IB revija 1-2/2006       UMAR    137
Gonzalo C. Caprirolo*
Proportional (“Flat”) Personal Income Tax Rate and
Competitiveness in Slovenia: Towards
Understanding the Policy Issues and Policy
Implications
* Ministry of Finance, Slovenia. The views expressed are those of the author and do not necessarily represent those of the
Ministry of Finance, February 2006
Summary
The Slovenian policy model has
performed relatively well over the
last decade in terms of efficiency
(rate of employment) and equity.
It has delivered an uninterrupted
economic expansion at a rate of
about 4% which is in line with the
level of productivity. Thus, the
welfare has improved and
accessibility to its benefits has been
broad. The human development
index 2005 has ranked Slovenia’s
wellbeing among the highest 24
countries. These achievements
have been made while preserving
competitiveness of the economy
and without major macroeconomic
imbalances.
The issue at stake is whether a
flat tax reform can contribute to
further improvement and
upgrading these achievements (i.e.
increase aggregate output and
welfare gains for all). The
assessment of the likeliness of such
a development presented in this
paper indicates that there are
potential risks in the short term
that should be carefully assessed
with respect to labor participation
of unskilled workers and labor
intensive industries performance.
As a result of the introduction of
a f lat tax rate, the inequality
statistics of the economy can also
deteriorate. The paper argues
that under an unchanged net
wage flat tax reform (Slovenian
proposal) the impact on labor costs
will be similar as in the case of
standard flat tax reform in which
the net wage adjusts to the new
f lat tax rate and gross wage
remains constant. The impact of
both types of reforms under the
parameters proposed (20% flat
tax rate and 19.5% APW fixed
tax deduction) is similar in terms
of labor participation of unskilled
workers and output. Both types of
reform are likely to generate
adjustment costs affecting low
skilled workers and labor
intensive industries in the short
run. Gains in output depend
critically on the overall elasticity
of labor supply. Additional impact
on output could come from the
unburdening of income of high
skilled workers and their income
split between consumption and
savings (investment). The
standard flat tax reform seems
to perform better in the short-term
than the Slovenian proposal as it
dispels uncertainty with respect of
short-term wage adjustment of
high skilled workers to the pre-
reformed gross wage (clear
incentives). The flat tax reform
could enhance incentives for
improving education attainment.
This objective should be carefully
scrutinized against the efficiency
of alternative instruments to
achieve this key goal which should
be at the top of policy priorities.
The paper in search for a win-win
situation proposes an alternative
avenue for personal income tax
reform which suggests gradual
carving down of average and
marginal tax rates below the
existing ones without affecting
labor incentives and equity. A
critical input for further progress
in personal income tax reform
remains the final assessment of
the effect of the recently adopted
personal income tax (split system)
with respect to labor incentives it
generates for high skilled workers.
A related important issue remains
the financing of the reduction of
the so-called “payroll tax”.
After the government decision on
the gradual elimination of “payroll
tax” in November 2005, any
discussion of labor taxation in
Slovenia should take into account
that the tax wedge for an average
production wage earner will be
reduced to a level slightly above
Mediterranean EU countries.
Additional unburdening of labor
costs for employers (i.e. reduction
of employer’s social security
contributions) that would not
result in reducing pension and
welfare benefits can be done at
expense of reducing personal
income tax (i.e. increasing net
wage) to zero and thus
transferring the risk of financing
pensions and health to individuals.
In this case, for an average
production wage earner the
maximum extent that employers’
social security contribution could
138     UMAR      IB revija  1-2/2006
be reduced would be about 11%
of gross wage. From that point
onwards the complete elimination
of employers’ social security
contribution can be carried out
only at the expense of cutting
pension and health care benefits.
In light of population ageing, the
challenge for Slovenia seems to be
more on the side of avoiding
increase of social security
contributions rather than of
cutting social security
contributions. Furthermore, in
facing the perils of globalization
and population ageing, the key
policy questions to address are
whether the overall tax and social
security system will be changed to
increase the income uncertainty
faced by households and if not,
what could be done to improve the
efficiency of existing policy
arrangements that provide a
relatively high degree of risk
pooling. A step in this direction is
to preserve the progressivity of the
tax system while searching for
efficiency gains as proposed in the
paper.
........................................................................................................................................................................................................................................................................................
Introduction
A proposal for introducing a proportional (flat)
tax rate on personal income — subject to impact
assessment of its introduction, social consensus
and alternative better options — has been approved
by the government. To date there is no formal
government proposal regarding the specific features
of the flat tax rate regime (e.g. the level of the rate
and the size of the single tax allowance). The
available information as to the specific features of
the personal income flat tax system can be inferred
only from the paper written by Messrs Damijan
and Polanec (2005). The purpose of this paper is
to contribute to the final assessment by the
government on further potential changes to the
personal income tax system just recently modified
at the end of 2005. In particular, the paper touches
upon the key issues to be observed in the tax
reform (efficiency and equality) and the likely
impact of the reform as envisaged in the labor
market and economic activity. The analysis
presented might also contribute to enhance the
research agenda that needs to be consummated in
order to thoroughly assess the impact of the
introduction of a f lat tax regime.
The paper builds on two key tax reform changes
that took place in late 2005: the gradual elimination
of the payroll tax and the systemic change from
the former income tax regime that used to tax all
types of income at progressive rates to the current
system (split-system) that taxes labor related
income and pensions at progressive rates (five tax
brackets) and capital related income (interest,
dividends and capital gains) at a single reduced
rate of 20%.
