IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
In January 2010, the largest tax reform in Denmark in more than ten years began taking effect, shifting some DKK 30 billion (€ 4.0 billion) of tax revenue when fully implemented in 2019. Of this, more than DKK 25 billion (€ 3.4 billion) is used to lower the marginal tax on income in order to encourage work and investment. In 2010 the top marginal tax rate was lowered from 63 percent to 56.1 percent – its lowest level in at least 40 years.
Later in the year, an “economic recovery package” postponed some of the tax cuts and increased other taxes in order to improve public finances. Along with the tax reform and other (minor) tax changes, the combined effect has been a general lowering of almost all marginal tax rates alongside a broadening of the tax base that will increase the overall tax burden in what is already the world’s most heavily taxed country.
Lowest marginal tax since 1970
The most notable element of the curent tax reform (which was agreed upon in 2009, and which began to take effect in 2010) was the abolition of the middle income tax rate of 6 percent. This effectively changed the Danish tax system from a three-tier system to a two-tier system. More importantly it also reduced the top marginal tax rate on labour income by some 5½ percentage points. The bottom income tax was also reduced by 1.5 percentage points, taking the total reduction in top income tax rate on labour to 6.9 percentage points (from 63 percent to 56.1 percent).
The tax reform also increased the threshold for the top income tax, therefore reducing the number of people affected by the tax. The threshold was increased from DKK 377,400 (€ 50,630) in 2009 to DKK 423,800 (€ 56,860) in 2010. As a consequence, the number of taxpayers paying the top income tax fell from just over 900.000 persons in 2009 to less than 640,000 persons in 2010 (from 19 percent to 13 percent of all taxpayers). Originally, the threshold was set to be increased further in 2011 (to DKK 444,700 / € 59,660), but, as part of the “economic recovery package” agreed upon in 2010, this increase has been postponed to 2014.
For persons earning less than the threshold for the top income tax, the reduction in the bottom income tax has lowered the marginal income tax by 1.4 percentage points to 40.9 percent and 42.3 percent respectively, depending on whether one benefits from the reduction in marginal tax due to the “employment deduction”, which reaches its maximum at an income (gross labour income) of DKK 320,000 (€ 42,930). The reduction in the bottom income tax also lowers the tax on transfer incomes such as unemployment benefits, etc.
The very positive effects of the tax reform on marginal taxes were unfortunately marred by one aspect of the reform. In order to offset the effects of higher energy taxes on poorer households, the centre-right (minority) government originally proposed a lump sum “green cheque” for every adult person. During the proceeding negotiations with other parties in parliament, this was changed to an income-adjusted tax rebate of maximum DKK 1,300 (€ 170) per adult and DKK 300 (€ 40) per child (maximum DKK 600 / € 80 per mother), The income adjustment of the “green cheque” adds 6.9 percentage points to the effective marginal tax at income levels between approximately DKK 395,000 (€ 53,000) and DKK 413,000-422,000 (€ 55,410-56,620), depending on the number of children. In this income interval, the marginal tax on labour income is de facto increased from 42.3 percent to 49.2 percent.
Lower tax on capital income
The reduction in tax rates and the increased threshold for the top income tax have also had a significant impact on the taxation of personal – net positive – capital income (excluding income from shares/stocks which is taxed separately). Since the 8 percent labour market contribution only applies to labour income, the 2009 top marginal tax on capital income was 59.7 percent for top income tax payers with net positive capital income. For those not paying the top income tax, the rate was 38.8 percent.
The reduction of income tax rates in the tax reform reduced the marginal taxes on capital income to 52.2 percent and 37.3 percent respectively, while the higher threshold for the top income tax reduced the number of taxpayers affected by the top rate. This effect was boosted by the introduction of a DKK 40,000 (€ 5,370)/person/year deduction in the capital income subject to top income tax. The deduction may be shared between spouses, thus ensuring that a married couple does not pay top income tax on the first DKK 80,000 (€ 10,730) in net positive capital income, regardless of their labour incomes.
Since the implementation of the tax reform, a further reduction of the top tax rate on capital income has been passed by parliament. In January 2010, the government – under pressure from the EU – proposed an end to the special tax treatment of certain (Danish) bonds. Hitherto, capital gain on certain high-yield bonds (provided they were issued in DKK) was tax-free (the interest was taxed as capital income). The government proposed – and later parliament agreed – to end this discrimination between Danish and foreign bonds by eliminating the tax advantage linked to these bonds. The resulting revenue was used to lower the top tax on capital income even further. In 2010, the top rate on capital income was lowered to 50.2 percent, and in the coming years the rate will be gradually reduced to 42.7 percent in 2014.
