Tax and fiscal policies after the COVID-19 crisis

 2.1. Economic growth has slowed

Sustained periods of low economic growth undermine tax revenues and make it difficult to address spending pressures, maintain public debt sustainability, and – more generally – improve populations’ living standards. Productivity growth has decreased in the majority of G20 countries over the past decades. Possible causes of this slowdown include, among other factors, disappointing gains from recent innovation waves, likely due to some extent to adjustment costs and insufficient diffusion of new technologies and innovations across firms; a decline in business dynamism and reallocation of resources; and a levelling of educational attainments. The COVID-19 crisis could have positive effects on long-term productivity, for example by accelerating digitalisation, in particular the adoption of digital technologies by small and medium-sized businesses in services sectors. However, large recessions can have long-lasting and negative effects on productivity, including on the productivity of labour market entrants. As past crises have shown, even if some scarring effects could be mitigated by well-designed temporary job-retention schemes that support productivity-enhancing job reallocation (Andrews et al., 2020[1]; Andrews, Charlton and Moore, 2021[2]; von Wachter, 2020[3]).1 In the case of the COVID-19 crisis, disruptions in education are likely to reduce skills, productivity and earnings of the current students, with possible negative effects on future GDP (Hanushek and Woessmann, 2020[4]).

Higher economic growth would lower the debt-to-GDP ratio on its own. Towards this end, governments should implement ambitious structural reforms to boost potential growth (OECD, 2021[5]). However, the experience from the past decade suggests that achieving higher growth quickly through structural reforms may be challenging without monetary and fiscal support. The sequencing of reforms will be particularly important to help the economic recovery gain traction, which implies starting with reforms that do not dampen aggregate demand in the near term and work particularly well in periods of economic slack. Such reforms include lowering regulatory barriers to entry in professional services or strengthening active labour market policies and expanding access to childcare and family benefits to promote labour force participation. Enhancing activation and skills acquisition, as well as facilitating competition and business entry and exit, will also improve labour market opportunities for all and help to foster productivity‑enhancing reallocation.

Public investment can also support long-term growth if it allows for the accumulation of productive capital (Bom and Ligthart, 2014[6]). In addition, public investment in sectors that have large positive externalities for the rest of the economy could help to meet important social and environmental objectives, where market failures (among other factors) cause underinvestment by the private sector, and boost potential growth (Égert, Botev and Turner, 2019[7]; Hendren and Sprung-Keyser, 2020[8]). This applies in particular to public infrastructure investment in digital networks, transportation and energy, and in education and health care. Public investment in these areas can improve productivity and be an important source of new jobs for displaced workers – provided there is adequate support for the transition, while helping to support demand as they usually have strong multipliers (Pain et al., 2018[9]). Current very low, and in some cases negative, bond yields make public investment particularly attractive. In this context, the initiatives in the European Union and the United States are welcome.2

There are, however, a number of challenges that can hinder public investment. These difficulties may include the need for co‑ordination across sectors, jurisdictions and governmental bodies; having sufficient capacity to design and implement investment strategies; and framework conditions related to good practices in budgeting, procurement and regulatory quality. Governments can improve the governance framework for infrastructure spending by moving to OECD best-practice principles in this area (OECD, 2017[10]).

 2.2. Digitalisation is accelerating

The digitalisation of the economy has been ongoing for several decades and is being accelerated by the COVID-19 crisis. While offering opportunities to enhance productivity and long-term growth with subsequent benefits for tax revenues and debt sustainability, digitalisation also poses challenges. For instance, a key challenge is that skills to use digital technologies are crucial in a more digitalised world, increasing the importance of public spending on education and lifelong learning (Gal et al., 2019[11]; OECD, 2019[12]). Digitalisation also affects workers through the rise of the “gig economy” which offers flexible business models but can result in tax distortions and gaps in social protection systems (Milanez and Bratta, 2019[13]; OECD, 2018[14]). In addition, specific features of digital markets that are conducive to a “winner‑takes-most” dynamic can contribute to the concentration of activities among a small number of highly profitable and intangible-intensive “superstar” firms, posing challenges for competition policy and corporate taxation (OECD, 2018[15]). Finally, school closures during the pandemic have also highlighted remaining gaps in access, quality and use of digital resources for learning by, and teaching of, children and students, requiring means to level up digitalisation take-up (OECD, 2021[16]).

Fiscal policy will need to adapt to a digitalising world, which imposes new pressures and constraints on social protection systems and income tax bases. Improving broadband connectivity, helping firms to develop online business models, enhancing acquisition of digital skills, and ensuring secure online payments and data privacy, are all areas of reform that would help to foster the digital transformation and ensure that poorer households, small firms and remote regions also have access and can benefit. Digitalisation thus provides opportunities for progress that fiscal policy can and should harness, as it will require investment in infrastructure and skills (OECD, 2019[17]; OECD, 2019[18]), while allowing for more efficient public administration and enhanced tax compliance (big data are for example increasingly used by tax administrations to combat tax fraud) (OECD, 2021[19]).

