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The Sad State of the Italian Tax Code

By: Alan Cole

It would be an understatement to say that Italy fares poorly under our International Tax Competitiveness Index. Italy ranks as the second-worst overall 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. system in the OECD, behind only France.

It takes a lot of things to go wrong for a tax system to be as uncompetitive as Italy’s. But the way these problems usually start is with narrow, poorly-defined 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. s. I think a look at Italy’s Value-Added Tax (VAT)A Value-Added Tax (VAT) is a consumption tax assessed on the value added in each production stage of a good or service. Every business along the value chain receives a tax credit for the VAT already paid. The end consumer does not, making it a tax on final consumption. is rather instructive here.

Italy’s VAT comes in at a 22 percent rate. That’s a really big number for a VAT. It’s a higher rate than that of most countries in Europe: for example, it’s above the rates in France (20 percent) and Germany (19 percent.) It’s more than twice the VAT rate in Australia (10 percent), and almost three times that of Switzerland or Japan (8 percent.)

With a VAT rate that high, you could typically fund a great many things. In fact, for a country like the United States, a 22 percent VAT with a broad base could fund most of the government all by itself. But Italy does not have a broad base. What does that mean, exactly? It means that the VAT, in practice, applies to relatively little of the economy. Some economic activity is taxed at the 22 percent rate, some is taxed at a reduced 10 percent rate, some is taxed at a further-reduced 4 percent rate, and some isn’t taxed at all.

While the U.S. does not have a VAT, this is similar, in practice, to the way that U.S. sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. es end up working out. Sales taxes, set at the state and local level, generally have all sorts of activities exempt from them. This is often because they apply explicitly to certain items, and then, as new services are invented, more and more of the economy becomes exempt from the tax. However, U.S. sales taxes are typically at much lower rates than the Italian VAT overall.

Italy’s corporate tax, like its VAT, also has some big issues. It has a high rate by European standards at 27.5%, but it doesn’t raise as much revenue as it could; it has a lobbying system for research and development incentives, and 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. ” with a lower rate in order to prevent more mobile kinds of corporate income from profit-shifting to other countries like Switzerland, Ireland, or Luxembourg. In practice, though, patent boxes can cost more revenue than they get back from international profit-shifting, and they always add complexity to the process of corporate tax filing. The most useful corporate 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/local taxes paid, mortgage interest, and charitable contributions. , however (the cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages.  for actual capital expenditures built in Italy) is fairly un-generous.

To make up for these issues with the corporate tax and the VAT, Italy also has to have high individual taxes, and three separate 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. es, each with different rates. Wealth taxes are notoriously complex because it’s much harder to evaluate the worth of something if it’s simply being held by an individual, rather than sold in a market transaction. Additionally, Italy’s income tax filing is among the most complex in the OECD.

So what would it look like if the U.S. turned its tax system into the Italian tax system? It would be sort of like if we tripled all of our state and local sales taxes, blew some holes in our 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. system while simultaneously worsening the incentives for actual real capital investment, made our income taxes even harder to file than they already are, and then added some other obscure taxes to nickel-and-dime people.

Italy, even more than the U.S., could benefit from serious tax reform. The country is in need of revenue, and the current system, despite high rates, doesn’t generate that revenue effectively.