The Lessons of Denmark’s Foreigners’ Tax Scheme

by Reihan Salam

Last year, the economists Peter Diamond and Emmanuel Saez published an argument for steeply progressive taxation, which among other things suggested that the top federal income tax rate could stand to be much higher. Arpit Gupta offered his thoughts on the Diamond and Saez article, and he briefly referenced Saez’s work on Danish tax policies designed to attract high-earning expatriates. VoxEU has just released a short summary of the findings from the authors, Henrik Kleven, Camille Landais, Emmanuel Saez, and Esben Schultz:

While an enormous empirical literature has studied the effect of taxation on labour supply and earnings within countries, there is almost no empirical work on the effect of taxation on the mobility of workers across countries. In a recent paper (Kleven et al. 2013), we break new ground on the importance of tax induced migration effects among top earners. To study these questions, we use quasi-experimental variation created by a Danish preferential tax scheme for high-earning immigrants enacted in 1992. Under this scheme, the tax rate on labour earnings is reduced to a flat rate of about 30% for a total period of up to three years. Eligibility for the scheme requires annualised earnings above a threshold (indexed to average earnings growth and equal to about €100,000 in 2009), corresponding roughly to the 99th percentile of the distribution of individual earnings in Denmark. This scheme is much more generous than the Danish regular tax system, which imposes a top marginal tax rate of about 62% above €47,000 (as of 2009). Absent the special tax scheme, workers with earnings above the scheme threshold would face average income tax rates of around 55%, about twice as high as the scheme rate. When the three years of preferential tax treatment have been used up, the taxpayer becomes subject to the ordinary Danish tax schedule on subsequent earnings.

We find striking evidence that the scheme had a very large effect on the number of highly paid foreigners in Denmark. Figure 1 summarises our results. It shows that the number of foreigners in Denmark paid above the eligibility threshold (that is the group affected by the tax scheme) doubles relative to the number of foreigners paid slightly below the threshold (those are comparison groups not affected by the tax scheme) after the scheme is introduced. This effect builds up in the first five years of the scheme and remains stable afterwards. As a result, the fraction of foreigners in the top 0.5% of the earnings distribution is 7.5% in recent years compared to a 4% counterfactual absent the scheme. This very large behavioural response implies that the resulting revenue-maximising tax rate for a scheme targeting highly paid foreigners is relatively small (about 35%). This corresponds roughly to the current tax rate on foreigners in Denmark under the scheme once we account for other relevant taxes (VAT and excises). Importantly, the revenue-maximising tax rate on natives is much higher, because the response of migration with respect to the net-of-tax rate among expatriate natives is very small. In other words, highly skilled expatriates (who would be eligible for the scheme if they haven’t been in Denmark for three years) do come back more because of the scheme.

The authors conclude that Denmark’s foreigners’ tax scheme has been so effective that it necessitates international tax coordination:

Absent international tax coordination, preferential tax schemes to high-income foreigners could substantially weaken tax progressivity at the top of the distribution. This will require international policy coordination and the design of rules regulating such special schemes in the EU in coming years.

I would suggest that the success of Denmark’s foreigners’ tax scheme is instead an argument for restraining increases in top marginal tax rates for all workers, immigrants and natives alike.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.