Good progress is being made through the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) to address the tax challenges arising from the digitalisation of the economy. The “Statement on a Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy” of 1 July 2021 (OECD, 2021[20]), which has been agreed to by 134 jurisdictions, marks a significant development in multilateral efforts to reform the international tax rules and ensure that they are “fit-for-purpose” in the modern economy. Under the two-pillar package, Pillar One seeks to ensure a fairer distribution of taxing rights among countries with respect to the largest and most profitable multinational enterprises (MNEs), including digital companies. It would re-allocate some taxing rights over MNEs from their home countries to the markets where they have business activities and earn profits, regardless of whether firms have a physical presence there. Pillar Two seeks to put a floor on competition over corporate income tax, through the introduction of a global minimum corporate tax rate that countries can use to protect their tax bases.

 2.3. Inequalities are rising

Increasing inequality across different economic and social dimensions adds pressures on government social programmes and undermines growth and political stability. Top income and wealth shares have grown notably in most OECD countries since the 1980s, and the incomes of the poorest 50% of the distribution have stagnated in many of the richer nations (Balestra and Tonkin, 2018[21]; Alvaredo, 2018[22]). G20 emerging-market economies are still home to almost half of the world’s people living in poverty (OECD/UNDP, 2020[23]).

Furthermore, in many G20 countries, real incomes of the lower and middle-classes have stagnated given higher consumer price inflation than wage inflation. Particularly strong inflation in education, energy, healthcare and housing costs has added to constrained opportunities for social mobility (OECD, 2018[24]; OECD, 2019[25]). The low-carbon transition will potentially create energy affordability concerns, at least in the short run, in particular for lower- and middle-income households that will need to be addressed.

The increase in inequality within advanced economies is partly due to automation and globalisation, which have affected the distribution of market incomes, inequality of opportunities and tax and transfer systems that have been less effective from a redistributive perspective (Causa, Browne and Vindics, 2019[26]). The COVID-19 crisis is likely to exacerbate economic inequalities in the medium to long‑run as its impacts have been disproportionately felt by already vulnerable groups, such as the young, low-skilled and women (OECD, 2020[27]). For example, school closures during the crisis have had a relatively more negative impact on the education of children from disadvantaged backgrounds, likely increasing the gap between their future employment opportunities (and earnings potential) and those from more affluent backgrounds (OECD, 2021[28]; Hanushek and Woessmann, 2020[4]).

Fiscal policy can address different forms of inequality, not only via a progressive tax and transfer system but also by promoting greater equality of opportunities. Inequality can be tackled by improving access to high‑quality education, health care, affordable housing and lifelong training programmes (O’Reilly, 2018[29]). The tax system can play a role in improving levels of inequality both before and after tax. For example, changes in inheritance taxation, such as limiting generous and regressive tax exemptions, could partially address wealth inequality while raising revenue for additional social spending (OECD, 2021[30]; Blanchard and Rodrik, 2021[31]). Adapting the support given to low-income households as countries emerge from the COVID-19 pandemic is likely to be an important component of government policy responses as they seek to tackle poverty and income inequality. In particular, including non-standard forms of work within the coverage of traditional social protection systems would strengthen equity (Milanez and Bratta, 2019[13]). A number of G20 and OECD governments have also recently increased income taxes and/or enacted wealth taxes on the highest earners and wealthiest households to increase revenue (OECD, 2021[32]).3 This suggests that there is space available to increase the progressivity of the tax system in some countries in response to rising inequalities.

Tax policy also needs to reflect ongoing challenges and progress in international co-operation on taxation. Broadening tax bases and improving compliance might be a way to increase tax collection and reduce the negative fiscal and social consequences of tax avoidance. For example, capital taxation may gain greater importance in future tax systems as the potential for more effective taxation of capital incomes has been enhanced by the implementation of the automatic exchange of taxpayer information (AEOI). The AEOI has ensured that countries now have increased tools available to detect any offshore assets and income (O’Reilly, Parra Ramirez and Stemmer, 2019[33]). Increasing the resources of tax administrations could boost tax revenues significantly and, likely, in a progressive way (Sarin and Summers, 2019[34]; Alstadsaeter, Johannesen and Zucman, 2019[35]; Londoño-Vélez and Ávila-Mahecha, 2021[36]).

 2.4. Populations are ageing

In most G20 countries, populations are ageing, in particular in high income economies, resulting from declining fertility and increases in life expectancy (UN DESA, 2020[37]). This process puts strong upward pressure on public spending related to pensions, health care and long-term care (Rouzet et al., 2019[38]). According to the OECD long-term projections, the median OECD country would require an increase in structural revenue of 8 percentage points of GDP by 2060 to stabilise public debt ratios near current levels, mostly due to higher expenditures linked to population ageing (see Figure 1).