The paper is divided in four sections. The first
section aims at characterizing the main features
of the Slovenian social model, reviewing labor
market characteristics, and key indicators such as
1 For a comparative assessment of the institutional features of a flat tax regime in light of tax principles see Kranjec (2005).
According to the author the proportional income tax has no clear advantage over the progressive tax system with respect to
any of the principles that are part of a good tax system (efficiency, transparency, simplicity and fairness).
competitiveness, productivity and education. This
section should provide the general background
against which any tax reform should be assessed.
The second section looks at the main features of
the current tax system to determine its main
characteristics. The third section presents an
assessment of the impact of the introduction of
the flat tax regime. The assessment is made with
respect to the main objective it pursues which is
unburdening the Slovenian economy, particularly
by reducing the gross labor cost.1 The final section
provides policy recommendations.
1. Slovenian Social Policy Model
An important policy change such as the
introduction of a flat tax reform should be assessed
against the background of the current Slovenian
policy model in order to disentangle its impact.
According to Boeri (2002) and Sapir (2005) EU
national welfare systems can be grouped in four
different social policy models. Nordic countries
model is characterized by the highest level of
expenditure in social protection and universal
welfare provision. Redistribution via tax and
transfers is the highest in EU. As a counterpart,
the share of tax revenue in GDP is also the highest.
Strong labor unions determine wage compressed
structures. Anglo-Saxon countries (UK and Ireland)
feature a social assistance system of last resort.
Transfers are oriented to people in working age.
Tax revenue in GDP is the lowest in the former
EU-15. Labor unions are weak, the wage dispersion
is wide, and there is a relatively high incidence of
low-pay employment. Continental countries
(Austria, Belgium, France, Germany and Luxem-
burg) feature an extensive array of insurance-based,
non-employment benefits and old-age pensions.
Their share of tax revenue in GDP is lower than
in the case of Nordic countries but higher than in
Anglo-Saxon countries. Unions are relatively strong
IB revija 1-2/2006       UMAR    139
and they influence the wage outcome to non-union
negotiations. Redistribution via tax and transfers
lay in the median position for Continental and
Anglo-Saxon countries. The fourth model is from
Mediterranean countries (Greece, Italy, Portugal
and Spain) where social spending is concentrated
on old-age pensions and entitlements are segmented
and vary with status. Redistribution via tax and
transfers is the lowest in EU-15. The tax revenue
in GDP, with the exception of Italy, is lower than
in the continental model but higher than in the
Anglo-Saxon model. They feature a high degree of
employment protection and early retirement
provisions. The wage structure is - at least in formal
sector - covered by collective bargaining and
compressed.
The Slovenian social model to a large extent
concurs to the Nordic model. It features a high
level of expenditure in social protection as well as
universal welfare provision. Taxes, social security
contributions and transfers play an important role
in income redistribution. However, the share of
tax in GDP is lower than in Nordic countries while
old-age expenditure in pensions is relatively high.
Inequality of income distribution and poverty after
taxes and transfers in Slovenia is among the lowest
in the EU-25, and similar to Nordic countries the
wage structure is relatively compressed.
According to Sapir (2005) the performance of the
four social models can be assessed based on two
criteria: efficiency and equity. An efficient model
is one that provides sufficient incentives to work,
thus generating high employment rates. A model
is equitable, if it keeps the risk of poverty low.
Taking into account the probability of escaping
poverty and employment rate the Slovenian social
model can be grouped close to the Nordic model
(Figure 1) which ranks above EU-15 average in
terms of both indicators. Undoubtedly, such an
outcome is related to the underlying policy
arrangements and institutions inf luencing labor
market outcomes.
The Slovenian model compared to the Nordic
model seems to perform poorly in terms of
employment in spite of higher participation rate
(82.5%) than in the EU-15 (77.2%) in the age range
25-54 years. This is due primarily to the very low
employment rate among the group aged 55-64
((23.5% in Slovenia) compared to the EU-15
average (41.7%). This can be attributed to a large
extent to the number of early retirees after
independence in 1991. The relatively low share of
employees aged 55-64 is an important policy
challenge.
The Slovenian social model has allowed an
uninterrupted economic expansion after early
recovery from independence. The average real
GDP growth rate in the past ten years has been
close to 4%. Such a growth rate is fully in line
with the level of productivity achieved by Slovenia
which places it among the middle developed
countries in the EU-25 (Figure 2). The Slovenian
average growth rate is also consistent with the
resulting rate from the correlation observed in the
EU-25 between productivity level and potential
GDP growth as recently estimated by the EU
Commission (2005) for the periods 2004-2010 and
2011-2030 (Figure 3). It is also possible to see
from Figure 3 that the ageing of the population is
a key challenge resulting in a decline in the
potential GDP growth from 3.7% in the period
(2004-10) to below 3% in the period (2011-30).
Furthermore, according to the EU Commission,
the GDP per capita of Slovenia will reach 94% of
EU-15 by 2030 and will remain in that level
thereafter. The Slovenian productivity level will
finally catch up with that of the EU-15 by 2050.
The Slovenian social model has delivered a
relatively low unemployment rate (the fifth lowest
among EU-25 (5.9% November 2005).