Taking into account the reductions already agreed upon in the tax reform, the combined effect will be a reduction in the top tax rate on net positive capital income from 59.7 percent in 2009 to 42.7 percent in 2014. An increase in the after-tax marginal income of more than 40 percent.
Finally, the tax reform also lowered the tax on capital income from shares, which is taxed separately from other incomes. In 2009, dividends and capital gains from shares were taxed at 28 percent up to a total of DKK 48,300 (€ 6,480); at 43 percent for the amount between DKK 48,300 and 106,100 (€ 6,480-14,240); and at 45 percent for any amount above. The thresholds are automatically shared between spouses. As part of the tax reform, the 45 percent bracket was abolished and the top rate lowered to 42 percent. Thus, a married couple will pay 28 percent on the first DKK 96,600 (€ 12,960) in combined income from dividends and capital gains from shares – and 42 percent on any amount above this level. In 2012, the low rate will be reduced to 27 percent.
Broader tax base
In line with all other major Danish tax reforms for the last 30 years – and indeed most tax reforms in the OECD countries – the lowering of marginal taxes on personal income were in large parts financed by a broadening of the tax base.
The single largest contribution came in the form of a one-year (2010) freeze of the automatic adjustment of all thresholds in the tax system. Normally, all thresholds in the tax system are adjusted upwards yearly to take account of the increase in wages. The adjustment is based on the development in wages two years prior, that is, the 2010 adjustment would have been based on the (quite substantial) wage increases of 2008. By suspending the adjustment, the government permanently increased the tax revenue by DKK 5 billion (€ 670 million), financing one sixth of the total tax reform.
As part of the economic recovery package, passed in 2010, the threshold freeze was prolonged another three years, meaning that tax thresholds will not be increased until 2014.
The tax reform also broadened the tax base by instituting maximum levels for some tax deductions, such as a DKK 100,000 (€13,420) maximum tax deduction for contributions to certain pension schemes. Hitherto, contributions to labour market pension schemes with monthly pension payments for at least 10 years (not lump sum pensions) were deductible against all income taxes except the 8 percent labour market contribution (consequently, payments from pensions are not subject to labour market contribution). Now, only the first DKK 100,000 (€13,420) will be deductible against other taxes, except if the payments are made into a lifelong pension scheme (annuity), in which case there is no maximum deduction.
Related, the tax reform introduced a temporary “equalisation tax” on large pensions payment meant to offset the “unfairness” that current pensioners or persons facing pension in the near future (with large pensions) would pay a maximum marginal tax on their pension payments of 52.2 percent, while having (as workers) enjoyed a deduction on their pension contributions of up to 59.7 percent (top marginal tax excluding labour market contribution). Originally, the government toyed with the idea of having the equalisation tax for some 30 years, but in the end, a 6 percent surtax was agreed upon (reflecting the abolished “middle tax”) for the years 2011-14, where after the rate will be reduced by one percentage point in the years 2015-2020. The tax applies to total pension payments exceeding DKK 362,800/year (€48,680).
The tax base for personal income taxes were also broadened by introducing a number of add-ons to taxable income, such as an add-on to taxable income for employees with company car available for private use. The size of the add-on depends on the mileage of the car and comes on top of the regular taxation of company cars.
More controversially, a DKK 3,000/year (€ 400) add-on to taxable income was introduced for employees with (partly or fully) employer-paid telephone, PC or Internet available for private use outside the workplace. This corresponds to a tax of DKK 1,200-1,700/year (€ 160-230) depending on income (top income tax payer or not). This “multi-media tax” has been hotly criticised and, late in 2010, the tax was amended so that married couples – if both are eligible for the tax – receive a 25 percent discount on the tax.
More fundamental, the value of most tax deductions to the personal income will be gradually reduced, beginning in 2012. Today, expenses related to the earning of income (e.g. unemployment insurance contribution, labour union membership fee, and a standardised transportation expense based on the distance between home and work) as well as any net negative capital income are deductible against municipal taxes and the 8 percent health contribution, which replaced the county tax in 2007 (making for an average tax value of 33.6 percent).
Beginning in 2012 the health contribution will be gradually phased out one percentage point per year, while the bottom tax rate will be increased correspondingly. By 2019 the health contribution will be abolished and the tax value of most standard deductions will thus be reduced to 25.6 percent (average municipal and church tax rate). As part of the tax reform, some standard deductions have been raised to (fully or partly) offset the effect, and the first DKK 50,000 (€6,710) in net negative capital income (double for married couples) will still be deductible at against municipal taxes plus 8 percent. However, the amount will not be indexes and thus be reduced in real terms by inflation.