 

Figure 1. The contribution of population ageing to future fiscal pressures is considerable in most OECD countries

Improvement in the underlying primary balance that would be required to offset projected fiscal costs related to population ageing between 2021 and 2060 (% of potential GDP)

Note: The chart shows the ratio of structural primary revenue to GDP must evolve between 2021 and 2060 to keep the gross debt-to-GDP ratio stable near its projected 2022 value over the projection period (which also implies a stable net debt-to-GDP ratio given the assumption that government financial assets remain stable as a share of GDP). The underlying projected growth rates, interest rates, etc., are from the baseline long-term scenario presented in Guillemette and Turner (2021[41]). Expenditure on temporary support programmes during the COVID pandemic are assumed to decline to zero within a few years. The component “Interest on COVID legacy debt” approximates the permanent increase in interest payments due to the COVID-related increase in public debt between 2019 and 2022. The component “Other factors” mostly reflects the correction of any initial disequilibrium between the 2021 structural primary balance and the one that would stabilise the debt ratio.

Source: Guillemette and Turner (2021[41]), “The Long Game: Fiscal Outlooks to 2060 Underline Need for Structural Reforms”, OECD Economics Department Policy Papers n°29, forthcoming.

One of the most effective ways of alleviating future fiscal pressures stemming from population ageing would be to undertake reforms to labour market policies and public pension programmes that raise employment rates and extend working lives (Rouzet et al., 2019[38]). Improving active labour market participation is likely to require changes in tax and spending policies to enhance financial incentives to work, such as by reducing marginal tax rates for second earners, and providing employment support services, including affordable, quality childcare provision. Another effective way would be to index long‑term fiscal programmes to their underlying drivers, such as life expectancy in the case of pensions, which can also help reduce fiscal uncertainty (Orszag, Rubin and Stiglitz, 2021[39]). Many countries have already moved in this direction (such as Denmark), although some of them have later seen some reform reversals (OECD, 2019[40]). According to stylised OECD simulations wherein OECD countries undertake ambitious labour market reforms and increase effective retirement ages, fiscal pressure in 2060 could be reduced substantially relative to a no-reform scenario, by between 2 and 8 percentage points of GDP (Guillemette and Turner, 2021[41]). The fiscal dividends would mostly accrue due to longer working lives reducing future pension and other primary expenditure as a share of GDP, with much less impact on health expenditure.

Countries will also need to consider how they ensure the sustainable financing of health systems. Where health financing currently relies strongly upon health social security contributions, the impact of an increasing share of older persons living beyond their working life may require new approaches to health financing. There is a limit to the extent that higher health (and pension) expenditure can be financed by increasing social security contribution (SSC) rates, as this will increase the tax-inclusive price of labour and price certain types of (in particular lower-productive) workers out of the labour market. Therefore, countries may want to consider a partial shift in the funding of health funds away from SSCs towards (less distortive types of) general taxation, in particular because the link between health contributions and health benefits received is weak. The financing of health could also be supported by greater reliance on well-designed health taxes (on alcohol, tobacco, sugar, pesticides, etc.), which could play a more central role in the tax system to help strengthen the resilience of health systems to the ageing of their populations. These taxes have significant revenue potential, including in developing countries. In addition, if these health taxes can support a healthier workforce, they could deliver additional benefits of greater productivity, longer participation in the labour market and a greener and healthier natural environment.

 2.5. Environmental sustainability and climate change call for urgent change

Climate change risks dire social and economic consequences. While the precise nature of the negative effects of climate change are uncertain, frequent extreme climate events (e.g. climate catastrophes) have the potential to reduce economic growth, increase its volatility and undermine political stability, with the destruction of physical infrastructure, disruptions to production, and population migration (Office for Budget Responsibility, 2021[42]). Such conditions could undermine fiscal sustainability as they would require, among other things, extra spending in response to climate events, as well as on social benefits and health care and would erode certain tax bases.

Mitigating climate change and associated negative risks calls for urgent action across a wide range of policy areas, with tax and government spending playing a key role. A crucial priority for the coming decades is to reduce carbon emissions, with an objective of net zero emissions by the middle of the century. The transition to a low-carbon economy could offer new opportunities for growth, improvements in the quality of life, new sources of government revenues and could bring a range of significant longer‑term benefits. However, it may also create disruptions to current business models and require substantial financial resources during the transition.

• Effective pricing of harmful emissions and polluting activities, through either taxes or cap-and-trade systems of emissions permits, is needed. Ambitious emissions pricing could raise large amounts of revenue in the short and medium terms, however the resulting lower consumption of fossil fuels, particularly in the transport sector, could also reduce tax revenues (Marten and van Dender, 2019[43]).4 Fossil fuel subsidies also continue to distort price signals and weigh on public budgets, and should be phased out.

