Treasury

Treasury finances 1997-1998. Annex. Overview of recent tax changes

1/8/1998

Treasury Finances 1997-1998
Iceland, December 1997

Annex. Overview of recent tax changes

Over the past ten years the tax system in Iceland has gone through a comprehensive overhaul, where the main aim has been to bring the tax system in line with that of other OECD countries. This must be seen in light of increased international cooperation and competition, especially as regards the corporate tax system in response to the integration in Europe. Another motivation has been to improve the tax system as a means of implementing tax policy by making it more responsive to economic developments through built-in stabilisers. These changes are reflected in a shift from indirect taxation, which earlier accounted for three-fourths of central government revenue, to increased taxation on wages and income.
In 1997, further steps have been taken in the direction of harmonization in the corporate tax system, where the main emphasis is on implementing changes that will strengthen the competitive position of Icelandic firms. This will be done through merging the present two-tier social security tax into one and introducing various changes in the corporate income tax system in order to make it more flexible. Also, on March 10, 1997, the Government announced a 4% reduction in the personal income tax to be implemented in three stages together with considerable changes in the child benefit system. The main aim of those changes is to reduce the marginal effects of both the income tax itself and related benefit payments in order to improve work incentives. In addition, in the beginning of 1997 a consolidated capital income tax became effective whereby all capital income is uniformly taxed by applying a 10% withholding tax on nominal interest income, dividends, rent and capital gains. Finally, further steps have been taken towards lowering excise taxes and consolidating the rate structure.
Following is a brief discussion of these tax changes.

I. The social security tax

Presently, the social security tax is levied at two different rates. At the end of 1996, the lower rate was 3.55% levied on agriculture, fisheries, manufacturing, hotels and restaurants, rental of cars and computer services, but the higher one was 6.85% on other sectors. The average rate is around 5S%.
On January 1, 1997 a first of four steps to harmonize the two-tier system of the social security tax into one became effective. The unified rate is to be 5S% for all industries when fully implemented in the year 2000, and the change will be revenue-neutral for the Treasury. The table below shows in broad terms the first effects of this harmonization on the main industries based on 1996 figures.
Today, the revenue from the social security tax is divided in three parts. The Unemployment Insurance Fund receives 1.3% of the tax base, the Occupational Safety and Health Administration receives 0.08% of the tax base, and the remainder is channelled to the social security system, for financing pension and insurance payments.

Revenues from the social security tax in 1996
Millions of krónur
At
present
Unified
rate
Estimated
effects
% of
turnover
Agriculture
162
278
86
0.4
Fishing industry
1,288
1,971
683
0.5
Manufacturing
891
1,363
472
0.4
Hotels and restaurants
157
240
83
0.6
Construction
1,145
908
-237
-0.4
Wholesale and retail trade
1,707
1,353
-354
-0.2
Transportation
1,041
832
-209
-0.3
Financial institutions, insurance
689
546
-143
-0.3
Other industries
2,600
2,189
-411
-0.5
Total of the private sector
9,680
9,680
-
-
The public sector
3,060
2,426
-634
-
II. The corporate income tax

At the end of 1996, the Parliament accepted various changes in the corporate income tax system in order to make it more flexible, but at the same time to take further steps towards integrating corporate taxation in Iceland with that of other European countries. One of the changes concerns the treatment of trading losses. Before, firms were allowed to carry their losses forward for five years, but now the period has been extended to eight years. Another change is an increased flexibility of depreciation rules, i.e. by changing the rates on machinery from 9-12% to 5-15% (straight line method) and similar changes are proposed for other items.
In the long run, these changes will have negligible direct effects on the Treasury, but could nonetheless have some negative cash flow effects on the revenue side in the short term.

III. The personal income tax

In 1988, the old system of personal income taxes which were levied and collected on basis of previous year's income was replaced by a Pay-As-You-Earn (PAYE) system. Furthermore, the actual system was completely revised. The main emphasis was on introducing a more simplified tax system by abolishing numerous exemptions and deductions and thus broadening the actual tax base.
The marginal tax rate was initially 35.2%, made of a 28.5% central government tax rate and a 6.7% local government tax rate. Since 1988, however, various changes have taken place which have served to highlight the deficiencies of the system. The situation at the beginning of 1997 was as follows:
First, the tax rate has crept up through the years to almost 42%. Second, in 1993 a 5% surtax on higher incomes was introduced, raising in effect the marginal tax rate to 47%. Third, the compulsory payment into pension funds, which generally amounts to 4% of wages has been exempted from the income tax. Fourth, the relative weight of means-tested child benefits has increased rapidly in recent years, now amounting for about a half of the total child benefits. As a consequence, the marginal effects of the tax system have become more pronounced. All in all, the two main features of the personal income tax system are a low average tax rate, but a fairly high marginal tax rate at low levels of income due to the extensive tax credits and means-tested benefits.
At the beginning of 1997, the personal income tax rate of 42%, constituted a central government tax rate of 30.5% and a local government rate of 11.5%. The basic tax credit amounted to 24,544 krónur per month deductible from the tax levied. This is a very important factor in the personal income tax system as can be seen in the table below. The tax credit is transferable between couples, up to a maximum of 80%. This means that a one-earner couple with monthly earnings below 105,000 krónur paid no personal income tax. All income above this threshold was, however, taxed by 42%, which is a relatively high marginal tax for that income level. This feature of the personal income tax has been under a heavy criticism for some time.

