Tax Foundation Europe, a non-profit think tank focused on tax policy, urged European policymakers to address the growing discrepancies between statutory and effective tax rates across the European Union. According to the report, on Tuesday 17 September 2024, aligning these rates is essential for improving tax competitiveness and economic efficiency within the region.

The foundation defined the statutory tax rate as the legally established rate applied to taxable income, while the effective tax rate is the actual percentage of taxes paid on total income.

The report examined both top marginal statutory tax rates--the percentage of tax applied to the last unit of income--and average effective tax rates in EU countries, assessing their impact on public revenue, tax system simplicity and overall economic growth. Statutory rates refer to those set by law, whereas effective rates reflect the actual tax burden borne by individuals and companies after accounting for deductions, exemptions and other allowances.

Tax rate disparities

The report concluded that European nations with smaller gaps between their top marginal statutory and average effective tax rates for personal income tax enjoy greater tax competitiveness. Santiago Calvo, guest author of the report, noted that such alignment fosters investment and economic growth by creating a more predictable tax environment.

Calvo highlighted Spain and Germany as two countries where further increases in statutory tax rates for personal income tax have failed to generate significant revenue gains. Both nations have reached what the report described as a “high tax rate threshold,” a situation in which additional rate hikes may not yield corresponding increases in tax revenues. This finding aligns with the Laffer Curve theory, which suggests that beyond a certain point, higher tax rates can reduce the incentive to work or invest, leading to diminished revenue collection.

In contrast, countries such as Denmark, Estonia, Hungary and Luxembourg were identified as having the smallest gaps between statutory and effective tax rates. These countries benefit from a more streamlined tax structure, which improves economic efficiency and reduces tax avoidance. Conversely, nations like Slovenia, Cyprus, Greece and Croatia were found to have the largest gaps, complicating revenue collection and distorting economic behaviour.

Tax policy implications

The report emphasised that tax systems with a minimal gap between statutory and effective rates are more efficient. Simplified systems with fewer deductions and exemptions, combined with broader tax bases, were found to be particularly effective in curbing tax avoidance. Such structures also lead to more predictable revenue streams.

“It is critical to understand the differences between statutory tax rates and implicit tax rates. Statutory rates are the rates set by law, while implicit rates reflect the actual tax burden borne by taxpayers, considering deductions and exemptions,” Calvo stated in the report. “Simplifying the tax system can help reduce the gap between these rates, making revenue more predictable and efficient.”

Recommendations

The report urged European policymakers to simplify tax systems by reducing deductions and exemptions and aligning marginal statutory rates more closely with effective tax rates. According to Calvo, this approach would not only reduce economic distortions but also improve tax certainty for businesses and individuals. He reasoned that a more predictable tax system would encourage investment and production, which are crucial for long-term economic growth.