Unemployment in Slovenia affects predominantly
low skilled workers which represents the same
policy challenge as in most EU-15 countries2. This
can be attributed to the gradual shift away from
‘traditional’ low-skilled work industries towards
services and higher value-added manufacturing. The
labor outcome in Slovenia is partly the result of
an employment protection legislation which
provides an EU-25 average protection to workers
but which is lower than the protection provided
by the Mediterranean and Continental European
models (Figure 4). Another element characterizing
labor market is the close-to-average (EU-25)
availability of f lexible forms of employment in
Slovenia due to the underdeveloped part-time
employment (Kajzer 2005). A third item
characterizing labor market arrangements is the
wage bargaining mechanism which is relatively
highly centralized and inf luences the wage
structure which is relatively compressed.
An important area that deserves particular attention
is labor force education attainment. While about
half of the persons employed in Slovenia have an
educational attainment of at least secondary
2 In Europe unemployment rates are higher for low skilled workers than for those with post-16 education. In some Member
States unemployment rates among those with low educational attainment is four times the level for graduates ‘Towards full
employment in the European union’, HM Treasury, DTI, DWP, 2002.
140     UMAR      IB revija  1-2/2006
education this level seems lower than for example
in Nordic countries (OECD (2004)). The share of
individuals with tertiary education is low while the
shares of individuals with primary school with
qualification and non qualified individuals are
relatively high (Figure 5). Lower education
attainment (primary school with qualification and
non qualified individual) is particularly high in
tradable sectors of the economy (e.g. manufacturing
(Figure 6). Taking into account the relatively high
share of individuals with low education attainment,
which to a large extent reflects the current industrial
base, this situation might argue for ranking
educational attainment as a top policy priority and
for a very careful management of the transition of
the economy towards a high skill based economy.
Among the policies considered towards increasing
education attainment should be not only those
whose causality runs from relative wages to labor
supply and vice versa but also from demand to
supply as most progress in technology is skill biased.
When assessing a personal income tax reform or
in general a reform affecting labor income it is
critically important to estimate the labor supply
elasticity with respect to changes in net wage as
labor supply is the driving force behind the post-
reform efficiency gains (i.e. increase in
employment). In particular, starting from an
equilibrium position in which gross wage equals
productivity, changes in marginal and average tax
rates affect labor decisions on labor market
participation and work effort. For Slovenia, in
absence of empirical estimates of labor supply
elasticity and taking into account labor market
characteristics and institutions brief ly discussed
above, it can be argued for a relatively inelastic
labor supply, at least for high skilled workers (short
in supply) and a relatively high degree of real wage
rigidity, particularly in the private sector. Such an
assumption seems to be broadly in line with
empirical estimates of labor supply elasticity in
other countries.3
The issue of the empirical relationship between
taxes on labor, labor costs and effect on
employment is hotly debated in the literature and
empirical evidence is at variance. Arpaia and
Carone (2004), for example, argue that there is a
lack of a significant long-term influence of the tax
wedge on wage costs. On the effect of labor cost
on employment, Nickell and Layard, (1991, 1994,
1999), argue that in the long-term change in the
tax wedge leaves equilibrium unemployment
3 A survey of 65 labor economists conducted by Fuchs, Kruger and Potreba (1998) found that the labor supply elasticity for men
is 0.18 and 0.43 for women.
4 See Immervoll et al 2005.
unaffected. These results partly contrast with the
results of Daveri-Tabellini (2000) and World Bank
(2005). The key issue at stake seems to be the
response of different groups in labor market to
changes in the tax wedge in light of the central
finding in the empirical labor market literature
that the extensive margin of labor supply (whether
or not to work at all) is more important than the
intensive margin (hours worked for those who are
working).4
Besides labor force and labor market characteris-
tics underpin-ning current policy model, an impor-
tant dimension to look at is labor cost evolution
and its relation with productivity develop-ments
and thus relative competitiveness. Different
indicators related to labor cost competitiveness
indicate that Slovenian competitiveness has
remained broadly satisfactory. The dynamics of the
real unit labor cost, a key measure capturing
changes in (labor) cost-competitiveness, shows that
labor cost in Slovenia has declined below the 1995
level and remains stable (Figure 7). The ULC-
based real effective exchange rate and the relative
profitability index have also remained broadly
unchanged since 1998. Beyond labor costs, if we
look at competitiveness in terms of the ability of
Slovenia’s goods to withstand competition in the
key export market, we observe that the export
market share in the EU-15 has experienced a
sustained recovery since 2001 (IMAD 2005).
An important question to address is what policies
can enhance labor contribution to the
competitiveness of the economy and what should
be the priority. Two types of policies can be
pursued: policies that focus on reducing the cost
of labor and/or policies that enhance the ability
and productivity of labor. Among the policies that
can lower labor cost are those that reduce labor
taxes (i.e. tax wedge). In this regard, the government
in 2005 decided to abolish payroll tax and its effect
on labor costs has to be carefully monitored.
However, the reduction of labor cost via reduction
of taxes is subject to limits and can not be the
primary tool for pursuing competitiveness. For
example, even in the case that total taxes related
to labor will be eliminated at once in Slovenia,
this will not result in lower labor cost in absolute
terms in Slovenia than in most new EU members
(Figure 8). On the other hand, if we compare labor
cost in Slovenia with the EU-15 average, labor cost
in Slovenia will remain cheaper at least up to
around 2030.
IB revija 1-2/2006       UMAR    141
Another limit on pursuing competitiveness by
reducing the tax wedge is given by the required
financing of pension and health benefits. In
particular, the maximum extent to which
employers’ social security contributions can be
reduced without hurting pension and health
benefits is given by the elimination of personal
income tax. However, even in this case employer’s
social security contributions will not be
completely eliminated, but the reduction of
employer’s social security contributions will
imply transferring the risk of financing health and
pensions to individuals.