• Fiscal policy could directly support environmental sustainability through fiscal incentives to R&D, direct grants, public research and support for early-stage development (OECD, 2011[44]; Hepburn, Pless and Popp, 2018[45]), as well as new infrastructure investment projects, including expanding and modernising electricity grids, renewables capacity and transport network.

• All such steps would need to be accompanied by a package of compensating measures to mitigate the adverse impact on poorer households, affected regions and small businesses, and to help displaced workers acquire new skills and take advantage of new employment opportunities, and consequently ensure public acceptance.5 They will also require international co-ordination due to the potential for emissions leakages (e.g. through supply chains) and the implications of tax and subsidies for countries’ competitiveness.

Efforts to significantly reduce climate change need to be complemented with measures to build resilience to climate change induced impacts. Even if global average temperature increases are limited to below 2°C, there will still be serious climate impacts. This implies that mitigation and adaptation are complementary, and adaptation can reduce the earliest costs of climate change (OECD, 2015[46]). Measures to adapt to climate change will be indispensable to not only safeguard lives and secure livelihoods, but also to contain rising inequalities exacerbated by a changing climate (Gamper and Lamhauge, 2021[47]). Such conditions will require, among other things, protective measures for vulnerable communities and infrastructure. However, climate adaptation measures should not undermine investment in mitigation as this would ultimately worsen the medium to long-term impact of climate change (Gamper and Rambali, 2021[48]).

 3.1. Growth-friendly tax policies

Tax policies to support inclusive and sustainable economic growth beyond COVID-19 will need to support the efficient use of productive factors, by encouraging labour market participation and skills development, and by increasing business investment, productivity growth and diffusion.

Structural trends and challenges are prompting a reconsideration of the relationship between tax design, investment and economic growth. While the literature on the impact of taxation and growth is long-standing, recent structural trends are prompting a rethink. Continued globalisation, through expansion in foreign direct investment (FDI) and deepening global value chains (GVCs), changing patterns of market concentration, and substantial changes to the international tax system all require a deeper analysis of the relationship between tax and investment, including of its international aspects, as well as how it varies across firms. There is also a need to understand how investment can support climate goals. Ageing societies, increased geographic worker mobility, and the growth of non-standard work are also prompting a reconsideration of the role of labour tax systems, focusing not only on the quantity of labour supply, but who supplies it, how, where and in what form. Skill-biased technological change, digitalisation, and automation all highlight the important role of human capital investment. The productivity slowdown, the rising role of intangibles, as well as concerns about productivity dispersion across firms, highlight the importance of considering how tax policies can support productivity growth, innovation, productivity diffusion, and business dynamism.

 3.2. Tax policies for equitable societies

Tax policy can play an important role in enhancing equity. Tax policies play a key role in addressing income inequality, along with direct transfers. To a lesser extent, tax policies are also used to address wealth inequality (OECD, 2018[118]). Beyond their role in narrowing income and wealth gaps, recent work has emphasised the role of tax policy in enhancing intergenerational equity, equality of opportunity (OECD, 2021[30]), and gender equality (Harding et al., Forthcoming[119]). Ultimately, tax policies that support greater equity can also contribute to economic growth and political stability (Cingano, 2014[120]; Alesina and Perotti, 1996[121]).

With rising public revenue needs and increasing inequalities since the start of the pandemic, taxes on personal capital income and property will likely need to play a bigger role in the future. The crisis has left countries with high budget deficits and significant increases in public debt levels (see Section 2). At the same time, the crisis has exacerbated some existing inequalities and hit many vulnerable households hardest (see Section 2.3). In this context, raising taxes on labour and consumption, as was done in the wake of the 2008 global financial crisis, might be less desirable from an equity and growth perspective and very difficult politically. Thus, the current crisis is prompting reflection on the need to turn to new or under-utilised sources of revenue. Taxes on personal capital income and property are among the taxes that governments are reconsidering (OECD, 2021[32]) given their potentially significant role in reducing inequality and their currently limited role in most countries’ tax mixes (OECD, 2020[122]).

There has been an increasing focus in particular on the taxation of top income earners and wealth holders (OECD, 2021[32]). This is partly explained by recent studies showing very low effective tax rates at the top of the income and the wealth distribution, especially with respect to capital gains and foreign source income (Advani and Summers, 2020[123]; Fairfield and Jorratt De Luis, 2015[124]; Cooper et al., 2016[125]; Londoño-Vélez and Ávila-Mahecha, 2021[36]) and new evidence on the extent of tax arbitrage and income-shifting among owners of closely-held entities (Cooper et al., 2016[125]; Smith, Pope and Miller, 2019[126]). Recent analysis has also shed light on tax evasion by wealthy taxpayers (Alstadsæter, Johannesen and Zucman, 2019[127]). Growing interest in top income and wealth taxation has also been encouraged by recent analysis suggesting that distortions to the real economy from the taxation of personal capital income are relatively limited (Kari, Karikallio and Pirttilä, 2009[88]; Alstadsæter, Jacob and Michaely, 2017[89]; Yagan, 2015[87]) and that tax cuts on wealthy households in recent decades have not had the anticipated growth-enhancing effects (Hope and Limberg, 2020[128]).

