Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
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Taxation in Estonia compared to other European tax systems

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Taxation in Europe - Yearbook 2013

Estonia

While Estonia has rebounded well from the crisis and is still an attractive destination for Nordic companies there needs to be a political thrive towards keeping Estonia’s competitive advantage. In the time were our close neighbours are discussing possibilities for making their economic environment more friendly to entrepreneurs, the local government has to react accordingly. Although being known for progressive and bold economic reforms, Estonia has become to a halt over the recent years. To battle the rising taxes and the growing public sector significant changes must be enacted. Unless necessary steps are made the current 10% public debt is only the beginning of a race to catch up with the Western Europe.

Estonia’s return to fast paced development

A fast growing economy has been Estonia’s trademark for the past two decades. While the crisis saw the GDP turn towards a deep fall that reached -14.1% in real value, it has turned around once again and is one of the fastest growing economies in Europe with 3.2% growth in 2012. This was partly the result of some successful policies by the government that focused on making the labour legislation more flexible as well as promoting entrepreneurship. A noticeable contribution was also made by European funds that were used to help starting new companies. Estonia has since gained a reputation as a great place for startups. Still, the long term benefits of this policy can be debated, as there have been several projects that did not turned out well, along with several companies going out of business altogether. Causing losses of thousands of millions euros.

Also, Estonia benefited greatly from other countries having to bail out their economies, making it possible to place exports back on the road to growth. Trade with Nordic countries, especially Sweden, and Russia has been highly beneficial to the Estonian rebound. In 2010 and 2011 Estonia’s exports grew more than 22% annually and in 2012 the growth continued at 5,6%. This surge resulted in a trade surplus; the first in a long time.
The recession has seen Estonian economy going through some structural changes with more focus towards sectors with high value added. Biggest shift in this direction has been in the production of electronic devices and equipment. Nordic countries that brought their production over here in order to escape from the more costly environment of their native countries plaid an important part in this change.

Taxes becoming a more important source of income

For a long time Estonia has been presented as a land of low taxes. Unfortunately this is a bit of a myth as the tax burden on Estonian citizens is not that different from what it is in other countries. Still, there remain significant differences structure of tax code. For one thing, the lack of corporate income tax has shifted the tax burden towards labour taxes. There is also a strong tendency towards taxing consumption through the value added tax and a variety of excises.
While total tax revenues are currently only slightly above 32% of GDP they have been even lower in previous years. The shift upwards was strongly affected by the crisis, which at one point pushed the share of the tax revenue rise above 34% of the GDP.

Tax revenues as percentage of GDP

Tax revenues as percentage of GDP

Although Estonian politicians have always tried to bend towards lower tax rates, this somehow changed during the crisis. To help combat falling tax revenues the value added tax and several excises were raised to avoid taking on too much debt.

Tax changes we have grown accustomed to are expected to stay for the future. It is indeed hard to imagine any significant fall in excise duties as they now provide a significant part of government’s income. In recent years their share has grown to more than 10% of the entire government budget. Most income is provided through social welfare and value added taxes.

Personal income tax

The flat tax system in Estonia has often been brought up as an example of a simple tax code. Right now the nominal tax rate on personal gross income is 21%. But there are some differences in the effective tax rate due, for instance, to tax-free income: No one will pay income tax on the first €144 of their income. In addition one can get extra tax-free income of €192 for pensions and €64 for workrelated accidents and illness. The current tax rate is expected to remain the same until 2015 when it will be dropped to 20%.

Corporate income tax

There is no corporate income tax as such in Estonia. Only the dividends that are paid out are taxed at the same 21% rate as personal income. This means that companies have a higher incentive to reinvest their earnings rather than pay out the profits to shareholders.

Capital gains tax

There is also no separate capital gains tax in Estonia. Rather, the earnings from dividends and investments are taxed following a principle similar to the one used for companies. Hence, one can have a designated personal investment account in a bank and pay the regular income tax only once one starts to withdraw more from the account than originally deposited.

Social welfare tax

The highest tax in Estonia is the social welfare tax that is 33% of the gross income and paid by the employer. Meaning that in addition to a €1000 gross wage paid to a worker the employer has to give an extra €330 to the state. This tax also applies to self-employed people who have to pay 33% of their income earned from business activities. The social welfare tax is meant to cover health insurance and other social benefits provided by the state.

Unemployment insurance tax

Another tax related to labour is the unemployment insurance tax that is paid by both the employee and the employer. While the worker has a tax rate of 2.8% on their gross income, the employer pays a rate of 1.4%. This tax goes directly to unemployment office that uses it to provide unemployment benefits. In 2013 the two rates will be lowered to 2% and 1% respectively.

Pension insurance tax

Final tax on personal income is the pension insurance tax at 2%. This is sent to individual’s personal pension fund where it will be invested. In addition the state pays twice that amount to the same fund. This money can be accessed once one retires on top of their state pension. While during the crisis the state that was not able to fulfil their part allowed people to stop their own payments into pension funds as well, in 2012 the mechanism was back in full gear but keeping in mind that in 2011 the tax rates were halved.

Value added tax

The value added tax used to be at 18% but was raised to 20% during the crisis. With some few exceptions this rate applies uniformly. There´s a lower 9% rate that applies to books, printed periodicals, some medicaments and few other items. In addition exported goods, vehicles used for air and land transport and air and land transport services are tax-free.