Given the limits to pursue competitive gains based
on reducing the tax wedge, the policy priority
should be to focus on rising labor productivity
rather than primarily on reducing labor cost which,
otherwise, reflects the level of productivity achie-
ved. Furthermore, changing the tax wedge can have
important consequences on equity that deserve
careful evaluation. Of course, redistributing the
tax burden from high skilled workers to low skilled
workers could, for example, in the long run change
incentives for rising education attainment, but such
a policy has to be assessed against the effectiveness
of the policy in itself and in light of the effectiveness
of other available policy instruments. However,
beyond any theoretical consideration about the
transition to a labor skill biased economy any
serious analysis of this process, which is beyond
the purpose of this paper, should start from a
diagnosis of the current matching between labor
skill and current industrial structure, the labor
demand structure and its evolution. Before
assessing the impact of the tax reform proposal,
next section looks broadly at the main features of
the current tax system.
2. The Current Tax System
The Slovenian social policy model is underpinned
by a relatively high share of tax revenue in GDP
(on average 40% during 1995-2002 (Figure 9)).
This share is lower than in the Nordic and
Continental social policy model. The bulk of tax
revenues are taxes on goods and services and social
security contributions (72%) which are regressive
taxes although the VAT has two rates (standard
and reduced rate) implying certain degree of
progressivity (Figure 10). The total share of these
taxes and social security contributions in total tax
revenue is higher than the average of EU and US
(62%). The share of income tax revenue is also
5 The Slovenian effective tax rates ranked according to multiples of APW among EU-25 in 2003 as follows: eleventh lowest on
67% APW; sixth lowest on 100% APW and; fifth lowest on 167% APW.
relatively low (20.1%) compared to the average of
these countries (31.1%). Tax on personal income
arising from labor and pension is levied at
progressive tax rates (five tax brackets) while
income from capital (interest, dividends and capital
gains) at a single flat tax. At aggregate level the
bulk of labor tax are social security contributions
(two thirds). Corporate income tax (CIT) is levied
at a single rate of 25%. CIT is subject to some
exemptions (mainly R&D).
A distinctive feature of the Slovenian system until
2005 was the so-called payroll tax levied on
employers paying social security contributions at
progressive rates. The tax is being gradually
abolished between 2006 and 2008. The payroll
tax revenue represented about 2% of GDP in 2004
and its share in total tax revenue is higher than tax
revenue on property which in turn is among the
lowest in EU.
In terms of their relative size in GDP, VAT and
personal income tax (PIT) exhibit distinctive
features. VAT revenue in GDP (8.9% average 2000-
2005) is among the highest in EU-25 (Figure 11)
while PIT is the seventh lowest in EU (6% on GDP
(Figure 12)). While there is not much work done
on revenue collection in general, a study on
Slovenian pension system (Wiesse 2004) indicates
that pension system has a high contribution
compliance rate. VAT revenue collection also
seems to be in line with a rule of thumb that
attributes 1% of GDP VAT tax revenue to two
percentage points of VAT rates. In the case of PIT,
the low revenue collection can be attributed to
relatively low tax rates applied to the bulk of
personal income taxpayers (90%) up to 167%
average production wage earner (APW). In
particular, Figure 13 shows that the effective tax
rates up to 167% APW in Slovenia are below the
EU average.5
Despite the fact that effective tax rates for
individuals earning a wage up to 167% APW are
relatively low in Slovenia, the top statutory and
marginal rates are high (Figure 14). This is also a
distinctive feature of the Nordic social policy
model. Notice also in Figure 14 that among EU
countries-members of the OECD there is no
country except Slovakia (after the flat tax reform)
with a top statutory PIT rate lower than 40%.
With regard to progressivity of personal income
tax system up to 167% APW Figure 15 shows that
the degree of progres-sivity in the Slovenian tax
regimes, calculated for each country by standardizing
142     UMAR      IB revija  1-2/2006
the tax schedules by their respective tax rate on an
individual earning 67% AWP, is not exceptionally
high or extreme. The degree of progressivity of
the Slovenian PIT is slightly higher than the simple
arithmetic average of the EU-15 countries and is
lower than the degree of progressivity in Ireland.
In the case of Nordic countries the progressivity
is lower but the effective tax rates are more than
double (Figure 13).
The distribution of PIT payers in Slovenia shows
that about 69% of taxpayers earning up to the
average APW pay 20% of tax revenue and the bulk
of taxpayers (90%) earning up to 167% APW pays
up to half of personal income tax revenue
(Figure16). The concentration of income tax on
the top of the income distribution might look
abnormal but data on the US show that for
example the top 5% of taxpayers pay about 54.5%
of total tax revenue while in Slovenia the top 10%
of taxpayers pay 55.5% of total tax revenue. The
top 1% in the US pays 33% of PIT while the top
1.2% in Slovenia pays 19.8%. It is likely that after
the introduction of a reduced rate on personal
income tax on capital in 2005 the burden on top
income payers will be reduced (Table 1).
Before assessing the potential impact of the flat
tax reform two key tax reform measures taken in
2005 affecting tax on labor deserve attention: the
transformation of the PIT system from a system
that taxed all income at progressive rate into a so-
called split-system by which labor and pension
income are taxed at progressive rates while income
from capital is taxed at single lower rate of 20%
(Table 2). Such a system is now similar to that of
Norway.