Higher “sin taxes”
The tax reform was also financed through increased taxes on tobacco, alcohol, sugar and fat.
In 2010 there was a 25 percent increase of the tax on ice cream, chocolate and candy (sugar-free candy exempt) as well as an increase in the tax on soft drinks containing sugar (and lower tax on sugar free soft drinks). Also, taxes on tobacco and cigarettes were increased. Later in 2010, as part of a “service check” with various amendments to the reform, the tax on tobacco was increased even further, and so too were taxes on wine and cider and “alcopops”.
More controversially, the tax reform also included a tax on saturated fats. Originally, the tax was supposed to take effect from January 2011 and to include only oil and dairy products (except milk) at a rate of some DKK 20-25 (€ 2.7-3.4)/kg saturated fat. This proposal, however, proved unacceptable to the EU, and as part of the “service check” of the tax reform, the tax was expanded to include meats, while the rate was lowered. A final proposal has not yet been put before parliament, and the tax will not take effect till July 2011. At present it looks like the final rate will be DKK 16 (€ 2.13) per kg of saturated fat.
Higher taxes on pollution and energy consumption
The tax reform included a number of tax increases on pollution and the use of energy, most of them related directly to businesses, while others have an impact on private individuals as well. One such example is the DKK 1,000 (€ 134)/ year surcharge for diesel powered cars without particle filter. The surcharge not only applies to new diesel cars, but also existing passenger cars (existing, but not new, cargo vans are exempt from the surcharge). The surcharge was supposed to lower particle pollution, but has been hotly criticised because most existing diesel cars cannot easily (and without substantial costs) be fitted with particle filters. As a consequence, only around 1000 out of more than 350,000 diesel driven passenger cars have been fitted with a filter.
In 2010, the tax on waste for landfills was also increased from DKK 375/tonne to DKK 475/tonne (€ 50 to € 64), and in 2011 the taxes on pollutants in sewage will also be increased. Beginning in 2012 the government has introduced a tax on toxic waste (hitherto exempt from tax to prevent illegal dumping). The tax will be DKK 160/tonne, rising to DKK 475/tonne in 2015 (€ 21 rising to € 64).
The increases in energy taxes consist first and foremost of a 15 percent increase of the tax on fossil energy consumption and electricity, which took effect January 2010. But there was also a number of other energy related tax increases in 2010 such as the reintroduction of tax on lubricating oil based on the energy content (DKK 60 / € 8 per GJ), and a tax on green house gasses other than CO2 used for energy consumption at DKK 150 (€ 20) per ton CO2-equivalent. Beginning in 2013, toxic waste used for energy will be taxed at DKK 19.6 (€ 2.6) per GJ.
More controversially, 2010 also saw the introduction of a tax on energy used in the processing industry. Hitherto, energy consumed in the manufacturing process has been exempt from energy tax (but not CO2-tax) in order to preserve the competitiveness of businesses exporting out of Denmark. But as of January 2010 this “process energy” is taxed at DKK 4.5/GJ (fossil fuels) and DKK 16/MWh (electricity) (€ 0.6/GJ and € 2.15/MWh). The tax was originally supposed to more than triple from 2013, but as part of the “service check” of the tax reform, it was decided that this would be too detrimental to competitiveness. Instead it was decided to bring forward the increase one year, while at the same time reducing the increase. The rates will thus be DKK 8/GW and DKK 31/MWh (€ 1.07/GJ and € 4.16/MWh) respectively from 2012 onwards.
In the next couple of years, the production industry will also be affected by the gradual reduction of the tax exempt CO2-emissions granted to heavy industry not part of the European Trading System (ETS), which were part of the tax reform, and which are set to mirror the reduction in free CO2-quotas in the ETS.
Finally, it was decided that all energy taxes should be adjusted yearly to account for inflation. In 2007 it had already been decided to do this for the period 2008-15 (to finance a lowering of the income tax in 2008 and 2009), but it has now been decided that this regulation will continue after 2015 – in theory indefinitely. The controversial part of this decision is not so much the decision itself, but more the fact that the generated revenue was not used to finance lower taxes, but rather to improve the public finances (see later).
Other tax increases for companies
In addition to the increased taxes on energy consumption and pollution, which will mainly be felt by businesses, the tax reform entailed a number of other tax increases on companies, including a nominal freeze on funds allocated as state aid in the years 2010 to 2015, as well as a reduction of the (already very low) number of VAT-exempt services. In 2010 and 2011 estate agents and travel agencies respectively will no longer be exempt from VAT.