Removing regressive tax expenditures is crucial, but more work is needed to help strengthen the effective taxation of top income earners and wealth holders. Previous OECD work has highlighted the role of tax expenditures in personal income and property taxation, which can have regressive effects and lower effective tax rates for taxpayers at the top-end of the distribution (OECD, 2018[129]), but further work on the use and prevalence of tax arbitrage and avoidance opportunities is needed. This will require carefully measuring the effective tax burden on households at the top of the income and the wealth distribution, and examining the drivers of lower effective tax rates on top income earners and wealth holders.

Raising top personal income tax rates will have limited effectiveness, if loopholes and arbitrage opportunities continue to allow those with the highest levels of income and wealth to shield their income from personal income tax. Apart from reducing the revenue-raising potential and fairness of existing tax systems, tax arbitrage and avoidance opportunities could render increases of top PIT rates largely ineffective if the income of the wealthy remains beyond the reach of the PIT system. A better understanding of existing tax arbitrage and avoidance opportunities, including those with a cross-border dimension, will be key to identifying reform options that could strengthen the effective taxation of the wealthiest households and ultimately ensure that they pay their fair share of tax.

Importantly, the potential for a more effective taxation of personal capital income and assets has been enhanced by the progress made on international tax transparency. The development of the automatic exchange of information between tax authorities over the last decade has increased the tools available to governments to detect any offshore assets and income and has reduced the opportunities for taxpayers to evade taxes by shifting assets abroad (O’Reilly, Parra Ramirez and Stemmer, 2019[33]).

Tax systems also need to provide adequate income support and enhance economic opportunities for those at the bottom. Tax measures, in combination with direct transfers, should be used to provide income support to households, which in some cases may need to be reinforced post-pandemic. In addition, tax measures could be used to enhance the longer-term economic opportunities and prospects of low‑income and vulnerable groups. For instance, tax measures that encourage employment, labour market participation and upskilling could contribute to reducing unemployment and addressing labour mismatches. Tax support measures should be carefully targeted, however, to contain costs for governments and ensure that they reach their intended targets. Indeed, there is evidence that tax incentives can lead to little additionality and be regressive when they are not targeted (OECD, 2017[130]). Such measures should therefore focus on those with low incomes and low levels of labour market attachment.

Tax systems can have profound implications for gender equality. Tax policy and social security systems have an important role to play in closing gender gaps, and this not only through a progressive tax system. High tax burdens on second earners can have a significant impact on the incentives for female labour force participation. This, in combination with social norms and a lack of adequate childcare, can lead not only to employment and pay gaps but also pension gaps in the long run. Women also often have lower incomes and less capital wealth than men. The design of public policy, including on tax issues, needs to account for these gender differences and should be reflective of inclusive societies.

Many developing countries have a large degree of informal employment that escapes taxation and regulation. Informal employment makes it difficult to provide sufficient social protection for workers and undermines tax collection efforts, often leading to high tax rates being imposed on those in formal employment or poor-quality government services. Informal markets can also result in unfair competition between sectors and inefficient production methods, and may even encourage illegal migration. Social protection systems in economies with a large informal sector are therefore often relatively ineffective because of contribution evasion by low-risk groups and a lack of coverage for the most disadvantaged working-age population groups.

Particular attention should also be paid to the distributional effects of taxes and the possible need for compensation measures. Assessing the distributional effects of tax measures or reforms is particularly important for taxes that are not linked to income, such as consumption, property and carbon taxes. Correctly assessing distributional effects also requires a careful examination of the final tax incidence of potential reforms as the taxpayers directly paying the tax may not be the ones ultimately bearing the burden of the tax. Compensation mechanisms may also be necessary to offset the distributional and poverty impacts of certain tax reforms on low-income households (e.g. carbon tax rate increases – see Section 3.3).

In the longer run, a priority will be to ensure that tax systems are adapted to future challenges and can continue to deliver on their equity objectives. Indeed, structural trends that are shaping the future, including automation and digitalisation, could make it more difficult for tax systems to achieve their equity objectives if reforms are not undertaken.

