An alternative fiscal model

In many OECD[1] countries the fiscal system is founded on the criterium of progressiveness. For example, the Italian Constitution introduces such concern in the 53rd article. Instead, in the U.S. progressiveness is established in the 1st article of Section 9. Progressive taxation is a system in which the tax rate increases along the tax base. This principle has been discussed and criticized by the most liberal political parties all over the world. However, criticizing progressiveness is not the objective of this article. Fiscal imposition is, undoubtedly, a fundamental instrument to reach a more equal distribution of wealth. It is even more important its role in guaranteeing crucial resources to provide some essential public goods, such as education. I just want to point out that the majority of taxes, proportional or progressive, create distortions in individuals’ behaviours. To apply the principle of progressiveness, income tax is the most suitable instrument. In other types of taxes it is more difficult to implement such a criterion. Imagine how difficult could be the application of different rates per person in the consumption taxes. How could you levy different rates on the same product, let’s say milk, to people belonging to different income classes? There, the progressiveness criterion is pursued by differentiating products by individuals’ needs, levying different rates for commodities and so on.

The main drawbacks which could arise with taxes are :

  1. Labor supply disincentives: i.e., people prefer to work less to avoid paying additional taxes.
  2. Tax evasion, often related to the underground economy’s problems.


To understand if a fiscal system is progressive there are several methods. The easiest one is probably the evaluation of the average fiscal rate, which should increase as the taxable amount increases. How does it work? For each additional unit of income,  the amount of taxes paid on that unit increases more than proportionally. For example, consider two individuals A and B. A has an income of €1,000 taxed with a rate of 25%. If B earns €2,000, he should be taxed with a larger rate, let’s say the 30%.
 In Italy the average fiscal pressure reaches 45% by the highest income classes. Also, many other countries have similar problems. As claimed before, in these cases people are discouraged to work and increase their income. Alternatively, they are incentivized to evade, in order to avoid the higher rates and ensure that the additional hours of work produce also an increase in their net income. The average rate is, then, a necessary measure of progressiveness of a fiscal system. It is possible to calculate it as the ratio of the total sum of taxes paid over the taxable income earned.


Here, I want to introduce a fiscal model that could reduce the negative consequences pointed out so far, respecting also progressiveness. The major contribution to this model was given by the economist and Nobel prize James Mirrlees:  the optimal taxation model with decreasing rates.[2] I want to explain it with a heuristic procedure, directly giving a practical example. This model is presented in a basic form and it is not directly applicable to any actual fiscal system.

There are three individuals, Bobby Charlie and Denny, who earn different incomes. In particular, Bobby earns €500 monthly, Charlie €5,000 and Denny €10,000. In this simple society the minimum income to conduct an adequate and sustainable lifestyle is assumed to be equal to €1,200. Bobby clearly does not reach the minimum standard, so instead of paying taxes he needs some help. The support could consist of a total exemption for taxes or negative taxes, i.e. subsidies, in order to allow him to reach the minimum income level. Such policies are currently used in several countries. For the other individuals decreasing marginal rates are applied every €2,000 exceeding the minimum income. The starting marginal rate could be equal to 23% and it should not be lower than a certain threshold, let’s say 19%. In order to be strictly progressive, the marginal rates[3] cannot decrease to infinity.  The choice of the minimum income level as well as the different income classes subjected to each rate are completely arbitrary. It is crucial to define a minimum standard of living and some welfare policies. Therefore, even if the marginal rates are decreasing, the average fiscal rates for each class of individuals is still strictly increasing. The criterium of progressiveness still holds. Who earns more pays, proportionally to his/her income, more taxes.

Don’t you believe it? Get a calculator and I’ll show you some number:

  • Bobby earns €500 per month. He will be completely exempted and he will receive €700 to reach the minimum standard.
  • Charlie earns €5,000 per month. On the first €1,200 he will not pay anything. The taxable income is reduced then to €3,800. So, he will pay an amount equal to 23% of the first €2,000 (€460) plus an amount equal to 22% of the remaining €1,800 (€396). The total amount of taxes paid by Charlie is  equal to €856. Then, the average rate is equal to 17.12% (€856/€5,000).
  • The same scheme will be applied for Denny. He will be exempted for the first €1,200 and a decreasing rate will be applied every €2,000 above the minimum standard. In particular, he will be taxed with a rate equal to 23% on his first €2,000 (€460), on the following €2,000 with a rate of 22% (440) and so on. The remaining taxable €800 will be taxed with a rate equal to 19% (€152). The total amount of taxes paid by Denny will be equal to €1,872 . Compared to his taxable income, it results in an average fiscal rate equal to 18.72%.

