What’s wrong with personal income tax: how to make the tax system fairer

Nevertheless, in Russia today there are very radical proposals to improve this system – from the introduction of a full-fledged progressive taxation scale, where the tax rate will progressively increase as the annual income of an individual increases, to complete exemption from personal income tax for low-income citizens and families. And recently there was a proposal to exempt large families with three or more children from this tax, regardless of the income level of the parents. The proposal looks interesting from the point of view of solving the demographic problem. But how effective will such initiatives be for the economy and social sphere? For comparison, let’s look at some features of taxation of individuals in other states.

A progressive tax scale exists in all G7 countries, as well as in countries with the highest standard of living and low Gini coefficient, which reflects the degree of social inequality in the state. The closer this coefficient is to zero, the lower the level of social inequality, that is, the smaller the income gap between the richest and poorest citizens of a given state.

Conversely, the closer the coefficient is to 100%, the higher the social stratification in the country. For example, in Germany, France, Great Britain, Japan, Italy, Canada, the Gini coefficient is, according to UN estimates, at levels from 30 to 36%. In these states, for centuries there has been a progressive scale of taxation for individuals, and the maximum income tax rates for individuals can reach up to 40%. And in the poorer countries of Eastern Europe – Bulgaria, Romania, the Baltics, where the Gini coefficient is higher and fluctuates around 40% – individuals pay income tax at a flat rate.

It varies in different countries – for example, in Bulgaria 10%, in Romania and Lithuania 16%, in Estonia and Latvia 20%. At first glance, such a difference in taxation systems for individuals seems logical: the richer the country and the higher the income of the population, the more grounds there are for introducing a progressive income tax scale. However, these examples do not at all reflect the full picture of the peculiarities of taxation of individuals in the world. For example, the Czech Republic has a flat personal income tax rate (the rate is 15%), and the Gini coefficient in this country is only 25%, that is, social inequality there is much lower than in Germany and the UK.

The same low value of the Gini coefficient is in the Scandinavian countries: Sweden, Norway, Denmark, Finland, where the tax scale, on the contrary, is progressive. So there is no direct relationship between the level of social inequality and the tax scale in a particular country.

It is quite interesting in this context to compare the levels of social inequality in Russia, the USA and China. Oddly enough, these great powers have almost the same Gini coefficient: in the PRC – 39%, and in Russia and the USA – 40% each. At the same time, the Russian Federation now has a hybrid flat-progressive tax scale on personal income, while the United States, which ranks first in the world in terms of the number of dollar billionaires, and communist China have a progressive tax scale.

It turns out that no matter how harshly the state seizes excess income from super-rich citizens in China and the United States, the Gini coefficient in these countries cannot be reduced even to the level of Western European countries. It should be noted that the taxation system for both individuals and businesses in the United States has been criticized for decades. Republicans have always advocated lowering taxes on businesses, on the richest citizens, in order to avoid their flight from the country. One of the most authoritative and successful US presidents, Ronald Reagan, was even credited with the aphorism: “If you want to increase tax revenues for the budget, reduce tax rates.”

In any case, the economic policy of his government, called “Reaganomics,” was precisely to reduce taxes on the richest individuals and large corporations. Let us note that during Reagan’s reign, the US economy flourished, and the dollar had the unquestioned authority of the most reliable currency in the world, and the US national debt did not go off scale as much as it does today.

And in Russia, in this context, although income differentiation is certainly present, it does not look so painful if similar differences in income exist in both the USA and China. This also means that, even if in the Russian Federation tomorrow the current flat tax scale for individuals is replaced with a progressive one with a maximum tax rate of 40%, such a tightening of taxation will not solve the problem of social inequality.

On the contrary, the shadow sector, which the World Bank previously estimated at almost a third of Russian GDP, will only increase after the introduction of a progressive personal income tax scale, and the state will receive less income. You may recall that in the 90s of the 20th century, individuals in post-Soviet Russia paid personal income tax precisely on the basis of a progressive scale with a maximum tax rate of 30%. But in those days in Russia, the economy was in a state of continuous decline for almost ten years, and the Gini coefficient was inexorably approaching 100%, and the salary of some Russians not only in envelopes, but also in US dollars was a completely ordinary story.

And there was a huge hole in the budget, which the state plugged for some time by issuing government short-term bonds, but this did not last long – in 1998, after the collapse of oil prices in Russia, there was a completely expected default on government bonds. And already at the beginning of the 21st century in Russia, the taxation system for individuals was replaced from a progressive one (which turned out to be completely ineffective) to a flat one, with a single rate for everyone of 13%.

Many developing countries, including poor ones with high levels of social inequality, nevertheless have a progressive tax system. In Brazil and South Africa, Russia’s BRICS partners, the Gini coefficient exceeds 53%, that is, the level of social inequality there is quite high, but these states, despite fairly frequent social and political upheavals, do not refuse a progressive scale of taxes on personal income. But it can be noted that in poor countries such as Botswana, Lesotho or El Salvador, the tax scale is flat and income tax rates are low, but this does not solve the problem of either improving living standards or social inequality.

How can we make the tax system in Russia more fair? In our opinion, there is no need to touch the existing system of taxation of individuals, although you can think about significantly reducing – to 5-7% – personal income tax rates for the poorest citizens. In Russia, in order to raise the level of real disposable (that is, after paying all taxes and obligatory payments) monetary income of citizens, it is necessary to make not so much the personal income tax scale, but the taxation system as a whole more flexible.

For example, reduce payroll tax rates not only for the IT sector, but for everyone, and then much fewer employers will divert employee income “into the shadows.” Reduce a large number of local indirect taxes on individuals, for example, reduce parking fees in large cities, which everyone uses several times almost every day. And, of course, a strong or at least more stable and predictable ruble would be very important for the growth of incomes and living standards of citizens.