Automation could contribute to increasing inequalities and affect tax systems. With automation, new and more productive jobs are being generated, but many existing jobs will disappear and some skills will become obsolete. Skill-biased technological change has already led to growing wage gaps and employment polarisation (Autor, Levy and Murnane, 2003[131]; Michaels, Natraj and Van Reenen, 2014[132]). Tax systems could reinforce the speed of automation when taxes on labour exceed taxes on capital. While tax support for automation may help enhance productivity (see Section 2), it could further reinforce inequality in the future. Automation could also have an impact on tax revenues if labour tax bases are eroded as a result of growing levels of unemployment. This would affect public finance sustainability more widely given countries’ high reliance on labour taxes. However, the evidence on the impact of automation on unemployment is mixed (Frey and Osborne, 2017[133]; Nedelkoska and Quintini, 2018[134]), so potential impacts on tax revenues remain unclear. Overall, a careful assessment of the links between automation and tax systems is needed to assess potential impacts on productivity, inequality and tax revenues.

Digitalisation is facilitating new forms of work, which present new challenges for taxation. A challenge for the taxation of labour income in an increasingly digitalised economy is the rising share of the workforce earning some or all of their income outside of traditional employee-employer relationships. Indeed, new technologies are facilitating the rise of non-standard or “gig” work, though the share of the population engaged in non-standard work arrangements remains relatively limited (OECD, 2019[135]). This may create particular challenges for social protection and tax systems in the future. Entitlements to social protection may diminish if individuals’ SSC contribution histories become irregular, reducing their entitlements and lowering social protection, for example with respect to unemployment, disability and retirement (OECD, 2015[136]), which may be particularly problematic given the higher share of vulnerable workers in non-standard jobs (OECD, 2020[137]). Reduced contributions may also undermine the fiscal sustainability of social insurance systems. In many countries, self-employed workers pay SSCs at lower rates compared to standard employees. Increases in self-employment could therefore lead to substantially lower SSC revenues in the absence of reforms. A greater number of self-employed/gig workers may also be associated with a reduction in SSC and income tax compliance.

Digitalisation is also increasing international taxpayer mobility, which could hinder the functioning of personal tax systems. The mobility of wealthy taxpayers has been a longstanding issue, but digitalisation is exacerbating risks of tax-related migration. Indeed, digitalisation has led to more mobile forms of work, including teleworking as well as new jobs that can be performed from anywhere (e.g. digital nomads), which could in turn enable individuals, particularly wealthy ones, to relocate more easily where taxation is more favourable. However, risks of increased mobility and PIT and SSC base erosion are difficult to assess and will likely vary widely across countries, sectors and types of jobs, and depend on other factors, including how widespread teleworking remains after the pandemic. Risks of increased mobility could nevertheless have significant implications for both tax revenues and equity, given that tax burdens could end up bearing more heavily on less mobile, and typically less wealthy, individuals. Thus, work should be done to assess these risks and start identifying policy options that could help ensure that tax systems are adapted to a world where individuals are increasingly mobile.

 3.3. Taxation for a sustainable environment

Limiting the adverse consequences of the major environmental challenges requires deep structural change. Addressing climate change, loss of biodiversity, and air and water pollution now is a policy priority. Curbing climate change involves reducing greenhouse gas (GHG) emissions to net-zero by around the middle of the century. To be on track for that goal, emissions of carbon dioxide (CO2) and other GHGs must be cut by a quarter to a half below 2019 levels by 2030 to put the world on an emissions pathway consistent with climate stabilisation targets.

Reaching greenhouse gas abatement goals requires a strong and coherent mix of regulations and incentive-based policies. The market failures involved with climate change are many, and responses require a combination of policy instruments. In addition, the political economy of climate policy is challenging and will become more so as ambitions increase. This calls for policy approaches that seek a balance between effectiveness, efficiency and what is publicly acceptable.

Tax policy can create incentives to reduce greenhouse gas emissions through favourable treatment of environmentally appealing technologies or behaviours, and by pricing greenhouse gas emissions. Apart from carbon taxes, emissions trading systems can also result in prices on pollution. If done well, pricing pollution is a strong environment policy principle because prices, from taxes or emissions trading systems, create ongoing incentives for cost-effective reduction of pollution, mobilise private investment, reduce rebound effects, and mobilise government revenues. The choice for taxing or trading is driven by political and administrative factors. Taxes are relatively more straightforward to implement and result in more stable prices. Trading systems tend to be easier politically, particularly in industry and electricity where a relatively small number of large emitters is targeted.

Current carbon prices on the whole fall well short of their potential. The OECD’s Effective Carbon Rates track, for OECD and G20 countries, the explicit carbon prices from carbon taxes and prices of tradable emission permits and the implicit carbon prices resulting from fuel excise taxes (OECD, 2021[138]). The main findings are that around 60% of energy-related CO2 emissions are not priced at all, either via a carbon tax, an ETS or an excise tax. Where there are prices, they are often low and they differ strongly across countries, sectors, fuels and emitters. Rates are lowest in the industry and electricity sectors, and are further weakened by fossil fuel support and where free permit allocation rules provide an advantage to carbon-intensive technologies. While the level of increased policy action needed varies from country to country, depending upon their level of ambition, energy mixes, and different starting points, the IMF estimates that reaching the emissions abatement objectives defined in nationally determined contributions requires measures equivalent to explicit carbon price increases of around USD 75/tCO2 or more by 2030 in the majority of G20 countries.

