Estonian Corporate Tax Model Should Return Home, to Lithuania

Quinten Massys, „Tax Collectors“, 1520.

Quinten Massys, „Tax Collectors“, 1520.

The Lithuanian government has enlisted Lithuanian Free Market Institute’s (LFMI) proposal for adopting the Estonian corporate income tax model among Lithuania’s main tax reform alternatives.

The Estonian corporate income tax model allows retaining profits tax-free and provides an inherent source of investment capital for firms, while also attracting foreign direct investment. According to the International Tax Competitiveness Index published by the Tax Foundation, the Estonian tax system has been recognized as the world’s most competitive system for the seventh year in a row. The Estonian corporate income tax regime, in effect since 2000, is named as one of the keys to success.

Lithuania applied a zero-tax rate on reinvested profits from 1997 through 2002. This reform, first crafted and advanced by the Lithuanian Free Market Institute back in 1995, gave an immense impetus to the country’s economic advancement. After the zero tax rate on reinvested profits was revoked, preferential tax allowances have been granted for different groups of economic entities and types of investments. These policies have only confirmed that a better environment is needed if we want to spur investment growth.

Today business profits in Lithuania are subject to the corporate income tax plus the personal income tax when dividends are paid out. The combined effective tax rate stands at 27.7 percent. At the same time Estonia and Latvia tax only redistributed profits, at 20 percent. Poland followed suit in January this year and adopted partly the Estonian model. With the double taxation of business earnings, Lithuania is clearly losing its competitive advantage in the region.

Back on track

Lithuania’s new coalition government comprised of the conservative Homeland Union-Christian Democrats, the Freedom Party, and the Lithuanian Liberal Movement has started public consultations on tax reform. LFMI’s recommendation for adopting the Estonian corporate income tax model has been put on the table together with two other reform alternatives. One of them is the expansion of the existing tax breaks for R&D and the other is a proposal from President Nauseda to grant tax breaks for companies that increase wages.

While only 1 percent of companies have been able to benefit from the existing R&D tax allowance due to complicated bureaucracy and rules, the President’s proposal seems to miss on economic laws governing the workings of the market, investments, labor productivity, and wage growth.

In a research report “What corporate income tax model would promote investment and prosperity?” LFMI builds the case for the tax regime that taxes redistributed profits only.

The disproportionate burden of the corporate tax is detrimental to economic growth: it drains investment resources and distorts business decisions, reducing the efficiency at the corporate level and in the country’s economy overall. LFMI argues that long-term economic growth in a post-COVID economy will depend on investment-driven productivity gains which in turn are essential for employment, income growth, and budget revenues.

Lithuania is facing growing regional competition for FDI. The country needs more high-value-added jobs, better conditions for domestic businesses to grow, and a stronger productivity boost. Domestic firms continue to suffer from a severe lack of access to credit, while the level of reinvested profits is among the lowest in the EU, standing at 20 percent compared to the EU average of 24 percent. Net capital stock per employer is 2.7-times lower than the EU average. Such a gap is the main reason for the differences in income and wages between Lithuania and Western European or Scandinavian countries.

LFMI argues that the actual corporate income tax model imposes a significant indirect burden on companies, especially small and medium-sized ones. The costs of administering the income tax are regressive: the smaller the company, the higher the ratio of the cost.

The Estonian corporate income tax model allows retaining profits tax-free and provides an inherent source of investment capital for firms. LFMI claims that the reform would accelerate Lithuania’s sluggish technological advancement and productivity growth while facilitating faster economic recovery from the COVID-19 crisis.

Difficult times require systemic changes. The Estonian corporate tax model should return home, to Lithuania.

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