Excises

Excises have been rising constantly for years in Estonia. Alcohol excises rose about 5% on average in 2012 with smaller differences for light alcohol like beer and ciders and bigger gains for stronger drinks like wine and spirits. Also tobacco excises rose in 2012, at an average of about 10% varying according to the type of product. The tax is lower for cigarettes and higher for cigarillos, cigars and other products. The official reasoning behind those taxes is to guide people towards healthier habits. The most important excise in Estonia is the one levied on fuel which can be up to €400 per 1000 litres and is expected to rise even more in 2013. The tax makes for about 30% of the retail price of fuel. This money is meant to go into road maintenance and construction. In addition there are also some smaller excise duties on electrical energy, gas and packaging. The idea here again is to nudge people towards a more environment friendly behaviour.

Fringe benefits and other taxes

On top of regular labour taxes the employer also has to pay for additional benefits provided to his workers. These can include a car for private use, healthcare and other services. In addition there are several taxes designed to protect the environment and modify people´s behaviour. These taxes are based on pollution levels, usage of natural resources, gambling, land, heavy trucks etc. The tax on land will be relieved for homeowners in 2013 but right now ranges from 0.1% to 2.5%.

Average income

The average gross income in 2012 rose to € 916 in the fourth quarter, which gives a yearly growth rate of 5.9%. In the next few years one could expect the gross income rising above the €1000 for the first time ever. The rise in income helped Estonians to bounce back from the hardships brought about by the recession. This has also provided fresh ground for private consumption, which finally in the last two years started to support exports in the recovery.

More a push for euro than austerity

Estonia has always held true to the principle of a balanced budget, which has been included into coalition agreements. Along with the currency board and the interdiction for the central bank to loan to the government any money, this has tied governments’ hands in case it wishes to go into any significant amount of debt. The government can only spend what it brings in in taxes and other revenue. In the past this has also helped to keep the public sector from growing too big.

The crisis brought a significant change in this regard. If Estonia used to see its balanced budget as a principle and some politicians have argued in favour of adding it to the constitution, some argue now that the balanced budget was simply the only option for a young country that has not yet managed to take on debt. But eventually will. As a matter of fact, the recession has seen Estonian public debt rise above 10% of GDP with the growth going on even now, despite the economy showing one of the best numbers in the entire Europe.

Estonia public spending and public debt as percentage of GDP

Estonia public spending and public debt as percentage of GDP

Although the public spending did go down during the recession, courtesy of spending cuts, its share of the GDP grew dramatically from 30% before to almost 40% after. And as growth was already present before the crisis it is hard to argue that spending will ever go back to that low 30% again. And hence the public sector keeps getting bigger.

The spending cuts enacted by the government were at least partly a necessity and for that reason pointing to Estonia as an example of a successful austerity is misleading. The main reason for the cuts on spending was the long-term goal of joining the Euro area which meant that the government could not allow too much of a deficit spending.

In addition to raising taxes, deficit spending has been avoided by the help of European funds that increased significantly during the crisis and up to this year. But here lies an important issue. As Estonia expects to become wealthier it cannot expect to keep receiving these amounts of European support. This means that in order to prepare for the possible cut back in finances from Brussels the government should start thinking more about saving. As all the external funds make up about 20% of the governments budget, more attention should be directed to the issue. Otherwise Estonia will go down the same road that has gotten the developed world into financial troubles.

Another reason to be more careful towards spending is the already mentioned financial weaknesses of other countries. As Estonia has decided to partake in the safety net measures created to help ailing countries there needs to be sense of urgency towards creating the funds that might be needed in times of distress. One cannot hope that it would be possible to get a loan from the market at a time of financial turmoil.

The dangerous road ahead for Estonia

The advantage that has played a part in the creation of the perception of Estonia as a low tax region is the relative simplicity of the local tax code. No small part in this has been played by the local flat income tax. Recently though this tax has become a target for growing criticism. Although the left leaning wing of the Estonian political landscape has been in favour of a more progressive tax system for a long time, there is additional pressure coming also from experts representing the European Union and other international organizations.

To think of possible effects of international politics on the Estonian tax code one only needs to think back to the time when Estonia was first joining the European Union. While before that step we had unilateral free trade across the globe, the decision to join the Union forced us to take on a great amount of trade tariffs. And the political trends in the European Union are having their share of influence again today with the coming of the financial transaction tax and possible environmental taxes. One can probably also expect the Estonian tax code becoming more complicated with the changes in international politics as can already be seen from different excise tax rates.

Another threat for Estonia is the push in Europe towards a more harmonized taxing. This goes directly against what has been Estonia’s competitive advantage over the years. And in order to fight or prevent the consequences of such changes the local politicians need to look for new reforms.

As a country on the periphery of the European Union Estonia can not count on luck and needs to take more aggressive steps towards guaranteeing its own position of economic significance and the well-being of its citizens. Although the government has called out for more innovative entrepreneurship in recent years, there needs to be more decisive steps also from the side of legislation to accommodate the needs of businessmen. European funds and government financial programs alone cannot build a sustainable model.

Robert Müürsepp,
Mises Institute Estonia

Opinions expressed in the article are purely the author’s personal views and not related to the institution he represents.
Source of statistics: Statistics Estonia

This is part of :

Taxation in Europe - Yearbook 2013
The yearly report on the evolution of European tax systems

A short presentation of IREF ’Yearbook on Taxation in Europe’ Series
Among the many ways to understand the climate of opinion and the culture of a country, looking at its fiscal system is one of the most rewarding. Sure, fiscal systems almost always rhyme with complexity; each system bearing the (...)


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