economic crisis and all member states

saw a contraction of their GDP, however the timing of the crisis varied across

countries: a third of the Union suffered a contraction as early as 2008 whilst the

average real GDP growth for the EU – 27 member states was 1.33 %. It is

-20

-15

-10

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5

10

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essential to stress at this point that average target group (EU – 15, EU – 27, new

member states) statistics will represent the arithmetical mean without adjustments

for the weight of individual countries to the consolidated values unless specifically

stated otherwise. This type of analysis is performed because the subsequent

model will be based on country ratios not regarding individual weights.

Even though the new member countries have demonstrated prolonged above-

average growth, the graph supports the notion of most of these countries being

significantly more sensitive to changes in the economic and fiscal environment with

a significantly wider range of fluctuations. Fraser Cameron in a 2010 working paper

suggests that the EU has adopted a more flexible approach to integration which

resulted in a multi-speed Europe with several tiers of integration. A differing

member-country base for the Euro zone, the European Union and the Schengen

passport free-zone is an example of the arrangement. Table 3 depicts the standard

deviations of real GDP growth for the target groups and indicates that the EU – 27

and especially the newest member states demonstrate higher variations of

macroeconomic data. It suggests that immediate unification of the EU – 27

member states would evoke additional obstacles due to the low level of

homogeneity for the two groups and supports the idea of allowing for a multi-speed

Europe. According to Christian B. Jensen and Jonathan B. Slapin (2010), there are

no less than two primary legal mechanisms for pursuing a multispeed approach

within the treaty framework; however the question of decision making by only a

portion of member states remains.

Year 1996 1997 1998 1999 2000 2001 2002 2003

EU - 15 2,50 2,32 1,75 2,22 1,81 1,24 1,65 1,88

EU - 27 3,42 3,87 2,20 2,51 2,42 2,03 2,12 2,78

New member states 4,52 5,45 2,80 2,50 3,12 2,46 1,94 2,77

Year 2004 2005 2006 2007 2008 2009 2010 2011

EU - 15 1,12 1,42 1,19 1,37 1,24 1,64 2,14 2,56

EU - 27 2,19 2,47 2,44 2,61 2,85 4,12 1,90 2,64

New member states 2,46 2,26 2,47 2,80 3,46 5,72 1,65 2,34 Table 3. Standard deviation of real GDP growth in 1996-2011

26 | P a g e

3.2. Budgetary dynamics

As mentioned, general government data will be used as an aggregate proxy

allowing us to perform country level comparison and bypass the variations in the

extent of centralization, municipal taxation and compulsory social welfare charges.

The European System of Accounts (ESA 95), section 2.69 defines the general

government sector as ‘all institutional units which are other non-market producers

whose output is intended for individual and collective consumption, and mainly

financed by compulsory payments made by units belonging to other sectors, and/or

all institutional units principally engaged in the redistribution of national income and

wealth‘ and is made up of the following four sub-categories: central government,

state government, local government and social security funds.

As seen in Figure 8, the dynamics of general government expenditure as a

percentage of GDP for both target groups follow a nearly identical trend with the

coefficient of correlation reaching a significant value of 0,897. The EU – 15

member states tend to have a higher level of GDP redistribution through the

budgetary system with the Scandinavian countries consistently holding the highest

levels during the sample period thus demonstrating the most typical characteristic

of welfare states. The lower range is dominated by the newest member states with

Romania, the three Baltic states and Ireland displaying the lowest redistribution

rates during the sample period; During the financial downturn Ireland moved from

the lower boundary to the highest value with an increase from 36,61 percent in

year 2007 to 66,79 percent in year 2010. The minimum and maximum bands of the

full EU – 27 sample period clearly visualizes the extreme differences of aggregate

expenditure incurred by the sectors of general government.

27 | P a g e

Figure 8. General government expenditure as a % of GDP, 1995 – 2011

General government expenditure data can be interpreted as a proxy of current

obligations by the budgetary system to its citizens, market participants, and other

bodies. In the opinion of the authors expenditure does not reflect the sustainable

level of budgetary redistribution and general government revenue along with the

borrowing rate should be examined for a more precise evaluation. The general

government revenue dynamics (see Figure 9) demonstrate an evidently lower level

of variance compared to general government expenditure with the standard

deviation of the EU – 27 average at 0,37 % and 1,80 % respectively. As with the

level of expenditure, the higher range of the revenue is dominated by the welfare

states of Sweden, Denmark and Finland. The lower range is represented by

Romania and the Baltic states of Latvia and Lithuania. The data suggests that

revenue is a lagging dimension that is momentarily compensated by the level of

borrowing. This notion is supported by the slight upward bend seen in Figure 9 for

year 2011. Glancing from a historical perspective, the minimum – maximum bands

30%

35%

40%

45%

50%

55%

60%

65%

70%

Ge

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EU - 15 New Member States EU - 27

EU - 27 min EU - 27 max

28 | P a g e

for the full sample have slightly contracted from 25,48 % in 1995 to 23,95% in 2011

but it remains difficult to argue for a visible trend in convergence between the

member states. There remains a pronounced disparity between the EU – 15 and

the new member states thus signifying a substantial obstruction to the idea of fiscal

convergence of the EU – 27 member states.

Figure 9. General government revenue to GDP, 1995 – 2011

It is visually evident (see Figure 10) that the general government borrowing rate

as a percentage of GDP follows a clear pattern for the sample states. Overall

increases in the borrowing level are evident during periods of recession (2008-

2011) and are often used in difficult periods of economic development to stabilize

the economic situation. These observations support the Keynesian standpoint of

countercyclical financial policy which originates from the notion that in essence

positive expectations and economic development encourage spending and

negative expectations combined with economic contraction provokes excessive

saving, thus fiscal policy should be employed to reduce the fluctuations. Borrowing

is the favored instrument for budgetary balancing due to its lower impact on social

25%

30%

35%

40%

45%

50%

55%

60%

65%

Ge

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EU - 15 New member states EU - 27


29 | P a g e

disorder and its immediate effect since the alternative rout of cutting budgetary

expenses and increasing the tax burden evokes immediate protests and resistance

and is not able to deliver the necessary results in a desirable time frame. However,

extensive borrowing causes certain hazards with a recent example demonstrated

by Greece and increasing distrust mounting on the EU – 15 states of Portugal,

Spain and Italy. European level discussions on fiscal austerity requirements hint on

limiting the use of borrowing for budgetary balancing.

Figure 10. General government borrowing to GDP, 1995 - 2011

Even though Maastricht criteria on the general deficit level were set out

demanded member states to limit their total government deficit to 3% of GDP as

well as limit total gross general government debt to 60% of GDP, changes were

introduced on 2nd May 2012. The new rule that is introduced in the present EU

Fiscal Compact Treaty6 allows limited temporary deviations and stipulates:

• ‘the budgetary position of the general government of a Contracting Party shall

be balanced or in surplus; 6 see Treaty on Stability, Coordination and Governance in the Economic and Monetary Union,

European Council

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30 | P a g e

• the rule under point (a) shall be deemed to be respected if the annual structural

balance of the general government is at its country-specific medium-term

objective, as defined in the revised Stability and Growth Pact, with a lower limit

of a structural deficit of 0,5 % of the gross domestic product at market prices.

The Contracting Parties shall ensure rapid convergence towards their

respective medium-term objective. The time-frame for such convergence will

be proposed by the European Commission taking into consideration country-

specific sustainability risks. Progress towards, and respect of, the medium-term

objective shall be evaluated on the basis of an overall assessment with the

structural balance as a reference, including an analysis of expenditure net of

discretionary revenue measures, in line with the revised Stability and Growth

Pact;

• the Contracting Parties may temporarily deviate from their respective medium-

term objective or the adjustment path towards it only in exceptional

circumstances, as defined in point (b) of paragraph 3;

• where the ratio of the general government debt to gross domestic product at

market prices is significantly below 60 % and where risks in terms of long-term

sustainability of public finances are low, the lower limit of the medium-term

objective specified under point (b) can reach a structural deficit of at most 1,0

% of the gross domestic product at market prices;

• in the event of significant observed deviations from the medium-term objective

or the adjustment path towards it, a correction mechanism shall be triggered

automatically. The mechanism shall include the obligation of the Contracting

Party concerned to implement measures to correct the deviations over a

defined period of time.’

The full content of the article 3, point 1 of the aforementioned treaty was quoted

in order not to distort or restrict the purport intended by the treaty. Provisions of the

Treaty are to be employed by Contracting Parties at the latest one year after the

entry into force. On 2nd May, 2012 the treaty was signed by – thus the Contracting

Parties constitute – all members of the European Union except two: United

31 | P a g e

Kingdom and Czech Republic. The key provision of the Treaty, as noted in the

quote, is the imposed limits on the use of borrowing in the budgetary balancing

process thus putting an emphasis on fiscal austerity consisting of expenditure

cutting and revenue boosting measures.

Figure 10 reveals that the new member states had retained constantly higher

levels of borrowing prior to their accession to the European Union and merged to a

unified trend for the years of membership with a correlation for the EU – 15 and the

new states rising to 0,959 for the period of 2004 – 2011. However as seen in table

4 the variance for the target groups indicates that the initial member states

experienced a consistently higher standard deviation after the last enlargement

stages. The standard deviation values represent substantial differences present

among the EU – 15 states with Luxembourg and the Scandinavian states of

Finland and Denmark balancing on the lower band of the range and Greece and

Portugal fluctuating on the upper band of the range along with the recent Member

States of Hungary, Malta and Slovakia. The overview of borrowing levels gives

ambiguous results since even consistent budgetary surpluses seem to be

significantly compromised in extreme situations as demonstrated by Ireland (spike

of 2009 – 2011) and to a lesser extent by Spain.

Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 EU - 15 standard deviation 3,10% 2,20% 2,26% 2,27% 2,06% 3,31% 3,09% 2,38% 2,29% New member states standard deviation 4,08% 3,35% 4,02% 3,14% 2,13% 3,08% 2,38% 2,92% 3,34% EU - 27 standard deviation 3,55% 2,74% 3,26% 2,96% 2,77% 4,03% 3,23% 2,93% 2,90%

Year 2004 2005 2006 2007 2008 2009 2010 2011 EU - 15 standard deviation 2,78% 3,31% 3,27% 3,34% 4,07% 4,69% 7,44% 3,76% New member states standard deviation 2,56% 2,54% 3,03% 2,36% 2,15% 2,43% 2,45% 3,16% EU - 27 standard deviation 2,65% 2,96% 3,22% 2,92% 3,33% 3,79% 5,75% 3,50% Table 4. Standard deviations of general government borrowing rates, 1995 - 2011

32 | P a g e

A visualization of the debt to GDP ratios for the target groups is presented in

Figure 11. These ratios generally represent the cumulative total of the borrowing

levels throughout a certain period that have to be adjusted for the changes in GDP.

