IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
This paper is excerpted from the forthcoming "IREF’s Yearbook on Taxation" 2012
In view of the great fragility of French public finances, all the candidates to the April 2012 Presidential elections have felt the necessity to explain their strategy to put the country back on track, if elected. As a result, fiscal policy has attracted more public attention than rarely ever in the past. Although propositions seem to vary substantially from one candidate to the other, standing back they pretty much come down to the same two-tier plan: (1) cut some taxes here and raise some there so that the net balance is zero and (2) cut some public expenses here and increase some there so that net balance is zero or slightly positive (small reduction in public deficit). In short, no substantial reform, neither in the field of taxation or in the field of public expenditures, is to be expected. This, some say, is justified by the desire to save the country from recession (GDP is expected to stagnate during the first quarter of 2012 and to grow by 0.2% in the second quarter). Keynesianism is still popular there: A strategy that displays a great deal of stubbornness if we recall that France has already one of the highest levels of public expenditures in the world.
If no real change is expected, still, a plethora of reforms was introduced, making it almost impossible to keep track of all the changes. As a matter of fact, many decisions that were taken earlier during Mister Sarkozy’s Presidential term have been amended or repealed. Such is the case with the wealth tax that was not abolished, despite what the President had promised. In the meantime, a “fiscal shield” was introduced that was then modified many times and finally suppressed. Sometimes, like in the case of the tax on capital gains, the law was changed in a substantial way taking investors, unfairly, by surprise. It looks like if predictability was no longer a principle of good taxation.
Below are presented the main changes introduced in 2011, most of them to be implemented in 2012. .
Fiscal policy geared towards improving the competitiveness of French companies
One of the guiding principles for fiscal policy in 2011 has been to use taxation in such a way as to lower the cost of labor, thereby increasing the competitiveness of French companies and boosting growth. The system, presented at the French Parliament last February (2012), will also, supposedly, penalize imported goods, further increasing the attractiveness of the “made in France” products. More precisely, the State will lower the level of social contributions paid by employers on low salaries—those contributions were used to fund family benefits. Furthermore, to keep the budget balanced without cutting on social benefits, the State will increase the normal VAT rate from 19.6% to 21.2% and increase the rate of social contributions on capital income by 2 points (more on this below).
This mechanism, known as “TVA sociale” (Social VAT), will penalize imported products in the sense that, while both foreign and domestic companies will have to cope with increased VAT, only the French companies will benefit from a cut in their production costs. Critics have been numerous, claiming in particular that this will have little effect on competitiveness if employers decide to grab the opportunity of a drop in social contributions to increase salaries that in most companies have remained unchanged for many years. Anyway, this “social VAT” will probably not survive the election of a socialist President.
Personal income tax
A new bracket in the progressive taxation scheme was introduced that should last until France brings it deficit down to 3% of GDP (which at the time the change was introduced was scheduled to happen in 2013). Hence, revenues above € 250,000 will be taxed at 44% instead of 41% and those above €500,000 at 45% (up from 41%).
For lower incomes, tax rates remain unchanged (good news for the taxpayer) but the brackets will also remain unchanged (bad news). Indeed, for the second consecutive year the government has decided that it will not adjust the definition of the brackets for inflation. As a consequence, some households that were not paying income tax so far will now be taxable, because of the inflation (2.1% inflation in 2011). For the same reason, others will end up in a higher bracket and for those who were not paying taxes so far, the change will be worsened by the fact that they might loose some benefits reserved to non-taxable households if their incomes have been indexed on inflation.
The same policy—i.e., no adjustment for inflation—will apply in 2012 and 2013 to the threshold above which one has to pay the wealth tax. Altogether, by not adjusting the thresholds of the PIT and of the Wealth tax, the State budget expects to get approximately € 1.7 billion in 2012 and twice more in 2013.
This trend is expected to be unchanged, despite of the election of the socialist forerunner François Hollande.He promised to introduce a new bracket at 45% for income above € 150,000 (so far taxed at 41%) and still another bracket at 75% for income above € 1 million. It is estimated that between 3,000 and 30,000 taxpayers have incomes above that threshold.
Another reform suggested by the socialists consists in merging the PIT with one of the social taxes, the CSG (“Generalized Social Contribution”). The Constitutional Council has judged recently that the CSG is indeed a tax (and not a contribution for social insurance)! It is a flat withholding tax with a very broad base (everyone pays it). Merging PIT and CSG would make the CSG progressive. A huge change! The second part of the proposal is to transform the PIT into a withholding tax, which would eradicate many (probably too many politically speaking) niches applying to the PIT. Furthermore, it would move the fiscal system from one that is “household based” (family quotient) towards one that would be based on “individuals”.