The other important change mentioned above is
the gradual phasing out of the payroll tax (the
progressive levy on employers paying social
security contributions for their employees). While
a thorough analysis of the impact of the recent
change in PIT system on average and marginal tax
rates, savings and investments has to be made, in
the case of the payroll tax the impact of reducing
total labor cost is clear. In particular, the tax wedge
taking into account the total labor cost before the
reform, including total social security contributions
and personal income tax for individuals earning
above the threshold upon which the payroll tax is
paid, will be reduced by more than three percentage
points depending on wage level (Figure 17). Since
the payroll tax is not part of employees’ income,
but a direct cost to the employer, its elimination
will not affect labor supply but will reduce the
absolute cost of labor and relative cost of high
skilled labor with potential positive effect on labor
demand and employment.
In relative terms the tax wedge for a 100% APW
in Slovenia comparing with EU countries members
of the OECD and US will be reduced as percentage
of new labor cost from being the highest ninth
(43.9%) to the highest thirteenth (Figure 18). The
tax wedge as percentage of the labor cost before
the reform (Figure 17) will be close to those in
Mediterranean EU countries (Figure 18). Notice
also that the share of payroll tax in GDP is about
2% of GDP. The financing of its reduction as
foreseen in the Slovenian Convergence Program
2005 will result in a decline of total tax revenue
of about 1% of GDP by 2008. Such a reduction
can not be considered as negligible if we take into
account that the tax burden in Slovakia after the
major flat tax reform dropped by approximately
0.5% of GDP in 2004 (Krajčír and Ódor 2005).
Further reduction of labor tax in Slovenia, particularly
employers’ social security contributions, without
reducing health and pension benefits and hindering
the financial position of Health and Pension funds,
can be carried out by reducing personal income tax
rates (i.e. increasing net wage) and, in the extreme
by eliminating it. After such policy scenario
employers’ social security contributions will be still
positive (5.4% of gross wage) while the risk of
financing pension and health will be transferred to
individuals (Figure 19). From that point onwards,
further reduction of the payroll tax can be done only
by cutting pension and health benefits beyond what
the ageing of population already demands. Such a
policy will result in reducing the collective insurance
against globalization resulting from risk pooling of
the population.
3. The Flat Tax Proposal and Its Impact
To date there is no formal government proposal
regarding the specific features of the flat tax rate
regime (e.g. the level, the size of the single
allowance and other). There is only the government
decision of introducing a proportional (f lat tax
rate) on personal income, subject to impact
assessment of its introduction, social consensus
and alternative better options. The available
information as to the specific features of the
personal income f lat tax system can be inferred
only from the paper written by Messrs Damijan
and Polanec (2005). This section looks at that
proposal in terms of the key objective it pursues
with the aim to enrich the research agenda,
highlight the key policy issues and policy
implications.
The purpose of the flat tax proposal is to unburden
the Slovenian economy and establish conditions
for increasing its competitive power on the world’s
IB revija 1-2/2006       UMAR    143
markets. The flat tax rate on income will: i) reduce
substantially the gross labor costs of Slovenian
businesses thus increasing business profits that will
be spent on enhancing their technological capacity
and increase employment and; ii) reduce the
relative price of high skilled employees with
respect to low skilled employees enhancing the
employability of high skilled workers.
A single f lat tax rate of 20% on income and a
single tax allowance of 19.5% APW will be
introduced replacing the current progressive PIT
split-system with its five tax brackets, tax
allowances including a general tax allowance of
17.7% APW. The reforms rests on the key
assumption that net wages will not change after
the reform, thus the reform will improve the
profitability of enterprises employing high skilled
workers. The constant net wage feature makes the
Slovenian flat tax reform different to standard flat
tax reforms (e.g. Estonia, Russia, Slovakia) in
which gross wage remains constant while net wage
adjusts as a consequence of the replacement of tax
brackets by a single tax rate.
The Slovenian flat tax reform is conceived to be
revenue neutral by means of offsetting the
reduction in PIT revenues with the revenues
resulting of introducing a single VAT rate of 20%
(the VAT reduced rate will increase from its current
level of 8.5% to 20%).
The analysis of the f lat tax proposal focuses on
the key objective of the reduction of gross labor
costs, as the aim of enhancing the employability
of high skilled workers is less of a policy issue
given the fact that most of skilled individuals are
already employed. In looking at whether the flat
tax reform will result in reducing gross labor cost,
the Slovenian flat tax reform and a standard flat
tax reform are compared in order to evaluate
whether they produce different outcomes
(efficiency and equity) and to determine the relative
effectiveness in delivering the objective the f lat
tax reform pursues.
The starting point of the analysis is the impact of
the flat tax reform on gross wage in the short and
long run when the adjustment in labor market
has been completed. In the case of Slovenian flat
tax reform proposal, leaving aside the implementa-
tion issues related to assuring that the net wage
remains unchanged, the resulting gross wage -
when applying the new 20% tax rate and taking
into account the general tax relief and employee’s
social security contributions -, will vary according
to wage level. From the theoretical point of view
the change in gross wage resulting from keeping
constant net wages will be equivalent to inducing
disequilibrium between gross wage and
productivity levels. On average the gross wage
will increase for individuals earning low incomes
up to 100% APW while it will decline for
individuals earning higher wage than the average
(Figure 20). In this case some enterprises, but
only those enterprises employing high income
earners, can in fact reduce labor cost while those
enterprises employing low income earners will
have to increase their labor cost.
