The Danish Tax Cut 2004
A short brief of the Danish Tax Cut 2004.
The aim of this paper is to give a short brief of the Danish Tax Cut 2004.
The Personal Income Tax System - a brief introduction
Personal income tax is payable on wages and almost all other forms of income, including profits from personally owned business. The tax revenue is allocated to the state, the counties and the municipalities.
Every citizen (above 18 years of age) has a personal allowance of DKK 36,800 per year, before the personal income tax is calculated.
The income tax collected by the state is calculated on the basis of the personal income with addition of positive net capital income according to a progressive scale:
- The basic tax rate (bundskat) is 5.5 per cent. If the taxpayer's income was below DKK 204,400 in 2003, the taxpayer only paid basic tax. From 2004 this threshold is raised to DKK 254,000.
- The medium tax rate (mellemskat) is 6 per cent. The tax is calculated only on the part of the income that exceeds the basic allowance of DKK 254,000.
- The higher tax rate (topskat) is 15 per cent calculated only on the part of the income that exceeds the basic allowance of DKK 304,800.
County and local tax varies depending on the county and municipality that the taxpayer is a resident of. The tax rate is a flat rate and the difference between counties and municipalities can be several per cent, depending on both the county and the local tax rate. In 2004 the average is 32.6 per cent - 22.1 per cent for municipalities and 10.5 per cent for counties. The County and local taxes are calculated on the basis of the taxable income (i.e. personal income with addition of capital income and various deductions like transport costs of commuting and trade union fees) after deduction of the personal allowance.
On all personal income, Labour Market Contribution (LMC) is calculated as a percentage of the personal income, before any deduction is made. The LMC is 8 per cent.
Besides the taxes above, there are other minor taxes and contributions. There is a contribution to the Danish Labour Market Supplementary Pension Scheme (ATP), and a tax that is paid by the members of The Danish Church.
Figure 1 below shows the marginal rate of income tax in 2003, i.e. before the tax cut from 2004.
Graph 1: The Marginal rate of income tax in 2003, i.e. before the tax cut from 2004.
Beside taxes and labour market contributions a compulsory contribution of 1 per cent of employee's gross earnings is paid to an individual Labour Market Supplementary Pension Scheme established for the employee. But this contribution is not considered as a tax or as a social security contribution. It is savings being made by the individual. In 2004 and 2005 this contribution is suspended to strengthen the economic upturn.
The Danish tax level has been rising steadily for several decades along with the expansion of the welfare state. Today the Danish level of taxation is among the highest of all western countries.
Table 1 shows the total taxation of an average production worker for the EU-countries, Norway and United States.
|Table 1: The average direct, the average indirect and the average total taxation of an average production worker in different countries (2002). Per cent.|
|Direct tax1||Indirect tax2||Total tax on labour income|
1: Percent of gross earnings.
2: Percent of gross consumption.
Source:The Danish Ministry of Taxation
The tax freeze
In order to avoid further rises in taxes the liberal-Conservative government imposed the tax freeze upon its election in the autumn of 2001. The tax freeze commits the government to abstain from raising any tax or duty either as a percentage rate or as a nominal amount. The tax freeze therefore disciplines the public spending not to rise.
The tax freeze also applies to local governments. It does not prevent individual municipalities and counties from adjusting tax rates on income and land. But tax rates set either by municipalities or counties cannot on average exceed the level in 2002.
Cuts in taxes on earned income from 2004
The tax freeze is the first step in the governments tax policy - the next step is cuts in taxes on earned income. The aim is to reduce the distortions on the labour market and to improve the incentives to work.
Denmark is preparing for the estimated effects on public finances of future demographic changes by aiming for structural general government surpluses of around 2 per cent of GDP. This enables public debt to be halved in 2010. To achieve this goal the strategy is a low growth in real public services standards and a significant increase in employment (2.25 percentage point rise in structural employment). The government sees the tax cuts as an important instrument in this strategy.
