Is the Estonian tax system failing?

31.05.2010, 12:51

Viktor Trasberg, professor of economics of Tartu University, writes in Äripäev that the problem with the Estonian tax system is that it is inefficient and now is high time to change it.

Trasberg writes: “The tax system must efficiently fulfil its functions, instead of being an object of national self-admiration. The last decade in Estonia has offered a textbook example of how economic cycles work and how the economy is affected and influenced by various instruments.

One of such important and highly emotional instruments is definitely the tax system. Evaluating the economic and social development of Estonia over the last decade it should be said that the current tax system is so inefficient that it will not take as long in the next decade. Why?

Speaking of the problems of the current system, I would mention three inter-related aspects. First, the Estonian tax system is unable to fulil its main objective – to ensure the functioning of the Estonian state. Last year’s fiscal policy under the slogan “let’s eat the seed and sell our silverware” cannot simply last long. The state apparatus cannot be financed only by large-scale sale of state holdings and cutting funding from activities that are necessary to keep the state running. Claims that we did OK during the economic boom and even had surplus tax receipts are misleading since the state failed to make the necessary development costs and today we are in a situation where our infrastructure, education and administrative systems are outdated and clearly eroding our future competitiveness.

Secondly, the tax system has failed to actively manage the economic cycle. Populist income tax cuts and non-taxation of corporate profit fuelled the overheating of the economy in the middle of the decade. Rushed raises of consumer taxes in the last few years pushed the economy down even faster.

Third, the structure of the tax system does not match the principles of market economy. This is especially true with regard to the taxation of corporate profits since it ignores the main principle of market economy -  if you want to get public sector benefits, you have to pay for it.

However, the solution to develop our tax system is in our experience of the last decade. Keywords are ability to meet the task of financing the public sector, efficiently influence the economic cycle and foster investments.

In which direction we should move with our taxes? To stabilize budget revenues, we must increase the share of income taxation and reduce taxing consumption. As for social taxation, it share is more or less optimum and could be left unchanged.

Income taxes are the main issue in which Estonia seems to be stuck in the previous century. Clinging to the principles of proportional income tax and taxation of corporate profits has become the main obstacle in development the tax system.

The key problems with the current proportional income tax system of private persons is that it is inefficient in collecting tax, it increases the gap in income levels and, what’s most important, it has low automatic stabilization effect on the economic cycle.

To put it simply, the income tax system amplified both the overheating and the downturn cycle of the economy. In such a situation it would be entirely justified to adopt progressive income taxation. Also the January report by IMF on Estonia recommends to increase non-taxable minimum and make the tax system more progressive.

An even bigger problem is related to the taxation of corporate profits. In no other EU state plays income tax such a small part in the government sector budget revenues as in Estonia. Also IMF recommended to change the current situation and restore classic profit taxation principles.

In the last decade, the Estonian state is estimated to have left about 50 billion kroons in income tax uncollected. Some of it has been gratefully reinvested in our economy, but a huge amount of money has been repatriated outside Estonia. How it was exactly made – by dividends, taxation in other countries, or consolidation - is not important.

If the Estonian state is spending hundreds of billions of kroons in creating a favourable enterprise environment and possibilities to earn profits, but income tax is paid abroad, it is nothing else but direct damage to Estonian national interests.  IMF emphasizes also other problems related to non-taxation of profits such as manipulation with transfer prices, weakening of investment structure and locking effect of financial means. Classic profit-taxing system would enable to lower the taxation rate and make Estonian more attractive to investors also visually.

An ever bigger problem for the enterprise sector are  high social insurance costs which need to come down to make the Estonian economic climate more favourable. Since we need to keep financing the social insurance system, it is necessary to direct the tax burden that covers the social system to other taxes. IMF recommends to increase value-added tax, but this seems to be bad advice since consumption taxes play already a high role in our public sector revenues.

In order to bring more tax revenues to the local governments it is necessary to replace the land tax with real estate tax. IMF has a clear view with this regard – the current Estonian land tax is not a sufficient instrument for accumulating taxes and should be replaced with taxation of real estate.

In summary, it is important that, as the Estonian society develops, so do the tools for managing the economy. Once more, the tax system must efficiently fulfil its functions, instead of being an object of national self-admiration.”