In the case of a standard flat tax reform that leaves
the gross wage at its pre-reform level but adjusts
net wages, the result of the 20% tax rate will be the
reduction of average net income for those
individuals earning up to 100% APW (Figure 21).
On the other hand, net income for those individuals
earning above the 100% APW will increase.
The impact on gross wage in the case of the Slovenian
proposal or on net wage in the case of f lat tax
proposal, besides income level, will also depend on
individual’s status. In the first case and in the short
run the gross wage will increase particularly for
individuals with one child earning up to 100% APW
(Figure 22). On average, the gross wage will increase
for low skilled labor force and decrease for high
skilled labor force (Figure 22).
A further insight on the impact of the flat tax
reform can be obtained by looking at the labor
supply and demand responses to changes in the
tax system and to the adjustment of the labor
market to the new equilibrium.
The effect of the flat tax reform on the labor supply
response can be assessed by looking at the average
tax rate (total taxes divided by pre-tax income) or
effective tax rate and the marginal effective tax rate
(taxes due from an additional tolar of income) which
both affect labor supply decisions. The average rate
(extensive margin of labor supply) affects decisions
regarding labor market participation, while the
marginal tax rate (intensive margin) affects decisions
regarding working hours for those who are working.
Further and more comprehensive insight on the
impact of the f lat tax reform on labor supply
decisions can be obtained from looking at the
composite marginal tax rate which considers labor
taxes as a composite of income, payroll, and con-
sumption taxes (Moore 2005).6 This is particularly
6 According to Nickell (1997) the relevant tax rate for the labor market is the sum of the payroll, personal income, and
consumption tax rates; and that payroll taxes will be shifted onto workers assuming capital is mobile internationally.
Consumption taxes including the VAT may be regarded as labor taxes in the long run, because neither a tax on consumption
nor a tax on labor income directly affects the return that can be achieved on savings.
144     UMAR      IB revija  1-2/2006
relevant because the 20% f lat tax reform is not
revenue neutral (i.e. total tax revenue is reduced)
and as a consequence it is envisaged the increase in
the VAT reduced rate to 20% to offset the tax revenue
short-fall. The change in PIT tax rate and increase
in effective VAT tax rate will affect worker’s income
net of all taxes and thus labor supply. Thus a
comprehensive assessment of the reform should look
at overall tax incidence and labor supply incentives
as captured by the composite marginal tax rate. 7
The effect of the tax reform on average tax and
effective marginal tax rates can be analyzed also
under the light of the two types of flat tax reforms:
Slovenian f lat tax reform and standard f lat tax
reform. In the first case, although the average tax
rate changes due to the recalculation in gross wage
this change does not have impact on labor supply
decisions as the net wage remains constant (Figure
23). The impact of the increase of average tax rate
affecting gross wages is born by labor demand
though changes in gross wages. Figure 24 shows
the effect of changes in average tax rate for all tax
payers according to their income as percentage of
the pre-reform wage level. The average tax rate
increases for 70% of tax payers, particularly for
those that are unskilled workers.8
In the case of the standard f lat tax reform, the
average tax rate will increase for low skilled workers
up to 100% APW depending on individual status
(e.g. individual with one child) but the average tax
rate for high income earners or skilled workers will
be reduced (Figure 23). In this case, given the fact
that net wages will change the labor supply incentives
and decisions will be also modified.
With respect to marginal tax rates, in the case of
the Slovenian flat tax reform, given that net wages
will remain constant, there will be perceived by
the labor force as if no changes on marginal tax
rates will have taken place (Figure 25). The effect
of changes in gross wage (i.e. higher for low skilled
workers and lower for high skilled workers) will
not affect net income and will thus not affect labor
supply decisions.
In the case of a standard f lat tax reform the
marginal tax rate will decline for all tax payers
except for low skilled workers. The adverse impact
on low skilled workers’ labor supply effort will
depend on their status. For example, the marginal
tax rate will increase more for unskilled workers
with one child than for a single individual (Figures
26 and 25). Skilled workers will benefit from
reduced marginal rates and could increase labor
supply effort.
If the impact of the flat tax reform on income and
the VAT increase is considered as captured by the
composite marginal tax rate, then under the
Slovenian flat tax reform the composite marginal
rate will increase for all workers and proportionally
more for low skilled workers (Figures 27 and 28).
This will be the case because the effective VAT
tax rate faced by low income earners is higher than
for high income earners. In this case the effect of
the reform will also be more adverse for individuals
with one child. The overall impact of the upward
shift in composite marginal tax rates could result
in labor supply reduction (labor participation and
effort).
In the case of a standard f lat tax reform the
composite marginal tax rate will be reduced for
high skilled workers but increased for low skilled
workers (Figures 27 and 28).
Depending on whether the net wage will remain
constant at the time of implementing the flat tax
reform, two scenarios for the labor supply response
can be envisaged. In the case of the Slovenian f lat
tax reform, where the average and marginal tax
rates will not change from the point of view of
labor, the overall labor supply should not be
affected. However, the increase in the composite
marginal tax rate due to VAT increase could
discourage effort across all taxpayers.
Alternatively, under a standard flat tax reform the
labor supply response would be mixed. The higher
average tax on low skilled labor force will deter
labor participation and high marginal rates could
reduce their labor effort. On the other hand, low
average and marginal rates could increase labor
supply of high skilled workers (particularly the
effort). The overall response of labor supply will be
undetermined. According to the theory the extensive
margin of labor supply (whether to work or not at
all) is more important than the intensive margin
(additional working hours of those working).