Tax and fiscal policy has a key role to play in shaping the distributional impact of environment policy, through the design of the environmental taxes themselves or – usually better – accompanying policies (targeted or broad transfers, selective PIT and CIT cuts, etc.). For this reason, deciding on the use of revenues from environmental taxes should be an integral element of the policy design challenge.

Environmental taxes can be regressive, but even when they are not they can still have disproportionate effects on vulnerable groups. In high-income economies, road fuel taxes tend to affect middle-income deciles more strongly than those with the lowest and highest incomes; taxes on heating fuels tend to be roughly proportional; and electricity taxes tend to be regressive. In lower income economies, road fuel taxes tend to be progressive given prevailing car ownership patterns, but by the same token, they may reduce accessibility to car ownership. Even a progressive tax can increase poverty risk for certain vulnerable groups. Evidence from selected OECD countries suggests that it takes about one third of the revenue from a tax increase on domestic energy use to avoid worsening energy affordability. In low income countries, reducing subsidies can result in strongly increased poverty risk, and this has induced governments to maintain subsidies for fuels used particularly by the poorest, e.g. kerosene. Removing these subsidies could increase poverty and push households towards informal fuels, with potentially worse impacts on health and the environment.

Transfers or other flanking tax reforms can make reforms progressive and increase energy affordability, but there is evidence that this may not always suffice to change perceptions, particularly where trust in government is low. Offering alternatives for highly taxed consumption patterns has strong potential to improve public support. Examples include situations where public transport is not a viable alternative to car use, while low-carbon cars are expensive and charging infrastructure is limited; or where investment in better insulation and more efficient heating systems are out of reach in response to higher heating costs. Using revenues from higher taxes to make alternatives more affordable is an option worth considering. In addition, given long lead times for some investments, gradual tax increases may be preferable.

Concerns about competitiveness, carbon leakage and free-riding make it difficult to advance with carbon pricing in trade exposed and energy-intensive industries. Existing measures to address competitiveness and leakage impacts of carbon pricing (e.g., free allowance allocations) become less effective with deeper decarbonisation. Pressure for border carbon adjustments (BCAs) to address competitiveness and leakage concerns is emerging with greater dispersion in explicit carbon prices across jurisdictions for carbon-intensive and trade-exposed sectors. International co-ordination, for example over minimum carbon prices, is potentially effective, though co-ordination needs to be equitable (accounting for countries differentiated responsibilities and respective capabilities) and pragmatic (recognising national circumstances), meaning also that it needs to take a broader view of mitigation efforts, going beyond explicit carbon prices from carbon taxes and emissions trading systems, considering in addition implicit carbon prices from a variety of mitigation policies.

There is a need for improved measurement of different mitigation policy instruments and approaches. At the G20 High Level Tax Symposium held in Venice on 9 July 2020, Ministers observed a relative dearth of comparable data on the stringency of greenhouse gas mitigation policies across countries where these take the form of implicit carbon prices. Explicit carbon prices are relatively well mapped and understood, but in order to achieve a more complete picture of the state of mitigation policies for the purposes of cross-country comparisons, a stocktake of mitigation policies other than through explicit pricing instruments is needed, and where possible their implicit carbon-price equivalent estimated.

The G20 is well placed to ensure the coherence of mitigation policies differentiated across countries, taking into account that the ultimate collective goal of net-zero emissions can only be reached with patterns and speed of adjustment that align with country-specific circumstances. Developing and sharing metrics and indicators on policy approaches is a pre-requisite to paving the way for common approaches at the international level. Assessing the relative merits of different responses to negative international spillovers – ranging from “carbon border adjustment mechanisms” to “carbon pricing floor agreements” and broader “climate clubs” – will help to strengthen co-operation with a view towards reaching our common climate goals.

 3.4. Tax policy challenges faced by developing countries

In April 2021, the G20 reaffirmed its engagement to support developing jurisdictions in strengthening the capacity to build sustainable tax revenue bases. The COVID-19 pandemic has had a huge impact on the health of both people and economies, with developing countries hit the hardest. For developing countries with limited fiscal space and heavy debt burdens, balancing the need to provide income support and collect revenue to finance spending has been extremely challenging.

This report provides valuable context, as the need to focus on domestic resource mobilisation is particularly acute in developing countries where tax revenues were already low as a share of GDP prior to the COVID-19 crisis. Many developing countries need to raise more tax revenues to finance the sustainable development goals (SDGs). Improving tax policy so that it is aligned to SDG financing strategies is an increasing priority for many countries to ensure vital public goods, such as skills development and education, health and infrastructure are properly funded and so that social protection is available to all citizens. As the Addis Action Agenda underlines, tax revenues are the only viable source for the financing of the vast majority of public goods and will be essential for the realisation of the SDGs. This is reflected in many developing countries’ medium- and long-term strategies for financing the SDGs.

