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

 

The Conference is aimed at the discussion on whether taxes have an impact upon competitiveness among countries and on whether tax reforms that have taken place in some countries (in my statement I will refer to Lithuania) have attributed to their competitive edge in any relevant region, in Europe, or world wide, or, on the contrary, have interfered with their competitiveness, therefore, in my presentation I will concentrate upon the provisions of Lithuanian laws on taxation, which to my mind are the main provisions that may have an impact of one kind or another upon our competitiveness in the region. 

 

Before addressing the issue of recent changes in the Lithuanian taxation system, I would like to say a few words about the impact of taxes upon competitiveness in general. Hardly anyone would dispute that taxes represent one of the areas in which countries try to compete with each other by introducing various rules of the game. This is indeed a fact in principle confirmed by differences in tax systems as well as by a wide variety of instruments we find in national tax systems that are said to be measures for fighting against tax avoidance or tax minimisation, however, in fact they are aimed at one obvious purpose, namely, at slicing the largest possible share of the cake that goes under the name of global income. We should raise a question whether the tax system is the key or one of the key factors in a country’s competitiveness. In my opinion, taxes as such do not represent the main element nor one of the main elements in a country’s competitiveness. I would say there are much more important factors, namely, its political stability, possibility to forecast its actions, economic growth, efficient (modern and transparent) administration, labour force quality, etc. In my opinion, the importance rests not so much with taxes as such, their higher or lower tariffs, their higher or lower benefits, but rather with their administration. I think that modern, efficient, individualised (at the same time fully in line with the principle of equality of tax payers requiring equal approach to similar cases – a similibus ad similia) and, importantly, flexible administration creates favourable business environment in the country, which undoubtedly encourages economic growth at the same time increasing competitiveness. A flexible tax system allows to create, in my opinion, one of its main characteristic features, namely, its neutrality and the least possible regulation of both the existing actual and reasonable economic reality and reasonable behaviour of the players involved. I take a risk of being misunderstood, but I think that competition between countries in terms of taxes, i.e. their attempts with the help of tariffs, various privileges or non-transparent administrative mechanisms to appear more attractive than others, first of all, more attractive than their neighbours, is not a positive phenomenon (of, course, one may argue whether it can be avoided – the answer, perhaps, is it cannot, as in this case we deal with the laws of inertia and inevitability: if everyone around me does it, I must do the same or else I will be completely out of the game), it is a road to nowhere. Taking a purely theoretical approach and further recklessly going along the path of tax reduction (i.e. if we reduce taxes instead of balancing out the load of taxes) we can reach the bottom line, when nothing remains for further reduction (at this point, however, a hypothetical question arises as to the purpose of taxes as such). All these measures are exactly the instruments that start regulating the economic reality, because they render separate economic phenomena and the behaviour of the participants of such phenomena dependent upon various taxation factors, and not upon traditional economic thinking based on business logic, which fact evidently refutes the purport of neutrality – one of the main characteristic features of a tax system. Besides, if we adhere to the classical liberal approach on the role of the state as the night guard, attempts to increase the competitiveness of the country (in this case, competitiveness in terms of taxes) with the help of regulatory measures will evidently refute this idea. Perhaps for the same purpose, namely, for the purpose of competition based on purely economic means or, in sports terminology, based on natural physical power, and not on drugs, both the European Union and the OECD approved special documents aimed at the elimination of harmful tax competition between countries. These documents are: the Code of Conduct for Business Taxation (EU document) and the Report on Harmful Tax Competition (OECD document).

 

Now back to Lithuania. As regards the situation in Lithuania and recent changes in its taxation system, I will mainly focus on three tax-related laws that in the context of competitiveness are, in my opinion, the most important ones (because the spheres covered by these laws are the areas that the EU countries have and in the nearest future will have highest sovereignty). The three laws are:

·         Law on Profit Tax

·         Law on Natural Persons’ Income Tax

·         Law on Tax Administration

 

I will leave aside the Law on VAT and the Law on Excise Tax, though they are also very important, for one very simple reason: these taxes have been basically harmonised throughout the EU, therefore, it will be no sense of speaking about any competition between countries in terms of these two taxes.

 

Perhaps it will not be wrong to say that this year has been marked by a lot of changes in the Lithuanian taxation system. This year four main laws on taxes have been enacted and have become or will become effective at the beginning of the next year. They are:

·         Law on Profit Tax, effective since 1 January 2002;

·         Law on Value Added Tax, effective since;

·         Law on Excise Taxes, effective since 1 July 2002;

·         Law on Natural Persons’ Income Tax, to become effective on 1 January 2003.

