A comprehensive tax reform should be considered in the context of a tax-to-GDP level that is above the OECD average and high in view of the income level in Slovenia, in addition to a tax mix that relies heavily on distortive taxes on labour. Slovenia has a sophisticated social welfare system that is successful in reducing income inequality. The system is financed largely though SSCs which are levied at very high rates, in particular for employees. However, there are discrepancies between the tax and SSC treatments of different types of workers, reducing transparency and increasing inequality.
The combination of high employee and employer SSCs and progressive PIT rates results in very high tax burdens on labour income. In general, it reduces incentives for employers to hire workers and for individuals to participate in the labour market and to increase work efforts, which is likely to be a particularly significant issue for workers with a weaker attachment to the labour market such as low-skilled workers and older workers.
Employers have to pay higher effective SSC rates for low income workers due to the imposition of a minimum SSC base for workers under a certain income threshold. This makes it expensive for employers to hire low-skilled and low-income workers and reduces the labour market opportunities for these types of workers.
Slovenia has high implicit tax rates on return to work for the unemployed. This arises due to a combination of high taxes on labour income and the loss of out-of-work benefits for the unemployed who re-enter the labour market – also known as unemployment and inactivity traps. Young people enter the labour market later in part due to extensions of their study periods, which is linked to the generous tax treatment of income from student work. Recent reforms have reduced the tax privileges for students but their income continues to benefit from preferential tax treatment. Moreover, almost all workers leave the labour market when they reach the age of 59, which is reflected in the sharp income declines at and after this age. The 2013 pension reform is having positive effects on the labour market participation of older workers but further reform efforts are necessary in order to significantly raise the effective retirement age of workers in Slovenia.
To compensate for the high tax burden on labour income, Slovenia has generous tax provisions that lower the tax burden in particular for families with children. While tax base narrowing measures can strengthen the fairness of the tax system by providing support to some taxpayers, they result in higher tax rates on all other taxpayers. Families with children benefit from both child tax allowances and child cash benefits. The design and interaction of these provisions is complex and needs to be reformed. Secondary earners, usually women, face very high marginal tax rates, partly as a result of the decline in child benefits at higher income levels
A stronger role for the PIT in Slovenia would allow reductions in employee SSCs, possibly by phasing in the reduction over time. Such a reform would encourage greater workforce participation among workers who are not currently active in the labour market, including low-income, low-skilled and older workers. Lower employer SSCs would stimulate labour demand, which would expand the tax base.
A cut in employee SSCs would require re-designing the PIT rate schedule in order to balance the budget. First, the top PIT bracket could be abolished. The current top PIT rate of 50% is too high, in particular in combination with the high employee SSCs. The top marginal “all-in” rate, which takes into account employee SSCs and the top PIT rate in Slovenia is 61.1% which is the highest all-in rate that is levied in the OECD. Such a high combined tax rate strongly discourages taxpayers from increasing work efforts and may encourage tax avoidance, such as business incorporation particularly as the top rates on labour and capital income are not aligned. Very few taxpayers pay the top PIT rate as it is levied on very high income levels. Simulations based on tax return data show that reducing the top PIT rate would come at a low tax revenue cost. Even if the top PIT rate was lowered to 45%, the marginal “all-in” rate would continue to be above the rates that can be found in countries such as Austria, Italy, and Germany.
The tax rates in the second, third and fourth tax brackets (which are 27%, 34% and 39% respectively) could be increased to help finance the cut in employee SSCs. The increase in the PIT rates needed to compensate for the cut in employee SSCs would depend on the size of the reduction in employee SSCs. The PIT rate in the bottom bracket (16%) could be left unchanged in order to maximise the impact of the cut in employee SSCs on low-income workers. The PIT rates in the third and fourth bracket could be increased more than the rate in the second bracket. However, the PIT rate in the fourth bracket (i.e. the new top PIT rate) should not be higher than 45%.
People on lower incomes face a lower tax burden due to generous basic allowances. However, low-income workers face disincentives to move up the income scale as, in addition to the general tax allowance, there is an additional basic allowance which is reduced at higher income levels and therefore increases marginal effective tax rates. One possible option could include replacing both tax allowances by a single tax credit which would not vary with income, but to compensate for the tax revenue cost by increasing the bottom PIT rate.
There is scope to broaden the PIT base, which would limit the extent to which PIT rates would have to be increased. The PIT base is relatively narrow as a result of exemptions and special tax provisions. First, tax provisions in Slovenia take the form of tax allowances, which give a larger tax reduction to people earning higher incomes. This is not aligned with best practice in the OECD, where tax credits are more widely used. Tax credits provide the same benefit to all taxpayers irrespective of their income and marginal tax rates. Among the tax provisions that could be abolished to broaden the PIT base are the tax exemption for the reimbursement of home-work travel expenses and meals during work. Across the OECD, the expenses that workers incur to earn taxable personal income, including home-work travel costs, are typically included in the basic allowance and therefore exempt from PIT through the basic allowance. Exempting the reimbursement for those expenses from tax, as is the case in Slovenia, results in a double tax exemption. In addition, the performance bonuses and annual bonuses, which are currently tax exempt up to the average wage, could be taxed as regular income under the PIT.
