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The Key Component of the Estonia’s Competitive Tax System

3 min readBy: Kyle Pomerleau

Last week, the Tax Foundation released its 2015 International Tax Competitiveness Index. Our International 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. Competitiveness Index (ITCI) measures the competitiveness and neutrality of national tax systems. In order to do this, the ITCI looks at over 40 tax policy variables, including corporate income taxes, individual income and payroll taxes, consumption taxes, property taxes, and the treatment of foreign earnings. This year, the United States placed 32nd of the 34 OECD countries, only ahead France and Italy and just behind Portugal and Poland.

For the second year in a row, the Index found that Estonia has the most competitive tax code in the OECD. There are many impressive features in the Estonian tax code. It has a flat individual income taxAn 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. rate of 20 percent, a broad-based 20 percent value-added tax, and has few distortive taxes such as the estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. or financial transaction taxes.

All of those features contribute the Estonia’s high score. However, the most important and competitive feature of the Estonian tax code is its 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. system. And not only is its corporate tax system competitive with a low, 20 percent rate, it is unique among OECD countries in how it works.

The Estonian corporate income tax is what is called a cash-flow tax. Rather than requiring corporations to calculate their taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. using complex rules and depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. schedules every single year, the Estonian corporate income tax of 20 percent is only levied on a business when it pays its profits out to its shareholders.

Not only does a cash-flow tax vastly simplify the calculation of taxable profit, it also provides an additional benefit: full expensingFull 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. of capital investment. Since profits are defined as the cash distributed to shareholders, there is no concept of depreciation in the 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. . This means that businesses do not need to delay the recovery of investment costs for years or decades as they do here in the United States. Economically, the ability to fully expense capital investments is important. It makes investment cheaper, thus boosts the level of business investment.

Even more, the Estonian corporate income tax of 20 percent is the final tax levied on corporate income. Shareholders that receive after-tax distributions, or dividends, from a company, do not have to pay additional tax on that income. This is a vast improvement over many corporate tax systems in the OECD that tax corporate income twice: once at the corporate level and then again at the shareholder level. In the United States, the combined, or integrated, corporate tax rate is slightly higher than 56.6 percent.

Overall, the Estonian corporate tax system is very conducive to economic growth. In fact, after Estonia enacted its cash-flow corporate tax in 2000, investment surged relative to its neighbors. Between 2000 and 2004, Investment growth in Estonia was 39 percentage points faster than neighboring Latvia and Lithuania.

A full blown cash-flow tax is probably out of the question in the United States. However, there are a few things that the U.S. could learn from Estonia’s tax code. Mainly, it is possible to have a fully integrated corporate income tax with full expensing while still raising sufficient revenue for the government’s spending priorities.