The medium-term fiscal strategy has been pursued for several years and has broad political support.
In the spring 2003 the government found parliamentary support for its plan for tax cuts. It was decided that the cuts should be implemented from 2004 to 2007. However in the spring 2004 it was decided to advance the cuts, and implement the full tax cuts already in 2004.
The total tax cut reduces incometaxes by DKK 9.9 billion or EUR 1.3 billion. In 2004 this corresponds to around 0.7 per cent of GDP.
There are two main elements in the agreement on tax cuts; An increase in the threshold for the medium tax bracket and an earned income tax credit.
The increase in the threshold for paying the medium tax bracket
In 2004 the threshold for paying the medium tax bracket increases by DKK 49,600 from DKK 204,400 to DKK 254,000 as shown in graph 2. (This increase is besides the ordinary annual increase adjusting for wage-increases).
Graph 2: The threshold for the medium tax bracket 2003 and 2004.
The medium tax bracket is 6 pct. An increase as showed above therefore gives the individual Dane a reduction of almost DKK 3,000 - given that his/her annual income is high enough. An income less than the new threshold will mean a lower reduction - and a yearly income less than the old threshold will mean no tax reduction at all as shown in Graph 3.
Graph 3: The effect for the individual Dane of the higher threshold for the medium tax bracket in 2004.
The earned income tax credit
In order to increase the labour force participation it is necessary to increase the incentives to get a job. Therefore the government proposed an earned income tax credit of 2.5 per cent of the taxable income below the new threshold for paying the medium tax bracket. i.e. for people with income above the new threshold the earned income tax credit is a fixed deduction per year of DKK 7,000. The value of the tax credit is about 1/3. i.e. the maximum value of the tax credit is about DKK 2,300. The isolated effect of the earned income tax credit for the individual Dane is shown in Graph 4.
Graph 4: The effect of the earned income tax credit for the individual Dane in 2004.
The tax cut - all in all
The total effect of the tax cut for the individual Dane is show in Graph 5 below. Nearly one million Danish families get tax cuts for more than DKK 5,000 in 2004. Beside these tax cuts the Government also decided in the spring 2004 to temporary suspend the compulsory 1 pct. contribution to employee's individual saving plans. This suspension releases in all DKK 3.9 billion in each year to private consumption or optional savings.
Graph 5: The total effect of the tax cut for the individual Dane
The tax agreement from the spring 2003 includes two further elements.
- Additional funds for social purposes in the budget for 2004 and onwards of totally DKK 1 billion.
- A mechanism to neutralize the impact on tax revenue from possible extraordinary increases in retail car prices due to the harmonization of car prices following from strengthened competition within the EU.
Tax cut and the income distribution
The Danish government has put a significant weight on the distributional effects of the tax cut as shown by Graph 6. The graph measures the tax cut in per cent of existing tax payments.
Graph 6: The tax cut in per cent of tax payments for 9 income levels from 2004.
The effect on marginal rates and labour supply
Nearly 90 per cent of the fulltime-employed taxpayers in Denmark pay one of the progressive taxes - The medium or top bracket tax. With the government's tax cuts the number of taxpayers of the medium tax bracket will be reduced by about 40 per cent i.e. around 745,000 persons as shown in the graph below.
Graph 7: The numbers of medium bracket taxpayers before and after the tax cut.
Graph 8: Marginal rate of income tax in 2003 and in 2004.
Graph 8 shows the tax cut's impact on the marginal tax rates. The tax cut gives small reductions in the marginal tax rate regarding the small incomes and an influential reduction regarding the medium incomes. There is no impact on the marginal tax rate for high incomes.
One of the main goals with the tax cuts is to increase the labour supply. The total effect is estimated to be in the area of 10-12,000 fulltime-employees - that is 0.4 per cent of the workforce. Approximately 2/3 of this increase is from an increase in working time (the internal margin) and approximately 1/3 is from higher employment (the external margin).
 All income levels and amounts are in 2004-level.