Flat income taxation, redistribution and labour market performance

Abstract

A flat tax rate on labour income has gained popularity in European countries. This article assesses the attractiveness of such a flat tax in achieving redistributive objectives with the smallest distortions to employment. We do so by using a detailed applied general equilibrium model for the Netherlands. The model is empirically grounded in the data and encompasses decisions on hours worked, labour force participation, skill formation, wage bargaining between unions and firms and a wide variety of institutional details. The simulations suggest that the replacement of the current tax system in the Netherlands by a flat rate will harm labour market performance if aggregate income inequality is contained. Only flat tax reforms that reduce redistribution will raise employment. This finding bolsters the notions from optimal tax literature regarding the equity-efficiency trade off and the superiority of nonlinear taxes to obtain redistributive goals in an efficient way.

Acknowledgements

We are grateful to Nicole Bosch and Joke Goes for preparing Figs 1, 2 and 3 and two anonymous referees for their valuable comments on an earlier draft.

Notes

¹ See Bovenberg et al. (2000) for a core version of MIMIC. A description of the full model and its calibration can be found in Graafland et al. (2001).

² MIMIC also contains a search-matching framework that further affects the labour-market and the impact of institutional changes. This part of the model is especially important for reforms that are very much targeted to specific groups in the labour market. As it is of minor importance for the flat tax reforms, we do not discuss this part of the model in great detail. For a more detailed description, see Graafland et al. (2001).

³ Jacobs (2005) and Bovenberg and Jacobs (2005) show that optimal marginal income taxes are lowered when learning is taken into account.

⁴ We increase the tax credit only for people with a positive income, not for nonparticipating partners. This avoids overcompensation of single earner couples. In the simulations, we assume that there is no problem associated with take up of the credit, e.g. because the tax bill becomes negative. Hence, the credit can be interpreted as a payable transfer, i.e. a negative income tax. In both reforms, we maintain the reduced rate in the first two brackets for the elderly above 65. Hence, the tax structure for the elderly is not flat.

⁵ If the public budget would be closed ex-post by changes in tax rates, endogenous revenues effects associated with behavioural responses would feed back into changes in the tax rate. In that case, we would arrive at flat tax rates of, respectively, 37, 43.5 and 26%. The economic effects will then be reinforced by this extra change in tax rates.

⁶ Rym and Koray (2004) discuss alternative methods to compute the average marginal tax rate. We take the weighted mean of all working individuals, where gross incomes are used as weights.