Taxing benefits

OECD Directorate for Employment, Labour and Social Affairs
Page 21 

Direct tax on public cash benefits, % of GDP, Australia, Denmark, Germany, Italy, Japan, the Netherlands, UK, US.

Public social spending levels vary in the OECD area, but not as widely as some might expect. A closer examination of tax and benefit systems shows why. 

Regardless of the overall level of taxation and public spending, public social expenditures constitute over half of all public spending in most OECD countries. But while media reports often suggest great gaps between one country’s public social expenditure relative to its GDP and another’s, a closer look at how tax and benefit systems interact reveals that the differences between countries are narrower than they seem.

Broadly speaking, public social spending covers four main areas: support to those in retirement; income support to the working-age population; healthcare; and other social services, like childcare. The relative importance of each of these items varies from country to country. For example, public spending to support the retired population in Italy was around 16% of GDP in 1997. Spending on social services, including public childcare facilities, is an important budget item in Denmark, while spending on disability programmes keeps Dutch spending on income support to the working-age population high, despite low unemployment. Health is an important item on public budgets everywhere and averages about 6% of GDP across the OECD.

As ever, there is more to the headlines than meets the eye. Denmark, for instance, may appear from the first chart to spend much more on social protection than, say, Germany or the United Kingdom, but does it?

The answer is no, for the data ignore three very important considerations: first, how income taxes, including social security contributions, affect benefit income; second, the impact of indirect taxes on consumption; and third, how tax breaks with a social purpose can alter the picture.

Take direct income tax and social security contributions, which some governments levy on cash benefits. While almost all social benefits in the Netherlands are taxable, taxation of benefit income in Germany is generally very limited. Consider the case of an average German production worker who in 1997 is the only earner in a family with two children. If that person loses his or her job, he or she receives over $19 000 in annual unemployment benefits and pays no income tax. By contrast, a similar person in the Netherlands receives nearly $25 000, but pays more than $6 000 in taxes. The net income for Germans is higher. Of all public transfer spending, the Danish and Dutch treasuries claw back about 4% of GDP though direct taxation, compared with about 2.5% of GDP in Italy and only around 1% of GDP in Germany. In Australia, Japan, the UK and the US, the tax claw-back on transfer income is smaller still (See chart below).

A similar picture arises when we look at indirect taxation. Social benefits finance consumption. Consumption taxes, like VAT, reduce the real purchasing value of the benefits. And like income tax, they establish another flow in tax receipts to the government. So, to provide benefit recipients with a net consumption of 100 units, a country like the US, with an average indirect tax rate of slightly over 5%, needs to pay a gross benefit of about 105 units. In Denmark, where the average indirect tax rate exceeds 25%, a much higher gross payment of around 125 units would be needed to arrive at the same net value.

Obviously, the flow back of revenue generated by this indirect taxation on consumption from benefit income is much higher in Denmark than in the US. In general, the average rate of consumption taxes in OECD Europe ranges from 12.5% to 16% – Denmark’s higher rate is an exception – while average indirect tax rates in other OECD countries are much lower, varying between 5% and 7.5% in Australia, Japan and the US. Apart from taxing income and consumption differently, some governments grant tax breaks with a social purpose. A children’s tax allowance is a common example of such a tax advantage, paid in lieu of cash benefits. Other tax breaks may be offered, for instance, in return for the purchase of private health insurance.

Tax breaks and cash benefits often mirror each other when it comes to family support. For example, in Germany the value of tax allowances for families with children approximated $32.5 billion in 1997. Another high-profile example is the Earned Income Tax Credit (EITC) in the US with spending at about $30.5 billion in the same year. This was made up of $6.1 billion in the form of tax credits (a tax advantage that mirrors a cash benefit) and $24.4 billion paid in cash to those low-wage earners whose tax credit entitlement exceeds their tax liabilities. So, what does all this tell us about public social spending in the OECD area? For a start, direct taxes and social security contributions claw back a bigger slice of benefit income in Denmark and the Netherlands (as much as a quarter of benefit income) than in most other OECD countries. Also, the value of benefit income clawed back through taxes on consumption is much larger in European countries than in Australia, Japan or the United States.

Moreover, countries with relatively limited direct taxation of benefit income (Germany, the UK and the US) make more extensive use of welfare-oriented tax breaks than countries with high direct taxes on benefit income (Denmark and the Netherlands). In general, governments claw back more money through direct and indirect taxation of public transfer income than they award in tax advantages with a social purpose. Only in the US does gross public spending actually underestimate public social effort, since the value of the tax breaks awarded exceeds the claw-back in revenue from benefit recipients.

Going back to our earlier question: where does this put Denmark? Gross public social expenditure indicators put public social expenditure in Denmark at six percentage points of GDP above that of Germany and 20 percentage points over that of the US. But accounting for the impact of the tax system as discussed here, net public social spending in Germany (27.2% of GDP) exceeds that of Denmark (26.7% of GDP), while the gap between Denmark/Germany on the one hand and the US is halved to 10% of GDP. The tax system significantly reduces the variation in the real value of social spending across countries. As we will show in the next issue of the Observer, the similarities in the share of GDP devoted to social spending across countries become even more apparent when the role of private social benefits are brought into the picture.

References 

• Adema, W., “Net Social Expenditure, 2nd Edition”, Labour Market and Social Policy Occasional Papers No. 52, OECD, 2001.

 Social and Health Policy Analysis, OECD, 2002, forthcoming.

 OECD Social Expenditure Database, 1980-1998, 3rd edition, (CD-ROM), OECD, 2001.

 Revenue Statistics, 1965-2000, OECD, 2001.

 Benefit Systems and Work Incentives, OECD, 1999.

©OECD Observer No 230, January 2002 




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