Hoover Daily Report

Could a Degressive Tax Be Better Than a Flat Tax?

Monday, October 20, 2003

Most current tax systems, including the United States income tax, have built-in disincentives to work, save, and invest. As rising incomes are taxed at progressively higher rates, some individuals choose more leisure over additional effort. I have argued that disincentives to work, save, and invest should be removed via a flat tax. But why not go a step further and improve incentives across the board by creating a degressive tax? Such an experiment is about to take place in Switzerland.

Residents of Switzerland are subject to personal income taxes levied by the central government and also by the 26 cantons and 2,900 municipalities. As of 2001, all the cantons were required to harmonize the concept of income and most of the deductions and allowances. The cantons and municipalities, however, are free to set the amount of deductions and the tax rates. As a result, individual tax burdens vary by canton and municipality.

Personal income tax rates in Switzerland are progressive. The federal income tax consists of nine brackets. It begins with a zero rate on income up to Swiss francs (SFr) 25,000 ($1 = SFr 1.37). Thereafter graduated rates climb to a maximum of 13.2 percent, after which they fall to a standard rate of 11.5 percent on income exceeding SFr 715,600.

The cantons and municipalities also impose their own local progressive income taxes, along with a net wealth tax and a parish tax. For a married couple without children, with a gross employment income of SFr 200,000, the combined federal, cantonal, municipal, and parish tax rates on income range from a low of 8.3 percent in Zug to a high of 19 percent in Delemont. Households with higher incomes pay higher rates.

The Swiss economy has faced hard times in the past few years. One canton, Schaffhausen, is doing something about it by changing its tax law to attract wealthy people. Beginning in January 2004, Schaffhausen will replace its system of increasing marginal tax rates on income with a system of degressive marginal rates. The cantonal tax rate will be set at just under 8 percent for income of SFr 100,000. It will rise to a peak of 11.5 percent for income between SFr 600,000 and SFr 800,000. Thereafter, the marginal rate declines with each incremental chunk of income: 10 percent at SFr 1,300,000; 8 percent at SFr 3,000,000; and just over 6 percent for income more than SFr 10,000,000. This is a true incentive-based tax system—the larger one's income, the lower one's marginal rate.

Declining marginal tax rates will also apply to wealth taxes, further enhancing the degressivity of cantonal taxes.

Schaffhausen has its own legislative parliament, which contains eighty deputies representing all regions within the canton. Eight political parties compete for these seats. Evidently Schaffhausen's voters support a tax cut that gives the greatest benefits to the richest people. They believe that attracting wealthy individuals to reside in their midst is good for everyone.

Can it be that degressive marginal rates are even better than the flat tax, especially for a faltering economy?