Wednesday 24 March 2010

Why the S&GP should go further in fighting tax credits

   One of the announced ways in which the S&GP aims at increasing tax revenue is the introduction of income-related limits to tax credits. This is a most welcome measure, and it will probably fall short of the desirable intervention in this regard.
   Let me give you a few basic facts about personal income tax deductions in Portugal. All the figures below are in thousand million euros. Using data for 2007 (available here), one can check that the total gross income in Portugal was around 80; an approximate amount of 23 is deducted from this. This deduction is equal to a given percentage of the maximum between the annual income equivalent to the minimum wage or the household's social security contributions. (Hence, greater for higher income households with higher SS contributions!) The household may also add itemized deductions related to professional union membership.

   This leaves us with a total of around 56.5 of taxable income, which would correspond to a total tax revenue of around 11.5 (taking into account the marginal tax rate structure). Tax credits of 3.2 are further deducted from this amount, leaving us with a final revenue of 8.2, that is, around 10.3% of the Portuguese families' gross income. There are two types of tax credits, which add up into the total: one which is pre-determined by law, depending on the household's composition, and itemized deductions such as health, education, child and elderly care expenditures, private pension plans, life and health insurance premia, computer acquisition for families with students.
   Should we worry? Yes, for (at least) four reasons. The first is the obvious revenue erosion caused by such numerous deduction schemes. The second is that so many different possibilities of itemized deductions increase the cost of monitoring and most likely create room for non-compliance. The third reason is the equity of the tax system. It is a well known fact that tax credits are regressive (for a recent application to the US case read here ). Not surprisingly, it is the richest in the country who tend to spend more on private health care, education and insurance schemes. Finally, economics like to think of deductions and tax credits as tax expenditure because these are, indeed, hidden government expenditure. The system's transparency and accountability naturally looses with the pervasiveness of such schemes.

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