Chapter 4. Strengthening the design of the personal income tax
Scope exists to strengthen the role of the PIT. Any cut in employee SSCs needs to go hand in hand with re-designing the PIT rate schedule to maximise labour market participation, to share the gains of the employee SSC reduction fairly across the income distribution and to help finance the reform. The PIT increases the tax burden on labour income, particularly for higher income earners. The top PIT rate is high and reducing it would come at a relatively low cost. The tax base is relatively narrow as a result of exemptions and special tax provisions. Tax provisions take the form of tax allowances, which is in contrast to best practice in the OECD, where tax credits are more widely used as they provide the same benefit to all taxpayers irrespective of their income and marginal tax rates. Broadening the tax base could be achieved by abolishing the tax exemption for the reimbursement of home-work travel expenses and meals during work and by taxing annual and performance bonuses as regular taxable income. Families with children are taxed significantly less than single taxpayers as they can benefit from both child tax allowances and child cash benefits. High tax burdens on labour income reduce the incentives for entrepreneurship. In response, Slovenia has introduced an alternative “flat-rate” regime which is overly generous and prevents businesses from growing.
4.1. Redesign the personal income tax rate schedule
The personal income tax (PIT) rate schedule is progressive. It is composed of five tax brackets similarly to the OECD average in 2016, with a top statutory PIT rate of 50% (Table 4.1). Certain types of income are taxed at a flat rate and are discussed in section 6.2.1. As described in Box 1.2, before the 2016 PIT reform, Slovenia had four tax brackets. The reform has introduced as of January 2017 an additional tax bracket (34%) and has lowered the second highest tax rate (from 41% to 39%).
4.1.1. The top PIT rate is high
The top statutory PIT rate in Slovenia is 50%, which is among the highest top PIT rates in the OECD (Figure 4.1). The top PIT rate in Slovenia has to be paid on gross earnings above 5 times the average wage (AW), which is a relatively high income level. The top PIT rate kicks in at lower income levels in the Slovak Republic (at 3.5 times the AW), Italy (2.7 times the AW), and the Czech Republic (0.3 times the AW). However, the top PIT rate kicks in at higher income levels in Austria, Germany and France, for instance.
Source: OECD Tax database.
A comparison of top PIT rates and top income tax brackets (i.e. the income level where the top PIT rate hits first) point at major differences across the OECD (Figure 4.2). Many East European countries have a low top PIT rate which hits at low income levels while Nordic countries have a high top PIT rate which has to be paid at low income levels. France and Portugal (and to a lesser extent Austria) have both a high PIT rate and a high top income tax bracket. In this sense, Slovenia is more similar to Italy and Austria than it is to other South East Europe (SEE) countries.
Source: OECD Tax database.
The combination of a high top PIT rate and high employee social security contributions (SSCs) results in high marginal effective tax rates for high income earners. The top “all-in” marginal tax rate, which takes the top PIT rate and employee SSCs into account, in Slovenia is 61.1% which is the highest rate in the OECD (Figure 4.3). On each additional euro earned, a taxpayer in the top PIT income tax bracket pays 61 cents in tax and keeps 39 cents in net pay only. This could induce taxpayers to work less or engage in tax avoidance behaviour. High effective top PIT rates may also make it difficult for firms to attract highly skilled foreign workers and retain Slovenian workers who may prefer to work abroad where working pays more.
The top PIT rate results in very high personal average and marginal tax rates for high-income taxpayers. Figure 4.4 presents net personal average and marginal tax rates at different income levels. The analysis shows strong increases in effective tax rates starting from the income level where the top PIT rate hits first. The net personal marginal tax rate increases with 8.5 percentage points from 52.5% to 61% at the top income tax bracket.
Note: The top “all-in” tax rate is calculated as the additional personal income tax, plus employee social security contribution, resulting from a unit increase in gross wage earnings at the earnings threshold where the top statutory personal income tax rate first applies. It takes account of the effects of tax allowances, tax credits, etc.
Source: OECD Tax database.
Note: The net personal average tax rate is defined as the sum of PIT and employee SSCs, minus cash benefits as a percentage of gross wage earnings. The net personal marginal tax rate shows the part of an increase of gross wage earnings that is paid in PIT and employee SSCs net of cash benefits.
Source: OECD (2017[2]).
The current revenues raised from the top PIT rate are relatively minor. In 2016, the top PIT rate was paid by only 3 581 taxpayers (Ministry of Finance of Slovenia tax record microdata). This reflects the condensed wage distribution in Slovenia, and possibly also the fact that taxpayers have organised their economic activities such that they can avoid paying the top PIT rate (e.g. through incorporation). The tax revenue cost of lowering the top PIT rate would be relatively modest, as presented in Box 4.1, while it would reduce significantly the tax burden on labour income and, therefore, strengthen the functioning of the labour market.
