The comprehensive income tax system also known by other synonyms as global income tax, unitary income tax or synthetic income tax is the most used taxation system in western European countries. It has got its name due to the fact that all income types are seen as a one and therefore are added together and taxed as one whole income. It was seen as the ideal tax system in Europe because in its original form it could align fully with the “ability to pay principle” and to both tasks of simplicity and fairness. This method is composed as a system which adds together all the taxpayer’s income (from labor, capital, rent and business) in a single measure and taxes it with a single progressive tax.
- Labor income is usually defined as income earned from activities as an employed individual.
- Capital income can take a variety of forms such as dividends, interests, income from real estate and to add further complications capital income is not always from a single organization, but can come from pension funds, life insurance companies, corporations, banks etc.
- Business income is income earned out of entrepreneurial activities.
Normally the minimum subsistence level remains tax free. Income surpassing this minimum level is typically taxed on a progressive scale. For example in Germany it starts with a tax rate of 15% and ends up as high as 50%. Losses of one income type can be offset with gains from other sources. One tax rate will then be applied on the taxpayer’s total income (Synthetic taxation system).
The idea behind the comprehensive tax scale is the assumption that someone with higher income is able not only in absolute but also in relative numbers to pay a higher share of his earnings to the government. This is by the majority of the most western cultures felt as a fair distribution of the tax burden also called “tax fairness”. This is the reason why there is a progressive tax table lying behind this structure.
Advantages of the Comprehensive Tax System
The comprehensive income tax system in its ideal form enjoys a good reputation due to the structure which is based on the ability to pay principle. In general this principle points out that taxpayers with the same low level of income are taxed at the same rate and the ones with higher income are taxed heavier.
What makes this taxation system even more attractive to countries is that due to the equalization of capital and labor income, there is no interest in income shifting. This would be a so called tax arbitrage profit. That means it is more profitable to transform labor income into capital income and pay less taxes due to the different tax burden between labor and capital income.
Disadvantages of the Comprehensive Tax System
Although this taxation system seems to be clear and easy, when installed and worked with there are always specialties and exceptions. These treatments were implemented during many years and destroyed the purity of the comprehensive system. The special treatments came along with a high amount of administrative costs and a loss of the simplicity. The possibility of the capital income to become negative and be cleared with the labor income is just one example. This even can be seen in the tax declaration. Hardly anybody is capable to hand in a correct tax declaration without concerning a tax accountant.
All countries with the comprehensive taxation system implied special tax treatment for a particular type of income (e.g. pensions, capital gains or lottery wins) to grant a tax relieve. But there is no systematic reason that for example lottery wins stay completely income tax free in Germany. Theoretically the State should levy taxes to generate income for funding its public tasks, as production public goods (eg. Schools, streets). It should not use the taxation system to channel the spending and investment behavior of its citizens and tax payers. By doing so the systematic foundation, the justification and the acceptance of the comprehensive taxation system gets lost.
The maximum rate should in no case surpass the 50% level because it is perceived as unfair from the tax payers when more than half of the money earned has to be transferred to the government.
Some decades ago Sweden had a maximum tax rate of 90% with the consequence that people had no incentive anymore to generate income and tried to transfer their income stream to foreign countries. This effect is described as a so called “Laffer” curve. (“It is used to illustrate the concept of Taxable Income Elasticity (that taxable income will change in response to changes in the rate of taxation). The curve is constructed by thought experiment. First, the amount of tax revenue raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but the Laffer curve hypothesis is that a 100% tax rate will also generate no revenue because at such a rate there is no longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing. If both a 0% rate and 100% rate of taxation generate no revenue, it follows that there must exist a rate in between where tax revenue would be a maximum. The Laffer curve is typically represented as a stylized graph which starts at 0% tax, zero revenue, rises to a maximum rate of revenue raised at an intermediate rate of taxation and then falls again to zero revenue at a 100% tax rate. One potential result of the Laffer curve is that increasing tax rates beyond a certain point will become counterproductive for raising further tax revenue because of diminishing returns.”)