Fiscal policy and family policy: the end of the “family quotient”?
The “family quotient” is a system that divides the amount of taxable income of a family by a number that increases with the number of children. A married couple with three children can hence divide its income by four to get its “taxable income”. The socialists had in mind to change that system for the reason, they say, that it reduces the levy on the wealthy and, more importantly, it does not bring one euro to those too poor to pay income taxes (but some, obviously, do not pay taxes precisely because there is a “quotient familial”). The idea was to replace it with a tax credit. Because the proposal was met with strong opposition, the socialist candidate has stepped back: he promised that if he is elected the quotient system will remain but the amount of the tax credit received by the wealthiest via the family quotient will be limited at € 2,000 (down from € 2,300).
Capital income and capital gain taxes
On both fronts the tax burden is significantly increased. Let’s us see first capital income tax. In France, income from financial assets (i.e., dividends and interests) can be merged with earned-income so that the regular progressive income tax applies to them. Alternatively, the taxpayer can choose to pay a flat tax on capital income in full discharge of any other tax on that part of his/her income. Although the possibility to choose between the two regimes is maintained, the flat rate (including social security tax) went, for 2011 incomes, from 30.1% to 32.5%. For 2012 incomes, the rate on dividends will be raised to 34.5% and on interest perceived to 37.5%, both up from 30.1% in 2010. Clearly, for many people this is getting very close to their top marginal rate on earned-income and paying the flat rate will no longer be attractive. As a matter of fact, this is precisely what the government was looking for as its members keep repeating: “income from capital should be taxed at least as much as income from labor.”
Regarding tax on capital gains, the situation is very similar; the rate on 2011 capital gains (social tax included) will be at 32.5% (instead of 30.1% on 2010’s capital gains). With, however, a major change: Until 2011, gains realized on sales below €25,830 were tax-free (or more precisely, only 12.3% in social taxes had to be paid). Starting in 2011, capital gains will be taxed from the first euro.
Tax on capital gains from real estate: soaring from 28.1% to 32.5%
If capital gains realized from the sale of your main residence remain untaxed, the tax regime for other gains from real estate transactions—a tax regime that was so far attractive compared to the regime applying to other forms of investment—has been profoundly modified. Indeed, until 2010, the seller of a real estate that was not his/her principal residence had to pay a withholding tax of 16% combined with social taxes of 12.1%, that is, 28.1% in total. Also, there was a tax allowance of 10% beyond the fifth year of ownership (so that no capital gain tax was paid on a real estate held for 15 years or longer) plus a €1,000 tax allowance per year starting from the very first year. This is over! For sales realized between 1 January 2011 and 1 October 2011, the rate will increase to 31.3% (19% of capital gain tax plus 12.3% of social taxes) after what it will be further increased to 32.5% (19% plus 13.5% in social taxes). Furthermore, the €1,000 tax allowance is abolished and one must now held a property for at least 30 years (previously 15) to avoid paying a tax on realized gains.
Meanwhile, owners that rent a studio (or room) will find it less profitable to do so as a new tax on “abusive rents” has been introduced. From 2012 on, renting a studio (or room) of less than 14 square meters for more than €40 per square meter will cost the owner an extra tax (on top of the regular income tax) with a rate ranging from 10 to 40% of the rent (according to the difference between the level of the rent and the threshold of €40/m2).
Introduced by the first socialist government of the 5th Republic, in 1982, this levy based on the wealth of the citizen (wealth including here real estate, financial assets, furniture, businesses, etc) has been the object of many debates in recent years. In 2006 a « fiscal shield » was introduced to guarantee that a taxpayer will not be forced to pay more than 70% of his/her income on direct taxes (income tax, real estate taxes, wealth tax, social taxes, etc.) Once President Sarkozy in office, that threshold was lowered to 50% hence making the shield thicker (in 2007). But that movement was reversed in 2011. Indeed, the 2011 fiscal law has brought two changes to the system. First the fiscal shield disappears; second—as compensation—the threshold and rates for the wealth tax are modified. The threshold is increased: Only people with wealth estimated above €1.3 million will pay the tax (up from €790,000), and the rate will be 0.25% if the wealth is estimated between 1.3 and 3 millions and 0.5% above €3 million. It is estimated that this reform will cut by 300,000 the number of taxpayers liable for wealth tax. The new mechanism (with no fiscal shield but a higher threshold for wealth tax) should cost some € 0.9 billion to the State budget.
