The Marginal Cost of Funds from Different Taxes in Finland – An AGE evaluation

The efficiency of the overall tax system has been debated in many countries for a long time now; in Finland, the debate has been mostly motivated by concern over the sustainability of public finances in the face of the increasing cost of providing public services and pensions for an ageing population. The current economic turmoil has added urgency to the debate, as the public sector deficit has rapidly grown. The challenge is two-fold: the ageing of the population increases agerelated expenses, which should be met with rising tax revenues; but it also decreases labour supply, which tends to have the effect of lowering tax revenues. However, as taxation also has an effect on the incentives to work and to invest, solving this two-fold problem calls for a comprehensive evaluation of the structure of the whole tax system. The aim of this study is to compare the welfare costs of raising revenue with different types of taxes, thus providing analyses and assessments that can be used in the evaluation of tax reforms. We focus on the effects of the tax hikes planned to take effect from 2013 on, aimed at raising an extra 1.1 billion euros in 2013, rising to 1,6 billion by 2016. The planned increases comprise income taxes and value added taxes. We are using VATTAGE, an AGE model of the Finnish economy, to compare the welfare effects of tax increases designed to reduce Finland’s budget deficits by using the concept of marginal cost of funds (MCF) for different taxes. VATTAGE is a MONASH-style model of Finland documented in Honkatukia (2009). However, unlike the original MONASH model, VATTAGE has been extended to include leisure and savings choice in the specification of household behaviour. We also allow for differences between household behavior between income deciles. These extensions are necessary for useful MCF calculations because the essence of these calculations is tax-induced distortions in choices between consumption, leisure and savings, and because the progressivity of income taxes necessitate the differentiation between households in different income brackets. We find that MCF is lowest for the income tax increases and highest for the value added tax increase. We also find that the MCF tends to rise over time, and while the overall Tax Package has a low MCF initially, it rises to about 1.5 in the long run, implying extra revenue to have a 1.5-fold societal cost. We also find that the package tends to decrease income differences.