OECD Taxation Working Papers N. 3 – Making Fundamental Tax Reform Happen. This paper discusses the objectives of tax reform and explores the most important environmental factors that influence the reform process, focusing on the circumstances that explain when these objectives and environmental factors may become an obstacle to the design and implementation of tax policies. The second part of this paper discusses strategies that might help policy makers to successfully implement fundamental tax reforms. Countries often succeed in implementing fundamental tax reforms. Sometimes, however, tax reform proposals never leave the drawing boards of studies departments or ministries of finance. In other cases, the tax reforms that are implemented have been revised to such an extent during the reform process that they no longer – or only partially – serve the original tax reform objectives. It also happens that the initial reform objectives are scaled down “pre-emptively”, as policy makers anticipate the obstacles that will have to be overcome and conclude that the cost would be too high or the prospects for success too uncertain to justify risking their political capital. In order to make fundamental tax reforms happen, policy makers have to be aware of the major challenges they are likely to face during the tax reform process. Fundamental tax reforms go beyond small changes in tax rates and provisions. They can be confined to one tax, as for instance a value-added tax (VAT) or personal income tax (PIT) base-broadening reform that finances a cut in the statutory rate of the tax, or they can involve a more complex package of tax increases and reductions. Fundamental tax reforms can be designed to be revenue neutral – either in the first year after implementation or in the following years – or to increase or decrease tax revenues. They can be systemic, involving fundamental changes in tax rules and structures, or they can be limited parametric changes in existing taxes. Examples of systemic reforms are the dual income tax reforms in the Scandinavian countries; the 2006 reform introducing an allowance for shareholder equity in Norway; the 2001 presumptive capital income tax reform in the Netherlands; the 2004 flat tax reform in the Slovak Republic; and the introduction of the alternative minimum corporate tax (IETU) in Mexico in 2008. An example of a parametric reform is the VAT rate increase in Germany in 2007, which financed a decrease in social security contributions. Policy makers have been successful in implementing tax reforms, as can be observed indirectly from changes in the tax mix over time (OECD, 2009a). Despite some significant differences in the distribution of the tax burden between tax instruments across countries, most OECD governments continue to extract the bulk of their revenue from three main sources: income taxes; taxes on goods and services; and social security contributions. On average, there has been a reduction in the share of tax revenue accounted for by personal income tax partly because of the introduction of “make-work-pay” policies targeted mainly at lower income workers and reductions in the top PIT rates in many countries in order to stimulate human capital formation, entrepreneurship and risk taking. Another recent trend in the taxation of personal income is that some OECD countries, particularly in Scandinavia, have introduced dual tax systems, which tax personal capital income at low and proportional rates, while labour income continues to be taxed at high and progressive rates. Several other countries have moved towards “semi-dual” personal income taxes. There has also been a continuously growing share of social security contributions, which are often levied at flat rates. Corporate income tax (CIT) rates have been reduced in many countries since the beginning of the 1980s. The share of the CIT in total tax revenues, however, has increased in the majority of the OECD countries, thanks largely to base-broadening measures, increased firm profitability as a result of globalisation (at least prior to the crisis) and greater incentives for businesses to incorporate – implying that the revenue effects of lower CIT rates will partly show up in lower PIT revenues (OECD, 2007). The increasing share of the financial sector in the value added of the business sector has also played a role, although this trend may now have come to an end. A growing feature of corporate tax systems is the use of tax credits or special deductions for research and development (R&D) expenditures. These are now available in most OECD countries (Palazzi, forthcoming). The share of taxes on consumption has declined gradually, but the mix of taxes on goods and services has changed markedly. In general, there has been a shift towards the greater use of general consumption taxes, particularly VAT (although there remains a lot of scope for further VAT base broadening in most countries) and a reduction in the revenue share of specific consumption taxes such as excise duties. The share of property taxes (on immovable property, net wealth, inheritances and legal transactions) has been approximately constant on average. There has also been growing interest in the use of environmentallyrelated taxes, with several countries introducing new taxes to deal with specific environmental problems. When reforming tax systems, policy makers must try to balance the different goals that tax systems aim to achieve. This implies a need to make difficult tradeoffs. Policy makers will have to balance the efficiency and pro-growth objectives/impact of tax reforms with their distributional objectives/impact, while also taking into account the impact on revenues, tax avoidance and evasion opportunities, and the costs of compliance, administration and enforcement – bearing in mind that those costs also feed into the marginal social cost of public funds. When reforming labour taxation, they must also consider the interplay between taxes and benefits. International tax issues, questions of fiscal federalism, the transitional costs of changing the tax system and complex timing issues also have to be considered, as do complex implementation, legal and administrative issues. The design and implementation of tax reforms are also influenced by the institutional context. Finally, political economy factors will have an impact on the outcome of the tax-reform process, for instance because elected politicians may seek to use the tax system to favour particular interest groups and increase their probability of re-election. Hence, the successful pursuit of tax reform involves not only public finance considerations, but also administrative, institutional and political economy factors. Policy makers can follow certain strategies to make fundamental tax reform happen. These strategies help them overcome or circumvent obstacles to tax reform and allow policy makers to reconcile the different efficiency, fairness and wider tax policy objectives. Even though these strategies do not offer a menu that can automatically be applied to all possible fundamental tax reforms in OECD countries, the analysis that follows will offer insights that policy makers may find useful in facing the challenging task of implementing fundamental tax reform. The remainder of the text identifies first the obstacles to fundamental tax reform by looking at issues of policy design and afterwards at political economy and institutional factors. The chapter then presents the strategies that might help to overcome these obstacles to the implementation of tax reforms. This is followed by a brief conclusion. Brys, B. (2011).