Therefore, it is easy to notice how this system, even if it is built with decreasing marginal rates, follows a criterium of progressiveness. Denny pays more taxes on average than Charlie. This system has many advantages. In my opinion, the most important is that taxpayers are not discouraged to increase their income, or at least they are not discouraged to file for taxes. On the contrary, they are motivated to produce more, to earn more and to contribute more to the economic growth, with the extension of the fiscal base. Indeed, the marginal cost for each euro earned is gradually decreasing. One could point out that the poorest individuals are not incentivized to work, preferring to rely on subsidies. However, before any practical implementation, this fiscal system should also include a mechanism that balances the substitution between subsidies and minimal wages, such that the poorest are motivated to supply labor. A big parenthesis could be opened on this issue, but this is not the purpose of this article. I just remind you that the choice of the minimum threshold is purely casual. For some countries it could be too high, for others too low. To sum up, subsidies are conceived for needy individuals, not for those who want to settle only with them. This model was studied for those individuals who could be discouraged to earn more money, afraid of facing increasing marginal costs, compared to leisure, ceteris paribus.

written by Giovanni La Rosa

[1] OECD is an intergovernmental economic organization with 37 member countries that share the democratic system and the market economy.

[2] Mirrlees, James A., (1971).  “An Exploration in the Theory of Optimal Income Taxation”, Review of Economic Studies 38, 175-208.,

[3] The term marginal rate refers to the percentage of the latest euro of income ( or class of income) that must be paid as taxes.

EU needs a joint reaction against the covid crisis

The covid-19 pandemic hit Europe violently. The new coronavirus, which infected the first human in the Chinese region of Hubei, is changing our lives, subverting the political and economic framework. In the initial phase, the response of the European countries was scarcely coordinated and, often, late. The impact of the virus has been particularly severe in the economically most developed regions: Lombardy, Emilia-Romagna and Veneto in Italy; the Community of Madrid and Catalonia in Spain; the region of Paris, Ile de France; Bavaria, North Rhine Westphalia and Baden Württemberg in Germany; the Stockholm’s county in Sweden; Flanders in Belgium. Inevitably, the deep integration among the economies of the various EU countries was also an efficient vehicle of transmission for the virus. In absence of a joint strategy for the reopening, at European level, the risk of new spreading of the infections through these paths will be even higher in the next weeks.


Here you can see the diffusion of the virus on the interactive map


The most affected countries, Italy and Spain, have adopted very strict measures. They allowed to continue to carry out the production only to the companies producing essential goods and services or involved in strategic activities for the management of the crisis. On the other hand, the majority of EU countries chose a softer lockdown, closing commercial business in contact with the public, leaving most of the production companies open[1]. However, these restrictions, necessary to reduce the sanitary emergency, risk to undermine the European economy. The dimension of the crisis will diverge country by country. Indeed, the strictness of the measures, the direct and indirect damages of the epidemic and the financial capacity of each country to support its economy will make the difference. A precise and punctual intervention from the State is needed, providing the required liquidity to make it through the crisis.


The necessity to finance the spending with debt and its critical issues.


The main sources of financing for a State are taxation and the issuance of bonds on the markets. In the midst of a pandemic, a short-term increase in taxation is not a sustainable tool. The objective is to safeguard firms and to keep the productive and economic system alive. Instead, it is inevitable to increase the public debt to reduce the impact that an announced economic recession will have on every citizen’s life. As they demand loans on the markets to finance their spending, the States issue debt securities. Like any other loan, also government bonds embed the market risk – a reduction in the market value of the bond may cause losses to the holder – and, in extreme cases, the risk that the capital lent will not be completely reimbursed.
Generally, the more investors – banks, financial institutions, pension funds and households – will find it likely that the loan will not pay off, the more they will demand a high yield for the risk they are bearing. At the same time, the cost of the debt for the State will increase as the risk perception of the investors increases. Political and economic events together with the amount of debt outstanding affect the finances of the States. Moreover, they influence also the investors’ expectations and bond yields. A typical unit to measure the risk on public debt is the spread between a safe asset – usually in EU the reference is the German bund – and another government bond. Besides, to evaluate the dimension of a public debt it is common to use the Debt/GDP ratio (this topic was also discussed here).