EU – 15 states tend to have a significantly higher debt to GDP ratio with a

correspondingly higher absolute standard deviation however despite the initial

differences a contraction of the range ensued with a common trend developing

afterwards. The EU – 15 and new member states have demonstrated a rather

uniform development of the debt to GDP ratio for 2004 – 2011 correlating at 0,91.

For individual countries Greece, Italy and Belgium dominate the upper range and

Luxembourg and Estonia consistently lead the lower range. An example of the

Baltic states of Latvia, Lithuania and Estonia suggest that significant differences

can exist between countries that share a common history, hold independence for a

unified period of time and are located in a relatively close proximity thus impeding

their comparability. Extreme deviations of debt to GDP and especially the growing

range pose a serious obstacle to the convergence of fiscal policies.

Figure 11. Debt to GDP ratio, 1995 – 2011

0,00

0,20

0,40

0,60

0,80

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33 | P a g e

3.3. Revenue composition

The key component of budgetary revenue for all member states is the revenue

from taxes and social contributions averaging 85,84 % of the total revenue in 2010

with lower and upper bands respectively at 76,50 % and 93,27 %. Deviations in the

percentage stem from varying proportions of European Union structural funding,

privatization proceeds, public company profits and other sources. The general level

of revenue from taxes and social contributions remained relatively stable during the

period of 1995 – 2010 with an evident slight downtrend.

The three major groups of revenue are indirect taxes (included in the ESA 95

under codes TRD211, TRD214, TRD29), direct taxes (TRD51, TRD59, TRD91)

and actual social contributions (TRD611). As depicted in figure 12 the proportions

of these groups vary significantly across the member states for year 2010 with

average values of the target countries reaching 35,73 % for indirect taxes, 29,82 %

for direct taxes, 30,86% for social contributions and 3,59% for other taxes which

includes voluntary social contributions, imputed social contributions and amounts

assessed but unlikely to be collected. The coefficient of variance for the sample

countries in year 2010 is lowest (0,192) for indirect taxes which allow us to assume

that direct taxes and their regulations are relatively more uniform in the EU

countries. Additionally it is important to note an essential difference in the

composition of tax revenue for Denmark – direct taxes correspond 61,75 % of the

total tax revenue and actual social contributions gather only 2,15 % of the total

revenue. The huge discrepancy should be treated as a mere misclassification if the

principle of substance over form would be used since commonly the compulsory

social contribution charges are directly dependent on personal income taxation and

comprise the total labor tax burden.

34 | P a g e

Figure 12. Composition of taxes and social contributions revenue as a % of GDP, 2010

Figure 13 shows decomposition of direct taxes for EU-15 in 2010. As one can

see personal income takes biggest proportion of all direct taxation.

Figure 13. Composition of direct, 2010

0%

10%

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35 | P a g e

During the period of 1995 – 2010 indirect taxes with value added tax in

particular demonstrated consistent growth as the proportion of total taxes and

social contributions climbing from 18,26 % in 1995 to 21,29% in 2010 while

proceeds from income taxes saw a consistent decrease from 30,20 % in 1995 to

20,70 % in 2010. Figure 14 depicts the composition of indirect taxes for the target

groups in 2010 with the principal portion of indirect taxes comprised of value added

type taxes. The specifics of value added taxes make it an efficient tax with

relatively low administration costs. Even though the proportion and importance of

value added tax has risen during the sample period, convergence of the proceeds

for the target groups could not be identified since the gap between the groups has

slightly widened from 5,43 % to 6,23 % for 1995 - 2010, representing a 14,78 %

increase.

Figure 14. Composition of indirect taxes as a percentage of total taxes and social contributions, 2010

3.4. Income tax overview

This section depicts and analyses tax structure along with labor tax in major

observable countries. As the lack of data for labor tax revenue appears in most of

Eastern European countries and some Western European countries, this section

0

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EU - 15 EU - 27

Other taxes on

products

Taxes on production

except VAT and

imports

VAT

36 | P a g e

provides tax analysis for the following 12 countries: Austria, Belgium, Denmark,

Finland, France, Germany, Italy, Netherland, Norway, Spain, Sweden, UK.

Generally, Sweden collects the highest labor tax revenue

GDP in comparison to other EU countries. UK, on the other hand, has the lowest

labor tax revenue ratio to GDP (Figure

Figure 15. Labor tax revenue as a percentage of GDP 1996

UK has the lowest implicit labor tax rate amongst EU countries. This is

illustrated in Figure 16. EU

cent in the period 1996-2010.



Generally, Sweden collects the highest labor tax revenues as a proportion of


labor tax revenue ratio to GDP (Figure 15).

Labor tax revenue as a percentage of GDP 1996-2010.


. EU-27 implicit labor tax rate ranges from 35 .5 to 36.5 per

2010.



s as a proportion of



27 implicit labor tax rate ranges from 35 .5 to 36.5 per

37 | P a g e

Figure 16. Implicit tax rates in EU countries 1996

Austria

Recently there is discussion weather high overall taxes in Austria downgrade

the pace of growth (Schratzenstaller, 2007). Personal income tax is progressive

and maximum marginal rate is 50%. In 2012 tax brackets for personal income tax

is illustrated in Table 5.

Income (EUR)

111,00125,00160,001 and over

Table 5. Personal income tax

Employment income is also a subject to wage tax, which is withheld by the

employer and transferred to tax authorities. Table

implicit labor tax rate dynamics for the period 1996

Implicit tax rates in EU countries 1996-2010.




Income (EUR) Tax rate(%)

1-11,000 0 11,001-25,000 36.5 25,001- 60,000 43.21 60,001 and over 50

Personal income tax rates in Austria, 2011


employer and transferred to tax authorities. Table 6 shows labor tax revenue and

implicit labor tax rate dynamics for the period 1996-2010. As one can see labor tax





shows labor tax revenue and

2010. As one can see labor tax

38 | P a g e

revenues amount more than half of total taxation, therefore taxes on labor are

significant in taxation system in Austria.

1996 1998 2000 2002 2004 2006 2008 2010Total tax revenue as percentage of GDP 42.8 44.1 43.0 43.7 43.0 41.5 42.7 41.9Total labor tax revenue as percentage of GDP 23.8 24.4 23.9 24.1 23.8 23.2 23.8 23.8Total labor tax revenue as percentage of total

tax revenue55.6 55.3 55.6 55.2 55.3 55.9 55.8 56.8

Implicit labor tax rate 39.4 40.3 40.1 40.8 41.1 40.9 41.3 40.5

Source: Eurostat

Table 6. Labor tax statistics of Austria.

As Reiss and Toglhofer (2011) discuss, tax rates on labor are relatively higher

in Austria compared to average labor tax rates in EU countries. However, many

wage-related taxes entitle taxpayers to specific benefits in return. Depending on

whether or not they entitle the taxpayer to specific returns, taxes on labor in Austria

can be assigned to the following categories:

• Taxes with specific contribution-based benefits that are relatively evenly

distributed: public pension insurance

• Taxes with specific contribution-based benefits that are highly unevenly

distributed:

• unemployment insurance, contributions to insurance against non-payment due

to insolvency, accident insurance;

• Taxes with contribution-independent benefits that are exclusively available to

those who pay them (and possibly their relatives): Chamber of Labor

contributions, health insurance;

• Taxes without specific direct benefits: wage tax, contributions to the Family

Burdens Equalisation Fund, part of the mandatory employers’ contributions to

the Austrian Economic Chamber, municipal taxes, the

“Wohnbauförderungsbeitrag” (contribution to housing subsidies), the “U-Bahn-

Abgabe” (Vienna Underground railways subsidy payable by Viennese

companies per employee).

39 | P a g e

Belgium

Belgium has progressive personal income tax system. Table 7 depicts tax

brackets for different income.

Income (EUR) Tax rate (%)

1-7,900 25 7,901-11,240 30 11,241- 18,730 40 18,731-34,330 45 34,331 and over 50

Table 7. Personal income tax rates in Belgium, 2011

Also there is additional tax-free allowance for dependent children: EUR 1,370

for one child, EUR 3,520 for two children and EUR 7,889 for three and more

children. As for labor taxes, an implicit labor tax in Belgium varies from 42.4 per

cent to 44 percent in the period 1996-2010. Labor tax revenues account for more

than 50 per cent of total taxation. This is illustrated in Table 8.


tax revenue54.5 53.9 53.7 54.9 53.5 51.8 53.3 54.1


Source: Eurostat

Table 8. Labor tax statistics of Belgium.

Denmark

Taxable income in Denmark is taxed at progressive rates up to 51.5 per cent.

The municipal taxes are determined by each county and range from 22.8 per cent

to 27.8 per cent; the health tax is 8 per cent and the church tax, which is optional,

ranges from 0.44 per cent to 1.5 per cent. The state tax consists of a bottom

bracket tax of 3.76 per cent, and a top bracket tax of 15 per cent for income

exceeding DKK 389,900. A special 25 per cent (or 33 per cent) taxation scheme

40 | P a g e

may be available for approved scientists or employees/individuals that meet the

high salary qualification.

In Table 9 one can see implicit labor tax rate decrease starting 2004. This can

be partly explained by tax cut introduced in 2004 (Eurostat, 2007).


tax revenue55.5 53.3 53.9 54.5 51.4 49.6 53.3 51.7


Source: Eurostat

Table 9. Labor tax statistics of Denmark.

Another tax reform was implemented recently. On 1 March 2009 the Danish

government formed a political agreement with Dansk Folkeparti (The Danish

Peoples Party) on a tax reform from 2010 – the so called Forårspakke 2.0. The

legislation was adopted by parliament by the end of May 2009 and will gradually

come into force during the years 2010-2019. The reform involves tax cuts and

financing of around 30 billion DKK corresponding to around 1.5% of GDP (The

Danish Ministry of Taxation, 2009).

Finland

Taxes on personal income are progressive and are shown in Table 10.

Additionally, municipal income tax must be added, which varies from 16.5 per cent

to 21 per cent.

Taxable income (EUR)

Tax on lower amount (EUR)

Rate on excess (%)

15,200 – 22,600 8 8.5

22,601 – 36,800 489 17.5 36,801 – 66,400 2,974 21.5 66,401 and over 9,338 30.0

Table 10. Personal income tax rates in Finland, 2011

41 | P a g e

As Table 11 illustrates, implicit labor tax rate decreases over the period 1996-

2010. However labor tax revenue remains significant and accounts for more than

50 per cent of total taxation.


tax revenue55.3 51.3 49.3 52.2 51.6 51.7 52.7 53.4


Table 11. Labor tax statistics of Finland.

France

Tax system in France is more complex compared to other EU countries.

Taxable income along with tax rate depends on marital status, the size of the

family and income earned during the year. The amount of taxable income, or

"revenu fiscal de référence" (RFR), is not equal to the income received by the

household in the year. Instead, the RFR is determined by dividing the income by

the number of "parts" in the fiscal household (1 part for every adult, 1 part for the

first child, and 0.5 parts for each successive child), and then diminished further by

a standard deduction and any other deductions the taxpayer may have claimed in

the year. Appendix 1 provides the percentage of income tax applicable to taxable

income, or RFR (rather than gross income) in 2012.

