Opinion – Why? Economês in good Portuguese: What does a government program need to contain? Taxes, part 2

A country’s tax system can be used to reduce the population’s income disparity, in this case, by charging proportionately more to wealthier individuals. This issue is particularly relevant to the Brazilian economy, because of the high and persistent inequality found here. We will certainly hear candidates talking about the subject, some even with proposals in their government programs.

This text is the last of a series that we produced in this column about what government programs for candidates to the Presidency of the Republic would need to contain to deal with challenges of the Brazilian economy in several areas —fiscal policy, monetary policy, trade policy and taxes. In the previous text, we discussed aspects of the tax system associated with economic efficiency. Here we will talk about distributive effects of taxes. The idea is not to exhaust the subject, but to raise some points of discussion that will certainly be part of the government plans of the eventual presidential candidates.

What is a progressive tax system?

To make income distribution more equitable, a tax system needs to be progressive, that is, the richer a person is, the proportionally higher the tax owed by him or her. Note the word “proportionately”. This not only implies that the richest would pay more taxes, but that the higher a person’s income, the greater the payment of taxes as a share of their income.

Personal income tax has this characteristic. It is made up of income brackets. The tax that an individual pays depends on how far he is from the floor of the lane of which he is a part. The higher his income, the further he will be from this floor, and the more tax he will pay as a proportion of his income. In addition, the higher the range, the higher the rate charged, which contributes to making the tax more progressive. Most Brazilians (especially the poorest) are still exempt from paying income tax.

An important point in the discussion of government plans is whether the tax system could be more dependent on this type of tax and less on consumption and production taxes, which do not have this progressive feature. On the income tax side, this could involve raising tax rates, particularly in the higher income brackets; and the introduction of more bands, with much higher rates for the portion of the population with the highest incomes. This would make the income tax even more progressive, and make it possible to reduce taxation on consumption of production.

Deductions and exemptions

There are, however, some features of the income tax that play against its redistributive role. One of them has to do with deductions, mainly for health and education expenses. Today, they allow taxpayers to deduct a portion of their private spending on these income tax payment items. Who bears part of these private expenses, therefore, is the rest of society.

It is just that people who carry out such expenditures privately tend to be wealthier, as poorer individuals depend more on state provision of health and education. Deductions thus play against the progressive character of the income tax. Candidates will need to talk about them.

Another point that is much discussed in Brazil is the taxation of profits and dividends, exempt from income tax on individuals in Brazil – and it is precisely the richest people who tend to receive this way. But this does not mean that these resources are not taxed: they are subject to corporate income tax. The conversation about taxation of profits and dividends must take both sides into account.

Changes in this margin can still be useful to reduce the phenomenon of “pejotization”, in which Brazilians open companies and act as service providers for other companies, in the search to pay less taxes. This option is generally available to the wealthiest, again undermining the distributive objective of the tax system.

wealth tax

We are sure to hear about wealth taxes, a topic that is on the agenda all over the world. First of all, a clarification. Income refers to how much an individual earns per year. Wealth is an individual’s wealth, usually accumulated over time, which includes bank accounts, investments, real estate, etc. An individual’s income is income from wealth (eg, homeowners receive rental income; investors receive interest on their investments), plus income from work.

As wealth is even more unequally distributed than income, the wealth tax would tend to be more progressive. The inheritance tax would also enter this discussion, as it is a way of transmitting wealth between generations.

Potential costs

As we discussed in the previous text, taxes are necessary for the provision of public goods and services, but they trigger costs for society that go beyond the money that comes out of our pockets. These are the distortions that arise from the behavioral reaction of individuals to the higher tax. In the case of income and wealth taxation, this reaction tends to be stronger precisely for the richest individuals, who have more opportunities to take their wealth to countries with lower taxes. Some people may even seek jobs abroad if the taxation is excessive.

Distributive improvements would certainly be achieved through taxation on wealth, or through aggressive income tax rates for the very rich. But this would engender behavioral changes, bringing potentially high costs to society, which cannot be left out of the discussion of government plans.

Mauro Rodrigues (Economics professor at USP and author of the book “Under the magnifying glass of the economist”) and the Por Quê?