Nordic Economic Policy Review 2024

There are two main tools in economic policy: fiscal policy and monetary policy. Fiscal policy allows changes to be made on either the expenditure side or the revenue side, and those actions can be discretionary or automatic. In general, tax and benefit systems are built in such a way that they reduce fluctuations in individuals’ after-tax income. It is important for policy makers to know and understand the behaviour and magnitude of the automatic stabilisers, which is the topic of the article. It estimates the income stabilisation coefficient for Iceland in 2020 and, to my knowledge, does so for the first time, which makes the article an important contribution to policy discussion in Iceland.

The paper estimates the income stabilisation coefficient in the same way as Dolls et al. (2012), where

The value of the coefficient can be interpreted as a measure of the income insurance provided by the government, where the higher (lower) the ratio, the higher (lower) the income insurance. In addition, according to Dolls et al. (2012), the definition of the income stabilisation coefficient is close to the definition of the average effective marginal tax rate.

The simulations in the paper clearly demonstrate the structure of the income tax system, and the results show that, as expected, the income stabilisation coefficient is in line with the tax brackets. The results also confirm that the Icelandic tax system does not differ significantly from the systems in the other Nordic countries.

The results are highly interesting and will be helpful in the discussion and execution of fiscal policy. The Icelandic income tax system relies heavily on the use of tax credits: the personal tax credit, child benefits and the private housing interest payment subsidy. These are all geared towards lowering the tax burden on lower-income individuals and those with higher interest payments on their owner-occupied homes. It is, therefore, interesting and somewhat surprising that when income increases and decreases proportionally, the effects on the income stabilisation coefficient are largely symmetric, with the difference remaining within 0.4 percentage points (see Table 1).

One of the explanations has to do with the joint taxation of couples, which is a controversial issue in the Icelandic income tax system. If both partners have similar taxable incomes, the effects of joint taxation on their tax liability are negligible. However, if there is a significant difference in income between them, being taxed jointly reduces the liability, and the greater the income difference between the partners, the greater the reduction. In nearly 90% of cases where tax is levied jointly, the husband has a higher income than the wife (Fjármála- og efnahagsráðuneytið, 2019). In other words, joint taxation has a strong gender effect as it provides a negative incentive to work for married/cohabiting women. Let us take a simple example of a husband with a  high income and a wife who does not work. If she took a job, the wife would pay a marginal tax rate of 46.2% on the first-earned króna instead of benefitting from the personal tax credit on her income. This will, of course, have an adverse effect on her willingness to take a job. Thus, joint taxation can have an adverse effect on the labour force participation rate for women. The effects of joint taxation are visible when comparing tables 1 and 4 in the article, where the income stabilisation coefficient is 0.3 percentage points higher without joint taxation when wages increase by 5%.

Table 7 shows the proportional effects of the tax credits on income distribution, where the income stabilisation coefficient is different depending on whether income is above or below the median. The difference is a staggering seven percentage points. The effect of a proportional decrease in wages is 31.9% if the income is below the median, compared to 38.1% for the population as a whole. On the other hand, with wages above the median, the income stabilisation coefficient measures 39.1%, which is close to the average of 38.1%. The redistribution of income due to the tax credits is, therefore, significant on wages below the median, while only mild effects are seen on wages above the median.

The analysis in the article is static and based on the tax system and payments in 2020. The next step would be to estimate the behavioural effects of changes to the tax system. In their QMM model, the Central Bank of Iceland (2019) has estimated the size of the fiscal multiplier. For a government expenditure shock, the short-run fiscal multiplier has been estimated at 0.8, while for an income tax shock, the short-run multiplier has been estimated at 0.3.

In general, not much research has been conducted into the Icelandic income tax system. Interesting aspects can be identified from the estimates of the income stabilisation coefficient in this article, some of which I have discussed here. It provides important information that will enrich the discussion on fiscal policy in Iceland, and I hope further research will emerge in the years to come.

Fjármála- og efnahagsráðuneytið (2019). Endurskoðun tekjuskatts og bótakerfa hjá einstaklingum og fjölskyldum. Retrieved from: https://www.stjornarradid.is/library/02-Rit--skyrslur-og-skrar/Endursko%c3%b0un%20tekjujuskatts%20og%20bo%cc%81takerfa.pdf

Dolls, M., Fuest, C., & Peichl, A. (2012). Automatic stabilizers and economic crisis: US vs. Europe. Journal of Public Economics, 96(3-4), 279-294.

Central Bank of Iceland (2019). A Quarterly Macroeconomic Model of the Icelandic Economy Version 4.0, Working paper 82. Retrieved from: https://www.cb.is/library/Skraarsafn---EN/Working-Papers/WP82_net.