Shifting the Tax Burden from Consumption to Income in Croatia: Preserving Efficiency while Reducing Inequality

This paper analyses the distributional effects of a fiscally neutral tax reform in Croatia that shifts the tax burden from consumption to labour income, capital income, and property. Such a reform can be considered justified given the imbalances of the Croatian tax system, which is characterised by an exceptionally high share of indirect taxes and relatively low taxation of labour, capital, and property income compared to the EU average, contributing to regressivity and greater income inequality.

The proposed reform consists of increasing the progressivity of the personal income tax (through the introduction of higher tax rates), raising taxation of capital income and property, while simultaneously reducing the standard VAT rate and expanding the reduced VAT rate. The analysis is based on the application of microsimulation models of direct and indirect taxes, using EU-SILC and Household Budget Survey (HBS) data, with corrections to the income distribution using administrative data to ensure a credible simulation of direct and indirect taxes.

In addition to distributional effects, the paper also assesses the impact of the reform on efficiency using a behavioural labour supply model. The results show that the reform does not have a significant negative effect on labour supply, increases the fairness of the tax system by reducing inequality, and delivers the largest gains to lower-income households and more vulnerable social groups, while the richest households incur losses due to increased direct tax burdens. Overall, the reform increases progressivity and the redistributive effect of the system without compromising economic efficiency.