On 11 February 2016 the IMF issued a staff report and selected issues paper in connection with discussions with the Netherlands under Article IV of the IMF’s articles of agreement. The selected issues paper covers the possibility of further tax reform to move closer to best practices.

The issues paper notes that the Netherlands tax reform of 2001 introduced the box scheme for different sources of personal income and introduced the presumptive tax on personal capital income in Box 3. This taxes capital income at 30% on an imputed rate of return on assets of 4%, thereby arriving at a presumptive capital income tax equivalent to a 1.2% wealth tax. This violated the neutrality principle and potentially introduced distortions in savings and investment decisions. Some capital income is taxed at progressive rates in Box 1, some at proportional rates in Box 2 and the rest is taxed regressively in Box 3. The presumptive tax in Box 3 encourages excessive leverage and risk taking.

The tax system also encourages debt financing for businesses rather than equity. This applies especially to small businesses and the self-employed whose income after deduction of interest is taxed progressively in Box 1. Also the tax system is favorable to owner occupied housing where the low imputed rental income is taxed net of mortgage interest payments.

Currently taxation of labor accounts for much of the tax revenue in the Netherlands. The personal tax rates are steeply progressive and the taxation and benefit systems may discourage low income workers from entering or staying in the labor market. This leads to shrinking of the tax base and consequently overloading of taxpayers.

The recent tax cut package is a step in the right direction and strengthens work incentives with an emphasis on low incomes and second earners. The paper notes that future measures should focus on low income groups and mothers, these being the groups with the largest labor supply elasticity. Incentives to work such as in-work tax credits for low income workers or income-dependent child benefit should be favored. There may also be scope for a slight reduction in the marginal tax rate on high income workers.

There is also scope for shifting revenue collection from taxes on labor to value added tax. In the Netherlands the burden of indirect taxation is among the lightest in Europe. Standardizing VAT rates by adjusting the reduced rates would raise additional revenue that could be used to reduce the standard rate or reduce labor taxes.

The system of tax allowances for the self-employed may have introduced a large distortion in the labor market involving medium and long term costs. Many of the features of the allowances are difficult for the tax authority to assess, such as allowances for research and development or for hours worked by partners in the family business, investment allowances or deductions for asset depreciation. Currently three quarters of the self-employed are active in a one-person company and this has negative consequences for productivity growth including a lack of on-the-job training and inefficient labor organization. Self employed people are often not part of the usual pension and social security arrangements and this may also have long term consequences.

The paper notes that there is also scope for decentralizing taxing powers in the Netherlands. Only 10% of regional government revenues came from local taxes in 2014. Transfer of taxing powers to local authorities could encourage greater commitment and more scrutiny. This would also provide an incentive for local government spending to be more efficient. Regional taxation could be increased by introducing local recurrent property taxes on owner-occupied houses, which could be combined with reduction of housing subsidies.

The paper concludes that although the Netherlands tax system is equitable it can be improved in terms of its efficiency. Capital income taxation is fragmented, regressive and it distorts investment decisions so that there is excessive investment in housing. The tax system leads to a preference for the use of debt rather than equity at both personal and corporate levels. A more homogeneous system of taxation for capital income would make a large contribution to correcting these distortions in the economy. A more equal tax treatment of debt and equity would reduce the amplitude and frequency of boom and bust cycles thereby making finances more stable.