Empirical evidence shows that the participation
elasticity is largest at the bottom of the distribution
(Eissa and Liebman (1996); Meyer and Rosenbaum
(2001); Immervoll et al (2005). In practice, the
overall response will depend on whether high skilled
workers have f lexibility to set their hours worked
and whether there are enough forms of flexible work.
7 In the case of the Slovenian flat tax reform the employers’ social security contribution will have to increase. This would further
increase the labor cost of unskilled workers but only offset the gains of reducing PIT on skilled workers.
8 It is assumed that income level is associated with the skilled level. Low income level relates to low skills while high income
level to high skills.
IB revija 1-2/2006       UMAR    145
For the labor demand response we can also identify
two scenarios depending on whether the net wage
remains unchanged. Under the Slovenian flat tax
reform the relative price of low to high skilled
workers will increase. Therefore, low wage
intensive industries will reduce labor demand as
it depends on gross wage.9 On the other hand,
industries employing high skilled workers could
increase labor demand or --as the envisaged reform
proposes-- enterprises could enhance their
technological capability by investment. This in turn
could reinforce the skill biased policy orientation
of the underlying policy.
Under a standard flat tax reform the labor demand
will remain in equilibrium (gross wage equals
marginal productivity). The effect of the increase
in VAT on wages and on labor demand in both
types of reform remains undetermined as it is the
result of wage negotiations.10
Depending on the type of PIT tax flat tax reform
chosen, the adjustment of the economy, the
transition to the new Slovenian policy model (i.e.
with lower employment rate but biased in favor of
high skilled labor) will be different and with
different degree of certainty. In the case of the
Slovenian flat tax reform, labor demand will be
the driving force in the labor market adjustment
towards the equilibrating gross wage (pre-reform
level) and to lower employment of unskilled
workers (ceteris paribus). In the case of the
standard f lat tax reform, labor supply will drive
the adjustment dynamics on the labor market
towards the new employment rate level with
potentially lower number of unskilled workers.
In the case of the Slovenian flat tax reform the
transition in the labor market to the new
equilibrium is likely to be as follows: The higher
gross wage will reduce labor demand for low skilled
workers driving gross wages to the pre-tax reform
gross wage level. The output in low skilled
industries is likely to decline.11 On the other hand,
the excess labor demand for high skilled workers
depending on their labor supply elasticity will drive
gross wages to the pre-reform gross wage level and
increase labor supply effort (Figure 29). As a result
of these conflicting labor supply responses, the
overall economy could enter into an uncertain
adjustment path —short term adjustment of labor
market conditions and activity in labor intensive
industries— towards the new Slovenian social
policy model.
Under a standard f lat tax reform scenario, the
transition is likely to be as follows: the participation
of low skilled workers could decline as net wage
will be reduced. On the other hand, high skilled
labor supply effort could increase depending on
labor supply elasticity. Overall effect on output
will depend on high skilled labor supply response
(relatively scarce (Figure 5)), offsetting the adverse
impact on low skilled labor supply. Under this
scenario, the transition to the new Slovenian social
policy model could be less uncertain as the net
income level of high skilled workers will increase
instantaneously over-compensating the loss of real
purchasing power due to increase in VAT.
Disregarding practical-legal issues of implementing
the Slovenian flat tax reform proposal, even if the
tax reform starts from an induced disequilibrium
position in which gross wage is different than
productivity level, the market mechanisms will
drive the economy to a similar outcome as in the
case of the standard tax flat tax reform in which
the gross wage will remain at the pre-reform level.
Thus, the gross labor cost in equilibrium will not
be reduced as a result of implementing the
Slovenian f lat tax reform proposal (Figure 29).
Such an outcome is in line with the theory (which
indicates that in a market economy gross wage
equals marginal productivity; if not, government
could be able to tax infinitely) and with the
empirical evidence that suggests that there is a lack
of significant long-term influence of the tax wedge
on wage costs (Arpaia and Carone (2004)). The
Slovenian 2004 PIT reform and Slovakian flat tax
reform also indicate that net wages change after a
personal income tax reform.
While in equilibrium there will be no gross labor
cost unburdening in the process of adjustment to
the new equilibrium the performance of labor
intensive industries is likely to be adversely
affected. Notice in particular that under the
Slovenian f lat tax reform the employment-
weighted labor cost after the reform will increase
in the industrial sector which is the sector that
generates about 50% of value added in the
economy (Figure 30).
9 In a standard neo-classical world, where firms are maximizing their profits, the demand for labor is a function of the price of
labor.
10 In the case of rising VAT labor will try to protect its purchasing power by raising nominal wage rates, while firms facing
unchanged prices for their output will be very reluctant to concede such a wage rise. In this case the outcome, in terms of wage
inflation, must depend on the strength of the different parties to the bargaining process.
11 The adverse impact of VAT on prices of labor intensive industries is not taken into account here.
146     UMAR      IB revija  1-2/2006
Besides the issue of efficiency the other important
dimension to consider when assessing the impact
of the tax reform is equity. The impact of the flat
tax reform on equity can be assessed first, by looking
at the distribution of the tax burden on wages once
they have reached their equilibrium and second by
looking at the effect of the single VAT rate on
consumption according to individuals’ purchasing
power (net wage). Figure 31 shows the net tax
burden after the f lat tax reform per individual
ranked in terms of multiples of the average gross
wage in the economy. It indicates that after the reform
the tax burden per individual will be higher for
those taxed up to the average gross wage in the
economy while it will decline for those taxed above
the average gross wage (AW). In particular, the
average tax burden per individual will change as
follows: for 525.750 individuals earning up to 100%
AW the tax burden will increase by EUR 117; for
174.414 individuals earning above AW to 200% AW
the tax burden will decline by EUR 445 and; for
40.838 individuals earning above 200% AW the tax
burden will decline by EUR 4187.