A significant cut in the top PIT rate in Slovenia would be necessary in order to align the country’s top “all-in” marginal tax rate with the “all-in” rates in neighbouring countries. Slovenia’s “all-in” marginal tax rate is the highest in the OECD (Figure 4.3) at 61.1%. For a given level of employee SSCs (either the current 22.1% rate or a reduced rate), Table 4.2 presents the top PIT rate which Slovenia would need to levy in order to reach a top “all-in” marginal tax rate equal to the rate levied in the country of comparison. In all the scenarios which are presented, Slovenia would have to lower its top PIT rate significantly. For example, with a 5 percentage points cut in employee SSCs to 17.1%, Slovenia’s top PIT rate would need to be reduced to 43.1% in order to levy the top marginal “all-in” tax rate of 52.8% in Italy. For smaller cuts in employee SSCs, Slovenia’s top PIT rate would have to be reduced even more. However, the comparison of top PIT rates should also take into account the income level where it kicks in; that complexity is not taken into account in Table 4.2.
In 2016, there are approximately 3 000 employees with taxable income above EUR 70 907.20, the threshold for the top 50% PIT rate. This cohort has EUR 122 million of taxable income above the threshold which is subject to the top rate. Therefore, assuming no behavioural change and linearity, a reduction in the top PIT rate to 45% is associated with a PIT loss of about EUR 6 million (Figure 4.5). The abolition of the top rate, modelled by reducing the rate to the second from top 39% rate, is associated with a loss of EUR 13 million or 0.03% of GDP.
Although such estimates are uncertain, they can indicate the likely extent of the tax loss – in this case, the PIT loss associated with abolishing the top PIT rate is likely to be very small relative to total PIT collected. At the same time, this loss could be compensated for by creating actual and perceived incentives for a range of potentially positive behavioural responses, which could improve economic efficiency. For example, these high income employees may respond by working more or decreasing the extent to which they avoid taxes. Furthermore, it may reduce emigration of high skilled employees and provide a signal to foreign companies to relocate their activities to Slovenia.
Note: The analysis assumes no behavioural change arising from the PIT rate reduction and linearity. Methodological information on the microdata is available in the annex.
Source: Authors’ calculations based on Ministry of Finance of Slovenia tax records microdata.
4.1.2. The bottom PIT rate hits at a relatively high income level
Single taxpayers start paying income tax at 45% of the AW. This is above the OECD average and the selected East European countries (Figure 4.6). The income level where taxpayers effectively start paying PIT depends on the level of tax allowances and/or the width of the zero rate bracket (if present) in the PIT rate schedule. As families with children and married couples may benefit from additional tax allowances or cash benefits, those families will have to start paying PIT at income levels typically higher than single taxpayers.
Employee SSCs increase the income level where taxpayers effectively start paying PIT. In almost all OECD countries, employee SSCs are deductible from taxable personal income. The higher the employee SSCs, the higher the income level where the PIT hits first. A reduction in employee SSCs in Slovenia would also imply that households would have to start paying PIT at lower income levels.
Source: OECD (2017[2]).
4.1.3. The PIT increases the labour tax burden significantly
Single employees without children face high tax burdens on their labour income. The combination of high employee SSCs and PIT rates result in high net personal income tax rates across the income distribution (Figure 4.7). Average tax wedges, which include also the impact of employer SSCs, are even higher. At low income levels, the steep increases in the net personal average tax rate were driven by the specific design of the general tax allowance before its most recent reform. In addition to the general tax allowance of EUR 3 302.70, an additional general allowance of EUR 3 217.12 was available to lower income taxpayers (with taxable income below EUR 10 866.37); taxpayers with taxable income between EUR 10 866.37 and EUR 12 570.89 could benefit from an additional tax allowance of EUR 1 115.94. Once the taxpayer earned income above the particular income thresholds, the tax allowances were lost, which resulted in very high marginal effective tax rates.
The basic allowance system was reformed in 2018 (see Table 4.8). The reform will reduce the two peaks observed in the net personal marginal tax rate, as the allowances will be gradually reduced when income rises. However, the tapering out will result in somewhat higher marginal tax rates over the income range where the additional tax allowances are tapered out compared to the results presented in Figure 4.8. Slovenia should evaluate the impact of the new basic allowance on work incentives and should evaluate whether the additional basic allowance, instead of tapering it out with income, could be integrated within the standard basic allowance of EUR 3 302.70. In order to prevent that higher incomes would gain, the first rate bracket of 16% could be increased. Moreover, the basic tax allowance could be turned into a basic tax credit to further limit the regressive effects.
Both low and high income taxpayers face high tax burdens. The net personal average tax rate for taxpayers earning 250% of the average wage amounts to 41% of gross wage earnings, which is significantly above the tax burden on average in the OECD (at 34%). These results are driven by the high employee SSCs and the progressive PIT rate schedule (as pointed out in Chapter 2). High employee SSCs result in high tax burdens on low incomes. For instance, lower-income taxpayers earning 50% of the AW pay 23% of their gross wage earnings in tax, which is above the average rate of 17% on average in the OECD.
