Spain’s Poorly Designed Tax Policy Hurts Its Competitiveness

Spain's central government could learn some valuable lessons from its regional governments and other European countries about sound taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy.

The Tax Foundation recently released the 2024 International Tax Competitiveness Index (ITCI). Since 2019, Spain has dropped from 27^th to 33^rd (out of 38 Organisation for Economic Co-operation and Development [OECD] countries) in the ITCI due to multiple tax hikes, new taxes, and weak performances in all five ITCI components. While Spain's central government is the main driver behind this drop, Spain's regional governments also play a role in the country's overall international tax competitiveness.

In Spain's case, some of the 40 tax policy variables in the ITCI are set by regional governments. Therefore, the Spanish Regional Tax Competitiveness Index (RTCI) complements the ITCI by comparing the 19 Spanish regions on more than 60 variables across five major areas of taxation: individual income tax, wealth tax, inheritance tax, transfer taxes and stamp duties, and other regional taxes.

Corporate Income TaxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.

Spain scores poorly on corporate tax policy, ranking 29^th, due to several poor policy choices. First, Spain has both a patent boxA patent box-also referred to as intellectual property (IP) regime-taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. and a credit for research and development (R&D). Sound tax policy treats economic decisions neutrally, neither encouraging nor discouraging one activity over another. Both the patent box and the R&D credit are tax incentives that apply to a specific type of economic activity and can thus distort economic decisions and make the tax system more complex. Second, Spain is one of 12 countries in the OECD that has implemented a digital service tax (DST). Since DSTs tax gross revenues rather than net income, they can lead to high marginal tax rates on businesses that are less profitable. Third, it has a relatively high corporate tax rate of 25 percent (28 percent in Navarra), above the OECD average of 23.9 percent.

Individual Taxes

Spain's individual tax component also declined from 15^th in 2019 to 22^nd. Spain has one of Europe's highest top income tax rates. When the Spanish central government increased the general top marginal income tax rate from 45 percent to 49 percent, Madrid approved a general tax cut, setting the overall (central and regional) top marginal income tax rate at 45 percent. Other regions like Andalusia, Castilla-La Mancha, Galicia, and Murcia followed Madrid's example and cut the top marginal income tax rate to 47 percent, while Castilla and Leon cut it to 46 percent.

However, the tax rate is only one important factor. While most European countries indexed their income tax to inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a "hidden tax," as it leaves taxpayers less well-off due to higher costs and "bracket creep," while increasing the government's spending power. in 2023 and 2024, the Spanish central government refused to do so. In Spain, as in most European countries, the personal income tax has a progressive structure where tax rates increase as individuals earn higher wages. However, if wages are pushed up by inflation, people may pay higher taxes even if their real earnings have not increased. This is known as bracket creepBracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions-both at the federal and state level-are adjusted for inflation. .

At the regional level, Madrid indexed its income tax to inflation to avoid bracket creep. It also raised the basic tax creditA tax credit is a provision that reduces a taxpayer's final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer's tax bill directly. and child tax credit, and increased the generosity of the personal income tax measures to support large families. Following Madrid's example, all regions except Asturias, Catalonia, and Castilla-La Mancha indexed the income tax for inflation, or cut the tax rates for low-income households. While the central government didn't index the income tax to inflation for all income groups, the regional pressure forced the central government to slightly reduce the effective tax rate for low income households (earning less than €21,000 per year) in 2023.

Consumption Taxes

Spain ranks 19^th on the consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. component. However, less than 50 percent of consumption is covered by the value-added tax (VAT) due to exemptions that complicate the overall system and distort consumer choices. Consumption taxes that exempt certain goods and services from VAT, or tax them at a reduced rate, require higher standard rates to raise sufficient revenue. A broader VAT base could create fiscal space for lowering the overall VAT rate of 21 percent.

