The government’s proposed progressive Personal Income Tax might hurt growth and is not the best answer for income inequality.
There are calls for the government to reintroduce a progressive personal income tax. Macedonia2025 has surveyed some key foreign private companies about the change. These companies are very concerned about the negative impact of a progressive tax on their companies and Macedonia. In this article we examine their concerns, and also the advantages of a flat tax for Macedonia. We also address some of the arguments used in favour of a progressive tax: income inequality and the low level of taxation in Macedonia: Macedonia is neither the most inequitable or lowest taxing country. Regardless, inequity is best addressed by increasing GDP and jobs in emerging industries with high wages. A progressive tax would only penalize these same industries.
A return to political stability is helping the country get back to business. However, many businesses who suffered under the political instability are worried by some proposed policy changes. They fear that some of the key advantages of why they have invested in Macedonia are being eroded. They are particularly concerned with the introduction of a progressive Personal Income Tax and inconsistent rulings on whether BPO (Business Process Outsourcing) is subject to VAT. We have been talking to many foreign companies and have also conducted a survey; we present their concerns here. The twelve respondents come from the IT, BPO, manufacturing, and financial services industries.
Foreign Investors help Macedonia
While foreign private companies invest in Macedonia for profitability reasons, their economic activity in the country has undisputable positive effects on the Macedonian economy. Their spending on workers, supplies, equipment, construction, etc. in Macedonia are income for Macedonian citizens and households and for Macedonian firms. Government also benefits from the extra company tax, and the personal income tax and social contributions from the workers of the foreign companies. The success of foreign investors are aligned with the success of Macedonia! Further, foreign companies also bring new thinking and technology to Macedonia which helps create new and modern industries such as the IT and BPO industries. They upgrade the skills of the Macedonian workers and help the country to reach its potential GDP. They are transforming the Macedonian economy and will provide many of the future jobs for Macedonia’s young people thus helping the country to better use one of its main resources: its human capital.
The Benefits of the Flat Income Tax
Flat income taxes are adopted because they help attract FDI and because their simplicity helps increase tax compliance and thus revenue. Currently over 20 countries have a flat income tax including: Belarus, Bosnia, Bulgaria, Estonia, Georgia, Hungary, Latvia, Lithuania, Romania, Russia, and Ukraine. These countries are not generally considered tax havens.
The introduction of the flat income tax in Macedonia in 2007 has helped attract FDI. The average annual value of FDI inflows in the 10 years after the flat tax was introduced is 97 per cent larger than the average value of FDI for the 10 years preceding the flat tax – see graph 2 below. The positive impact of the flat tax in attracting FDI has also been confirmed anecdotally by the foreign companies we have spoken to.
The introduction of the flat tax simplified the tax system and resulted in increased tax compliance. In 2008, the number of voluntary and official duty personal income tax returns by citizens increased by 520 per cent (from 19,447 to 120,396). Moreover, revenues from personal income tax increased despite the decline of the tax rate. It cannot be disputed that the reduced tax rates and the introduction of the flat tax have increased the compliance and reduced the informal economy. The latter is especially important in the country given the relatively high informality.
What would happen if a Progressive Income Tax is introduced?
In addition to losing the benefits of the flat tax, as described above, the introduction of a progressive tax would have a number of other negative effects. From our survey of foreign companies and members of the organization, respondents indicated that if a progressive income tax was introduced:
- They would likely decrease their number of employees – reported by 100 per cent of respondents;
- They would likely decrease their future investment in Macedonia – stated by 88 per cent of the respondents;
- New companies would likely be deterred from investing in Macedonia – 100 per cent;
- There would likely be an increase in informal employment (an increase in the grey economy) – 100 per cent;
- Companies would find it hard to attract and keep top employees in Macedonia (brain drain) – 75 per cent.
If these scenarios prove true then both GDP and tax revenue could be lower than what it would be under a flat income tax.
Does Macedonia really need a progressive income tax?
Those individuals in favour of a progressive income tax argue that it will improve income inequality in Macedonia and that Macedonia’s tax revenue is too low. Neither of these arguments are convincing.
Macedonia’s income distribution (GINI index of 38.5) is in fact more equal than countries like the USA (41), Russia 40.9), Turkey (40.2), and is very similar to countries like Bulgaria (36.6), Spain (36.2), Portugal (36.2) and Greece (36.1). Income inequality can and should be improved but Macedonia is by no means a global outlier in terms of income inequality. According to the official statistical data published by the State Statistical Office (using Eurostat methodology), income inequality has been improving with the Gini index declining from 40.6% in 2010 to 33.6% in 2016 (with a moderate, but continuous decline through those years).
Regardless of how unequal some may believe Macedonia is, a progressive income tax system is not the most efficient way to address income inequality. Indeed, the country until 2007 had a progressive tax system, but the Gini index was higher than today. Macedonia should look to encourage and attract high-productivity industries that pay high wages, e.g. IT and BPO. These industries should not be penalized because of their success. The answer to income equality is not more taxes but more jobs and higher wages. Macedonia’s unemployment rate, 22.4 per cent (2017), remains very high by world standards. Growing and modern industries need to be encouraged.
Income inequality would also be better addressed by improving the efficiency of current social spending. More social spending is not necessarily the answer. Often more spending can simply mean more waste and inefficiency. The planned reform by the Government and the introduction of a guaranteed minimum income may help the reduction of the inequality and poverty.
One effective method for addressing income inequality in the tax system is to re-design the personal exemption. While in Macedonia this exemption is universal, for every individual, there are systems in which the exemption depends on the some individual and household characteristics. For instance, tax exemption may be higher for adults with children, etc. While this is a viable option which may be effective in reducing poverty and inequality, we have to state that adding such complexity to the system may create confusion, unintended evasion and greater informality.
Those who believe that Macedonia is the Cayman Islands of the Balkans are mistaken. While there are many countries with higher taxes than Macedonia, Macedonia’s tax revenue as a percentage of GDP (16 per cent) is better than the average for OECD members (15 per cent) and is similar to the average for the European Union (20 per cent) – see the chart below. Macedonia could choose to tax like a Scandinavian country, but it is important to note that Macedonia is already taxing relatively more than the USA and Germany, while providing less (quality) services to its citizens. An increase in GDP would increase tax revenue without increasing taxes.
In summary, the flat income tax has helped increase FDI and tax compliance in Macedonia. Introducing a progressive income tax would reduce these benefits and raise the prospect of decreases in employment, and an increase in the brain drain and informal economy. Some individuals have argued that a progressive tax is needed to address income inequality and because taxes in Macedonia are too low. However, international comparisons show that Macedonia is neither a tax haven or an outlier in terms of income inequality. Income inequality would be best improved by growing the economy and reducing unemployment. In particular, high-growth and high-wage industries, like IT and BPO, should be encouraged. Introducing a progressive income tax would act as a brake on these industries. Maintaining the current simplicity of the system is crucial as well.
World Bank, World Development Indicators, Foreign direct investment, net inflows (BoP, current US$).
Macedonian Public Revenue Office (УЈП) 2008 Annual Report, p24.
World Bank, World Develop Indicators, GINI index, 2013. 2013 was chosen because it had a larger number of countries reported than more recent years.
World Bank, World Development Indicators, total tax revenue as a percentage of GDP. 2012 was chosen because it had a larger number of countries reported than more recent years.