What is the right mix between direct taxes, such as personal income taxes or social security contributions, and indirect taxes like the Value Added Tax (VAT)? This question is controversially discussed in both the economic literature as well as among policy-makers, since direct and indirect taxes affect work incentives and people’s budgets in different ways. Proponents of indirect taxes argue that shifting taxation from labor to consumption would increase work incentives by lowering marginal tax rates and hence increase competitiveness and employment. Opponents however object that increasing consumption taxes would increase income inequality, since the ratio of consumption taxes paid over disposable income is typically higher for low-income households. Hence, a shift from direct to indirect taxes is associated with the classical trade-off between efficiency and equity. This implies that the extent to which potential increases in employment incentives are outweighed by adverse distributional impacts is an empirical question.
In a recent discussion paper, IZA researchers Nico Pestel and Eric Sommer provide such an analysis and investigate the mechanisms of the efficiency-equity trade-off for Germany. Using IZA’s behavioral microsimulation model IZAΨMOD, they simulate the effects of an increase in the standard VAT rate while simultaneously reducing either personal income taxes (PIT) or social security contributions (SSC). They show that reducing progressive income taxation and increasing the VAT leads to a higher level of inequality: rich households benefit while low-income earners, pensioners and unemployed are found to be the main losers in such a scenario. However, reducing social security contributions instead of income taxes yields distributional outcomes, which are far less severe, since SSC are themselves a regressive form of taxation.
Pestel and Sommer therefore conclude that reducing payroll taxes seems particularly promising, given that SSC reductions affect household budgets already at a rather low income level, and therefore bear a higher potential for increasing work incentives than lowering income tax rates for the rich. This is especially true for a country like Germany with a comparatively high level of payroll taxes. Moreover, from a distributional perspective, reducing social security contributions is superior to a shift from personal income taxes. Still, shifting taxes from labor to consumption would imply negative distributional effects for a significant share of the population, mainly pensioners, who do not benefit from lower direct taxes but would be burdened with higher consumption taxes. For that reason, the authors believe that policy-makers would have to work out compensations for the losers to make such a reform politically feasible.