Based on household size and marital status the certain tax rate is applied,

which are shown in Table 12.

Income Share (EUR) Tax Rate (%)

1-5,963 0

5,964-11,896 5.5

11,897-26,420 14

26,421-70,830 30

70,831 and above 41

Table 12. Personal income tax rates in France, 2011

42 | P a g e

Labor tax rate during the period 1996-2010 fluctuates at the tight range 41.0-

42.1 per cent (Table 13).


tax revenue52.2 51.7 52.0 52.7 52.9 52.1 52.7 54.3


Source: Eurostat

Table 13. Labor tax statistics of France.

Germany

In 2000 Germany has performed tax reform, which is considered to be the most

ambitious tax reform in postwar German history (Haan and Steiner, 2005). Since

the tax reform was complex, basically personal tax rates were raised, but tax base

were narrowed.

Although a slight decrease of implicit labor tax rate is observed since 2000,

labor tax revenue in Germany still constitutes large share of all tax revenues

collected (Table 13).


tax revenue59.6 59.4 58.2 60.7 59.3 56.2 55.4 56.2


Source: Eurostat

Table 13. Labor tax statistics of Germany.

Italy

Italy has progressive tax system. Personal income tax is applied depending on

income level. Table 14 depicts different personal income tax rates.

43 | P a g e

Taxable Income

(EUR)

Tax Rate (%)

Up to 15,000 23

15,001 – 28,000 27

28,001 – 55,000 38

55,001 – 75,000 41

Over 75,000 43

Table 14. Personal income tax rates in Italy, 2011

The share of labor tax increased during the period 1996-2010. In 2010 labor tax

revenue was 51.6 per cent of total tax revenue, while implicit labor tax rate jumped

to 42.6 per cent (Table 15).


tax revenue47.5 48.9 47.5 49.5 49.6 48.6 50.4 51.6


Source: Eurostat

Table 15. Labor tax statistics of Italy.

Netherlands

The Netherlands has a system of personal income tax known as the 'box

system'. The boxes contain three different types of income. Taxable income is

divided as follows:

• Box 1: Taxable income from work and home (only the main residence);

• Box 2: Taxable income from substantial interests in companies with limited

liability;

• Box 3: Income from savings and investment.

As for box 1, tax rate is progressive to 52 per cent (Table 16).

44 | P a g e

Taxable Income (EUR) Tax rate under age 65

(%)

Tax rate above age 64

(%)

0 - 18,218 33.45 15.55

18,219 - 32,738 42.00 24.05

32,739- 54,367 42.00 42.00

Over 54,367 52.00 52.00

Table 16. Personal income tax rates in Netherlands, 2011

Implicit labor ax rate is relatively low compared to other EU countries – in 2010

it reached highest level since 1996 and was 36.9 per cent (Table 17).


tax revenue52.1 50.7 51.9 49.7 50.6 51.3 52.7 55.0


Source: Eurostat

Table 17. Labor tax statistics of Netherlands.

Norway

In Norway, the general combined rate of the national and municipal income

taxes is 28 per cent. A lower rate of 24.5 per cent applies for the counties of

Finnmark and Nord-Troms. An additional national income tax is payable on gross

personal income. The rates of the national income tax are provided in Table 18.

Taxable income (NOK) Tax Rate (%)

0 – 456, 400 0

456, 401 – 741, 700 9

741, 701 and above 12

Table 18. Personal income tax rates in Norway, 2011

45 | P a g e

A personal allowance of NOK 84,420 is available to jointly assessed married

couples and for single persons with dependents. The allowance for single persons

without dependents and married persons assessed separately is NOK 42,210).

In addition, social security taxes are paid. Employees pay 7.8 per cent of gross

salary income. For self-employed individuals the rate is 11 per cent.

Table 19 shows that implicit labor tax in Norway is lower compared to other EU

countries. Also labor tax revenue makes only 36.8-42.9 percent of total tax revenue

(range for the period 1996-2010). This shows that labor tax is not so important as it

is in other EU countries, still it remains significant in total tax composition.


tax revenue42.9 47.4 40.4 43.2 41.3 36.8 38.5 41.5


Source: Eurostat

Table 19. Labor tax statistics of Norway.

Spain

Personal income tax rates in Spain are progressive to 43 per cent. Detailed tax

rates are shown in Table 20.

Income (EUR) Tax Rate (%)

0 - 17,707 24

17,707 - 33,007 28

33,007 - 53,407 37

53,407 and more 43

Table 20. Personal income tax rates in Spain, 2011

When the earned income is less than EUR 22,000, the individual is not obliged to

prepare a tax return. If there is more than one individual in the same family unit, the

limit is EUR 8,000. Although personal income tax is progressive, Spain has many

46 | P a g e

different allowances, which depend on age, health, the number of children. All the

allowances are shown in Appendix 2.

Not surprisingly, implicit labor tax rate is not the highest in Spain – in 2010 it

was 33 per cent (Table 21).


tax revenue51.0 47.8 45.8 47.4 45.6 43.9 50.5 52.2


Source: Eurostat

Table 21. Labor tax statistics of Spain.

Sweden

In Sweden individuals pay both national income tax and municipal income tax.

First, individuals can deduct a basic allowance of between SEK 12,900 and SEK

33,900 on taxable earned income (employment and business activity). After the

basic deduction national income tax is 20 per cent of that part of the taxable

earned income that exceeds SEK 395,600. If taxable earned income exceeds SEK

560,900, state income tax is 5 per cent more on that part that exceeds SEK

560,900. Municipal tax is approximately 29-34 per cent, church tax and burial

charges are approximately 1-2 per cent.

Analyzing labor tax, total labor tax revenue as a percentage of total tax revenue

plummeted from 62.5 per cent in 1996 to 56.4 per cent in 2010. Implicit labor tax

rate decreased also – form 48 per cent in 1996 to 39 per cent in 2010 (Table 22).


tax revenue62.5 62.5 59.7 62.5 61.5 58.7 59.7 56.4


Source: Eurostat

Table 22. Labor tax statistics of Sweden.

UK

Personal income tax rates are shown in Table 23.

47 | P a g e

Income (GBP) Tax Rate (%)

0 – 37,400 20

37,401 – 150,000 40

Over 150,000 50

Table 23. Personal income tax rates in UK, 2011

United Kingdom has the lowest implicit labor tax rate amongst all observable

countries. Implicit labor tax rate was 25.7 per cent in 2010. Total tax revenue as a

percentage of GDP is the lowest as well. In 2010 more than 40 per cent of total tax

revenue was collected from labor tax (Table 24).


tax revenue38.1 37.8 39.0 39.2 39.5 39.2 38.7 40.2


Source: Eurostat

Table 23. Labor tax statistics of UK.

3.5. VAT overview

Value added tax in European Union is applied in a relatively uniform manner.

The common system of VAT applies to the production and distribution of goods

and services bought and sold for consumption within the European Union and the

actual tax burden are visible at each stage in the production and distribution. VAT

is finally borne by the final consumer in the form of a percentage addition to the

final price of the goods or services (The European e-Justice Portal under the

European Commission). The application of Value added tax was regulated by the

Sixth Directive up to 1 January 2007 and by the VAT Directive onwards. The VAT

Directive does not set out specific rates to be applied in the member states, the

main requirement is for the minimum value of the standard rate of 15 %; the

Directive also allows Member States many possible exceptions and derogations

from the standard VAT coverage. The VAT system is currently in a transitional

mode as a destination based system with the intention of transforming to an origin

48 | P a g e

based system thus changes in the future are inevitable. The major source of

variation between member states are the tax rates including reduced rates and

zero rating, and exemptions that follow individualized provisions, i.e. the minimum

registration threshold for small enterprises.

VAT revenue has demonstrated a consistent increase as a percentage of GDP

during the period of 1995 – 2010 (Figure 15). The higher band of the range is

mainly populated by the new member states like Bulgaria, Estonia and Lithuania

and the lower band of the range by Italy, Luxembourg and Belgium. Despite the

uniformity of VAT regulations, the proportion of revenue to GDP remains highly

scattered. The significant differences are induced by varying levels of zero-

rating and exemptions as individual countries are free to determine VAT

thresholds. The thresholds range from 5580 EUR in Belgium to 81843 EUR in

United Kingdom with the absolute majority of member states clustering around the

lower part of the range. Controversially the new member states are generally

exhibiting higher threshold limits than the EU – 15 states (Appendix 3).

Figure 15. VAT revenue as a percentage to GDP, 1995 - 2010

5%

10%

15%

20%

25%

30%

35%

40%

VA

T r

ev

en

ue

to

GD

P

EU - 15 New member states EU - 27 EU - 27 min EU - 27 max

49 | P a g e

Standard VAT rates have also demonstrated a consistent rise throughout the

sample period with an especially sharp increase in years 2009 and 2010 (Figure

16). This sharp rise indicates that value added taxes might be used as a primary

line for budgetary revenue balancing and might be used to offset the possible

limitations of borrowing accessibility. Empirical data implies that VAT rates have

grown strongly as a result of the crisis. VAT standard rates have often changed

from 2009 onwards, in the vast majority of cases upwards with an impressive

relative 3,73 % increase for 2008 – 2010. The amazing aspect of this development

is the rapid spread of VAT rate increases throughout the Union. While in 2008 only

Portugal changed the standard VAT rate, six did in 2009 and another eight

countries increased their rates in 2010, among which Greece by four points and

Romania by five. During the last 5 years only United Kingdom employed a VAT

rate cut of 2,5% in 1 December of 2008 but abandoned it in 1 January 2010

additionally announcing a rate hike of 2,5% in 4 January 2011.

Figure 16. Average VAT rates in EU – 27 for 1995 – 2010.

The period of value added tax employment in the European Union member

states saw a total of 120 changes in the standard tax rate (European Commission

VAT report, 2012). In a majority of cases the standard tax rate was increased (92)

with only 28 reported instances attributed to a VAT cut, 9 of the cuts were

18,4%

18,6%

18,8%

19,0%

19,2%

19,4%

19,6%

19,8%

20,0%

20,2%

20,4%

Av

era

ge

VA

T r

ate

s

50 | P a g e

employed by Ireland and France – member states with the most changes

performed. According to the report, eight countries applied a zero rate in

consumption. The most dominating sectors of zero-rating are the sales of

newspapers and/or other printed materials (Belgium, Denmark, Ireland, Sweden,

United Kingdom, Finland), medicine (Ireland, Malta, Sweden, United Kingdom) and

consumption associated with the agricultural sector (Ireland, Malta, United

Kingdom) and other. United Kingdom and Ireland offered a widest coverage of zero

rated consumption; however the exact value of actual zero-rated consumption

cannot be supplied due to the confidentiality of data.

