Executive summary
Slovenia needs a comprehensive tax reform that rebalances the tax mix away from employee social security contributions (SSCs) towards personal income tax (PIT) and less distortive taxes such as value-added tax (VAT) and recurrent taxes on immovable property. The tax reform will have to prepare Slovenia for the ageing of its population. The reform should incentivise older workers to stay in the labour market longer and younger workers to enter the labour market sooner and should reduce unemployment, in particular of the low-skilled. In order to put the funding of the welfare system on a solid footing, without reducing entitlements to social benefits, the reform should partly shift the funding of the pension and health system from SSCs towards general taxation. The tax reform should be complemented with a broader set of reforms, including the pension and health care systems.
A comprehensive tax reform should be (at least) budget neutral and aligned with the country’s fiscal rule. Over the past two decades, Slovenia has undertaken a number of extensive reforms. Some of these reforms were not fully funded, resulting in significant budget deficits as high as one quarter of the current public debt of Slovenia. In recent years, the government has narrowed the budget deficit. The level of public debt has been falling since 2016, while the country’s highly redistributive tax and benefit system has been maintained. A comprehensive tax reform should therefore ensure that public debt can be further reduced.
The population in Slovenia is ageing rapidly with over 30% of people projected to be older than 65 by 2050, which will be one of the highest proportions in the OECD. The increase in age-related expenditure, especially on health and public pensions, will put pressure on the budget and require accompanying fiscal measures. In addition, population ageing will reduce PIT and SSC revenues, thereby exacerbating the challenges associated with financing the costs of ageing.
Older workers leave the labour market in Slovenia too early. While Slovenia is the top performer in the OECD with respect to the employment rate of workers in the prime age category of 25-54, for both men and women, it is one of the weakest performers with respect to the labour market participation of its workers who are older than 54. The 2013 pension reform increased the legal retirement age to 65 for both men and women, which has increased the number of workers in employment aged 55 and above. Nevertheless, tax return data for the year 2016 reveals that a significant gap remains between the official and the effective ages of retirement. Such a low rate of participation of older workers in the labour market is unsustainable in the context of Slovenia’s ageing population. Further efforts to continue increasing the effective retirement age are needed.
A well-designed PIT is the cornerstone of a tax system that can effectively produce inclusive economic growth. While the PIT raises 25% of total tax revenues on average in the OECD, it raises only 14% in Slovenia. In contrast, SSCs raise 26% of total tax revenues on average in the OECD, while they raise almost 40% of tax revenues in Slovenia.
By broadening the PIT base, Slovenia has an opportunity to rebalance the tax mix away from employee SSCs towards PIT. The combination of high employee and employer SSCs and progressive PIT rates results in very high and distortive tax burdens on labour income. These high tax rates also reduce incentives for employers to hire workers and for individuals to participate in the labour market and to increase work efforts. The narrow PIT base presents a challenge for reshaping the role of the PIT in Slovenia, and the PIT base could therefore be broadened.
Opportunities also exist to rebalance the tax mix towards taxes on capital income at the individual level. The recent move towards the automatic exchange of financial account information (AEOI) between tax administrations creates an opportunity for countries to reassess the way they tax personal capital income under the PIT system.
In addition to broadening the PIT base, there is scope to finance a cut in SSCs by broadening the VAT base and by strengthening the role of the recurrent tax on immovable property in the financing mix of municipalities away from revenues from PIT.
Reshaping the personal income tax in Slovenia
A stronger role for PIT in Slovenia would allow a significant reduction in employee SSCs in the order of 5 percentage points. Such a reform would encourage greater workforce participation among workers who are not currently active in the labour market, including low-income, low-skilled and older workers.
A cut in employee SSCs would require redesigning the PIT rate schedule in order to balance the budget. First, the top PIT bracket could be abolished. The current top PIT rate of 50% is too high, in particular in combination with the high employee SSCs. The combined employee SSC and top PIT rate in Slovenia is 61%, which is the highest in the OECD. Few taxpayers pay the top PIT rate as it is introduced at a high income level; abolishing the 50% top PIT rate bracket would, therefore, only have a small impact on PIT revenues.
Second, the tax rates in the second, third and fourth tax bracket (respectively 27%, 34% and 39%) could be increased to help finance the cut in employee SSCs. The increase in the PIT rates would depend on the size of the reduction in employee SSCs. The PIT rate in the bottom bracket (16%) could be kept unchanged in order to maximise the impact of the cut in employee SSCs on low-income workers. The PIT rates in the third and fourth bracket could be increased more than the rate in the second bracket. However, the PIT rate in the fourth bracket (i.e. the new top PIT rate) should not be higher than 45%.
To compensate for the high tax burden on labour income, Slovenia has generous tax provisions that lower the tax burden particularly for families with children as they benefit from both child tax allowances and child cash benefits. The design and interaction of these provisions is complex and could be reformed.
Scope exists to broaden the PIT base. The PIT base is narrow as a result of exemptions and special tax provisions. First, tax provisions in Slovenia take the form of tax allowances, which give a larger tax reduction to higher incomes. This is not aligned with best practice in the OECD, where tax credits are more widely used as they provide the same benefit to all taxpayers irrespective of their income and marginal tax rates. Second, broadening the tax base could be achieved by abolishing the tax exemption for the reimbursement of home-to-work travel expenses, meals during work and by taxing performance bonuses and annual bonuses as regular income under the PIT.
The SSC base could be broadened by limiting the number of different contribution rates and bases, and aligning the treatment of different types of incomes. A cut in employee SSCs would also imply that self-employed SSCs, which are high by international standards, are reduced.
High tax burdens on labour income and high tax compliance costs reduce the incentives for entrepreneurship. In response, Slovenia has introduced an alternative “flat-rate” tax regime for self-employed entrepreneurs. However, the design of this regime induces entrepreneurs to conceal their income and discourages businesses from growing. The flat-rate regime is very generous in that it allows a deduction of “presumptive costs” equal to 80% of income, which is significantly higher than the actual costs incurred by most businesses. This approach not only results in low PIT liability but also reduces the SSC base. The flat-rate regime needs to be reformed or abolished.
Self-employed who do not opt for the generous flat-rate regime have a tax-induced incentive to incorporate in order to transform highly taxed labour income into low-taxed capital income. The tax burden on labour and capital income needs to be more closely aligned by lowering the tax burden on labour income and increasing the tax burden on capital income.
The financing of the health system needs to be strengthened. A wide range of measures are available. An in-depth evaluation of the efficiency of the health and welfare systems should be undertaken. Such an evaluation would be welcome along-side the introduction of measures that would allow the Health Insurance Institute of Slovenia (HIIS) to focus on its core activities and to put its financing on a more sustainable footing in light of the challenges linked to the ageing of society.