The effective tax rate on labor income

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Estimating effective tax rates has a long tradition in the macro-fiscal literature. Its foundation is based on the economic theory that teaches us that tax policy affects economic behavior through the incentives generated by the effective tax rate (whether average or marginal) on firms and families. In the case of taxes on labor income, it is well recognized in the literature that the marginal rate is fundamental for the decision to adjust hours worked. In contrast, the average rate is relevant for decisions on participation in the labor market.

The design of methodologies for estimating effective tax rates has received enthusiastic support from the Organization for Economic Co-operation and Development (OECD), the main multilateral forum for developed countries on international tax issues. The OECD is charged with resolving or proposing solutions to problems caused by differences in national taxation systems, such as double taxation or the harmful consequences of international tax competition. Therefore, it is not surprising that the current estimates are limited to the experience of developed countries.

Effective tax rate, without comparable measurement

In Latin America and the Caribbean (LAC), except for a few efforts in some individual countries, the issue of the effective rate of taxation has been wholly ignored. There is no measurement of effective tax rates comparable throughout the region. This is true not only for wage income, pensions, and the various forms of social transfers that work receives (unemployment benefits, etc.) but also for capital income and its various forms (dividends, capital gains, etc.). Interest, income, etc.). The multiple analyses that address the issue use a very poor approximation:

  • The tax ratio
  • The relationship between the amount collected from some tax
  • The aggregate of taxes
  • GDP

Thanks to the publication in 2016 of the first edition of Taxes on Salaries in LAC, a magazine produced jointly by IDB/ECLAC/CIAT/OECD, for the first time. We can make this international comparison, not only regionally but also with developed countries. Unfortunately, the comparison is only possible for one type of income: labor income, and for a single point in time: the year 2013. We cannot say anything about its evolution over time or its comparison with any other type of tax. What does this novel comparison reveal?

The OECD “Taxing Wages” methodology

Before showing some results, it is necessary to make a quick methodological digression to understand what is known as the “Taxing Wages approach.” There are two major methodological approaches for estimating effective tax rates.

The first uses observed tax payment and tax base data and estimate the average effective tax rate as the ratio between the amount of taxes paid on the labor factor and labor income before taxes. It is an implicit rate of taxation. In its calculation, aggregate data from national accounting and tax collection statistics can be used, or disaggregated data obtained from the income tax returns of natural persons, or natural persons, as they are known in some countries.

In the second method, which serves as the basis for the publication Taxing Wages of the OECD, the average effective tax rate is calculated based on the parameters defined in the tax statute. It is a statutory or legal rate. The existing literature has found that the two approaches generally provide different views on the level and evolution of effective tax rates. Each method has advantages and limitations. For example, differences between countries in implicit tax rates may reflect different tax policies concerning labor income and differences in income distribution, in the age structure of the population, or differences in the effectiveness of administrations. Tax. The most significant benefit of statutory rates is their comparability.

The statutory effective rate methodology measures the average tax burden that falls on eight different types of the taxpayer, who only receive income from work and whose annual labor income amounts to a given fraction of the revenue the average worker receives in the economy [ one]. The corresponding tax regime is applied to each type of taxpayer. The results that we present below refer specifically to a taxpayer prototype with the following structure: a household where only one of the spouses receives labor income, which is equivalent to 100% of the average salary of a full-time adult worker, with two children between the ages of 5 and 12. This type of taxpayer is chosen because it is the one that generally has the lowest tax burden, either because it receives special income tax treatment or because it qualifies for tax deductions or credits that depend on the dependent spouse or the number of dependent children.

The tax wedge that falls on the work factor is the difference between the total costs incurred by the employer for this contract and the net amount that the employee can ultimately take home. This difference is explained by the income tax regime for natural persons (with their deductions, exceptions, and credits and the government for dependent children and spouses), by employer and employee social security contributions, by taxes on payroll, and by the benefits system (harmful taxes or cash transfers from the government). The effective tax rate is calculated as the ratio between the tax wedge and the total work cost for the employer (payment of wages and employer contributions to social security).

Figure 1 shows that the highest effective tax rate on labor income is imposed in Argentina (33%), followed by Brazil (32.2%), Uruguay (29.8%), Costa Rica (27.2%), Colombia (27.0%). ) and Mexico (26.9%). The lowest rates are observed in Honduras (10%), Trinidad and Tobago (11%), and Guatemala (13.0%). The tax burden of the 20 LAC countries reported in Figure 1 arises almost exclusively from employer and employee social security contributions. Only in thirteen countries [2] of the 20 considered, the taxable income (after standard deductions) of the prototype taxpayer turns out to be positive, and only in one country (Mexico), that income ends up being taxed (with a tax charge).

In another entry, we will talk about the effective collection of personal income tax. For now, we can conclude that the low groups are not due, among others – as has been suggested in the literature – to the high tax exemptions (personal deductions and exempt income) included in the tax codes.

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