Part of that loss in terms of fiscal revenue will be made up for by an increase of inheritance tax and donation tax rates; the rates applied to the top two brackets climb from respectively 35 and 40% to 40 and 45%.
Tax on fiscal transactions
Those who were dreaming of a Tobin tax must be happy: it is about to be implemented in France, thanks to the former President Sarkozy. . While the draft of a directive for the taxation of financial transactions was released in Brussels, suggesting a start date by January 2014, the French government was proposing to its Parliament to unilaterally start implementing such a tax scheme to transactions realized in 2012. Not all transactions are concerned however. The new tax will hit transactions involving (1) shares, debts or derivatives related to top French companies, (2) Credit Default Swaps on sovereign debt and (3) high frequency trading. The rate is fixed at 0.1% (the minimum rate included in the European directive).
Although the new proposal is promoted as increasing “fiscal fairness” (the claim being that the financial sector is partly responsible for the crisis and should therefore pay its due to the recovery plan), it is of course very uncommon to tax the transaction rather than the benefits made from it. In the present case, of course, both the transaction and the benefits if any will be taxed.
Tougher sanctions against tax evasion and tax fraud
In July 2011, a law was passed that introduced an « exit tax » (this is the French name given to the new tax!). The idea behind the law is to counter some strategies of fiscal optimization that reduce fiscal revenues. More precisely, taxpayers that were paying the wealth tax and have decided to move their fiscal residence out of France after 3 March 2011, will pay capital gain taxes on the gains realized in France before they leave if they realize those gains less than eight years after leaving France.
In the same spirit and in preparation for the 2012 Presidential elections, President Sarkozy has expressed his desire to counter what he calls “fiscal exile”; the 2012 fiscal law already introduces much tougher sanctions on tax evasion and tax fraud, especially when a tax haven is involved. Hence, the fine for hiding from the French tax authority a bank account or some life-insurance policy held abroad will climb from a range of €1,000 to €15,000 (depending on the amount hidden) to 5% of the balance of the hidden account. Also, the maximal penal sanction for fiscal fraud has been modified (the last change was in 1977) soaring from €37,500 to €500,000. When the fraud is coupled with some other illegal behavior (fake invoice for instance), the maximum penal fine will be multiplied by ten, going from €75,000 to €750,000. And if a tax haven has been involved, the fine will reach €1 million and up to 5 years in jail.
After the abolition of the “Professional tax” in 2010, the main fiscal sources of revenue for local governments are real estate taxes (the residence tax and the ownership tax) and a new “contribution économique territoriale” (local contribution to the economy, paid by businesses). Those three taxes represent together about 50% of local administrations’ revenues, the rest coming from transfers from central government and borrowing.
Considering only the 40 largest cities, rates for real estate taxes have increased in average by 0.9% in 2011; which is less than in 2010 (+2.8%) or 2009 (+5.1%). But the spread is high between cities. In Marseille, second city by population, a household with two kids, living in an apartment whose rent is 1.5 times the average rent in that city, will, in 2012, pay €1,162 for residence tax (up 13.4% from previous year) and € 852 for ownership tax (up 2.9%). A couple living in Toulouse in a similar situation will pay for the same taxes respectively € 869 (+0.1%) and € 989 (+3.2%); while the Parisian couple will be paying € 444 (+2%) and € 612 (+2%).
On 13 July 2011 the Parliament has adopted a project for a constitutional reform that would impose a control from the Constitutional Council on the budgets of the State and of the Social Security System, making it impossible to vote a fiscal law with the effect of increasing the debt beyond a given threshold. Because a change in the constitution requires a qualified majority of the 3/5 of the Congress (the Congress merging Assembly and Senate); such a « golden rule » is unlikely to pass since the (then) socialist opposition said they would vote against it.
Never mind: With or without the golden rule, the former government Fillon was committed to reduce the deficit to 4.5% of GDP in 2012, 3% in 2013 and 2% in 2014. The present survey shows that the government intended to reach those targets essentially by increasing the fiscal burden. This is even more truth for the new socialist government. It is indeed noteworthy that no major structural change is being debated during the 2012 campaign for Presidential election. With higher taxes and no structural reforms the probability that those targets will be met appears low.