Regarding the sample countries reduced rates are used extensively and in

varying proportions with five states – Spain, France, Ireland, Italy and Luxembourg

using super reduced rates for certain fields of consumption. The rate itself varied

significantly in the range of 2,1 % to 4,8% and huge deviations in the super

reduced rate coverage applied across the countries was evident with food

products, printables (especially periodicals and newspapers) and construction

sector being the primary beneficiaries of the rate. Luxembourg enjoyed the widest

coverage of super reduced rates and Ireland employed the rate only for food

products.

VAT revenue ratio is a universal indicator compounding the effects of reduced,

super reduced and zero rates, VAT exemption and VAT evasion. The VAT revenue

ratio consists of actual VAT revenues collected divided by the product of the VAT

standard rate and net final consumption, i.e. final consumption expenditure minus

VAT receipts. In essence the ratio represents the proportion of the theoretical

(calculated on the assumption that all consumption would be taxed at the standard

rate and consumption would not react to the change in VAT burden) and actual

VAT revenue.

A low value of the ratio suggests that exemptions, reduced rates, or tax evasion

have a significant impact on revenue collection. The final consumption expenditure

(P3 in ESA 95) includes the household final consumption expenditure (private

consumption), non-profit institutions serving households (NPISH) final consumption

expenditure and general government final consumption expenditure. The indicator

51 | P a g e

shows that in 2010 exemptions, reduced VAT rates and evasion resulted in only

around 50 % of the theoretical VAT revenues being collected. The situation varies

from country to country with the VAT revenue ratio as low as 36 % in Greece and

as high as 92 % collected in Luxembourg. A significant proportion of Member

States – 13 out of 27 – fall below the 50 % limit and nine more fit a range of 50 % –

60 % (Figure17).

Figure 17. VAT revenue ratio in 2010.

Austria: Three VAT rates used, standard rate is 20 %. A reduced rate of 10 %

applies to basic foodstuffs, books and newspapers, public transport, renting of

residential immovable property and since 2009 also to pharmaceuticals. A 12 %

VAT parking rate applies to wine from farm production carried out by the producing

farmer.

Belgium: Four VAT rates used, standard rate is 21 % since 1996. A reduced 6

% rate applies to public housing, refurbishment of old housing, food, water,

pharmaceuticals, animals, art and publications and some labour intensive services.

An intermediate rate of 12 % applies to a limited number of transactions and, since

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

52 | P a g e

1st January 2010, to food in restaurants and catering services. A zero rate applies

to newspapers and certain weeklies.

Bulgaria: Two VAT rates used, standard rate is 20 %. The reduced rate of 9 %

applies to hotel accommodation and was increased from 7 % in April 2011.

Cyprus: Four VAT rates used, standard rate is 15 %. Reduced rates of 5 %

and 8 % are used for foodstuff and pharmaceutical products,

construction/purchase of the first residence, accommodation and restaurant

services, etc. Zero rate is applied on supplies of goods and services to sea-going

vessels, and international transportation, as well as exports and intra-Community

dispatches of goods and services In addition Cyprus exempts certain products –

letting of immovable property, cultural, sport, banking, insurance, medical and

hospital services.

Czech Republic: Two VAT rates used, standard rate is 20 %.Reduced rate of

14 % applies to food products, pharmaceuticals products as well as to some

services. Certain services (e.g. postal, broadcasting, banking, insurance, financial,

health and social welfare, transfer and lease of land and buildings or structures,

provision of lotteries and similar games of chance and education) are exempted

without credit for input tax.

Denmark: Two VAT rates used, standard rate is 25 %. Zero rate applied to

newspapers.

Estonia: Two VAT rates used, standard rate is 20 %. A 9 % reduced rate

applies to a limited list of goods (books, periodicals, medicine, accommodation).

Finland: Three VAT rates used, standard rate is 23%.The reduced rate of 13 %

is applied on selected goods and services, including food and restaurants.

Reduced rate of 9 % is applied on hotels, medicines, books and tickets to cultural

events, newspapers etc.

France: Four VAT rates used, standard rate is 19.6 %. Reduced rates of 5,5 %

is applied to essential goods and 7 % to the housing sector, accommodation and

restaurant services. Additionally a super reduced rate of 2.1 % applies to

newspapers, theatre performances and approved medicines.

53 | P a g e

Germany: Two VAT rates used, standard rate is 19 %. A 7 % reduced VAT

rate is applied to certain products, e.g. for staple food, public transport and books,

hotels and pensions. Few exemptions are also granted (rents and doctors'

services).

Greece: Three VAT rates used, standard rate is 23%. A reduced rate of 13 % is

applied to goods such as fresh food products, some pharmaceuticals,

transportation and electricity, certain professional services, and services by doctors

and dentists. A 6.5 % rate applies to hotel accommodation services, newspapers,

periodicals and books. For the regions of the Dodecanese, the Cyclades and

Eastern Aegean islands the above rates are reduced by 30 %.

Hungary: Three VAT rates used, standard rate is 27%.A reduced rate of 18%

is applied to while milk, milk products, bread, bakery products, and accommodation

services. 5 % is applied to district heating services, specific medicines and medical

materials, books, newspapers, etc.

Ireland: Four VAT rates used, standard rate is 21 %. The reduced rates of 13.5

% applies to various services, newspapers, building work and household energy

and fuels and 9% applies to hotel services. A zero rate applies to basic food,

children's clothing, children's footwear and books along with Exemptions on

transport services.

Italy: Three VAT rates used, standard rate is 21%. A reduced rate of 10 %

applies to non-luxury housing, other foodstuffs, electricity, mineral oil, medicines

and artistic performances. The super-reduced rate applies mostly to staple

foodstuffs, newspapers, some medical appliances, and residential housing.

Latvia: Two VAT rates used, standard rate is 22%. The reduced rate of 12 % is

applicable on: supplies of medicines, medical devices and medical goods,

specialized products intended for infants, the inland public transport services,

supply of heating to households and guest accommodation services.

Lithuania: Three VAT rates used, standard rate is 21%. The temporary

reduced rate of 9 % applies to books and non-periodical publications, residential

heating and the 5 % rate is applicable to medicines.

54 | P a g e

Luxembourg: Six VAT rates used, standard rate is 15 %. A reduced rate of 6

% applies to gas, electric power, flowers and labor-intensive services such as

hairdressing and window cleaning. An intermediary rate of 12 % applies to wine

and coal. Rates of 4 % or 10 % apply to farmers and foresters subject to a specific

regime. A super-reduced rate of 3 % applies to food and beverages,

pharmaceutical products, books and newspapers and passenger transport.

Malta: Four VAT rates used, standard rate is 18 %. A 7 % reduced rate is

applied to holiday accommodation, 5 % rate applies to letting of sites for artistic or

cultural activities, electricity, printed material, medical accessories and goods

intended for the use of disabled persons. Zero-rated supplies include food,

pharmaceutical goods, local transport and cultural services.

Netherlands: Two VAT rates used, standard rate is 19 %. The reduced rate of

6 % applies to inter alia, food, water, pharmaceuticals, art, cultural events and

publications.

Poland: Four VAT rates used, standard rate is 23 %. The reduced rates of5 %

and 8 % applies to certain foodstuffs, children’s footwear, domestic transport,

social housing, etc. Zero rate is used of international transport, etc.

Portugal: Four VAT rates used, standard rate is 23 %. The 6 % reduced rate is

applied to domestic transport services, construction, agricultural inputs, etc. The 13

% rate is applied to catering services, and zero rate is applied to international

transportation.

Romania: Four VAT rates used, standard rate is 24 %. A reduced rate of 9 %

applies to goods such as pharmaceutical products, medical equipment for disabled

persons, books, newspapers, admission to cultural services and hotel

accommodation. A 5 % reduced rate applies to the supply of social and some

private dwellings. VAT exemptions without right of deduction apply to, among

others, medical treatments, some educational and cultural activities, public postal

services, certain banking and financial transactions, insurance and reinsurance.

Slovakia: Three VAT rates used, standard rate is 20 %. The 10 % reduced rate

is applicable to medicines, certain other medical and pharmaceutical products to

55 | P a g e

books. Zero rate applies to intra-Community supply of goods, export of goods,

provision of services consisting of work on movable assets returned to a third

country, transport services and passenger transport, and services directly related

to import and export of goods.

Slovenia: Two VAT rates used, standard rate is 20 %. The reduced rate of 8.5

% applies to supply of goods and services including, inter alia, books, food,

agricultural and pharmaceutical products, certain services provided at the local

level.

Spain: Three VAT rates used, standard rate is 18 %. The 8 % rate applies to

specific categories of goods like catering, domestic and international

transportation, agricultural inputs and others. The super reduced rate of 4 %

applies to some foodstuffs, books, newspapers and other periodicals,

pharmaceuticals and construction services.

Sweden: Four VAT rates used, standard rate is 25 %. A reduced rate of 12 %

applies to foodstuffs and to services related to tourism, restaurants and catering. A

reduced rate of 6 % applies to domestic daily and weekly newspapers and

periodicals; domestic transportation of persons and ski-lift services; cinema, circus

and concert admission fees. A zero rate is applied to prescription medicines, gold

for investment purposes, and a number of financial services as well as insurance

and reinsurance services. Some sectors are exempt from the tax altogether, like

the purchase and rental of immovable property; medical, dental and social care;

education, banking and other financial services, certain cultural and sporting

activities.

United Kingdom: Three VAT rates used, standard rate is 20 %. A reduced rate

of 5 % applies, for example to fuel and power and also on the installation of energy

saving materials. A zero-rate is used extensively as it applies to some food items,

books, new constructions, passenger transport, some supplies to charities and to

children's clothing and footwear. Some exemptions also apply.

56 | P a g e

4. LABOR TAX REVENUE ESTIMATION

4.1. Labor tax ratio determination

Tax rate on labor usually is not unique in single country. EU countries have

complex tax system and most of the countries have several income tax rates

depending on tax base brackets or even marital status. For example, in the UK

there are three different income tax rates: 20 per cent, if person's taxable income is

under £35 500; 40 per cent if taxable income is in the range of £35 001 - £150 000;

50 per cent if taxable income is over £150 000. In Ireland tax brackets varies for

married taxpayers and single ones - threshold for single taxpayers is 32 800 €, for

married taxpayers – 41 800 €. Because of such complexity and other tax

exemptions and deductions, we cannot apply weighted tax rate method.