The SSC base could be broadened by limiting the number of different contribution rates and bases, and aligning the tax treatment of different types of incomes. A cut in employee SSCs would also imply that the SSCs that the self-employed have to pay, which are high by international standards, would be reduced. Slovenia could further align the SSC treatment of employees and the self-employed. However, this would not only imply a convergence in SSCs, but also a convergence in benefit entitlements for the different types of workers. As part of such a reform, Slovenia could consider introducing a SSC ceiling for employees or abolishing the ceiling for the self-employed; the latter reform would require an accompanying increase in the maximum pension for the self-employed in order to ensure that the link between contributions made and benefits received remains intact. Such a reform would also require that, instead of exempting 25% of the income from tax, the income earned by the self-employed would be split in a return for work and a return for the capital invested; both returns could then be taxed separately.
Generous tax provisions have long-run costs for the taxpayers who benefit from them. The remuneration which workers receive for home-work travel and meals during work are exempt from PIT and SSC, which narrows the base and reduces their effective tax burden. However, as taxpayers do not pay SSCs on tax-exempt income, they also do not build up rights to future benefit entitlements (e.g. a pension). While a narrow base might have advantages in the short run for some taxpayers, it also comes at a cost in the longer run for individuals and society more generally.
The financing of the welfare system, including the health system, needs to be strengthened. An in-depth evaluation of the efficiency of the welfare system, and in particular of the health fund, would be welcome along-side the introduction of measures that would allow the Health Insurance Institute of Slovenia (HIIS) to focus on its core activities and to put its financing on a more sustainable footing in light of the challenges linked to the ageing of society.
While the link between SSCs and benefits could be strengthened, the link at low income levels could be relaxed to prevent labour market distortions. Wages and pensions in Slovenia are relatively low by OECD standards, although not necessarily in comparison with some other East European countries. Tax return data shows that the wage structure is compressed principally at the low end of the wage distribution. This implies that financing the welfare state primarily through SSCs, as is the case in Slovenia, is challenging as raising sufficient revenues would require levying high SSC rates. Typically strengthening the link between the SSCs that workers pay and the benefits that they will receive constitutes good tax policy. However, in the presence of low wages and a condensed wage distribution it may be challenging to implement. In order to ensure that low income workers will be entitled to a minimum pension that prevents them from falling into poverty when they retire, very high SSCs are levied, which might price these workers out of the labour market. In such a setting, a more balanced financing mix of the welfare state beyond SSCs would be optimal and would prevent a drop in pension and other benefits. Indeed, the minimum SSC base for workers under a certain income threshold, which is planned to increase further, will be too high leading to very large effective employer SSC rates; this threshold should be abolished for both employees and self-employed or, if that would not be feasible in the short run, lowered to the minimum wage.
The flat-rate regime for self-employed workers needs reform. High tax burdens on labour income and high tax compliance costs reduce the incentives for entrepreneurship. In response, Slovenia has introduced an alternative “flat-rate” tax regime for self-employed entrepreneurs. However, the design of this regime encourages entrepreneurs to conceal their income and discourages businesses from growing. The flat-rate regime is very generous in that it allows a deduction of “presumptive costs” equal to 80% of income, which is significantly higher than the actual cost incurred by many businesses. This approach not only results in low PIT liability but also reduces the SSC base. A large share of the self-employed under the flat-rate regime therefore pay SSCs on the minimum SSC base. Abolishing the flat-rate regime and the minimum SSC base therefore needs to go hand in hand.
The self-employed who do not opt for the generous flat-rate regime have a tax-induced incentive to incorporate in order to turn highly taxed labour income into low-taxed capital income. The tax burden on labour and capital income needs to be more closely aligned by lowering the tax burden on labour income and increasing the tax burden on capital income.
Strengthening the design of consumption taxes could help finance a cut in SSCs. The standard VAT rate is high and the reduced VAT rate, which is relatively low, applies to a large number of goods and services. As the VAT rate in neighbouring countries is somewhat lower than in Slovenia, the standard VAT rate should be maintained at its current level. However, there is scope to address regressive distributional effects of the reduced VAT rate in Slovenia. Some of the products and services that are taxed at the reduced VAT rate benefit the rich more than the poor both in relative and absolute amounts. This is the case for cultural activities, hotels, restaurants, and air transport.
The recent move towards the automatic exchange of financial account information between tax administrations creates opportunities for Slovenia to revisit the way it taxes personal capital income. Tax rates on capital income at the individual level in Slovenia are not particularly high and effective tax rates on household savings vary widely across assets. Some assets, such as owner-occupied and rental immovable property and private pension savings are taxed particularly lightly. The capital income tax system also lacks progressivity, which is typical under dual income tax systems. Slovenia could consider increasing the progressivity of its capital income tax system.
Finally, improving the design of the tax system will also require property tax reform and changes to the way municipalities are financed. The introduction of the new real estate tax is much-awaited as it creates opportunities to rebalance the tax mix and to reform the financing mix of local governments. Municipalities currently receive a significant share of PIT from central government which facilitates underuse of the recurrent tax on immovable property. For instance, the formula that assigns additional tax revenues to municipalities could be adjusted to take into account the extent to which the municipality faces the opportunity to collect revenues from recurrent taxes on immovable property. Analysis presented in this report indicate that central government could lower the PIT revenue sharing ratio from 54% to 36% once the recurrent tax on immovable property is in place and then continue to lower the ratio gradually over time to a ratio between 30% and 18%.
Table 1 presents the key tax reform recommendations. More detailed recommendations are included at the end of each chapter in this report.
