Latvia Joins the Cash-Flow Tax Club

As of January 1st, 2018, Latvia joined Estonia in replacing their traditional corporate income tax system with a cash-flow tax model. Under the new model, corporate income taxes will only be collected when profits are distributed to shareholders instead of on an annual basis. Not only will this change dramatically simplify the corporate income tax landscape in Latvia, but it also provides treatment equivalent to full expensing by allowing businesses to delay paying taxes on retained earnings. Due to these recent reforms, businesses in Latvia will be more inclined to use their profits to reinvest into their firms, leading to new capital formation and increased economic growth.

In the United States, and many other industrialized countries, corporations must determine their tax liability by deducting depreciation allowances from their income on an annual basis. While the arrangement may seem simple on the surface, calculating depreciation allowances can be notoriously complicated and arbitrary. Not only does our current system discourage new capital formation by imposing regulatory burdens in the form of costly tax compliance, but it also directly discourages investment.

Designing a corporate income tax system around the concept of depreciating assets over time inherently discourages new capital formation due to the changing present value of money over time. For example, a business building a $1 million, nonresidential structure in the United States would deduct the $1 million over the structure’s 40-year asset life. While that may sound fair on the surface, consider that the value of a $1 million depreciation deduction would decline over time, preventing the business from fully recovering the cost of the initial investment. According to the Consumer Price Index, $1 million some 40 years ago has almost the same purchasing power as $4 million does today, indicating the declining value of depreciation deductions over time. Additionally, when businesses don’t have access to their depreciation allowances immediately, they will otherwise forgo other potentially worthwhile investments, representing the businesses’ opportunity cost. Assets with shorter asset lives are affected by the same problem, albeit to a lesser degree. By moving to a cash-flow tax model, businesses in Latvia won’t use complicated depreciation allowances to calculate their tax liability because they will only pay corporate income taxes on distributed profits.

Another important point to note is that Latvia’s recent tax reform eliminated the effective double taxation on distributed corporate profits in the form of dividends. Prior to the reform, dividends in Latvia were hit with one layer of tax at the corporate level and then a second layer of tax at the individual level. The reform waives personal income tax liability for dividends that have already been subject to the corporate income tax. The United States, however, still taxes dividends on two separate levels. The effective federal income tax rate for qualified dividends in the United States is 39.8 percent, which is first comprised of a 21 percent corporate income tax on profits and is then followed by a 23.8 percent individual income tax on qualified dividends.

Latvia’s recent tax reform will improve the country’s rank in the next annual update of our International Tax Competitiveness Index. With the recent passage of sweeping tax reform legislation in the United States, tax policy has taken a back seat in the current political climate as there is a perception that many issues have finally been resolved. However, pressure from abroad in the form of reforms overseas, which challenge the United States’ international tax competitiveness, will undoubtedly prove that tax reform isn’t done, and there’s plenty left to improve. We could learn a lot from Latvia.