Analysis of tax return data confirm the high average tax burdens paid by employees (Box 4.2). In contrast, the effective average tax rates paid by full pensioners (i.e. pensioners who, besides a pension, do not have another source of wage or business income) or the self-employed are significantly lower.
Source: OECD (2018[3]).
Source: OECD (2018[3]).
Figure 4.9 shows PIT and SSCs as a share of total labour costs by percentile in 2016 for employees (Panel A), full pensioners (Panel B) and self-employed (Panel C).
For employees, PIT as a percentage of labour costs is extremely low at the bottom of the distribution and increases slowly but progressively for higher incomes. For the first 10 percentiles, it is at or below 0.3% and for the first 30 percentiles it remains below 5.0%. It does not exceed 10% until the 78th percentile. In absolute terms, employee SSCs are always higher than the employer SSCs over the income distribution (except for the first percentile) and the difference increases progressively for higher income levels.
The average tax wedge increases slowly but progressively for higher levels of earnings - from a low of 32% to a high of 48%. For example, at the bottom 10th percentile, where average total labour costs are EUR 9 102 (average gross incomes are EUR 7 834) the average tax wedge is 32%. At the median, where average labour costs are EUR 18 392, the tax wedge is 38%. In the 90th percentile, the tax wedge is 43%.
Note: Gross incomes are averages within decile. Panel B: Health SSCs refer to payments made for medical care and sickness leave on behalf of pensioners by the employer Pension Fund to the Health Fund. Methodological information on the microdata is available in the annex.
Source: Authors’ calculations based on Ministry of Finance of Slovenia tax records microdata.
4.1.4. Taxpayers are concentrated in the lower rate bands
Employees pay a large share of PIT. Most taxpayers are employees (53%) or pensioners (42%) and a small proportion are self-employed (5%) (Table 4.3). The proportion of income held by employees is 70% while the share of the PIT paid is 89%. For pensioners, the proportion of income held is 26% while the share of the PIT paid is 7%. For self-employed, both shares are 4%. This is reflected in the effective PIT rates for employees (12%), pensioners (2%) and self-employed (9%).
Pensioners and self-employed are concentrated in the first rate band. In 2016, 87% of pensioners and 84% of self-employed are in the 16% tax bracket. Their base for taxable income is narrowed by a combination of high employee SSCs and substantial allowances (and to a lesser degree by tax credits in the case of pensioners) resulting in very small effective PIT rates and associated PIT. Therefore, most of the very small amounts of overall PIT paid by pensioners and the self-employed are paid by the remaining narrow base of taxpayers. For example, half of all PIT (48%) paid by pensioners is paid by 1.4% of taxpayers (7 973 individuals) in the top two brackets. Similarly for the self-employed, 60% of all PIT paid by the self-employed is paid by 4.6% (3 146 individuals), again in the top two brackets.
The vast majority of employees are in the first two bands. 50% of employees are in the 16% rate band, and 40% in the 27% rate band. These first two bands account for 55% of the PIT, and 70% of the PIT and SSCs combined. The 3 021 employees (less than 1% of all employees) in the top band earn 3.3% of all income and pay 4% of total tax and SSCs (as a share of gross income).
Disposable income declines only modestly across age in Slovenia. Even though most taxpayers who are at work pay the bottom PIT rates only, the combination with high employee SSCs reduces their disposable income significantly. Pensioners, on the other hand, pay only small amounts of SSCs and their pension is on average so low that they pay hardly any PIT. The combination of these factors explains why disposable income remains relatively constant when workers move into retirement. Figure 4.10 shows median gross and disposable income in 2016 by age in Slovenia. There is a significant difference between gross and disposable incomes for the working-age population but the gap virtually disappears for those aged over 65. For example, while median gross incomes declined sharply (by 26%) between the ages of 58 and 60, disposable incomes declined only modestly (by 12%).
Note: Disposable income defined as gross income less employee SSCs less PIT as reported on the tax records. Methodological information on the microdata is available in the annex.
Source: Authors’ calculations based on Ministry of Finance of Slovenia tax records microdata.
4.1.5. The effectiveness of the PIT is enhanced by an employee SSC rate cut
This section extends the previous employee SSC rate cut simulation (presented in Chapter 3, section 3.2) to include PIT rate increases. The previous employee SSC rate cut analysis showed that a 5.24 percentage points cut could result in a loss of EUR 519 million (cost of employee reduction of EUR 700 million net of a PIT recovery of EUR 181 million). Table 4.4 extends that analysis by showing the potential additional PIT revenues from increasing the PIT rate in brackets one to four given the employee SSC rate cut and not.
According to the analysis, the overall effectiveness of the PIT is enhanced by an employee SSC rate cut. Employees now have higher taxable income and some employees move up to higher PIT brackets. For example, a two percentage points increase in the PIT rate in the second, third and fourth brackets is estimated to produce EUR 61 million for no change in employee SSC, and EUR 71 million if employee SSCs were reduced to 16.86%. A simulation is also provided showing the impact of PIT rate increases given a significant base broadening - reducing tax allowances for all employees by 15%. The analysis shows that, given a broader tax base, smaller PIT rate increases that are necessary to offset other employee SSCs reductions.