Figure 32 shows the total net tax burden per total
number of individuals ranked by size of their wage.
It indicates that the tax burden will increase for
about 70% percent of tax payers and decrease for
the rest. The total net tax burden will decrease by
SIT 45 billions which should be financed by raising
the reduced VAT rate to the level of 20% (single
VAT rate).
The introduction of a single VAT rate will also
have welfare effects. The single VAT rate will
increase the effective VAT rate (i.e. the tax rate
weighted by structure of consumption) facing
individuals according to their income level. Figure
33 shows the current VAT (made up from two
rates) and the single VAT effective tax rates for
individuals classified in five income quintiles. It
shows that the effective tax rates rise for all
individuals but more adversely for those in lower
quintiles. The impact of changing the effective VAT
on consumption will depend on the short run on
which type of flat tax reform is considered. Under
the Slovenian proposal, the consumption for all
individuals (earning a salary or other type of
income (e.g. pensions) will decline. This could
have a negative impact on aggregate demand in
the short-term compounding the adverse effect on
labor demand for low skilled workers. Figure 34
shows in particular the impact on consumption
measured in tolars for individuals earning different
multiples of APW. In the case of standard flat tax
reform the consumption of those earning up to
100% APW will be reduced while it will
substantially increase for those individuals earning
above the average wage. At aggregate level private
consumption and aggregate demand could increase.
However, given high income earners’ lower
propensity to consume, the final outcome could
be higher savings and, potentially, investment.
In summary, there are six issues that should be
carefully assessed when introducing the flat tax
reform as planned: i) the cost of labor for the
employer is not likely to change in equilibrium,
thus there will be no competitive gains in absolute
terms (no reduction of gross labor cost); ii) the
labor supply response is undetermined as the tax
reform can discourage labor participation and
distimulate additional labor effort of low skilled
workers while create incentives for additional work
effort of high skilled workers; iii) output could
potentially expand in medium to long run
depending on labor supply response (high elasticity
of low skilled labor supply while relatively low
elasticity of high skilled labor supply). If net wage
is enforced administratively, severe adjustment can
take place in labor intensive industries; iv) the tax
burden will shift from high income earners (high
skilled) to low income earners (low skilled) or
about 70% of tax payers; v) incentives for higher
education attainment will improve (with unclear
effect on education attainment particularly in short-
term); vi) the reduction (elimination of progressive
taxes) and the single VAT rate will increase
inequality in the distribution of income and
consumption, thus the current Slovenian social
policy model will be abandoned.
4. The Way Forward: Searching For a
Win-win Situation
The Slovenian economy does not have major
structural problems beyond the long-term issue of
the ageing of population. Structural reforms can
contribute to enhance growth potential and the
capacity of response of the economy to the
challenges of globalization and the need of
increased productivity. Slovenian industry is very
much integrated to those in EU and because of
that the pace of overall industrial change is
primarily determined by our trading partners and
technological progress that is skill biased and
mainly demand driven. Thus the transformation
of the Slovenian economy towards a high skilled
economy should be balanced and carefully
planned. Education and training, efficient financial
system and SMS enterprises’ access to financing
are among the policies at the hart of this process.
Thus the economic transformation of Slovenia does
not deserve shock therapy that will result in
undermining current welfare situation but policy
reforms that build on status quo thus aiming at a
win-win situation.
IB revija 1-2/2006       UMAR    147
Radical changes can unnecessarily push vulnerable
segments of the economy that require
transformation off the cliff. The experience of other
countries in the EU on tax reform for example the
Danish reform, despite of starting from very high
tax rates, can come handy. The Danish economy
has undergone 12 years of systemic reform aiming
at reducing labor tax burden but at the same time
not hurting labor participation and labor incentives
(Figures 25 and 26). Progressive average and
marginal tax rates have been reduced carefully and
gradually based on tax broadening and alternative
taxes other than labor (e.g. Green taxes).
The way forward in PIT tax reform in Slovenia
should be to look for a win-win situation (i.e.
aiming at higher gains in efficiency and equity
(Figure 1). This could be pursued by considering
the following sequencing: first, the financing and
eventual speeding up of the elimination of payroll
tax should be ensured without creating fiscal
imbalances. The relative size of payroll tax revenue
is not insignificant (2% GDP). This measure will
effectively unburden enterprises as the payroll tax
is their direct cost; second, the impact of the
recently adopted personal income tax system (split
system) on average and marginal rates on high
skilled workers should be thoroughly assessed.
Based on such an assessment, further reform
directions should be devised; third, the reduction
of progressivity of PIT without compromising
distributional objectives (i.e. maintaining existing
Slovenian social policy model) could be pursued.
Such a search should ensure revenue neutrality,
avoiding the creation of labor market disincentives.
Thus Slovenia should pursue a Lisbon strategy
oriented tax reform that would not hinder (i.e. does
not burden) low skilled workers but would at the
same time increase effort of high skilled workers
(increase employment and growth). The gradual
lowering of average and marginal tax rates for low
and high skilled workers could be pursued taking
into account: a) a partially self-financed tax
reduction; b) introduction on tax on immovable
property and; reduction of general government
expenditure.
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