Myths around tax progressivity and private passive income

Having followed the Portuguese budget preparations that call for a move beyond flat taxation of private passive income (whether limited to rental income or also covering investment income and gains) and the myriad of opinions floating around, I decided to put pen to paper on some personal thoughts hopefully to help crack some perceived "myths" over this topic.

1st Myth – “the change is a tax policy decision that a government may adopt based on its political views/aims on the tax system”. In my view this is wrong. This is wrong first because structural tax cornerstones should not change at the flavour of government colour. Secondly, the dual system of taxing at progressive rates employment/pension related income and flat rates passive income is entrenched in our system already for some years and should be deemed structural. In other words, only revised and discussed through a more far-reaching tax reform exercise that assessed carefully all impacts of such measures.

2nd Myth – “Such change is justified because we are following the international benchmark on taxing passive income”. In my view this is also wrong. Despite being a strong supporter on the use of benchmarkings on tax reform processes, my personal experience thought me a lesson - you may not use innocuously references such as “if country X, Y or Z taxes passive income like this, we should also tax passive income like them”. In other words, a benchmark on a structural tax policy decision such as this one needs to be framed in a much wider analysis to grasp the tax and non-tax policies behind each country choice, GDP and tax mix.

3rd Myth – “Most European countries tax passive income at progressive rates”. This is also wrong. First, the instances where passive income is taxed at progressive rates is limited to certain specific categories (such as capital gains, rental income, or dividends in some countries) and always subject to several exemptions for long-term holdings, reduced rates depending on size of entities divested, reliefs for double taxation, wider deduction of expenses such as mortgage loan interest, etc… Those preferences (unfortunately found in all small letter print of all tax laws) significantly lower effective rates (even when not taxed at flat rates). Indeed, if there would be a rule in Europe it would be the rule of flat rates (at even lower rates than the 28% currently charged in Portugal).

4th Myth – “The current 28% rate is a low rate”. This is also wrong. A professor once told me “tax policy is generally not a question of getting the tax rate right but mainly a question of getting the tax base right”. You can identify hidden progressivity when certain types of expenses are not taken into account to deduct income or when certain losses and are not offsetable against profits. Definitely the 28% is not a rather low rate and if you analyse further the tax base you reach the conclusion that in certain cases the effective rate in Portugal may be higher than the purported 28% (without opting for aggregation). For example for a shareholder of a closely held-company deriving 100 of pre-tax profits he will see an aggregate effect of CIT and PIT of 44,2% (not counting with state surtaxes that may apply at CIT level and other charges). As for rental income, there is no relief for mortgage interest.

5rd Myth - “Such change is an effective way for the richer pay their fair share of tax”. This assertion is also in my view wrong. First, the debate of the fair share is strongly contaminated by political bias and would require a more careful analysis on the right forum, which definitely is not a first budget discussion. Secondly, the debate of inequality (underpinning the call for progressivity) is not dealt simply by progressivity. Inequality is a national (or worldwide) debate where tax policy measures are one of the tolls available. Thirdly, unless the intention of such measure is to affect investment choices or patterns of the wealthier (a goal undoubtedly achieved) the outcome is short-minded because further progressivity on passive income will make investors seek investments of capitalization where tax is deferred to realization (and realization can be a very, very long term thing). The aim should be simplification and neutrality across type of assets invested. 

In conclusion, it is easy to catch that I am against “more progressivity” on passive income (even if limited to rental income). Portugal needs in my view to move on the opposite direction. Portugal is now “trendy” and trends change fast and this timing (public finances aside) may represent the “last opportunity” to truly incentivize entrepreneurial activity, enhancement and diversification of savings and position Portugal clearly as a flat tax system on capital gains, rental income, and investment income (dividends and interest) that is competitive internationally. Eliminate certain preferences across types of assets and have a 20% rate – I suspect the tax proceeds would increase. Now back to reality, since lower tax is not possible under the current setting, my personal request as taxpayer is simply not to change nothing. Better “play motionless“ than “play wrong”.

"Opinions expressed are solely my own and do not express the views of any law firm or organization to whom I am affiliated"

16 November 2019