4.2. Unify and broaden the PIT base
4.2.1. The design of the PIT base is complex and rules depend on the type of income earned
The PIT differentiates between six categories of income: employment income, personal business income, income from agriculture and forestry, rents and royalties, capital income (including rental income), and other income. In order to calculate the personal income tax liability, the tax base of each of the different sources of income are determined separately and afterwards aggregated. According to the microdata for 2016, gross income is about EUR 21.2 billion, of which EUR 19.7 billion or over 90% is employment income (Table 4.5). Salaries (64.1% of total income) and pensions (20.6%) constitute the largest share of total gross income. Personal business income, income from agriculture, rental income and capital income comprise 2.7%, 0.5%, 1.8% and 1.4% of total income respectively.
The employment income tax base is narrow
For a regular employee, the tax base is income from employment reduced by mandatory employee social security contributions. Employment income consists of: income from an employment relationship including holiday payments, income from other contractual relationships, and fringe benefits such as the use of a personal vehicle for private purposes, accommodation, a loan free of interest or with an interest rate lower than the market interest rate, etc.
However, special tax rules apply that narrow the tax base considerably. From January 2017 onwards, annual bonuses and performance bonuses are exempt from PIT, but not from SSCs, up to an amount equal to 70% (up to 100% from 2018 onwards) of the average salary in Slovenia. Some benefits in kind are also exempt from PIT, including subsidized meals during work, catering, mobile phones and computer equipment, and additional education and training expenses related to the business of the employer, etc. Other exempted benefits in kind include: specific health care doctor visits, vaccination and insurance for work accidents; use of parking places, mobile phones and computer equipment; Christmas gifts to the employees’ children younger than 15 years (up to EUR 42); non-cash gifts to employees (up to EUR 15 per month). Other special tax rules include the deduction from the taxable income of premiums of voluntary pension and disability insurance up to 24% of the mandatory contributions for pension and disability insurance, with a maximum of EUR 2 390 per year.
In addition, the reimbursement of expenses incurred in relation to work-related travel is not taxed under the PIT (up to a certain amount). This includes transportation costs to and from work (cheapest public transport from the residency to the workplace, or the cost of the mileage EUR 0.18 per kilometre – see Table 4.6 for the average allowance by employee), expenses for meals (maximum EUR 6.12 for each day with more than 4 working hours – see Table 4.6), and expenses incurred on business travels (from 32 EUR to 64 EUR a day on average). Any amount received above the tax-free threshold is included in the tax base for employment income and subject to PIT and SSCs.
A special tax treatment for student income exists. Students under 26 who earn income from temporary or occasional work can benefit from a special tax allowance. In 2017 (taking effect on 1 January 2018), the special personal tax allowance for student work was increased from 70% to 100% of the general allowance and amounts to EUR 3 302.7. Since February 2015, certain SSCs are paid on student work. These include employee and employer SSCs for pension and disability insurance (8.85% and 15.5%), employer SSC for health (6.36%) and employer SSCs for injury at work (0.53%).
Two different regimes exist for the taxation of personal business income
Personal business income can be taxed under the regular regime which allows for the deductibility of actual costs incurred or under the flat-rate regime. In the actual costs regime, tax losses can be carried forward indefinitely (subject to some limitations, such as non-performance businesses). In the flat-rate regime losses cannot be carried forward (or backward). The actual cost regime is the regular regime; taxpayers can choose to be taxed under the flat-rate regime if certain conditions are fulfilled.
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Under the actual costs regime, the base for taxation is the profit derived by deducting actual costs from actual revenues. In that regime taxpayers can use tax deductions and/or allowances, and must keep appropriate books and records. The net business income (profit) computed with the actual costs regime is subject to the progressive PIT rates schedule (Table 4.1). In 2016 the effective tax rate for taxpayers in this regime was 4.1% but 66% of taxpayers had an average effective tax rate of less than 2%.
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Under the flat-rate regime (also called the 20:20 regime), actual business income is reduced by a presumptive amount of costs equal to 80% of business income irrespective of actual costs incurred; businesses that have low costs clearly benefit the most from the flat-rate regime. The net income is taxed at a 20% rate which results in a 4% effective PIT rate. No other allowances relating to business activity or personal allowances can be deducted. The taxpayer needs to meet the following conditions:
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Income from activities in the previous fiscal year does not exceed EUR 50 000. In this case the nominal expenses in the amount of 80% of income shall be considered but not more than EUR 40 000.
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Income from activities in the previous fiscal year does not exceed EUR 100 000 and the taxpayer covered full-time compulsory insurance for at least one person for an uninterrupted period of at least five months. In this case the nominal expenses in the amount of 80% of income shall be considered but not more than EUR 80 000.
