The Best Part of the Estonian Tax Code Is Not 5-Minute Tax Filing

July 21, 2015

Kyle Pomerleau

Kyle Pomerleau

Recently, Republican Presidential hopeful Jeb Bush claimed that it only takes 5 minutes to file taxes in Estonia. This claim was confirmed by a number of reporters and tax authorities in Estonia.

For those of us that do our taxes by hand, this sounds like a dream. Depending on your situation, filing your taxes can take a significant amount of time and due to the numerous steps involved (especially if you are claiming credits) may lead some to make errors. According to the IRS, it takes an average taxpayer with no business income 8 hours to fill out their 1040 and otherwise comply with the individual income tax. Triple that for those with business income.

Reducing the compliance time from 8 hours to 5 minutes would be a large improvement. People would spend less time and money on complying with the tax code and spend more time and money on productive activities.

While 5-minute online tax filing is a great feature that the U.S. should strive for, I would argue that it is not the best part of the Estonian tax code.

The best part of the Estonian tax code has more to do with its tax base (what it taxes) rather than how fast people can pay their taxes. Specifically, the Estonian tax code has a fully-integrated individual and corporate income tax. This means that corporate income is taxed only once either at the entity level or at the individual level.

The Estonian tax system has a rather unique set up. When a corporation earns a profit it does not immediately need to pay the 20 percent corporate income tax. Instead, it only pays the 20 percent corporate tax on dividends it distributes to shareholders. Shareholders are liable for no additional tax. Capital gains are taxed in the hands of shareholders at the same 20 percent tax rate, but since retained earnings are tax-free at the entity level, capital gains are also only taxed once.

In total, the tax rate on corporate income is 20 percent in Estonia. Compare this to the integrated tax rate on corporate profits of 56 percent in the United States.

Even more, this tax system provides de facto full expensing for capital investments because the corporate tax is only levied on the cash distributed to shareholders, which is also a significant boon to investment and economic growth. Our estimates show that full expensing alone (let alone the benefits of corporate integration) would increase the size of the economy by about 5 percent over about a 10-year adjustment period.

Tax reform should make the tax code simpler and easier to comply with. However, this should not be our only goal. In a way, we should focus even more on how our tax code raises revenue. Integrating the corporate and individual income tax codes like Estonia would be a huge step towards a neutral, pro-growth tax code. And it would be worth it even if we had to spend even 10 times longer filling out our tax returns than Estonian taxpayers.

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A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.

The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

Full expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.

An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.

A corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.