 

Undoubtedly, such a fast change is indeed a challenge to the entire taxation system, its participants, business community, and to tax administrators. One may ask, why all at once and why so fast. The answer could be: we cannot not wait any longer – tax reform issues have been discussed in Lithuania since the end of 1998, when the functions of tax policy and tax administration were clearly defined and separated, and a specialised subdivision engaged in drafting tax regulations, namely, the Tax Department, was established with the Ministry of Finance, whereas tax administration was left under the responsibility of the State Tax Inspection. As a consequence, however, the only one Law on Taxes was amended, and a new Law on Levies was adopted that eliminated the fiscal function of levies. All the rest was left for continuous amendments: often one was really lost as to what goes with what and where. It was impossible to live with the old laws on taxes adopted back in 1990-1994, as the economic relations were making fast progress while taxation laws were full of elementary gaps, tax administration was detuned and rigid, the level of revenue was low (which, I firmly believe, was due not only to the crises of 1998-1999, but also due to malfunctioning and distorted taxation system), the tax load was totally unfair, overburdening natural persons – high income tax tariffs, unavoidably increasing excise tariffs (due to integration processes and liabilities), primitive mistakes in imposing taxes on income from an increase in property value (without imposing any tax on income from an increase in the value of securities) at the same time further decreasing income from profit: familiar standard situation when dividends are not paid out, but shares are distributed and subsequently sold. All this evidenced the only thing: the existing taxation system was completely wrong. 

 

What was undertaken? Beyond any doubt, the reform was primarily aimed at finding a way to change the distribution of the tax burden between the population and companies, because in Lithuania revenue from profit tax has been rapidly decreasing already since 1997, over 2000-2001 reaching a critical level of 3-4 per cent, as against to 7-8 per cent in 1997, of the total budget income. Therefore, the first step taken was a reform of profit taxation.

 

The profit tax reform had two main objectives, namely, to:

·         reduce the imbalance between corporate and personal income tax

·         strengthen Lithuania‘s competitiveness in the region

Based on these objectives, the main requirements for the new profit tax were set:

1.      simplicity of profit tax calculation system with a significantly lower basic rate, at the same time withdrawing any exemptions or privileges;

2.      simplification in the recognition of expenses as costs by allowing to deduct all amounts related to earning of income, not merely those specified by the law;

3.      introduction of accelerated depreciation/amortisation and encouragement of the implementation of advanced technologies;

4.      attracting of financial investments in companies and at the same time in the State (in this case we do not have in mind investments in fixed tangible assets);

5.      tax evasion prevention.

 

Taking into account the set objectives and requirements, we might point out the main and the most important provisions of the new Law on Profit Tax that might be presented as advantages of the new corporate tax system as against the old one:

·         reduction of the profit tax rate (a standard corporate tax rate of 15% vs. 24% in 2001);

·         shifting to a system of accelerated depreciation (amortisation) (with a particular focus on encouraging the implementation of advanced technologies by providing a possibility to accelerate the depreciation of IT hardware and software, and to immediately include development and research into costs);

·         a new concept of dividend taxation: participation exemption (dividends received by holders of more than 10% of company‘s stock capital are tax-exempt, otherwise, dividends are taxed at 15% instead of  29%);

·         anti-avoidance measures (CFC rules; sale versus rent; carry forward of losses; payments to target territories; hybrid financing; related entities);

·         introduction of transfer pricing rules (we would like to eliminate (several statements in the new law have been made) economic double taxation, which includes also anti-avoidance measures).    

 

We should particularly stress the importance of the first three provisions of the new profit taxation procedure. It is highly probable that a significant reduction of the basic profit tax rate, a new concept of dividend taxation and the introduction of accelerated depreciation (amortisation) system will increase Lithuania’s competitive edge in the region, and this is what all these measures are aimed at.

 

As regards any drawbacks of the new income taxation procedure, in my opinion, the main disadvantage is related not so much with the new Law, but rather with its enacting procedure: the law was adopted in December 2001, and in January 2002 it became effective, therefore, there was very little time to grasp the new rules of the game both for companies and tax administrators. Undoubtedly, there is not enough time to prepare for the implementation of the new anti-avoidance measures aimed at the formation of correct practice in the application of such measures so that, on the one hand, fair business is not affected and, on the other hand, that these measures are not recklessly applied.

 

Summing up the drawbacks of the new Law, we should, perhaps, stress not so much the drawbacks of its contents, but rather the uncertainty regarding the practice of application of the new provisions.