Developing countries often have large informal sectors that narrow the tax base and put tax revenues under pressure. While informality is a multidimensional phenomenon, tax policy together with social protection and labour market policy can have both direct and indirect effects on its reduction. High levels of informality can create a vicious circle of high tax rates paid by formal sector workers and businesses, creating incentives for them to operate partially or fully in the informal sector, and in turn increasing the need for governments to raise statutory tax rates further. Developing countries therefore typically face narrow tax bases and high tax rates, which reduces the tax revenues available to finance public good provision. Significant opportunities exist to improve the design of simplified and presumptive tax regimes that can induce informal businesses and workers to enter the formal sector and formal businesses to continue growing in the regular economy.

Investment tax incentives may reduce tax revenues and thus limit efforts to mobilise domestic resources and progress towards the SDGs. Forgone revenue resulting from tax incentives is of particular concern when the incentives do not attract additional investment, and rather result in windfall gains to investors for projects that would have taken place in the absence of the incentives. Reforms to improve tax incentive design and limit the use of wasteful and redundant tax incentives is therefore crucial6.

COVID-19 has thrown into sharp relief the need for tax systems to support the financing of robust and responsive health systems in developing countries, particularly in times of crisis. Health financing presents a range of challenges including the design and use of SSCs and the role of taxation to encourage healthier behaviour. In many developing countries, public expenditure on health is comparatively low as a share of GDP, necessitating a high share of private expenditures on health-care, which can be both regressive and inequitable, leaving many without adequate healthcare. Restricted public financing also limits the ability of the health system to develop capacity to respond to increasing healthcare needs in the community. Improving health financing through the tax system requires careful consideration of the design and use of health SSCs, through broadening the contribution base, ensuring adequate rates, and promoting formal labour force participation. Improving the design of taxes with strong links to the health sector can also contribute to the financing of health systems, such as on products that are harmful to health such as tobacco and alcohol consumption. Environmentally related taxes that help reduce pollution can also play an important role in boosting public revenues as well as reducing harmful product consumption; as can other health related taxes, such as taxes on sugar, which are increasingly being considered.

Significant scope exists to strengthen the functioning and design of VAT systems in developing countries. In particular, reform to increase the efficiency and the revenue-raising capacity of VAT systems could be considered by reducing the significant number of VAT exemptions and reduced VAT rates that exist in many developing economies. Strong e-commerce growth is also creating increasingly important challenges for VAT regimes in developing countries. The main VAT challenges relate to the strong growth in online sales of services and digital products to private consumers (such as "apps", music and movie streaming, gaming, ride-hailing, etc.) and to the exponential growth in online sales of low-value imported goods, often by foreign sellers, on which VAT is not collected effectively under existing rules. To support developing economies wishing to implement the OECD standards for addressing the VAT challenges of digital trade, the OECD together with the World Bank Group and other partner organisations is developing VAT Digital Toolkits that provide detailed guidance for the implementation of a comprehensive VAT strategy directed at e-commerce. These Toolkits are based on the internationally agreed OECD policy framework and draws on the expertise and best practices from jurisdictions that have already successfully implemented these standards.

Developing countries are increasingly vocal that greening the tax system and addressing the challenges posed by climate change are a priority for future global tax policy discussions. Developing countries that are reliant on fossil fuels will need to urgently design strategic policies to navigate the energy transition and to intensify investments into economic sectors that will deliver sustainable economic growth and tax revenue. This includes eliminating wasteful fossil fuel subsidies and increasing environmentally related taxes and carbon pricing through carbon taxes or emissions trading systems. These measures will need to be accompanied by policies to ensure energy affordability.

Many developing countries also have opportunities to improve the design and implementation of personal income and property taxes. Broadening the base of personal income taxes and strengthening the overall progressivity of these taxes will be an important part of the tax policy debate in developing countries over the coming years. The potential for more effective taxation of capital incomes in developing countries has also been enhanced by the implementation of the automatic exchange of taxpayer information.

Developing countries should prioritise to abolish and redesign poorly targeted and ineffective tax expenditures. Many developing countries have narrow tax bases as a result of a wide range of special tax provisions. These provisions are often not well designed nor targeted, and are often beneficial to households and firms that need the support the least. As well as improving the equity of the tax system, broadening the tax base and improving the design of tax expenditures will be important to improve tax revenues. A crucial step in this process is developing an annual tax expenditure report that lists all tax expenditures and calculates their tax revenue foregone and, possibly, their distributional implications. Such a tax expenditure report should be made publicly available, as this increased transparency will lead to better-informed tax policy decision making.