In many academic studies tax revenues are expressed as a ratio of some

aggregate tax base. Such ratios are often called as average tax ratios, or as

implicit tax rates. The discussion and research of implicit tax rates started with the

paper of Mendoza, Razin, & Tesar (1994). They suggested using average effective

tax rate, which is easy to compute. Using Mendoza et al. (1994) methodology, it is

possible to calculate indicators of the tax burden on, for example, consumption,

labor, capital and corporate income. Mendoza, Razin, & Tesar (1994) distinguished

following five different tax ratios: a personal income tax ratio, a labor income tax

ratio, a capital income tax ratio, a corporate income tax ratio and a consumption

tax ratio. Later Mendoza, Milesi-Ferretti, & Asea (1997) updated data of previous

study. Jarass & Obermair (1997) also came up with a “natural resources &

environment” tax ratio. OECD Revenue Statistics report compares tax ratios

among different countries by expressing the aggregate revenue of one particular

tax as a percentage of GDP. Other method to measure differences among tax

systems is to compare the impact of statutory tax rates, calculated for individual

taxpayers. The example can be found in the OECD publication The Tax/Benefit

Position of Employees (OECD 1998b).

57 | P a g e

In this paper, the methodology of Mendoza et al. (1997) is chosen to calculate

tax rate on labor. Volkerink and de Haan (2001) points out the following

advantages of average effective tax ratios:

• Effective tax ratios are much simpler to calculate than marginal effective tax

rates, where one has to take into account all kinds of deductions and reliefs

that are probably not very representative anyway.

• Effective tax ratios are much easier to compare by country because they are in

most cases constructed in a similar way for each country.

• Effective tax ratios are an appropriate input for macroeconomic models

• Effective tax ratios indicate real changes in the tax system that might be over-

or understated by, for example, a tax-to-GDP ratio.

In order to calculate the average effective tax ratio on labor (τl), it is necessary

to calculate the average effective tax ratio on total household income, τh. Average

effective tax ratio on total household income allocates personal income tax to

capital and labor under the assumption that the average tax rate paid on each is

the same. τh is calculated as follows:

τh = 1100/(OSPUE+PEI + W) (1)

Where7

1100 – Tax revenue on income, profits, and capital gains on individuals,

OSPUE - Operating surplus of private unincorporated enterprises,

PEI - Property and entrepreneurial income,

W - Wages and salaries.

Equation (1) states that the average effective tax ratio on household income is

personal income tax revenue divided by the household income. Household income

comprises operating surplus of the unincorporated sector (OSPUE), property

income (PEI) and dependent wage income (W). It has to be noted that imputed 7 The symbols and mnemonics are used in OECD National Accounts and Revenue Statistics

58 | P a g e

rentals on owner-occupied housing are included in OSPUE and that pension fund

and life insurance earnings, which are imputed to households in the National

Accounts, are included in PEI.

τl = (τh *W +2000 +3000)/(W +2200) (2)

Where8

2000 – Social security contributions,

3000 - Taxes on payroll and workforce,

2200 - Social security contributions of employers,

Equation (2) states that the average effective tax ratio on labor is labor tax

revenue divided by the labor income. Labor tax revenue is defined as sum of

labor’s share of household taxes, all social security charges (2000) and payroll

taxes (3000). The term in the numerator (τh *W) represents the share of labor taxes

in all household’s taxes. This term allocates household taxes to labor in line with its

share in household income. Labor income consists of compensation from

dependent employment, including employers’ social security contributions (2200)

(but excluding employers’ contributions to private pension funds).

The results of average effective tax ratio on labor are shown in Appendix 4.

4.2. Labor tax revenue determination

Labor tax revenue is collected by levying labor income. In this section the

determination of labor tax revenue and its components is introduced. The model is

set up in order to figure out the determinants of the labor tax revenue.

It is assumed that labor tax revenue depends on tax rate, tax base and the rate

of compliance to pay labor taxes.

Therefore, the following model is suggested:

8 The symbols and mnemonics are used in OECD National Accounts and Revenue Statistics

59 | P a g e

R�� = α�� × B�� × v�� (3)

Where

Rjt – revenue form labor tax for country j at time t,

αjt – the compliance rate for country j at time t,

Bjt – tax base – labor income for country j at time t,

vjt – labor tax rate for country j at time t.

In order to compare revenues among different countries the ratio to GDP is

included:

�� = α�� × β�� × v�� (4)

Where

Yjt – GDP at market prices for country j at time t,

βjt – tax base as a proportion of GDP for country j at time t.

The latter equation defines that labor tax revenue as a proportion of GDP will

increase directly with a tax rate, an increase in the tax base and increase in

compliance.

Tax rate, as depicted above, is derived as a ratio between labor tax revenue

and labor income using Mendoza et al. Therefore as for tax base the definite data

is used. Tax base (Bjt) is the product of average wage in country j at time t and total

labor force in country j at time t. This tax base could be referred as “potential” tax

base, showing the maximum possible size of the tax base if all the labor force

worked for average wage. That is the model is constructed with the assumption

that the maximum tax revenue can be collected if all the labor force worked for

current average wage and paid taxes of average effective tax ratio. However,

maximum revenue is not collected because current tax rate might be too high for

60 | P a g e

some individuals and they evade taxes by shifting to shadow or black economy.

The model assumes that unemployment is highly related to compliance to pay

taxes. Generally, tax base is reflected by formula:

B�� = w�� × L�� (5)

Where

wjt – average annual wage for country j at time t,

Ljt – total labor force for country j at time t.

Consequently,

β�� =��×��

�� (6)

The compliance ratio (αjt) is a function of “black economy” in a country.

Matthews (2003) uses currency to GDP ratio to measure the level of “black

economy”. He argues that argued that countries with a high ratio of currency to

GDP have a greater level of “black economy” activity and a lower compliance ratio

than countries with a lower currency to GDP ratio.

One of the determinants of the compliance ratio α is the level of black economy

is the level of black economy as a proportion of GDP as estimated by Schneider et

al, (2009). The empirical method used by Schneider et al is based on the statistical

theory of unobserved variables, which considers multiple causes and indicators of

the phenomenon to be measured, i.e. it explicitly considers multiple causes leading

to the existence and growth of the shadow economy, as well as the multiple effects

of the shadow economy over time. In particular, a Multiple Indicators Multiple

Causes (MIMIC) model – a particular type of a structural equations model (SEM) –

is used to analyze and estimate the shadow economies. The model uses variables

such as tax and social security contribution burdens, intensity of regulations, extent

of public sector services etc. With reference to Keen and Smith (1996) one can

assume that the incentive to evade is not linear in the tax rate and ambiguity is

captured by including quadratic term of the tax rate:

α�� = α(v�� ,m��) (7)

61 | P a g e

where mjt is the level of black economy as proportion to GDP in country j at time

t.

The full equation of labor tax revenue model is following:

�� = v�� × β�� × α(v�� , m��) (8)

4.3. The Data

The data for average effective tax ratio is collected from OECD Revenue

Statistics and Eurostat. The period of analysis covers 1965-2010 with some of

exceptions for several countries. The analysis is made for 11 EU countries and

Norway. Due to lack of the data we could not include more EU countries. For

example recent EU members provide data only since 1999, in some cases only

since 2004.

The main problem in the process of data collection was that only one country

(Germany) distinguishes tax revenue by different source of income – labor tax

revenue, capital tax revenue and corporate income tax revenue. Therefore, the

methodology of Mendoza, Razin, & Tesar (1994) was applied. Labor tax revenue is

considered to have the same weight in total income tax revenue as the wages and

salaries have in the sum of sum of the operating surplus of private unincorporated

enterprises, property and entrepreneurial income and wages.

Despite minor problems the empirical examples of most of the countries

illustrate humped shape of Laffer curve (Appendix 5). Figure 18 shows the scatter

plot of labor tax revenue as a percentage of GDP against average effective tax

ratio for all 463 observations.

62 | P a g e

Figure 18. Labor tax revenue as a percentage of GDP compared to labor tax rate.

4.4. Model

Taking Equation (8) and assuming that function of α is linear in its arguments,

we get the following estimation of the model:

�� = �� + ��v�� + ��β�� + ��v�� + ��m�� + � ! (9)

Where:

c0 – an intercept;

c1, c2, c3, c4 – coefficients;

vjt – labor tax tare in country j at time t;

βjt – tax base as a proportion of GDP for country j at time t;

mjt –the level of black economy as proportion to GDP in country j at time t;

εjt – error term.

We run the regression on 166 observations, because the data for mjt is

available only for the period 1995 – 2010. Also the data for UK is excluded

because of abnormality in the residuals. One can see in Appendix 5 for UK that the

63 | P a g e

relation between labor tax rate and labor tax revenue as GDP is not humped

shaped but more random.

The primary results of the regression are shown in Table 24. Initial estimation

indicates that more than 87% of the dependent variable is explained by the model.

Also F-statistics show that the hypothesis that all the coefficients are null, can be

rejected. Contrary, all the coefficients are significant at the 2% level. As shown in

Figure 19 residuals are distributed normally – Jarque-Bera test does not reject

hypothesis of normal distribution of residuals.

Table 24. The output of the initial regression.

However, Durbin-Watson test indicates possibility of serial correlation – Durbin-

Watson statistics is 0.585, which is close to zero. Durbin-Watson statistic

measures the linear association between adjacent residuals from a regression

model. If the statistic is below about 1.5, it is a strong indication of positive first

order serial correlation (Vebbek, 2000).

64 | P a g e

Figure 19. The distribution of the residuals of the model.

Appendix 6 shows the correlogram for the first 36 lags. The correlogram has

spikes at lags up to four and at last five lags as well. The Q-statistics are significant

at all lags, indicating significant serial correlation in the residuals.

Additionally we perform Breusch-Godfrey Serial Correlation Lagrange multiplier

(LM) Test. This test belongs to the class of asymptotic tests. (Vebbek, 2000).

Unlike the Durbin-Watson statistic, the LM test may be used to test for higher order

autocorrelation errors and is applicable whether or not there are lagged dependent

variables. The results of LM test are shown in Table 25. Using the lag of 2 yields,

the test rejects the hypothesis of no serial correlation up to order two. Serial

correlation means that the residuals are correlated with their own lagged values.

This correlation violates the standard assumption of regression theory that

disturbances are not correlated with other disturbances.

Table 25. The output of Breusch-Godfrey Serial Correlation LM Test.

0

2

4

6

8

10

12

14

16

-0.015 -0.010 -0.005 0.000 0.005 0.010 0.015

Series: ResidualsSample 1 173Observations 166

Mean 2.46e-18Median -0.000220Maximum 0.017747Minimum -0.016697Std. Dev. 0.006416Skewness -0.106868Kurtosis 3.162675

Jarque-Bera 0.499013Probability 0.779185

65 | P a g e

The Durbin-Watson and the LM test both indicate that the residuals are serially

correlated and the equation should be re-specified. We use the first-order

autoregressive, or AR(1), model for serial correlation. The AR(1) model is specified

as:

yt = xt’β + ut

ut = ρut – 1 + εt (10)

The parameter ρ is the first-order serial correlation coefficient. In effect, the

AR(1) model incorporates the residual from the past observation into the

regression model for the current observation (Vebbek, 2000).

Results of the model with adjustments for the first-order serial correlation are

shown in Table 26. Durbin-Watson statistic is 1.686 and does not indicate serial

correlation. Breusch-Godfrey Serial Correlation LM test also rejects hypothesis that

model contains serial correlation (Table 27).

