Paper delivered at an international conference “Tax Competition and Competitiveness,” Vilnius

 

 

Being a very small country Estonia has always been trying to have attractive and competitive economic policy. We have passed fast and radical privatisation and monetary reform, been very open to trade and capital movement, have a flat income tax, and have kept fiscal balance. For 3 years we have had income tax system where reinvested profits are not taxed.

 

In 1994 the idea of abolishing of corporate income tax was written in the program of Estonian Reform Party, the leader of which has been today`s prime minister Siim Kallas. A couple of years later the first attempt to realize it was made in the Parliament. A technically primitive bill was presented to the Parliament, declaring that corporate income would remain untaxed, and eliminating all the previous corresponding paragraphs in the income tax law. This variant quickly appeared to be useless because it would have caused massive tax erosion.

 

This initiative induced other ideas to the same direction but those had less meaning for the economy-lowering of the tax rate from 26% to 15%, or exemption of investments in buildings and equipment, except for Tallinn and its neighbouring municipalites.

 

By the beginning of 1999 the completely new law was ready, passed in December and put into force since the beginning of 2000.

 

 

Our goal was to promote economic growth via attractive investment climate and making additional funds available for resident legal persons and non resident legal persons having permanent establishment in Estonia. We also needed to prevent tax free profit transfers through off-shore companies

 

The new law taxed profit distribution instead of taxing profits.

 

Dividends, fringe benefits, gifts and donations, non-enterprise costs have remained subject to taxation. As problems of tax erosion are much more crucial, if profits remain untaxed, transactions with off-shore companies must meet stricter treatment, payments to them are subject to income tax.

 

Fringe benefits were imposed equal effective tax rate with salaries.

 

Estonian income tax system is very different from tax heavens and provides fair competition, because corporate income tax has preserved, only its principles have changed; taxation of payments to natural persons and hidden profit transfers have been preserved; all kind of companies are treated equally; accounting and reporting obligations, public registers, information exchange between authorities have remained; tax free profit transfers out of the country are not allowed.

 

 

The income tax law has been valid only for less than 3 years, so we cannot tell for sure whether certain things have happened in Estonian economy because of the reform, or simply after that. But the general belief is that the reform has been effective, the law technically good, it has influenced our economy very positively and made our investment climate more competitive.

  

 

In 2000-2001 the average real growth of investments in capital assets was 9.1%. In 2000 the fastest growth, 30% took place in the smallest companies (with up to 19 employees). In 2001 due to some changes in statistics we cannot compare all the numbers, but we could say that in companies with 20-49 employees it was 73%, in bigger ones 14%, in 2002 the trend is also in favour of smaller enterprises.

 

The reason for that is the problem of funding which is more serious for smaller companies. The reform helps to solve it.

 

Those companies are the ones where the whole employment growth comes from.

 

 

 

 

 

The amount of foreign investments is fluctuating and dependent on finished privatisation and certain bigger transactions. But the growth of reinvested profits is convincing, the share of it in investments has grown from 16% in 1999 to 40% in 2001.

 

 

 

Investment rate was very high during the first half of 2002.

 

Inquiries carried out among foreign investors estimate income tax reform to be the most important improvement in the investment climate.

 

FDI balance is clearly positive, but the outflow of investments also grew by 30%, which shows and secures competitiveness of our companies.

 

75% of Estonian business leaders said the tax reform influenced their company positively.

 

Unemployment has decreased constantly since the reform, from 14,6% at the beginning of 2000 to 9,1% in the third quarter of  2002.

 

Dividend payments for previous periods increased in 2000 because of some transition regulations, but decreased after that, as dividends became the subject to taxation, not the profit itself.

 

The biggest fear, loss of budget income, was overcome successfully.

 

 

 

 

It was disciplining that public expenditures were cut by around 1 billion kroons. But in the course of time the loss has been partly compensated by the tax on profit distribution first of all, dividends and fringe benefits. We can say that decisions of investments in any kind of asset or profit distributions have been made by necessity, for generating development, not for the reason of taxation. The term “investment” has not been defined, that is investing in any kind of asset is not discriminated. The result has been more investments and more rational structure of expenses and assets. 

 

The declared profits of companies have raised sharply after the reform.

 

This shows how conditional corporate income is. We got much more adequate picture of the economy when there was no more stimulus to hide profits.

 

Tax administration was given a strong stimulus to deal with fraud. For the last couple of years its authority and quality of work has considerably improved.

 

There is much less reason for using off-shore companies now.

 

Of course, there have been difficulties with introducing such a radical change. There has been a lot of international jealousy and suspicion as well. We have had to prove that the law is a form of fair competition, which a small economy needs, that we are not a tax heaven and not in contradiction with European regulations. We had to make slight changes in tax agreements, and managed to prove ourselves at EU negotiations. We were given transition period for until 2009 to cope with the parent-subsidiary directive. The question is whether tax on dividends to parent company is an obstacle to free capital movement.