Banks and other financial institutions are still exempt from VAT, but have instead been paying a special tax based on their total payroll. As part of the tax reform, it was decided to increase this special payroll tax for the financial sector from 9.13 percent to 10.5 percent. The rise was not supposed to happen till 2013, but as part of an emergency tax relief package for the farming sector (lowering the tax on farm land), it was decided in the summer of 2010 to move the tax increase forward to 2011.
Effective from 2010, the tax reform also reformed the way shares held by companies are taxed. Hitherto, taxation depended on the number of years the shares had been held – with no tax on shares held for more than three years. Now, taxation depends solely on the number of shares held by the company. If a company owns less than ten percent of another company (“portfolio shares”), any capital income (dividends, capital gains) from these shares is added to corporate income and taxed accordingly; whereas capital income from daughter companies (ownership of ten percent of the shares or more) is tax-free. At the same time, the tax system was changed so that companies are now taxed based on the value of their portfolios at the end of the year compared to the beginning of the year (any losses may be carried forward), rather than when assets are sold (unlisted shares may still be taxed when sold, rather than based on current value).
The new system for taxing companies’ financial assets was generally welcomed by the business community, especially when companies were given the option to exclude unlisted portfolio shares from the yearly taxation (and choose to have them taxed when sold instead). However, for some business angels and entrepreneurs, the new 10 percent limit proved troublesome. As newly founded companies grow – and bring in new investors to fund the expansion – the share owned by the original investors (through parent companies) may drop below the 10 percent limit, meaning that profits will be taxed twice (once in the expanding company and then again in the parent company). This fact was strongly criticised, and in the fall of 2010, the government made an amendment that will ensure tax freedom to the capital invested in the earliest stages of a small or medium sized enterprise, providing the shares are kept for at least five years.
The tax reform also included a reform of the registration fee for taxies (which is much lower than the standard fee for passenger cars). The change effectively lowered the (taxi) registration fee on cheaper cars and increased the registration fee on more expensive cars. This was done to encourage taxi companies to choose cheaper and more fuel efficient cars. With the same intention, the base for the yearly tax on cargo vans was changed from weight to mileage – and increased. It now follows the same principles as the yearly “green” fee on passenger cars. The change only affects new cargo vans, as existing vans will continue to be taxed based on weight. Finally, the reform included the introduction of road pricing for lorries / trucks, which were originally planned for 2011. Due to technical difficulties, the introduction has been postponed several times, and is now not due till 2013 at the earliest.
Death of the “tax freeze”
As already mentioned, the tax reform was constructed in such a way, that while the tax cuts would initially be underfinanced, this would soon change as tax increases took effect. Officially, the reform was to be underfinanced in the years 2010-12, to balance in 2013, and then give a net profit to the treasury from 2014 onwards. In the long run, taking into account interest, the reform would be net neutral to the public finances, ensuring that the reform conformed to the general principle of the government’s “tax freeze” which had been in place since 2001.
In the end, however, this proved not to be the case.
Firstly, the tax reform directed some of the extra revenue raised by higher taxes towards covering the inflationary loss arising from the nominal tax freeze of property tax and some duties in the period 2016-19. Without the reform, the government would have had to cover the inflationary loss by cutting expenses (or increased the deficit), and thus effectively saved almost DKK 3½ billion (€ 470 mill.) on the yearly budget by this manoeuvre (permanently).
Secondly, the government used the pretext of the tax reform to simply abolish the nominal freeze of energy taxes from 2016 onwards. The freeze had already been suspended for the period 2008-15, but this was – in accordance with the tax freeze – in order to finance lower taxes on income. From 2016, energy taxes will automatically be inflationary adjusted, and revenue will not be redirected to the taxpayers – but simply go to the state purse. The long run effect of this change is quite substantial, with the public finances being improved by some DKK 15 billion (€ 2 billion) per year.
Lastly, the increased tax revenue from the supply side effects of the tax reform – estimated at some DKK 5½ billion (€ 740 million) per year - will also not be used to lower taxes (in violation of the overall tax freeze). Instead, the revenue will be used to increase the public budget. This all adds up to a net effect of the tax reform of increasing long run tax revenue to the tune of DKK 24 billion (€ 3.2) per year.
In addition, the economic recovery package, which was passed in 2010 as an emergency measure to ensure that the Danish state budget would adhere to the EU budget requirements, added another DKK 8½ billion (€ 1.1) per year in permanent tax increases, primarily by extending the one-year freeze in tax thresholds (already part of the tax reform) another three years.
So while Denmark now has the lowest marginal tax rates in a generation if not more, the tax burden – already the world’s highest – is set to rise even further in the years to come.