Table 26.The output of AR(1) model.

66 | P a g e

Table 27. The output of Breusch-Godfrey Serial Correlation LM Test for AR(1) model.

It is has to be noted that all the coefficients are significant at 5 % level. T-

statistics show that for each coefficient separately and F-statistics reject hypothesis

that all the coefficients are equal to zero. Also R-squared is 0.9388, which shows

that the regression accounts for 93.88% percent of the variance in the dependent

variable. Figure 20 depicts fitted, actual residual values. The actual and fitted

values almost match each other, indicates high success of the regression in

predicting the values of the dependent variable within the sample.

Figure 20. Actual, fitted and residual values for AR(1) model.

Additionally, we use another method for dealing with serial correlation. The

method is called first difference method. It is a transformation on a time series

-.02

-.01

.00

.01

.02

.03

.00

.02

.04

.06

.08

.10

25 50 75 100 125 150

Residual Actual Fitted

67 | P a g e

constructed by taking the difference of adjacent time periods, where the earlier

time period is subtracted from the later time period. (Wooldridge, 2002). It has to

be noted that using first difference method intercept has to be omitted. The results

after adjustments are depicted in Table 28. Durbin-Watson statistics is 2.08,

Breusch-Godfrey Serial Correlation LM test does not indicate any serial correlation

(Table 29). Furthermore, all the coefficients are significant at 5% level and R-

squared is 55.78%. Figure 21 shows actual, fitted and residual graph.

Table 28. The output of the regression after first difference adjustments.

Table 29. The output of Breusch-Godfrey Serial Correlation LM Test for adjusted model.

68 | P a g e

Figure 21. Actual, fitted and residual values for adjusted model.

Additionally we test if the variance of the error term is constant. If the error

terms do not have constant variance, they are said to be heteroskedastic. We use

White test to test for heteroskedasticity. Table 30 shows output of White test. With

F-statistics of 1.295 (p-value 0.22) we can reject hypothesis that error terms are

not constant.

Table 30. The output of White Heteroskedasticity Test.

-.04

-.02

.00

.02

.04

-.04

-.02

.00

.02

.04

.06

.08

25 50 75 100 125 150


69 | P a g e

4.5. Results

The results of the regression are summarized in Table 31. Initial regression, in

which the serial correlation was detected, is also depicted. Therefore, two different

models were applied in order to correct serial correlation. AR(1) model includes an

intercept, which indicates that if other variables were equal to zero, the revenues

collected would be equal 15.4% of GDP. First difference model contains no

intercept, which tells that if tax rate and other variable were equal to zero, no tax

revenue would be collected.

Initial regression Adjusted with

AR(1) model

Adjusted with first

difference model

Equation (1) Equation (2) Equation (3)

Intercept 0.074 (2.476)

0.154 (3.658)

-

" ! 0.579 (4.296)

0.809 (4.445)

0.882 (4.591)

" !� -0.939 (-6.304)

-1.165 (-5.759)

-1.222 (-5.737)

# ! 0.086 (8.257)

0.051 (3.487)

0.038 (2.461)

$ ! -0.038 (-2.564)

-0.063 (-2.123)

-0.092 (-2.397)

R-squared 0.872 0.939 0.558

R-Squared Adjusted 0.869 0.937 0.549

Standard Error 0.007 0.005 0.005

Probability (F-Statistic) 0.000 0.000 -

Durbin-Watson

Statistic

0.585 1.868 2.081

Revenue maximizing

rate

- 33.39% 33.88%

Table 31. Dependent variable – labor tax revenue as a proportion of GDP; 11 countries

(166 observations); t-values in parenthesis; significant at 5% level.

After adjustments with first difference model the results suggest that an

increase in tax base as a proportion of GDP (βjt) by one unit leads to an increase

70 | P a g e

in labor tax revenue as a proportion of GDP by 0.038 units. Also there is an

indication that changes in “black economy” levels influence revenues collected. As

the results show, the change in black economy level as a proportion of GDP (mjt)

affects the change in labor tax revenue as a proportion of GDP by 0.092 units. This

conclusion could be a good suggestion to politicians to fight “black economy” more

actively because it can add more revenues to the budget.

Important point of the results is that quadratic term in tax rate is significant and

correctly signed. Thus, we calculate revenue maximizing labor tax rate. This is

done by finding derivate of each equation and setting the derivate to zero. We

found that revenues maximizing tax rate is 33.39% in AR(1) model and 33.88% in

first difference model. Many countries, such as Germany and Sweden, have higher

average tax rate than the maximizing one, therefore there is a room for labor tax

cuts, which would lead to even higher tax revenues. However for such countries as

Finland and UK, where average tax rate is lower than maximizing one, upward

changes in tax rate could raise political and social tension.

It has to be noted that the conclusions may not be accurate enough as there

are very few observations – only 166. The problem arises because of the lack of

data. For example, the methods and calculation for “black economy” levels are

available since 1995. Hopefully, bearing in mind that more qualitative and more

precise statistics are collected in these days, after a decade similar model will be

conducted and provide improved results.

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5. VAT REVENUE ESTIMATION

As described in European Union law, the common system of VAT applies to the

production and distribution of goods and services bought and sold for consumption

within the European Union and the actual tax burden is visible at each stage in the

production and distribution chain. Generally, a value added tax resolves one of the

biggest drawbacks of a sales tax- omits the distortive effect of taxation on

intermediate consumption. To ensure that the tax is neutral in impact, irrespective

of the number of transactions, taxable persons for VAT may deduct from their VAT

account the amount of tax which they have paid to other taxable persons. VAT is

finally borne by the final consumer in the form of a percentage addition to the final

price of the goods or services. Double taxation is avoided and tax is paid only on

the value added at each stage of production and distribution (The European e-

Justice Portal under the European Commission). The main argument against VAT

is argued to be greater administrative and compliance costs because it envelopes

market participants in all stages of production and services, not only the final stage.

Since there are fixed costs of compliance that fall on the producers, it is generally

argued that VAT rates should not be levied at rates below 10%. Additionally,

extensive use of zero-rating and tax exemptions can substantially increase the

costs of VAT (Hagemann et al, 1988)

Even though the potential for evasion is believed to be reduced by the self –

policing nature of the value added taxes, European authorities have recently and

with growing concern addressed the VAT gap problem. The ‘Study to quantify and

analyse the VAT gap in the EU-25 Member States’ report issued on 21st

September 2009 the impact of the VAT gap in the member states. VAT gap is

described as the gap between the amount of value added tax due and the amount

received by the member states. VAT gap is not a measure of VAT fraud instead for

example it might include VAT not paid as a result of legitimate tax avoidance

measures and VAT not collected due to insolvencies. The VAT gap is primarily

estimated on national accounts data and depends on the accuracy and

completeness of the data, thus it might not take into account some activities that

72 | P a g e

are outside the scope of national accounts. The VAT gap in the period of year 2000

to 2006 is estimated to be as high as 30 percent of the aggregate theoretical tax

base.

As presented in the above mentioned report, there is a lack of data for the

estimation of VAT fraud, since:

• (a)’published data on the size of different types of VAT fraud are insufficient to

piece together an estimate of VAT fraud in the economy as a whole.

• (b) There may be a selection bias. Presenting the value of the different types of

VAT fraud detected by tax agencies, as reported by some in annual reports,

would risk giving a distorted account of the relative importance of different

types of VAT fraud as well as of overall level of VAT fraud.

• (c) The raw data underlying the estimates of particular types of VAT are based,

almost invariably, on operational data held by the tax agencies. Generally,

these are confidential, as are the methods used to derive them.’

5.1. VAT Revenue Determination

This section will set out a framework for the determination of VAT revenues by

the decomposition of its components and the modeling of the determinants of the

VAT base. In the broader sense, VAT revenues will depend on the VAT base, the

VAT rate and the compliance rate. The following model is suggested:

R�� = α�� × B�� × v�� (11)

Where:

Rjt – VAT revenue for country j at time t;

αjt – the compliance rate as a proportion of GDP at market prices for country j at

time t;

Bjt – VAT base for country j at time t;

vjt – the representative VAT rate for country j at time t;

73 | P a g e

In order to compare revenues among different countries the ratio to GDP is

included:

�� = α�� × β�� × v�� (12)

Where:

Yjt – GDP at market prices for country j at time t,

βjt – tax base as a proportion of GDP at market prices for country j at time t.

Equation (12) is used for the comparability of the VAT revenue results between

all member states. It states that VAT revenue as a proportion of GDP will increase

directly with the VAT rate, an increase in the VAT base as a proportion of GDP,

and an increase in compliance.

The weighted average value added tax rate would be the appropriate measure

of the representative VAT rate. However such data is not readily available for most

countries and if available it would significantly limit our sample due to the irregular

intervals available. The standard VAT rate will be used as a proxy for the weighted

average value added tax rate.

Despite the fact that value added taxes are relatively uniform in their

application, the VAT base differs significantly from country to country. The VAT

base will be proxied by the VAT revenue ratio which is the proportion of actual VAT

revenue to final consumption adjusted by the tax revenue. VAT base is derived

from the final consumption expenditure accounts which are calculated based on

purchasers’ price. According to the European System of Accounts (ESA 95 3.06

and 3.92), purchasers’ price is the price the purchaser actually pays for the

products; including any taxes less subsidies on the products (but excluding

deductible taxes like VAT on the products), etc. The second proportion expresses

the VAT base a percentage of GDP. The arguments of the function are presented

as available in the Eurostat statistic databases:

74 | P a g e

B�� =%��

&��×('��(%��)× '��

*%'�� (13)

Where:

D211�� – value added type tax revenues;

P3�� – final consumption expenditure;

012 ! – gross domestic product;

An additional argument is added in order to evaluate the appearance of cross-

border trading between member states. We sought to evaluate the extent of cross

border trading originating from the fundamental differences in the application of

VAT amid member states. We employed a variable representing the VAT gap (G��) – an estimate that was presented by Reckon LLP, (2009) in a European

Commission report (see Study to quantify and analyse the VAT gap in the EU-25

Member States). VAT generally indicates the effect of reduced and zero rating of

the tax base and can be argued to be one of the factors determining the distinct

volumes of cross-border trading in the EU member states. The VAT base is

expressed by:

β�� = β(B��, G��) (14)

The compliance rate ‘α’ is the function of the shadow economy in a country. It

may be argued that the extent of tax evasion and tax fraud is dependent on the

national cultural and economic factors, on the perception of the quality of life and

other qualitative factors causing distortions in the compliance rate. We are lacking

substantial data both for quantitative and qualitative factors for the compliance rate

therefore a model estimating the aggregate compliance rate will be employed.