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Most self-employed choose the actual cost regime. There were 111 600 self-employed taxpayers in 2017, of which 66 400 are self-employed under the actual cost regime and 45 200 under the flat-rate regime. However, the number of self-employed under the flat-rate regime is increasing. Compared to 2016, the number of taxpayers under the flat-rate regime increased by 18% (+32% from 2015 to 2016) while the number of self-employed under the actual cost regime declined by more than 7% (-6% from 2015 to 2016). In 2016, the amount of PIT collected under the actual cost regime (EUR 56 million) is higher than under the flat-rate regime (EUR 28 million) (Table 4.7). The self-employed which choose for the flat-rate regime operate in the following sectors: legal/accounting jobs, arts, IT and communication, and manufacturing. The actual cost regime is chosen by the self-employed who operate in the construction sector, wholesale and retail trade, manufacturing, legal/accounting jobs, transportation, and accommodation and food.
In the actual costs regime, the self-employed who operate in the cultural sector benefit from a special tax treatment. Self-employed who operate in the cultural sector benefit from a reduction in the tax base of 15% up to EUR 25 000. The same special tax relief applies for journalists and athletes.
4.2.2. PIT allowances are numerous
Tax allowances narrow the PIT base considerably. The PIT system in Slovenia includes many tax allowances (Table 4.8). Generous tax allowances come at a significant tax revenue cost, increase complexity, create distortions and may be more beneficial to richer than poorer households. Countries that have generous tax allowances often have very high tax rates in order to compensate for the revenue cost. Certain allowances are common practice in the OECD countries such as employee SSCs which are deductible from taxable PIT or tax provisions for third pillar private pension savings. Nevertheless, there is significant scope in Slovenia to broaden the tax base.
Many countries have turned their tax allowances into tax credits. The main argument in favour of tax credits, which are deductible from tax liability while tax allowances are deductible from taxable income, is that the value of tax credits is independent of income while the value of tax allowances is increasing in the taxpayer’s marginal tax rate and so tax allowance benefit higher incomes more (OECD, 2006[4]).
Various PIT base broadening opportunities exist including thee tax treatment of transport costs in relation to work, which is overly generous and has negative environmental effects. As pointed out, the reimbursement of expenses incurred in relation to work-related travel, including transportation costs to and from work, is not taxed under the PIT. These tax provisions were installed in a context of limited transport infrastructure in Slovenia. However, the policy rationale for this generous tax treatment has become weak. Moreover, it stimulates transport and commuting, and therefore creates negative environmental effects. The current tax regime in relation to work travel should be revised. As the basic PIT tax allowances are already generous, an additional allowance for transport expenses may not be required. In fact, the main policy rationale for the basic allowance in the PIT is that it covers the minimum costs incurred to earn taxable labour income; this includes work-home travel (and meal allowance). Any remuneration for transport costs or food at work should be treated as taxable personal income. In addition, the meal allowance could be treated as regular taxable income under the PIT and SSCs. Moreover, the performance bonuses and annual bonuses, which are currently tax exempt up to the average wage, could be taxed as regular income under the PIT. Slovenia should also evaluate whether some of the fringe benefits which are tax exempt could be brought within the reach of the tax system.
Slovenia should continue with its plans to include a tax expenditure report as part of its annual budget cycle to inform policy makers of the tax expenditure costs. Tax expenditure reporting assists in the management of the overall fiscal position and budget allocations. It involves the estimation of the tax revenue foregone of tax expenditures. This allows governments to assess whether the tax expenditure meets its objectives compared to the cost involved. More generally it can serve for the evaluation of public policies. Tax expenditure reporting also enables the distributional assessment of tax relief across different taxpayers and helps increasing transparency of government policies.
Reducing allowances would significantly increase revenues. To simulate the impact of reductions in tax allowances (personal allowance, family allowance, etc.) on PIT revenues, allowances on the tax records are reduced to 95%, 90%, 85%, 80% and 75% and substituted into estimated taxable income (Figure 4.11). According to the analysis, reducing tax allowances by 5%, 10% and 15% could increase PIT through higher taxable incomes by EUR 58 million, EUR 120 million, EUR 184 million, EUR 251 million and EUR 319 million respectively.
Note: All taxpayers included. Not all tax allowances are available on the tax records such as the child allowance. The analysis assumes no behavioural change and linearity. Methodological information on the microdata is available in the annex.
Source: Authors’ calculations based on Ministry of Finance of Slovenia tax records microdata.
4.2.3. Tax provision for families with children are generous
Slovenia provides both tax allowance and cash benefits for children
In addition to child tax allowances (see Table 4.8), Slovenia also has a system of (tax-exempt) child cash transfers (OECD, 2018[3]). The cash benefits are calculated for each child separately according to the level of net family income per family member (over 8 income classes), the ranking level of the child (3 levels: first, second, third and any subsequent child), and the school level (primary, secondary) (Table 4.9). In 2017, the maximum annual cash benefit for children in primary school in a two-parent family was EUR 1 371.72 for the first child, EUR 1 508.76 for the second child, and EUR 1 646.16 for the third child (or subsequent child). For children living in a one-parent family, the cash benefit is increased by 30% and by 20% when a pre-school child does not attend childcare.
