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Estonia’s Growth-Oriented Tax Code

7 min readBy: Kyle Pomerleau

On October 15th, 2015 the TaxA 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. Foundation held a reception honoring Estonia for having the most competitive tax system among the 34 member nations of the Organization for Economic Cooperation and Development (OECD) according to our 2015 International Tax Competitiveness Index.

The Estonian Ambassador to the United States, Mr. Eerik Marmei, was our special guest at the event. The Ambassador gave a speech stressing why a neutral and competitive tax code is important to Estonia.

The following is the transcript of the Ambassador’s speech:

I am honored to receive this award tonight on behalf of the Government of Estonia and I would like to thank Tax Foundation for recognizing Estonia for ranking us #1 on the 2015 Tax Competitiveness index for the second year in a row.

The 2015 International Tax Competitiveness Index attempts to display which countries provide the best tax environment for investment and for starting and growing business. The report considers more than forty variables across five categories: Corporate Taxes, Consumption TaxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. es, Property Taxes, Individual Taxes, and International Tax RuleInternational tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden. s.

According to these findings, Estonia has the most competitive tax system in the OECD. Estonia has a relatively low corporate tax rate at 20 percent, no taxation on reinvested dividend income, a flat 20 percent income tax rate, and a property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. that taxes only land (not buildings and structures).

This recognition is a result of a rather long policy of Estonia in keeping the tax system simple and transparent with a broad tax baseThe 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. and low tax rates, as well as keeping exemptions to the minimum.

To understand where and why we are today, I would like to go back in time and give you a short overview of the Estonian tax system

The main components of the Estonian tax system have been in place since the beginning of the 1990s. After Estonia regained independence in 1991, the country needed a tax system that was compatible both with the limited experience of the taxpayer who came from the Soviet communist controlled society and effective tax administration. It was essential that the tax system should support economic growth, not impede it. Therefore, a tax system was developed with an emphasis on indirect taxAn indirect tax is imposed on one person or group, like manufacturers, then shifted to a different payer, usually the consumer. Unlike direct taxes, indirect taxes are levied on goods and services, not individual payers, and collected by the retailer or manufacturer. Sales and Value-Added Taxes (VATs) are two examples of indirect taxes. es. To keep the system simple, transparent and easy to use, only a few exceptions were allowed, as at the same time, tax rates were kept rather low.

A cornerstone of Estonia’s fiscal policy was corporate and personal income tax reform, which introduced the proportional, or flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. rate of 26% in 1992, which has been reduced to 20%. Since 1999, reinvested corporate profits are no longer subject to income tax. Today, Estonian income tax system, with its flat rate of 20%, is considered one of the simplest tax regimes in the world

There have been some changes, but in principle the system has remained the same, providing stability and legal certainty for the persons as well the legal entities. It is important to recognize that simple and clear rules of taxes create confidence among businesses, promote business expansion, capital investment and most importantly, create jobs.

One of the strength of our tax system is its broad tax base which has enabled us to collect enough taxes, thus contributing to retaining the balanced budget and a low level of general government debt. Today, Estonia has the lowest general government external debt level in the EU and I think, in the world (external debt amounts to 10% of GDP, whereas the average in the EU is around 90%).

Estonia leads all OECD member-states in tax collection effectiveness and it goes without saying that efficient tax collection creates steady revenue streams that permit government to support stable economy and enhance economic growth. Estonian state budget will be nominally in balance in 2015, largely due to the positive effects of the economic cycle of tax receipts.

Just a few days ago at the annual meeting of the IMF and World Bank, Estonian minister of finance Sven Sester stressed, that the right economic policy mix, which is coupled with a well-functioning tax system, is crucial for economic development. ‘A simple and clear tax system is one of our main economic drivers’, he said.

For many years, tax neutrality and growth-orientation have been the cornerstone of our tax system. In neutral tax settings, taxpayers, both individual and corporate, make decisions that are based on economic logic rather than on state-driven incentives or limitations, which can often be questionable. For growth-orientation, we have so far preferred to tax consumption, resource-usage, and pollution, rather than to tax earning profits and income. Why such a focus, you may wonder? Well, because we are not that rich yet to allow taxation to hurt motivation to earn capital.

Kyle Pomerleau from Tax Foundation has said: “the Estonian tax code has a fully-integrated individual and corporate income taxA 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. . This means that corporate income is taxed only once either at the entity level or at the individual level.”

Indeed, Estonia is renowned for its well-developed e-governance system, which allows for fast and efficient administration and communication with the authorities. In 2000 Estonia introduced a public system for electronic tax filing. Our e-tax system along with X-road’s access to multiple government and private sector databases, has made tax filing unimaginably simple, at least by U.S standards. No one even considers paper as a possibility anymore. If you are a private citizen, you make five or six clicks and all the data is already there; everything is prefilled, so unless something is wrong, you don’t need to add anything. Many foreigners know that reporting your taxes online takes 5 minutes in Estonia. I confirm that in most cases this would be wrong – unless you had, for example, lots of stock trading to report, you would most probably file your taxes yourself in under 3 minutes. And if there are no mistakes your refund will be on your banking account in 5 working days. In this context, it can be said that simple tax rules and digital user friendly solutions for paying taxes are mutually reinforcing. This also helps to reduce the transaction costs, as well the administrative burden with regard to the taxpayers and the tax administration.

As you all have noticed by now, Estonia is a great place for business. In this regard our innovative mindset and ICT solutions have played a crucial role in creating favorable environment and Estonia is becoming more attractive for businesses. Recently, one Estonian ICT company ERPLY developed a software for efficient management control in tax collection. It enables to tackle such challenges as tax evasion and slow growth of tax base. This software automatically transmits tax information to the government agency responsible for the intake of government revenue; it also issues fiscal receipts which are uniquely identifiable electronically. These kind of solutions can be efficiently used in other countries in order to make tax collection more efficient.

Although, tax is not usually a primary factor when people decide to start up a business, it often becomes an important consideration after the initial decision has been made. Simple tax environment motivates the entrepreneurs to create new value added jobs. It will invite investors to invest in Estonia. Competitive tax environment becomes vital in attracting foreign direct investments to Estonia.

We are one of the leading countries in Eastern and Central Europe regarding foreign direct investment per capita. At the end of 2014, Estonia attracted investments in total of $19.2 billion. My country offers excellent opportunities for businesses in a number of economic sectors like information and communication technology (ICT), chemicals, wood processing, and biotechnology.

Since December 1, 2014, Estonia offers foreigners an e-residency option. An e-resident is a person who has received the e-resident’s digital identity (smart ID-card) from the Republic of Estonia. This does not entail full legal residency, citizenship or right of entry to Estonia, but gives secure access to Estonia’s digital services such as business registration and an opportunity to use digital signatures in an electronic environment. Such digital identification and signing is the legal equivalent to face-to-face identification and handwritten signatures in the European Union. The idea is to provide a gateway by which people outside of Estonia can make investments in Estonia, establish business there and, eventually, use the country as a bridge to commerce elsewhere in the European Union.

To sum it up, we admit that Tax Competitiveness Index rating is not an absolute measurement of how perfect our system is, because there is probably no such thing as a perfect tax system, it rather compares us in relation to other OECD countries. Unless we keep striving for further improvement of our tax regulations, we can be easily surpassed by some other countries on the list. To our competitors, I want to say that improvements are coming in tax policies and some of these improvements are already in our government’s four-year action plan.