75 | P a g e

As for the base of our compliance rate we will use data of the shadow economy

as estimated by Schneider et al, (2009). The extent of the shadow economy is

expressed as a proportion of GDP in market prices for each of the European Union

member countries. Previous studies of Schneider (1994b, 2000, 2004, 2005 and

2007) and Johnson, Kaufmann and Zoido-Lobatón (1998a, 1998b) found

statistically significant evidence for the influence of taxation on the shadow

economy suggesting a connection between the compliance rate and the extent of

the shadow economy. The estimates in question are aimed at quantifying the

aggregate extent of the shadow economy therefore we will try to model the

compliance rate for VAT.

As proposed by Kent Matthews (2003), the theory of direct tax evasion is

ambiguous on the effect of tax rates on evasion. A higher tax rate will increase the

incentive to evade, but evasion is a risky activity and greater risk could result in

increased compliance. The standard results regarding the ambiguity of the effect of

the tax rate on the compliance ratio follows through the assumption of risk

aversion. However, Cremer & Gahvari (1993) show that compliance decreases for

an increase in the indirect tax rate in the case of a competitive risk neutral firm. The

incremental change of the tax rate can be also argued as an important factor and

will be added to the model.

The number of VAT rates is another factor leading to possible tax avoidance.

Agha & Haughton, (1996) suggest, that the compliance rate depends on the level

of the average value added tax rate and on the presence of multiple tax rates.

Thus the higher the number of VAT rates, the higher possibility to misclassify

goods and the lower the compliance ratio. The ambiguity of the effect of the value

added tax rate on compliance is captured by a quadratic term in the VAT rate since

it is reasonable to assume that the incentive to evade is non-linear in the tax rate,

Kent Matthews, (2003).

Statistical economic data suggests the existence of significant underlying

differences between EU member states based on the date of their accession to the

Union with the newest member states showing a significantly higher level of

shadow economy and non – compliance. In order to reflect the transitional state of

76 | P a g e

the countries that have experienced a shift from a planned economy to a free

economy and to compensate for the distortions a dummy variable will be added to

the equation with the value of =1 will be attributed to the ex – members of the

Warsaw Pact zone, and =0 for the EU – 15 member states and Malta, Cyprus and

Slovenia. Based on the presumptions presented above, the compliance rate will be

estimated as:

α�� = α(v��, v�� , m��, N��, ∆v��, Dum��) (15)

Combining equations (14) and (15) into the equation (12), we can finalize the

model as:

�� = (v��, v�� , m��, N��, ∆v��, Dum��, B��, G��) (16)

5.2. The Data

We have collected a balanced panel of data on 25 countries of the EU, omitting

Romania and Bulgaria from the sample due to a shortage of data inputs. The

estimation period has been drastically curtailed because of data availability issues

connected to the VAT base and compliance. The bulk of statistical information

used in the estimation was obtained from Eurostat databases. Information on the

historical tax rates and their reductions was drawn from a European Commission

taxation paper VAT Rates Applied in the Member States of the European Union,

Situation at 1st January 2012.

Ideally, the weighted average VAT rate would be most appropriate measure of

the effective VAT rate. However, the weighted rates are considered confidential

data by the Directorate-General for Budget, European Commission and could only

be acquired for a single year. The use of the standard rate is based on two factors:

most of VAT-rated consumer spending is taxed at the standard rate across the EU,

and the correlation between the available weighted average tax rates and standard

rates for the sample was 0,923. Even though it does not provide information about

77 | P a g e

the correlation of the rates over the full sample it serves as an indicator of the

cross-section variation of the rates.

Schneider et al, (2010) base their estimation of the shadow economy on the

following definition: ‘the shadow economy includes all market-based legal

production of goods and services that are deliberately concealed from public

authorities for any of the following reasons:

• to avoid payment of income, value added or other taxes;

• to avoid payment of social security contributions;

• to avoid having to meet certain legal labor market standards, such as minimum

wages, maximum working hours, safety standards, etc.;

• to avoid complying with certain administrative procedures, such as completing

statistical questionnaires or other administrative forms.’

The empirical method used by Schneider et al, (2010) is based on the statistical

theory of unobserved variables, which considers multiple causes and indicators of

the phenomenon to be measured, i.e. it explicitly considers multiple causes leading

to the existence and growth of the shadow economy, as well as the multiple effects

of the shadow economy over time. In particular, a Multiple Indicators Multiple

Causes (MIMIC) model – a particular type of a structural equations model (SEM) –

is used to analyze and estimate the shadow economies. Previous studies of

Schneider found statistically significant evidence for the influence of taxation on the

shadow economy.

Our dataset was severely trimmed by the availability of data and constituted of

135 observations for 23 member states (excl. Romania, Bulgaria, Denmark and

Cyprus). The humped shape of the variables is evident in Figure 22.

78 | P a g e

Figure 22. . VAT revenue as a percentage of GDP compared to VAT rate

5.3. Model

Taking Equation (16) and assuming that function of α is linear in its arguments,

we get the following estimation of the model:

�� = �� + ��v�� + ��v�� + ��m�� + ��N�� + �7∆v�� + �8Dum�� + �9B�� + �:G�� + � ! (17)

Where:

�� – the intercept;

��, ��, ��, ��, �7, �8, �9 – coefficients;

� ! – error term for country j at time t;

Hsing, (1996) argues, that in empirical work additional functional forms like the

log-log and the semi-log (the log-linear and the linear-log) should be used to

identify a form that better fits the sample and Laffer curve.

4%

5%

6%

7%

8%

9%

10%

12% 14% 16% 18% 20% 22% 24%

VA

T r

ev

en

ue

to

GD

P

VAT rate

79 | P a g e

5.3.1. Linear-Linear Model

After the initial estimation two independent variables (Dum�� and ∆v��) were

rejected based on their p-values computed by the statistical package because of

their insignificance. The remaining significant variables were tested for

multicollinearity with all except v�� and v�� (should be ignored since the expression

of the quadratic function has been introduced for a bell-shaped Laffer curve)

showing tolerable levels (Table 32).

R_Y V V^2 N M B G

R_Y

1.0000 V

0.5849 1.0000 V^2

0.5660 0.9982 1.0000 N

-0.1982 0.2374 0.2605 1.0000 M

0.3619 0.0026 -0.0133 -0.3259 1.0000 B

0.2068 -0.2744 -0.2651 0.0546 -0.0892 1.0000 G

-0.0511 -0.0897 -0.1112 -0.4379 0.5598 -0.4329 1.0000

Table 32. Correlation matrix of variables

The results of the linear-linear estimation are presented in Table 33. The

regression indicates a high level of significance with the R-squared and adjusted

R-squared nearly reaching the 80 % level. All of the coefficients indicate

significance at the 1% level and the residuals follow a normal distribution (Figure

23). Durbin-Watson statistic measures the linear association between adjacent

residuals from a regression model. If the statistic is below approximately 1.5, it is a

strong indication of positive first order serial correlation (Vebbek, 2000). Since the

Durbin-Watson statistic indicates serial correlation, we will use the first-order

autoregressive, or AR(1), model for serial correlation.

80 | P a g e

Dependent Variable: R/Y Method: Least Squares Date: 05/27/12 Time:11:10 Sample: 1 135 Included observations: 135

Coefficient Std. Error t-Statistic Prob.

C -0.151767 0.028480 -5.328999 0.0000 V 1.916126 0.304879 6.284863 0.0000

V^2 -4.350458 0.823815 -5.280867 0.0000 G -0.024721 0.006234 -3.965165 0.0001 N -0.002789 0.000477 -5.844515 0.0000 M 0.034025 0.004549 7.479112 0.0000 B 0.038542 0.004539 8.491431 0.0000

R-squared 0.798851 Mean dependent var 0.070864 Adjusted R-squared 0.789422 S.D. dependent var 0.008245 S.E. of regression 0.003783 Akaike info criterion -8.265912 Sum squared resid 0.001832 Schwarz criterion -8.115269 Log likelihood 564.9491 Hannan-Quinn criter. -8.204695 F-statistic 84.72380 Durbin-Watson stat 1.113466 Prob(F-statistic) 0.000000

Table 33. Output of the initial linear-linear estimation.

Figure 23. The distribution of residuals for the initial regression

0

4

8

12

16

20

-0.010 -0.005 0.000 0.005 0.010

Series: RESIDSample 1 135Observations 135

Mean 4.25e-17Median -4.98e-05Maximum 0.009876Minimum -0.010075Std. Dev. 0.003698Skewness -0.045116Kurtosis 2.818441


81 | P a g e

After the adjustment, the Durbin-Watson statistic exceeds the value of 1.5

indicating that the hypothesis of no serial correlation can be accepted. It has to be

noted, that after the adjustment the coefficients are significant at the 1 % level and

the R-squared and adjusted R-squared projects a high level of significance

exceeding 85 %. The value of coefficient c� has a negative value thus confirming a

bell-shaped Laffer curve for the sample for the linear-linear estimation (Table 33).

We also test for the indications of heteroskedasticity – to check if the variance of

the error term is constant. If the error terms do not have constant variance, they

are said to be heteroskedastic. We use the White test which produces the value of

F-statistic equal to 1.47 (p-value 0.0885), signifying that we can accept the null

hypothesis of constant error terms. We do not identify strong outliers for the

residual sample of the AR(1) adjusted model (Figure 24).

According to optimization theory, tax revenue is maximized when the first order

derivative of VAT revenue to GDP with respect to the VAT rate is set equal to zero,

assuming that the coefficient of the quadratic term assumes a negative value

otherwise the tax revenue minimizing rate would be calculated and the Laffer

principle violated.

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Dependent Variable: R/Y Method: Least Squares Date: 05/27/12 Time:101:11 Sample (adjusted): 2 135 Included observations: 134 after adjustments Convergence achieved after 12 iterations


C -0.199409 0.055125 -3.617404 0.0004 V 2.571848 0.599064 4.293106 0.0000

V^2 -6.329918 1.621351 -3.904101 0.0002 G -0.019332 0.005522 -3.500977 0.0006 N -0.001379 0.000436 -3.162574 0.0020 M 0.030692 0.005359 5.727234 0.0000 B 0.022272 0.004498 4.951637 0.0000

AR(1) 0.664340 0.068474 9.702030 0.0000

R-squared 0.859624 Mean dependent var 0.070755 Adjusted R-squared 0.851825 S.D. dependent var 0.008177 S.E. of regression 0.003148 Akaike info criterion -8.626461 Sum squared resid 0.001248 Schwarz criterion -8.453455 Log likelihood 585.9729 Hannan-Quinn criter. -8.556157 F-statistic 110.2271 Durbin-Watson stat 2.117891 Prob(F-statistic) 0.000000

Inverted AR Roots .66

Table 33. Output of AR(1) adjusted regression

Heteroskedasticity Test: White

F-statistic 1.469760 Prob. F(26,107) 0.0885 Obs*R-squared 35.26280 Prob. Chi-Square(26) 0.1061 Scaled explained SS 67.84692 Prob. Chi-Square(26) 0.0000

Table 34. Output of White Heteroskedasticity test

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Figure 24. Actual, fitted and residual values for the AR(1) adjusted estimation

5.3.2. Log- Log Model

We will estimate alternative functional forms, namely the log-log form, as

specified by Hsing, (1996). In the log-log form, the coefficients are the elasticities,

which are assumed to be the same during the sample period. Taking logs of

equation (16) we arrive at:

ln �� = �� + ��ln(v��) + ��>?(v��)� + ��ln(m��) + ��ln(N��) + �7 ln@∆v��A +

�8ln(Dum��) + �9ln(B��) + �:ln(G��) + � ! (18)

The equation is regressed on the same set of observations for the full list of

independent variables and the model is adjusted for the insignificant variables just

as the linear-linear form. Ln(Dum��) and ln(∆v��) are rejected due to non positive

number value issues. Ln(G��)is rejected based on insignificance (probability of

0.337). The subsequent model displays robust qualities with all of the variables

significant at the 1 % level and the R-squared and adjusted R-squared exhibiting

-.008

-.004

.000

.004

.008

.012

.05

.06

.07

.08

.09

25 50 75 100 125


84 | P a g e

sufficient significance of 78 % – 79 % (see appendix 7). The residuals display

properties of normal distribution (Jarque-Bera of 1.819549 with the probability of

0.403, see Figure 25) therefore we continue with tests for auto-correlation and

heteroskedasticity.

