The Income Taxation System of the Czech Republic

Table of Content

1. Introduction

2. General Principles of Income Taxation

3. Income Taxation in the Czech Republic
3.1 Type of Income Taxes and Surcharges
3.2 Definition of a Resident Taxpayer
3.3 Income Categories
3.4 Personal Allowances and Family Taxation
3.5 Tax Rate

4. Conclusion

References

1. Introduction

The objective of this paper is to analyze the general principles of an income taxation system with regard to its realization and application in a specific European country, i.e. the Czech Republic. Therefore, the principles of an ideal tax system are introduced first, before relating those concepts to the respective tax rules of the Czech Republic. Specifically, the type of income taxes, the definition of a resident taxpayer, the income categories, personal allowances and family taxation, and the tax rate of the country will be presented and linked to the general principles of a tax system. Please note that the Czech Republic uses the Czech crown as a currency. All numbers quoted have been converted into the Euro using the following exchange rate: 24.45 CZK = 1 EUR.

2. General Principles of Income Taxation

In general, six principles build the foundation of a tax system that is considered to be “good”: sufficient and stable revenue collection, efficiency/neutrality, vertical and horizontal equity, minimum costs of administration and compliance, flexibility, simplicity and transparency and international competitiveness. Four of those principles date back as far as to the 18th century when Adam Smith put forward the “so-called maxims with regard to taxes in general”¹. Two of the six principles have been added by later economists.

The most straightforward principle is revenue collection. Income taxation is a fundamental tool to achieve a steady flow of revenues to finance governmental policies. Therefore, the tax system needs to ensure a stable revenue yield by a consistent taxation that is “resistant to business-cycle fluctuations”² and can cover government expenses. At the same time, income taxation should be carried out at minimum costs of administration and compliance to avoid a dilution of the revenue stream. All costs associated with the collection and payment of taxes should be in a reasonable relation to the amount of taxes collected, otherwise it is inefficient. Efficiency is therefore another main principle of an ideal income taxation system. Taxes should have “no impact on people’s preferences to work, invest, save and consume”³. Hence, the tax system should be as neutral as possible in order to enable economic growth instead of creating burdens to it. A fourth principle relates to the matter of fairness or equity. Vertical equity means the redistribution of income from high- to low-income households by the government whereas horizontal equity describes the equal treatment of persons in a similar position. This implies also that people in dissimilar positions are treated unequally⁴. Both is perceived to be fair because it is closely related to the “ability to pay” principle which suggests that people should be taxed according to their financial capacity. Generally, net income is widely accepted as a good indicator for the financial capacity of an individual. A further principle of income taxation is flexibility, simplicity and transparency which basically means that a tax system should be resistant to changes in political values of individuals and society and that its measures should be easily understandable and transparent. Otherwise people might not accept and can oppose it. The last principle of a “good” tax system is described as international competitiveness or adaptability. In times of increased globalization with very flexible and mobile workers, capital and commodities the need for adaptable national tax systems rises. That means, taxation should be “flexible in responding to international tax issues”⁵ and responsive to any economic developments.

In practice, however, no country is able to implement such an ideal tax system because several counteracting forces and trade-offs exist. A typical trade-off involves vertical equity and efficiency. By collecting higher taxes from people with a high income, excess burdens are created that influence the decision or preference to work for those persons. Political objectives can also create trade-offs, as political parties might promote one or several principles over the others. For example, allowances for specific age groups that are the main target for the party might foster vertical inequalities and increase the complexity of a tax system. Other counteracting forces can be economic objectives, e.g. through introducing tax breaks for investment income to promote savings. Thereby, inefficiencies in the tax system are created and administration costs rise. Henceforth, the design of an optimal tax system depends on different objectives and values and this is why tax systems vary from country to country.

3. Income Taxation in the Czech Republic

As indicated above, several different types of tax systems coexist in the world. As an example for the application of the above mentioned principles of an ideal tax system, the income taxation system of the Czech Republic is presented in this section.

3.1 Type of Income Taxes and Surcharges

In the Czech Republic, two types of income taxes exist: the regular income tax and a final withholding tax. The difference is that a final withholding tax withholds the tax due directly at source. This means that the gross amount of taxable income, without deducting any costs, serves as the tax base. The regular income tax, on the other side, allows for several deductions and allowances which reduce the tax base and lower the amount of tax due. Generally, the tax system of the Czech Republic can be described as quite simple. Although there are several different categories of income (see section 3.3), most of the taxable income is aggregated into a single tax base which is subject to the regular income tax. Nevertheless, there are a few items of “passive income”⁶ of which each constitutes a separate taxable base (see also section 3.3). No deduction for expenses is allowed for these items, they are taxed on gross income, as described above. Besides those two income tax types there are no other surcharges that are levied. This keeps the tax system simple and transparent and reduces costs of administration.

3.2 Definition of a Resident Taxpayer

A resident taxpayer of the Czech Republic is defined as a person who has its permanent home (residential address) in the country or stays in the country for at least 183 days a year, except for any stays for studies or medical treatment. The latter definition is shared by most European countries to simplify the cross-border rules for an increasingly mobile society. By applying the principle of unlimited tax liability (worldwide principle), the Czech authorities also prove flexibility with regard to residents working abroad and keep the stable revenue yield alive. Thus, these definitions make the tax system internationally, or at least pan- European adaptable.

3.3 Income Categories

In general, income and capital gains are divided into the following five categories: employment income, business and professional income, income from capital, rental income, and other income. Other income includes any income not belonging to one of the other categories. Taxable income is computed separately for each category by subtracting any allowable expenses.

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¹ Vermeend et al. (2008) p. 59

² Ibit

³ Spengel (2010) p. 61

⁴ See Vermeend et al. (2008) p. 59

⁵ Vermeend et al. (2008) p. 60

⁶ IBFD: European Tax Handbook (2010) p. 191