The current situation of Public debt in the main EU countries;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

It seems clear that the European States are not all in the same condition. Spain and Italy currently are facing the hardest consequences from the pandemic, but they are also the States with the highest debt. In the last years Italian GDP grew slowly[2], and its debt reached 134% of GDP in 2018[3]. Similarly, Spain had a Debt/GDP ratio equal to 97.6%[4] in the same year. However, recently Spanish GDP had a consistent growth, 2% in 2019 and an average growth of 2.8% per year since 2015[5]. Nonetheless, before the financial crisis in 2007 Spain had a debt/GDP ratio equal to 35%[6]. The huge increase in debt due to the crisis forced the Spanish government to reduce the public spending and to enforce several additional reforms to increase its competitiveness and maintain the possibility to raise funds issuing debt on the markets.


Therefore, Spain and Italy are caught in the crossfire. On one side they are facing an unprecedented sanitary crisis, on the other they have to spend massive amount of money for the reconstruction of their economies. In addition, they may not be able to benefit of cheap borrowing on the markets.


Already as 21st April, the yield on 10 years Italian government bond (BTP) was 2.02%[7]. The equivalent yield on Spanish bonds was 0.97%[8]. As a comparison, it is interesting to see that the yield on 10-years German bonds is negative, equal to -0.481%[9]. Germany had a Debt/GDP ratio of 61.9%[10] in 2018. While, Netherlands has a yield of -0,177%[11] and France has 0.06%[12]. Following the increase of these debts, also the related yields will grow. The cost of financing will increase for all the EU countries, but this effect will be much bigger for the States that already have a high debt.;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E


The debate about the EU measures against the crisis


The sanitary crisis is a global emergency. In front of covid-19, there is no virtuous country, nor vicious. It makes no sense to blame the most affected countries with moral judgements. This crisis is symmetric, differently from the financial crisis of 2008. Notwithstanding, its impact and the timing will be different country by country. Since the beginning of the emergency, there has been a hard debate in the EU. The two factions were the supporters of a joint issuance of debt as common response to the crisis – among them Italy, Spain, France – and the opponents – among them Germany and Netherlands. At least in the initial phase, the opponents, confident on their ability to face the economic crisis on their own, were available to help the other countries only under strict conditions. Their proposal involved rigid rules on the repayment of the public debt and on the duration of the loans – European Stability Mechanism (ESM) with enhanced conditions credit lines.
Meanwhile, the European institutions gave their support to the most damaged countries with the specific Pandemic Emergency Purchasing Programme (PEPP) of the European Central Bank (ECB). So far, this intervention allowed to all the countries to maintain a low yield rates on their bonds. This is especially true for Italian BTP. Additionally, EU allocated other 540 billion euro to support the economy (more info here). Unfortunately, the dimension of the crisis requires further interventions. Issuing common debt – Eurobond or European recovery bonds – to finance the economic reconstruction can be the correct solution. Eurobonds would allow to the countries in difficulty to borrowing low cost from the market, making a step further in the European integration process.


Why a joint intervention is in the interest of the whole EU?


It’s not only a matter of European solidarity. Facing a recession of Eurozone GDP estimated as 7.5% by the IMF[14], no one is stable. There are not solid countries and individualism is not a feasible option. Furthermore, the European Union is a supranational organization that has shared for many years the benefit of being an open economic area. Freedom of movement for workers, goods and capital generated an interdependence among the member States. This is also confirmed looking at the destination countries for the export of Netherlands, Spain, France, Germany and Italy in the figures below.;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

The export is a fundamental component of the GDP for all the countries above. Especially for Netherlands that accrued an export/GDP ratio of 82.5% in 2019. Instead, Germany had a export/GDP of 46,9%[15]. Analysing the destination of this export it is extremely evident that the biggest share is directed to other EU countries. Italy is the fifth country for the percentage of goods and services received by the Netherlands and the sixth for Germany. While, Spain is the seventh destination country by dimension of export for Netherlands and the eleventh for Germany. Moreover, Germany and Netherlands are also destination of a significant share of Italian and Spanish export[16].

The European economies are deeply connected. Now it’s time for the European leaders to find an agreement for common and strong measures against the crisis. It will take time. It may require changes in the treaties and the EU budget has to be increased with additional contribution from every single country. This is in the interest of all the member States. Otherwise, the economic crisis will follow the same paths as the epidemic. The risks are an economic depression and the rise to the power of Eurosceptic parties, which may lead to the end of the European project.


Michele Corio



































Nuggets of Public Finance

The Government Budget is a complex document that represents in a detailed way the financial and economic condition of a country. In addition, through an accurate analysis of the public expenses, it is possible to find out important information about the culture and the social structure of the State.

Depending on the information searched and the goals pursued, we can distinguish several types of budget statements.

In this article, I will briefly refer to the final budget and the provisional budget to give an idea about the essential content of a public budget statement and about the role of Gross Domestic Production (GDP) in the evaluation of the total wealth produced, of the national income and of the welfare level inside a society.



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