The estimated revenue from the personal income tax in 1997 1
Accruals basis
Billions
of krónur
%
The personal income tax base
281.0
-
1. The personal income tax, gross
118.0
41.98
- Thereof the Treasury
85.5
30.41
- Thereof the municipalities
32.5
11.57
2. The personal income tax credit2
55.1
19.61
- Against the Treasury personal income tax
50.4
17.94
- Against the municipalities' personal income tax
4.4
1.58
- Against net wealth taxes
0.3
0.09
3. Other tax rebates (seamen tax credit, tax relief when buying shares)
2.2
0.79
4. Charges to the church3
1.6
0.55
5. Benefits
8.8
3.13
- General child benefits
2.8
1.00
- Means-tested child benefits
2.4
0.83
- Interest rebates
3.6
1.30
6. The personal income tax, net
47.9
17.05
- The Treasury's share
16.3
5.80
- The municipalities' share
31.6
11.25

1) The changes recently accepted are excluded from this table.
2) The Treasury finances the tax credit in full, also for the amount that goes against the municipalities' share.
3) A fixed amount per individual.

Changes announced in 1997.

In March the Government announced a 4% reduction in the personal income tax which will take effect in three stages. On May 1, the tax rate was lowered by 1.1%; on January 1, 1998, a further 1.9% reduction takes place and, finally, on January 1, 1999, a 1% reduction comes into effect. Still, the personal income tax threshold will remain unchanged, as the tax credit per individual will be lowered simultaneously with the lowering of the tax rate. The surtax on high incomes will, however, be raised to 7% in 1998 which, in effect, will mean that the marginal tax on higher earnings will only be reduced by 2%, from the present 47% to 45%. The income limits for the surtax will, however, be raised by about 11%. The total revenue loss due to the tax reduction is estimated at 5.2 billion krónur when fully implemented. This will be financed partly within the tax system and partly through expenditure cuts. First, a special tax rebate for purchases of shares will be phased out in the next three years. This is expected to yield an additional 1 billion in revenue. Second, a new consolidated tax on capital income, which is expected to boost the revenue side by close to 1 billion when fully effective, will at least partly be used to finance this change. Third, the freezing of all tax credits and benefits in 1997 is expected to raise revenues by 1.1-1.2 billion.
The benefits (cash transfers). There are two kinds of benefits related to the personal income tax system, i.e. child benefits and interest rebates. Both are means-tested to income and before the recent changes, the marginal effects could be as high as 21%.
The system of child benefits was twofold. First, there was a general system, (a lump-sum system) where the amount depended on the age and number of children, while single parents got considerably higher benefits. Second, there were means-tested supplementary benefits for low income families. The payments were means-tested both to taxable income and net wealth with a one year lag and the rate varied with the number of children, with the marginal effect being 15% maximum for 3 children or more. Together with the recent changes of the personal income tax system, the Parliament passed changes in the child benefit system, whereby all benefits will as of January 1, 1998, be means-tested. This means that the lump-sum part of the benefits will be merged with the means-tested part and consequently, high income families will loose their benefits. The savings incurred by this change is then used to reduce the marginal effects in the system, from 15% to 11% for families with three children or more, from 11 to 9% for two children and from 6 to 5 for families with one child. The changes in the child benefit system will not entail additional costs for the Treasury.
The interest rebate is granted to individuals investing in owner-occupied housing. This rebate is means-tested to income through a 6% deduction of actual income from the interest outlays paid on which the rebate is based. This rebate also depends on the net wealth position and the interest burden of the individual, but the critical factor has been the income means-testing.

IV. A consolidated tax on capital income

As of January 1, 1997, a consolidated tax on capital income came into force. The new tax will, however, not affect the Treasury outcome this year, measured on a cash basis as it accrues only once a year, i.e. in January. This change represents a complete overhaul of the former system. Before, there were large discrepancies between taxation of different forms of saving with distorting effects on the saver's choice. Interest income was tax exempt, while other capital income was subject to up to 42-47% personal income tax. Starting in 1997, a general 10% withholding tax is levied on interest income and capital gains, which eliminates the present discrepancy between various forms of capital income. Thus, all capital income, such as interest income, dividends, capital gains and rent is currently subject to a uniform nominal tax of 10%.
It is uncertain how much revenue this taxation will yield over the next few years, but when fully in force its total yield is projected to be around 1 billion krónur. In 1998, the revenues from the capital income tax is estimated to be 800 million krónur. The Government has stated that the revenues from this source will, at least partly, be used to finance the recent lowering of the personal income tax.

V. Excise duties

Various changes were made to the system of excise duties in the spring of 1996. One of the reasons behind this reform was a formal charge against the Icelandic authorities from the EFTA Surveillance Authority to the effect that the system did not fully comply with the EEA Agreement. In this context, the 25% estimated mark-up on wholesale prices of imported goods was abolished, while the collection rules between imported goods and domestic products was harmonized. In short, these changes imply that the number of rates are now four instead of six before, ranging from 15-30%, levied on the cif- or product value, except on candy, soft drinks and several food products where the ad valorem duty was replaced by a quantity charge.
Then, further adjustments were made to the excise duty system taking effect at the beginning of 1997. The excises on goods with the general rate of 30% was lowered down to 25%, excises on cosmetics, films for photography, pens and pencils was abolished, while excises on spare parts for automobiles was lowered from 20% to 15%.