 

Personal Income Tax reform has two main objectives:

·         to reduce the taxation on income of private individuals;

·         to simplify the taxation on income of private individuals.

The main ways whereby it is attempted to implement said objectives with the help of the new Law on Personal Income Tax to become effective in the year 2003 and which should be treated as advantages of the new system of personal income taxation as against the currently existing are to:

·         radically increase the tax-exempt minimum: 214 LTL → 290 LTL

·         provide for limited tax-exempt deductions (deductions of contributions to pension funds, life insurance contributions, interest on housing loans, education expenses)

·         reduce the number of tax brackets (based on a source of income to apply 2, instead of currently applied 8)

·         introduce a system of general declaration of income (by submitting an annual declaration of income tax)

 

If the above stated measures are implemented, the main objective of the reform will be achieved: the effective income tax rate will indeed decrease. The only question is, if enough? In fact, it is the main issue in discussing whether the personal income tax reform could be more profound. It may be a starting point for discussing drawbacks in changes of personal income taxation. The main drawback is related to actual preservation of the main 33% rate. Psychologically it has an impact, though there is indeed a considerable decrease (taking into account the allowable deductions, an increase of the tax-exempt minimum). In this particular case, another way was selected, namely, an increase of the tax-exempt minimum, and not a decrease of main rate. A high main personal income tax rate gives rise to the following problems:

1)                unequal taxation terms in case of a business undertaken individually or as a legal person: in the first case - 33%, in the second - 15%;

2)                18% difference in tariffs is an irresistible temptation to avoid labour relations, administration and legalising problems, as the amount of savings in the event of tax evasion is too tempting outweighing the fear of being disclosed;

3)                labour costs are not reduced and remain at the same level.

 

In terms of competitiveness, the latter factor is important, as a reduced personal income tax rate would enable employers to cut labour costs, which in turn would indeed contribute to competitiveness. At the same time, it is obvious that an increase in the tax-exempt minimum at the same time reducing the main tariff is unrealistic from the perspective of the financial possibilities of the state, therefore, if an option of an increase in the tax-exempt minimum is selected, the issue of decreasing the rate is automatically set aside or at least postponed for the future (unless unexpectedly a large oil deposit is discovered and our budget income structure is essentially changed for the benefit of other than tax revenues). Future will show whether such a step was correct.

 

The main objective of the tax administration reform, which is still going on: the Ministry of Finance has produced a new draft law on tax administration, also, tax administration and the administration of social security contributions will have to be merged in practice) was to make tax administration a flexible and efficient system based on the principle of self-assessment, that would:

·         ensure honest competition (i.e. would not give space for tax evasion)

·         ensure that the role of a tax administrator is that of a night guard, and not that of the key player;

·         ensure proper application of the provisions of new taxation laws.

 

Taking all this into account, several major amendments to the existing Law on Tax Administration were made, namely:

·         delegation of authority in decision-making to a lower (regional) level;

·         similarly, delegation of responsibility for the decisions made to a lower level;

·         centralisation of representation in taxation disputes (an attempt to have uniform application of tax legislation)

·         implementation of the ‘substance over form’ concept (an attempt to change from formal auditing procedures over to an audit of the substance)

In principle, all these ideas, if viewed from the perspective of international tax administration praxis, do not represent anything prodigious or new – all these measures are have been successfully implemented and applied in countries with normal taxation and tax administration traditions. In my opinion, they are regular measures enabling tax administrator to adapt to the changing business environment without becoming an obstacle on the path of progress, yet at the same time carry out its duty against the society. What are, in my view, the drawbacks of changes in the tax administration system? I will be quite assertive: I see no major drawbacks. At the same time, however, I cannot maintain one can feel fully at ease. Not indeed. First of all, because there is no certainty about the trends in the future tax administration praxis, as incorrect practical application may bring even the best ideas to nought. Another alarming thing is that there are fears to make some decisions absolutely necessary for tax administration – maybe daring decisions that break the long-standing traditions, yet adequate under new circumstances (one that is not of an instructive nature), improvising with the possibilities offered to the tax administrator by the new provisions of the Law on Tax Administration and other specialised tax laws.

 

I would like to conclude by wishing everyone to be more open to improvisations and non-standard decisions, as this is the only way to have an edge over others – over those who behave in a standard way. This is what I would first and foremost like to wish those who keep looking backwards and complain: do improvise, take a non-standard approach – the game is not over, it is going on, so the most important thing is to grasp its rules, as this is the only way for both the player and the game to improve.