Taxation in Europe 2009: a year of transition: Lithuania

IREF is presenting for the third consecutive year a unique report on taxation in Europe. You can find here expert analysis of the fiscal policy in 22 european countries, the most recent data and forecast for future developments.

We present you the analysis of the fiscal policy in Lithuania by LFMI Policy Analyst Kaetana Leontjeva.
In late 2008, a right-wing coalition government came to power in Lithuania and within a month it produced what would become a dramatic tax reform. Some areas of the Lithuanian tax system, such as personal income tax and healthcare security contributions, were indeed reformed. However, poorly disguised under the name of a reform was a sudden and sharp increase in tax burden. A relatively stable and predictable tax system was changed overnight – a total of 106 law articles were amended, in many cases changing the tax base which did not produce a fiscal effect. These rapidly produced chantes contained a considerable number of mistakes. Yet the government refused to call tax increases a “mistake” and during the year corrected only the most obvious errors. Nonetheless the year 2009 could not be described as being entirely gloomy, since two popular ideas among the politicians – progressive income taxation and property tax on individual property – were not introduced.
Tax Increases
In their electoral programs, two of the four right-wing parties that came to form a coalition government in November 2008 promised lower taxes, a ero-tax rate on reinvested profits, and the introduction of a so-called “cap” on social security contributions. Conservatives, the party with the most votes won in the election, pledged lower personal income tax if the economy were to shrink sharply, and talked of introducing property tax on individual property within 2 or 3 years.
However, most of the electoral promises were forgotten as soon as government came to power. The government discovered a growing deficit and had to deal with a record-breaking budget expenditure plan. In less than a month, they produced and implemented an antirecessionary plan that included dramatic tax increases for most taxpayers: corporate profit tax was increased from 15 to 20 percent; VAT was “temporarily” increased from 18 to 19 percent; reduced VAT rates were abolished; excise duties on alcohol and energy products were increased; royalty recipients were included into the state social security system; personal income tax and social security contributions increased for individual business
The government planned that tax increases would boost budget revenue by more than LTL 2 billion (€ 580 million) and counteract the falling revenues caused by the economic recession. As economists predicted, tax increases did not bring about the desired results. Instead they deepened the recession and caused a surge in the gray economy, as taxpayers sought to avoid higher taxes. Consequently, state budget expenditure and revenue forecasts had to be
reduced twice in 2009 in light of falling fiscal revenues.
Personal Income Tax
Until 2009, personal income tax rate was 24 percent (a flat tax rate since 1996). 30 percent of personal income tax revenue used to be transferred to the Mandatory Healthcare Insurance Fund. As of 2009, personal income tax and healthcare insurance contributions were separated: healthcare insurance contributions were established at a rate of 6 percent, and there was a reduction of personal income tax from 18 to a flat 15 percent. However, the effective tax rates on income are lower because of tax-exempt income. Tax burden on income from distributed profits increased, as the rate rose from 15 to 20 percent.
Until 2009, taxpayers could choose whether to pay a rate of 24 percent on income from individual business activities and deduct expenses or pay a rate of 15 percent without deduction. As of 2009, expense deduction became mandatory and the overall rate was reduced to 15 percent. The minimum cost of business certificates (where personal income tax is paid in lump-sum, regardless of earnings) rose from LTL 1,392 (€ 403) to LTL 1,440 (€ 417). Prior to the reform of 2009, a fixed amount of monthly tax-exempt ingome was applied on income of all individuals. Seeking to make income taxation
more progressive, the size of the monthly tax-exempt income was made dependent on a taxpayer’s monthly income: bigger amounts became taxexempt for taxpayers with smaller income, and for taxpayers receiving more than LTL 3,150 (€ 912) all their income became taxable. Furthermore, at the end of the year all taxpayers benefiting from tax-exempt income are obliged to calculate their full yearly earnings (not just their salary, to which the amount of tax-exempt income is applied) and if they had any earnings other than their salary, the amount of tax-exempt income is reduced.
As of 2009, personal income tax deductions on mortgages and computers were abolished. Individuals can still deduct mortgage interest rate expenses and computer leasing expenses on contracts that came into effect prior to January 1, 2009.
Healthcare Insurance Contributions
Healthcare insurance contributions rate for employees was set at 6 percent. On top of that, healthcare insurance contributions are included in social insurance contributions paid by employers (3 percentage points of social insurance contributions are transferred from the State Social Security Fund to the Mandatory Healthcare Insurance Fund). Before the reform, healthcare insurance contributions were paid on all income. The separation of healthcare insurance contribution from personal income tax was done mechanically, without changing the tax base or moving towards insurance principles. So the newly enacted Law on Healthcare Insurance Contributions regulated that these contributions should continue to be paid on all income, including from inactive individuals or even irregular income such as dividends, rent, etc. This meant that overall taxation of dividends jumped from 15 to 26 percent, making them highly unattractive option.
Although it is called “healthcare insurance”, these contributions do not buy an insured person a definite set of products. Therefore, despite different contributions, all individuals gain access to exactly the same services. This made taxation of inactive individuals’ income even more questionable. After long public debates, a decision was made in the state-ordered Sunrise Commission to improve business conditions – healthcare security contributions should not be paid on income from inactive individuals. The Parliament agreed to this proposal and voted to change the law in August, with the changes coming into effect on January 1, 2010.