Figure 25. The distribution of residuals of the initial log-log model

The Durbin-Watson statistic displays a value of 1.006 which suggests that

autocorrelation exists therefore we apply the AR(1) model just like in the linear-

linear form. The intermediate estimation output is presented in Appendix 8. ln(N��)

is rejected due to insignificance (probability of 0.1889). The Durbin-Watson statistic

for AR(1) adjusted model is 2.033 and does not indicate serial correlation. Once

again we use the White test which produces the value of F-statistic equal to 1.78

(p-value 0.0584), signifying that we can accept the null hypothesis of constant error

terms (Table 35). We do not identify strong outliers for the residual sample of the

AR(1) adjusted model (Figure 26).

0

2

4

6

8

10

12

14

-0.15 -0.10 -0.05 0.00 0.05 0.10

Series: RESIDSample 1 135Observations 135

Mean 1.63e-15Median 0.005697Maximum 0.131565Minimum -0.154806Std. Dev. 0.053739Skewness -0.275387Kurtosis 2.858143


85 | P a g e

Heteroskedasticity Test: White

F-statistic 1.782242 Prob. F(12,121) 0.0584 Obs*R-squared 20.12717 Prob. Chi-Square(12) 0.0647 Scaled explained SS 38.51611 Prob. Chi-Square(12) 0.0001

Table 35. Output of White Heteroskedasticity test for log-log

The final AR(1) adjusted log-log estimation is significant at the 1 % level and

produces R-squared and adjusted R-squared values exceeding 85 %, implying a

high level of significance. Statistical tests indicate that the error terms are not auto-

correlated and are homoskedastic. The coefficient values support the humped

shape of the Laffer curve and allow us to calculate the VAT revenue maximizing

tax rate (Table 36). Additionally we attempted to employ the first difference model,

but the subsequent coefficient did not support the bell shaped curve and the overall

significance of the model was under 10%, suggesting that no valid conclusions

could be drawn from the model.

Figure 26. Actual, fitted and residual values for the AR(1) adjusted log-log estimation

-.15

-.10

-.05

.00

.05

.10

.15

.20

-3.0

-2.9

-2.8

-2.7

-2.6

-2.5

-2.4

25 50 75 100 125


86 | P a g e

Dependent Variable: LOG(R/Y) Method: Least Squares Date: 05/27/12 Time: 11:15 Sample (adjusted): 2 135 Included observations: 134 after adjustments Convergence achieved after 10 iterations


C -9.708906 2.282341 -4.253924 0.0000 LOG(V) -9.260168 2.672665 -3.464770 0.0007

LOG(V)^2 -2.900493 0.782417 -3.707094 0.0003 LOG(M) 0.078993 0.013872 5.694525 0.0000 LOG(B) 0.265414 0.036618 7.248280 0.0000 AR(1) 0.686951 0.066574 10.31856 0.0000

R-squared 0.859430 Mean dependent var -2.655220 Adjusted R-squared 0.853939 S.D. dependent var 0.116510 S.E. of regression 0.044528 Akaike info criterion -3.341677 Sum squared resid 0.253785 Schwarz criterion -3.211923 Log likelihood 229.8923 Hannan-Quinn criter. -3.288949 F-statistic 156.5161 Durbin-Watson stat 2.033227 Prob(F-statistic) 0.000000

Inverted AR Roots .69

Table 36. Final AR(1) adjusted log-log estimation output

The initial and subsequent estimations of a semi-log model would not produce a

negative coefficient for the quadratic term meaning that any interpretations of the

model would be void and a U-shaped Laffer Curve would be plotted thus

contradicting the Laffer theory.

5.4. Results

The results of the regressions are summarized in Table 37. Initial Linear-Linear

regression, in which the serial correlation was detected, is also depicted, but the

maximizing rate is not calculated. The models include an intercept since data

points are available only in a limited range of tax rate values and it would not be

87 | P a g e

possible to extrapolate the tax rate from 0 % to 100%. The same applies to the

initial Log-Log.

Initial Linear-Linear

regression

AR(1) adjusted

Linear-Linear regression

Initial Log-Log

regression

AR(1) adjusted Log-Log

regression

Intercept -0.151767

(-5.328999) -0.199409 (-3.617404)

-6.403651 (-5.494488)

-9.708906 (-4.253924)

" ! 1.916126

(6.284863) 2.571848 (4.293106)

-5.738982 (-4.208469)

-9.260168 (-3.464770)

" !� -4.350458 (-5.280867)

-6.329918 (-3.904101)

-1.928708 (-4.820699)

-2.900493 (-3.707094)

0 ! -0.024721 (-3.965165)

-0.019332 (-3.500977) - -

B !

-0.002789 (-5.844515)

-0.001379 (-3.162574)

-0.055023 (12.03949) -

$ !

0.034025 (7.479112)

0.030692 (5.727234)

0.081697 (6.645544)

0.078993 (5.694525)

C !

0.038542 (8.491431)

0.022272 (4.951637)

0.401906 (-3.334546)

0.265414 (7.248280)

AR(1) - 0.66434 (9.702030) -

0.686951 (10.31856)

R-squared 0.798851 0.859624 0.790085 0.85943 R-Squared Adjusted 0.789422 0.851825 0.781949 0.853939

Standard Error 0.003783 0.003148 0.054771 0.044528 Probability (F-Statistic) 0.000000 0.000000 0.000000 0.000000 Durbin-Watson Statistic 1.113466 2.117891 1.00613 2.033227

Revenue maximizing rate - 20.57% - 20.26%

Table 37. Dependent variable – VAT revenue as a proportion of GDP; 23 countries (135 observations); t-values in parenthesis.

In the linear form the slope remains constant while in the Log-Log form the

coefficient is the elasticity, which is assumed to be the same during the sample

period. Coefficient values of the quadratic term support thr bell shaped Laffer curve

and allow us to calculate the revenue maximizing rates, which are relatively

uniform, with the maximizing rate between 20.26 % and 20.57 %. Matthews, K.

(2003) present a slightly lower range for the maximising rate at 18.0 % - 19.3 %.

The differences can be justified by the widening of the sample – all of the member

states of the 2004 enlargement stage are included. A sharp increase in the

average VAT rate for EU was visible in the period of 2008 and 2010 with the

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average rate reaching 20.19%. The uniform actions of raising VAT rates across the

Union suggest that the rates were on the upward slope of the curve, but caution

should be practiced when debating additional VAT rate hikes, because according

to our research the rates are close to the theoretical maximising rates and might

easily sway to the prohibitive side of the curve.

Coefficients of the VAT gap estimate support our assumption that the increasing

extent of zero and reduced VAT rating stimulate surplus cross-border trading. The

assumption of negative effect of the number of officially administered on the VAT

revenue was also affirmed, as indicated by the negative coefficient values.

According to the coefficients, an increase in the VAT base corresponds in an

increase of VAT revenue.

Controversial conclusions can be drawn from the shadow economy estimates,

since according to the coefficient values an increase in the shadow economy and

simultaneously in VAT fraud would result in growing VAT revenue. The

discrepancy might be caused by error of the estimation of shadow economy,

because it is not hard data and should be interpreted with caution.

Finally, it has to be noted that the conclusions may not be accurate enough as

there are very few observations – only 135. The lack of data constitutes the

greatest obstacle in quantifying the tax revenue curve and we can only hope that

more frequent and obtainable data will be accessible in the future for the estimation

of optimizing tax rates.

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6. CONCLUSION

Labor taxes and value added taxes are the most substantial taxes levied on

individuals. Therefore upward or downward changes of these taxes are of sensitive

nature to the wider society. On the other hand the level of these taxes is important

for the state’s budget, as in most European countries labor tax revenue accounts

for about half of all taxes collected, while VAT revenue accounts for more than a

fifth of total tax revenues. The goal of each government is to set such tax rates

which would be acceptable for the society at the same time maximizing the tax

revenue. The theory of the Laffer Curve explains the relationship between tax

revenue and tax rate. The question is whether the theory works in practice.

The results of the analysis performed in this paper support the notion of the

Laffer Curve representing a bell shaped arch. Both the function of VAT revenue

and the function of labor tax revenue are parabolic and illustrate that efficiency of

the tax system declines with an increase in tax rates. Labor tax revenue is

positively dependent on tax base and tax rate itself. However the level of the black

economy negatively influences labor tax revenue. The same dependency applies

to VAT revenue just additionally we found that the number of tax rates is significant

and has an impact on VAT revenue. The only controversial observation was the

positive effect of an increase in the shadow economy on VAT revenue collection.

This distortion could be justified by the soft nature of the shadow economy

estimates and should be interpreted with an appropriate level of tolerance

In order to test how Laffer Curve works out with real-life data, the quadratic term

of the tax rates was introduced. It was found to be significant with the correct sign

of the coefficient. The quadratic term allows for the computation of revenue

optimizing tax rates. As for the labor tax rate, we found that the revenue

maximizing tax rate is in the range of 33.39 – 33.88 per cent. VAT revenue

maximizing tax rate lies in the range of 20.26 % – 20.57 % Countries such as

France, Austria and Belgium have higher average labor tax rates than the

maximizing one, therefore tax cuts should be considered. Accordingly this would

90 | P a g e

lead to even higher tax revenues. However, for countries such as Greece, Finland

and UK, where average tax rates are lower, upward changes in tax rates could

raise political and social tension. As for VAT rates, countries like Denmark,

Sweden, Hungary and Finland seem to be positioned on the prohibitive slope of

the curve and should introduce tax cuts while Spain, Malta, Luxembourg and

Germany could benefit from an increase in tax rates. Additionally, and expansion of

the VAT base that is taxed on the standard rate could be an efficient measure of

generating additional tax revenue.

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