: / Analytics / The Tax System of the Kyrgyz Republic (2003)

Kyrgyzstan Review, 10 years ago

5.4. Estonia

After disintegration of the USSR Estonia, like a majority of the post-soviet countries, remained with ineffective planning economy characterized by big macroeconomic imbalances, but already a decade later Estonia is now considered to be one of the most developed countries of Eastern and Central Europe, it is also one of the first nominees for joining the European Union. The tax system and its reforming in 2000 is considered to be one of the reasons for this success.
In Estonia the tax reform began with imposition of income tax with the progressive scale of 16% to 33%, but this system was replaced with the unified 26% tax a year after its introduction in 1994. At the same time corporate tax rate was reduced from 35% to 26%. Thus, from the very beginning the idea of the reform boiled down to fixing of a similar income tax rate for natural persons and legal entities, which promotes simplification of the tax system and shows its neutrality in respect of various forms of economic activity. But this was not the last stage of the tax reform, and in January 2000, in accordance with the new legislation, resident organizations and resident representatives of foreign companies were exempt form profits tax provided profit is re-invested in production rather than distributed.
It is necessary to discuss the main reasons for reforming of profits tax in Estonia in 2000.
¨ The Russian crisis has unfavorably influenced the economy of Estonia, its economic growth rates fell from 10% in 1997 to 0.7% in 1999, and the government budget deficit sharply grew. So, the will of Estonian authorities to help the economy of the country, to recover business activity, to create incentives for domestic producers for non-exportation of capital and investing it in production instead, may be considered the main reason for the reform.
¨ The first factor is inseparably connected with the struggle of the Baltic countries for foreign investments, whose level fell in Estonia from 10% of GDP in 1998 to 5.8% of GDP in 1999. One may suppose that Estonia decided to revoke profits tax, which was a decisive step in itself, to leave behind its main competitors on attraction of direct foreign investments Latvia and Lithuania, whose tax systems are being increasingly brought to conformity with the EU norms.
Some changes are taking place in the Tax Law under the EU influence. EU sets a number of complicated tasks to Estonia. Failure to solve these tasks will make joining the European Union impossible for Estonia. Among EU requirements, that of establishing a simple and just tax treatment in the country alongside with leveling the tax rates, is of a certain importance. This, first and foremost, refers to excise tax, whose rates must be brought to conformity with EU norms, which means their increase compared to the current rates.
To improve administration of excise tax on alcohol, the system of customs warehouses was established for storage of goods, in regard to which customs clearance was not effected. For the purposes of struggle with smuggling all constituent parts of fuel were subject to duties in 2000. Estonia has to gradually reduce tax privileges and decrease the list of goods and services with the zero rate of VAT, which is also one of the requirements for joining the European Union. Estonia will have to revise taxation of dividends of non-residents taxed at the rate of 26%, while dividends paid to resident companies are not taxed. EU considers such approach as discriminating, so Estonia, as the future member of the European Union, will rather have to make some amendments to the Provision on Profits Tax.
It is evident, that the level of tax receipts in Estonia is very high compared to the CIS countries, though it fell to some extent against 1999. This is connected with decrease of receipts of direct taxes to 20.8% of GDP in 2000, namely of profits tax and income tax, this being directly connected with their reforming. In the structure of tax receipts one can clearly see the tendency of the decrease of direct taxes share in GDP, namely the share of profits tax to 0.8% in 2001, the share of income tax to 7.5% of GDP. The share of indirect taxes is growing: that of VAT in GDP grew to 9.1%, excise tax receipts increased from 2% in 1994 to 3.6% in 2001.
All this caused some losses incurred by the budget; one should remember, however, that positive effect of tax burden reduction is characterized with a sufficient lag, but reduction of rates in Estonia did not lead to significant losses, and in 2001 the budget was made with surplus. The tax system was simplified and tax administration improved. Economic growth in Estonia started again from 0.7% in 1999 to 6.9% in 2000, in 2002 the growth continued. The increase of both foreign and local investments is considered to be an important factor of the growth rate as well. Such increase takes place due to partial revocation of profits tax. Funke[13] showed in his calculations that investments in equipment increased by 6.07% due to the tax reform. All this gives grounds to consider the tax reform in Estonia to be a success, and the objectives set by the reform to have been achieved by the reformers. A favorable economic situation in Estonia and its economic growth are not solely the result of profits and income tax reforming. This is a consequence of a number of efforts, among which the tax reform takes one of the important places.
If Estonia were taken as a model for Kyrgyzstan, one should have taken into account some peculiarities of our economies, which stipulate significant differences between the problems of the tax system of the CIS countries and the countries of Baltia. The largest share in Estonian GDP belongs to such branches as services (trade, transport, communications) and industry, while the share of agriculture is insignificant (6.3% of GDP in 2001).
In such branches as transport, storage and communications, the share of medium and big enterprises (more than 50 employees) constitutes more than 77%. Among all the employed only about 25% work at the enterprises with the number of employees less than 50[14].
Quickly developing exports, which is sufficiently diversified and is not targeted solely to raw materials, is considered to be the main source of economic growth.
As we see it, these two factors give grounds to suppose, that tax receipts, which are so high in Estonia, cannot be the result of high extent of responsibility of Estonian citizens or a very good work of tax bodies only. The overwhelming majority of big enterprises used to decrease the risk of income concealment, especially because all companies with the authorized capital of more than 24200 euro and the volume of sales of more than 60 600 euro a year must file their annual financial reports with the visa of the auditing company within 6 months of the year following the tax year.
Diversity of exports, the main subjects of which are medium and large firms, and large share of manufactured goods in exports results in the fact that honest observance of the rules by these organizations with the aim of getting VAT paid credit is advantageous for them as well as demanding observance of the rules by the local companies. All these factors start up such mechanisms in economy, which promote improvement of tax administration and tax discipline of taxpayers.
Finalizing analysis of the Estonian experience, we would like to stress utilization of alternative sources of budget expenditures financing, namely, of inflation tax and accumulation of debt, which is of great importance for effectiveness of the tax system. Estonia has rather quickly coped with high rate of inflation, and in 1998 already its level fell below 10%. Budget surplus allowed but minimal utilization of external loans. Unlike Estonia, Kyrgyzstan has actually used to the maximum both inflation sources of budget replenishment and credit possibilities, thus breaking connection between a taxpayers and a budget.

[13] Bank of Finland, Institute for Economies in Transition, Helsinki 2001 (BOFIT).
[14] The National Statistical Committee of Estonia.