Housing cash benefits are paid to low-income families. Married couples with two children at low levels of income can receive significant housing benefits in addition to their family/child cash benefits (Figure 4.12). While family/child cash benefits are large, also the additional housing cash benefit results in considerable additional income for low income households. Cash benefits are reduced when income rises, but at modest rates. For instance, families at average earnings continue to receive significant child and housing benefits (Figure 4.12).
Note: This chart takes into account the child allowance.
Source: OECD Benefits, Taxes and Wages dataset.
Child tax allowances and child benefits reduce the tax burden for families with children significantly
Child cash benefits and child tax allowances significantly lower the net personal average tax rate for families, especially at lower incomes. For instance, the net personal average tax rate for a one-earner married couple with two children is 2.6% at 67% of the AW, 12.3% at the AW and 27% at 167% of the AW (Figure 4.13). It is significantly lower than for single taxpayers without children; the difference in effective tax rates ranges between 32 percentage points at the lower end of the income distribution and 7 percentage points at higher income levels (Figure 2.5). The difference in the net personal average tax rate for single taxpayers without children and one-earner married-couples with two children at AW earnings in Slovenia is 21 percentage points, which is among the highest in the OECD (Figure 4.14). Poland (at 30 percentage points) and the Czech Republic (at 23 percentage points) subsidise children even more strongly than is the case in Slovenia.
The net personal marginal tax rate increases step-by-step but shows peaks at income levels where the cash benefits are reduced (Figure 4.15). Peaks are observed at 60%, 105%, 130%, 157% and 208% of the AW. Single taxpayers without children and one-earner married couples with two children face the same net personal marginal tax rate at gross earnings above 160% of the AW; this result does not apply to the net personal average tax rate because of the impact of child tax allowances (Figure 2.5).
Source: OECD (2018[3]).
Source: OECD (2018[3]).
Source: OECD (2018[3]).
Child tax allowance and cash benefits reduce incentives for second earners to participate in the labour market
Tax and cash benefits targeted at children create a disincentive for second earners to participate in the labour market and to work more hours. The net personal average tax rate for a second earner at 67% of the AW in a married couple with two children with a partner (the principal earner) at 100% of the AW is 43% in Slovenia, which is very high compared to average tax rates for second earners in other OECD countries (Figure 4.16). In contrast, a second earner without children in Slovenia faces an average tax rate of 34%. The high net personal average tax rate for second earners is a combination of the high employee SSCs and PITs in Slovenia and because the principal earner who claims the child benefits and child tax allowances will lose some of the advantages when the second earner starts working because of the increase in family income. This loss is added to the tax burden of the second earner and therefore results in significant reduced work incentives.
Source: Thomas and O’Reilly (2016[5]).
The design of the child tax allowances and cash benefits is complex
Most countries, including Slovenia, lower the net personal average tax rate for families with children through a combination of PIT reductions and cash transfers (Table 4.10). Five countries provide PIT reductions only; nine countries only provide child benefits. The Netherlands is the only country which reduces employee SSCs for families with children (OECD, 2018[3]). Whether to choose for cash transfers and/or PIT reductions depends on different factors. Cash transfers can reach individuals who do not file a tax return. On the other hand, PIT relief for children does not require government to create a separate cash transfer system.
The design of the support for children in Slovenia is complex and not very transparent regarding the overall benefit they provide across incomes. One the one hand, the cash transfers are decreasing in family income (Table 4.9). On the other hand, the tax allowances for children are constant (although higher allowances are available for each extra child) (Table 4.8) and, as is typically the case with tax allowances, their value is increasing in taxpayer’s income.
Slovenia should consider whether the current system of support for children could be reformed. Different reform options exist. The tax allowances could be turned into tax credits. Alternatively, the current tax allowances could be abolished and replaced by higher cash benefits for children. As Slovenia has a condensed wage distribution, the cash benefits could be provided to all families irrespective of their income level. Such an approach would prevent that marginal tax rates would be increased when the benefits are tapered out. This would also tackle one of the underlying causes of the high tax burdens, and therefore reduced work incentives, for second earners in Slovenia. Alternatively, the cash benefits could be reduced at high income levels only in order to limit the impact on work incentives as much as possible.
4.3. Reduce tax disparities between different legal forms
4.3.1. The flat-rate regime is too generous and needs to be reformed
Many tax reliefs apply for business income. Personal business income can be taxed under the regular regime, which allows for the deductibility of actual costs incurred, or under the flat-rate regime, which reduces actual business income with a presumptive amount of costs equal to 80% of business income (see also section 4.2.1). No additional allowances are available under the flat-rate regime. Under the actual costs regime, additional deductions in the form of tax allowances can be claimed, including (non-exhaustive list):
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Tax allowance of 100% of the R&D investment;
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Tax allowance equal to 40% of investment in equipment and long-term intangible assets;
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For employment of young and older workers: additional reduction in the tax base amounting to 45% of the salary paid to a new employee younger than 26 or older than 55 and previously long term unemployed;
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For employment of disabled persons: additional reduction in the tax base from 50% to 100% of the salary of the disabled employee.