Property Taxes

Of the ITCI's categories, Spain scores the worst on property taxes (ranking 37^th). Spain has multiple distortionary taxes, including a tax on real property, a property transfer tax, capital duties, and a financial transaction tax. Additionally, Spain levies a net wealth taxA wealth tax is imposed on an individual's net wealth, or the market value of their total owned assets minus liabilities. A wealth tax can be narrowly or widely defined, and depending on the definition of wealth, the base for a wealth tax can vary. , an inheritance taxAn inheritance tax is levied upon an individual's estate at death or upon the assets transferred from the decedent's estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. , and a gift taxA gift tax is a tax on the transfer of property by a living individual, without payment or a valuable exchange in return. The donor, not the recipient of the gift, is typically liable for the tax. . However, not all regions in Spain levy a net wealth tax. In 2008, when the Spanish central government repealed the net wealth tax and then reintroduced it three years later, Madrid preserved 100 percent relief from the tax. Following the example of Madrid, the regions of Andalusia and Extremadura approved 100 percent relief, while Galicia offered 50 percent relief. The rest of the Spanish regions levy a progressive wealth tax ranging from 0.1 percent (in Galicia) up to 3.5 percent.

Although most OECD countries have repealed their wealth taxes, Spain's central government introduced a national temporary solidarity tax on high-net-worth individuals for the tax years 2022 and 2023 (to be collected in 2023 and 2024), with tax rates between 1.7 percent and 3.5 percent. However, since the government made this tax permanent, some of the regions that offered 100 percent relief approved a tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. for the difference between the regional wealth tax liability and the solidarity wealth tax liability. This would allow Andalusia and Madrid to retain the revenues the central government planned to collect while still offering relief to individuals with a net wealth below €3 million. Additionally, three other regions raised the exemption threshold to €3 million (Balearic Island and Cantabria) and €3.7 million (Murcia) to equal the tax relief offered by Andalusia, Extremadura, and Madrid.

Similar to the net wealth tax, the inheritance and gift taxes in Spain are collected and administered by regional governments. For unrelated or distant heirs, the top inheritance tax rate reaches 87.6 percent (in Asturias). Unsurprisingly, Spanish regions have the highest inheritance tax rates in Europe.

While inheritance and gift taxes collect little revenue, a recent study revealed that inheritances can reduce wealth inequality as transfers are proportionately larger (relative to their pre-inheritance wealth) for households lower in the wealth distribution. And this is especially true for Spain, where inherited wealth as a portion of net wealth reaches 95.6 percent. Therefore, given their limited capacity to collect revenue and negative impact on entrepreneurial activity, saving, and work, policymakers should consider repealing inheritance and gift taxes. However, like the wealth tax, the central government is looking to introduce a new inheritance tax on top of the current one, to eliminate the deductions for close heirs that most regions currently apply.

What Is Next?

Spain should implement principled tax reforms that support economic growth by making the tax code more neutral and competitive.

Under the turmoil following the flash floods in Valencia, the central government introduced a series of amendments to the global minimum tax draft legislation. However, these amendments that raise current taxes have nothing to do with the global minimum tax.

One of the amendments proposes to extend the windfall tax on the banking sector, introduced temporarily for 2023 and 2024, for three more years. However, this tax was not designed to tax profitability (windfall or not) since it uses a bank's net interest income and net fees as the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . While the previous tax applied a flat rate of 4.8 percent, the new tax rate is progressive, ranging from 1 to 6 percent, and can be partly deducted from the corporate income tax base.

The European Central Bank (ECB) objected to Spain's windfall tax on banks as it could reduce credit supply and banks' resilience in an economic downturn.

Maintaining this Franco-type windfall tax would likely raise interest rates, further hit banks that are already not profitable, distort competition in the banking sector, increase litigation, and punitively target certain industries because the tax base is poorly designed.

The amendments also raise the excise duty for diesel by 9.37 cents per liter (11.33 cents per liter when counting for VAT) when purchased by private consumers, while excluding transportation companies. Furthermore, the tax on capital gains above €300,000 would increase by 1 percentage point to reach 29 percent. While this tax hike will raise little or no revenue, it follows a trend that started in 2019; since then, the top capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. has increased by six percentage points.

While these tax reforms might change during the approval process, policymakers should avoid tax hikes and consider repealing windfall, solidarity, and wealth taxes. As public spending, debt, taxes, and transfers to Catalonia increase, Spain's current economic challenges could turn into a long-term recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. . Spain should follow Portugal's lead and use the additional revenue raised during the past years to cut taxes.

To increase its internal and international tax competitiveness, perhaps Spain's central government should look to its successful regional governments and overseas competitors for ideas.

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