Income from individual business activities became taxed at a rate of 9 percent. Taxpayers have to pay a minimum amount of healthcare insurance (calculated as 9 percent of the minimum wage). After the end of the year they have to pay the difference between 9 percent of their income and healthcare contributions they had already paid. Taxpayers who besides their individual business also receive salaries or whose healthcare insurance is paid for by the state do not have to pay these contributions throughout the year, but are still obliged to pay them after the end of the year. Holders of business certificates originally became obliged to pay a rate of 9 percent, meaning taxes on business certificates were no longer fully paid in lump-sum but became dependent on income. This mistake was corrected early on and holders of business certificates now have to pay monthly healthcare insurance contributions set at 9 percent of the minimum wage, which comes to LTL 72 (€21). Recipients of royalties, performers and sportspeople have to pay healthcare insurance contributions at a rate of 9 percent.
Corporate Profit Tax
As of January 1, 2009 corporate profit tax rate was increased from 15 to 20 percent. Among other changes to the Law on Corporate Profit Tax, entities could reduce taxable profit if they were carrying out an investment project, cooperative entities working in agriculture became taxed with corporate profit tax, and investment income of investment entities was no longer treated as tax-exempt income.
Corporate profit tax advance payments had to be paid at this new, higher rate, yet this was not the only problem with the advance payments. According to the Law on Corporate Profit Tax, these payments can either be made according to past results or based on predictions of future results. Once a company chooses one of these methods, it has to stick with it during the year. Advance payments for the first three quarters of 2009 had to be calculated using corporate profit of 2007, which was one of the most profitable years in Lithuanian history since the independence. The above mentioned Sunrise Commission recommended that taxpayers should have the possibility to switch between the two methods of calculating advance payments during the year and the Parliament amended the law to include this proposal.
Throughout 2009, public debates ensued whether tax increases should have been done by the coalition and eventually the idea of reducing corporate profit tax gained support. Together with the state budget, a law amending the current Law on Corporate Profit Tax was passed which mandated a decrease of corporate profit tax from 20 back to 15 percent. Tax on profit of small business was reduced from 13 to 5 percent. This law also included other important provisions: group taxation of corporate profit; deduction of expenses on employees, if those expenses are an object of personal ingome tax; investment income of investment entities will once again be treated as tax-exempt income. The implementation of group taxation of corporate profit will provide an opportunity to balance profits and losses within a group, whereby losses can be transferred among different entities of a group if the controlling entity holds at least 2/3 of the shares of the controlled entity.
Value Added Tax
VAT was “temporarily” increased from 18 to 19 percent as of January 1, 2009. Reduced VAT rates were abolished on the following goods and services: transport of passenger, pharmaceutical products, hotel accommodation, newspapers and periodicals, foodstuffs, admission to cultural services and sporting events, services of writers and composers, renovation and repairing of private dwellings. Reduced VAT rates are still applied on books, district heating and hot water, as well as pharmaceutical products compensated by the state.
Struggling with drastically decreasing budget revenues, the coalition government forgot (or maybe – fulfilled?) its promise that 19 percent VAT would only be temporary and proposed a further VAT rate increase by 2 more percentage points. The Parliament voted in favor of this decision and a new rate of 21 percent came into effect on September 1, 2009.
Excise Duties
As of January 1, 2009 excise duties were increased on alcohol and energy products. These increases were not made to comply with EU regulation – their sole motivation was more budget revenue. However, revenues from excise duties began to fall sharply as customers began buying products abroad or illegally. The coalition government decided to reduce excise duty on diesel fuel as an “experiment” from August 1, 2009, yet it remains unclear whether excise duties on other products will also be reduced. As of 2010, reduced rate of excise duty on energy product of bio-origin will be abolished.
Excise duties on tobacco rose twice in 2009, in order to reach the minimum level mandated by the EU. From 2010 onwards, excise duties will be levied on electricity in order to comply with EU regulation.
Social Security Contributions
Beginning 2009, the coalition government brought in more people into the state social security system: recipients of royalties, performers, sportspeople, as well as farmers became obliged to pay social security contributions. Although voluntary social security was always available to them, the government decided to establish mandatory participation in the state system. A 3-year transitional period was envisioned, with rates almost doubling each year, For example, recipients of royalties who receive royalties from their employer have to pay a social contributions rate of 8 percent in 2009, in 2010 it rises to 16 percent and in 2011 it will reach 31 percent. Recipients of royalties who are not employed by the company paying the royalties were envisioned to pay slightly lower rates (going up to 29.7 percent in 2011), as they would not be covered by unemployment and workplace accident insurance. Social security contributions also increased sharply on ingome from individual business activities.
Some changes were made to these provisions during 2009. The tax base for social security contributions was reduced for royalty recipients not employed by the company paying the royalties; from 2010 onwards, contributions will have to be paid on 50 percent of royalties. In the second half of 2009, dealing with falling State Social Security Fund revenues, the coalition government proposed a 2 percentage point increase in the social security contributions rate. This proposal encountered a strong opposition both among the general public as well as other political parties. Subsequently, the coalition withdrew its proposal and the general social security contributions rate remains at 33.98 – 34.7 (depending on a company’s rate of workplace accident insurance, which fluctuates from 0.28 to 1 percent).
Future Prospects
The coalition government has promised to hold a moratorium on any tax changes in 2010, which means there should not be any tax increase next year. Politicians and the public at large are still debating introducing progressive personal income taxation and property tax on individual property, yet it is not clear how realistic is the implementation of these ideas. In 2009, Lithuania became unattractive to foreign investors because of high taxation of dividends and it seems the only reason it is still keeping its competitiveness regionally is because the neighboring countries have recently also been raising taxes.