SSC treatment differs between unincorporated and incorporated businesses. The SSC regime for self-employed entrepreneurs was described in section 3.4. While it is overall very similar to the tax regime for regular employees, including manager-owners of closely held corporations, the main difference is the SSC ceiling for the self-employed which does not apply for regular employees.
The flat-rate regime distorts the labour market and leads to tax evasion
The flat-rate regime was created to stimulate entrepreneurship. The flat-rate regime was introduced in 2013 during the economic crisis to encourage individuals to start their own business. The main objective of the regime was to lower the tax administrative burden for small businesses – there is no requirement to keep books of accounts but only records – and to provide more transparency and certainty about future tax liabilities.
The number of taxpayers within the flat-rate regime is steadily increasing. The number of taxpayers increased from 14% of self-employed businesses to 35% in 2016 (which represents around 38 300 taxpayers) (Ministry of Finance of Slovenia, 2016[6]). In 2015, up to 55% of businesses fulfilled the criteria to be taxed under the flat-rate regime. This shows that many more businesses could potentially choose to be taxed under the flat-rate regime.
The flat-rate regime induces self-employed entrepreneurs to conceal their income. An in-depth evaluation of the regime by the Ministry of Finance has found that the regime induces taxpayers to under-report their income below EUR 50 000 in order to qualify for the regime (Ministry of Finance of Slovenia, 2016[6]). Stricter tax enforcement therefore seems justified, although this increases the risk that the regime will induce taxpayers to work less in order to stay below the income threshold.
The flat-rate regime distorts the functioning of the market. The regime can cover hidden employment relationships. Bogus self-employment (people forced to take that business status to work for an employer) is estimated to have doubled from 3.8% of total employment in 2012 to 6.6% in 2015 (European Commission, 2017[7]). The flat-rate regime is particularly vulnerable to be misused for these purposes. Slovenia has attempted to deal with these challenges by introducing anti-avoidance provisions in the flat-rate system in 2017 (with effect as of January 2018) (see Box 1.1). However the reduction of the 80% cost rule (to 60% or 70%) was not implemented.
The flat-rate regime needs to be reformed because the effective tax burden under the regime is very low (at 4% effective rate on income) and because it induces businesses not to grow – or to split up their business – in order to qualify for the regime. Several reform options could be considered:
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The presumptive costs of 80% of income could be lowered significantly; in addition, the low tax rate of 20% could be increased.
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The regime could be phased out over time. This would ensure that the flat-rate regime is used for individuals to start a business only but, once the business has proven to be economically viable, the self-employed would be taxed under the regular regime.
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Another option would be to abolish the flat-rate regime but, instead, (continue to) provide self-employed a temporary cut in SSCs or a PIT credit for the first years after having created a business.
4.3.2. Entrepreneurs face a tax-induced incentives to incorporate
The significant difference in the tax burden on labour and capital income creates tax-induced incentives for business owners to incorporate. The tax burden on labour income in Slovenia is very high as a result of the combined effect of PITs and high SSCs, as discussed earlier in this report. Although the self-employed can lower their effective PIT burden if they choose for the flat-rate regime, they will continue to face the high self-employed SSCs. The SSC ceiling for the self-employed reduces the tax burden on labour income, but the ceiling hits at 350% of the AW only. The tax burden on capital income is significantly lower (see Chapter 6). While top wage earnings are taxed at a top PIT rate of 50%, the tax rate on distributed dividends at the individual level is 25% only (39.25% if the corporate income tax, CIT, is taken into account as well). These differences in the tax treatment of labour versus capital income create a strong incentive for self-employed businesses to incorporate their business. In order to minimise their tax liability, managers-owners of closely-held corporations then face an incentive to pay a low wage only and to get the remuneration the form of dividends. Alternatively, they can retain the profits within their corporation and distribute them later or realise the capital gains when they sell the shares in their business.
In order to limit this type of tax-arbitrage behaviour, countries may want to oblige manager-owners of closely held corporations to pay themselves a “minimum” wage. In Belgium, for instance, manager-owners have to pay themselves a salary of at least EUR 36 000 (IMF, 2017[8]) and this wage has recently been increased even further. Slovenia requires closely-held corporations to pay their manager-owners a “minimum” wage of only 54% of the AW. This is low and creates many opportunities to actively engage in tax arbitrage opportunities to limit overall tax liabilities.
Closely-held corporations face a tax-induced incentive to accumulate funds within their corporation. The capital gains tax rate which is levied on realised capital gains is reducing in the holding period of the shares (see Chapter 6). If the shares are held for more than 20 years, no capital gains tax has to be paid. As a result, manager-owners of closely-held corporations can reduce the tax burden to the CIT levied on retained profits. The very high level of wealth that is kept within businesses (Figure 4.17) seems to confirm that these types of tax-arbitrage behaviour are actually occurring in practice.
Indeed wealth held in self-employed business - regardless of whether the business is incorporated or not - is substantial in Slovenia. In households with a self-employed head of household, self-employment wealth is three times higher than average holdings of self-employment wealth across the entire population (60% of total real wealth vs. 20%) (Figure 4.17). This is above the average: the households where the head of household is self-employed hold 33.9% of their total gross wealth inside their self-employed business, compared to 10.1% on average in the total population. As the number of self-employed remains around 10% of total employment, this likely suggest that most of the wealth is held in incorporated businesses.
Source: OECD (2018[9]).
Several options exist for reducing the tax-induced incentives for businesses to incorporate. First, the “minimum” wage which manager-owners of closely-held corporations have to pay could increase considerably. Currently the threshold is set at 54% of the average wage. Slovenia should consider raising that level to (at least) the AW. Further efforts might be welcome to better align the tax burden on capital and labour income. Reducing the top PIT rate of 50% and increasing the taxes on capital income at the individual level (see Chapter 6) would be an integral part of such a reform. Another option would be to introduce a capital gains tax which is constant over time and does not decrease with the holding period. This option, however, would not enable taxation of income of non-residents in Slovenia, as, under tax treaties, such capital gains are usually taxed only in the residence jurisdiction.
4.4. Main recommendations
Objective: Redesign the PIT rate schedule
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Abolish the top PIT rate bracket and rate of 50%
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Increase the PIT rates in the second, third and fourth tax bracket and evaluate the design of the PIT brackets in response to a significant cut in employee SSCs
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Evaluate the impact of the multiple basic tax allowances, and their taper rates, on personal marginal tax rates and work incentives
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Possibly integrate the additional basic tax allowance (which is reduced when income rises) within the main basic allowance and increase the bottom PIT rate of 16% to offset the impact on higher incomes
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Objective: Broaden the PIT base
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Enlarge the PIT base by abolishing the tax exemption for:
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Annual bonuses
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Performance bonuses
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Remuneration for home-work transportation costs
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Meal allowance
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Tax fringe benefits as much as possible as regular income
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Turn tax allowances into tax credits
Objective: Redesign the provisions that provide support for children
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Consider increasing the generosity of the child transfers and abolishing the child tax allowances
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If the current design mix of both tax provisions and cash benefits for children is maintained, turn the child tax allowances into child tax credits
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Consider turning the cash benefits into amounts that do not vary with the taxpayer’s income to prevent distortions in work incentives; alternatively, phase out the child benefits at high incomes only
Objective: Reduce tax disparities between different businesses legal forms
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Reform the flat-rate regime
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Reduce the 80% assumed costs significantly while increasing the 20% tax rate
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Introduce a time limit so that the self-employed can only benefit from the regime during the first year’s after the start-up of the business
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Alternatively, abolish the flat-rate regime but, instead, maintain for a certain length of time a reduction in SSCs when a new self-employed business is created
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Reduce tax-induced incentives to incorporate
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Increase the “minimum” wage that manager-owners of closely held corporations have to pay to, at least, the average wage
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Align the tax burden on labour and capital income (see also Chapter 6) by
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Lowering the top PIT rate levied on wage earnings
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Increasing the tax rate on dividends at the individual shareholder level
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Increasing the capital gains tax rate and do not lower the rate for longer holding periods for closely-held corporations
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Objective: Improve transparency
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Publish an annual tax expenditure report, make it publicly available and develop its scope and content gradually over time
References
[7] European Commission (2017), ESPN Thematic report on access to social protection of people working as self-employed or on non-standard contracts.
[8] IMF (2017), Belgium : Selected Issues, https://www.imf.org/en/Publications/CR/Issues/2017/03/17/Belgium-Selected-Issues-44749 (accessed on 18 April 2018).
[6] Ministry of Finance (2016), Analysis of the flat-rate expenses system within the framework of CIT and PIT (personal business income), Ministry of Finance of Slovenia.
[1] Ministry of Finance (2018), Taxation in Slovenia 2018, Ministry of Finance.
[9] OECD (2018), Taxation of Household Savings, OECD Publishing, Paris, https://doi.org/10.1787/9789264289536-en.
[4] OECD (2006), Fundamental Reform of Personal Income Tax, OECD Tax Policy Studies, No. 13, OECD Publishing, Paris, https://doi.org/10.1787/9789264025783-en.
[2] OECD (2017), Taxing Wages 2017, OECD Publishing, Paris, https://doi.org/10.1787/tax_wages-2017-en.
[3] OECD (2018), Taxing Wages 2018, OECD Publishing, Paris, https://doi.org/10.1787/tax_wages-2018-en.
[5] Thomas, A. and P. O’Reilly (2016), “The Impact of Tax and Benefit Systems on the Workforce Participation Incentives of Women”, OECD Taxation Working Papers, No. 29, OECD Publishing, Paris, https://doi.org/10.1787/d950acfc-en.