Fiscal disciplinary council makes proposals on improving tax system 17 February 2020
Full text of the report is available in Latvian only. Below are the summary and conclusions and recomendations sections.
2018 tax reform results and criteria for further improvement of the tax system
Opinion of the Fiscal Discipline Council
The primary task of the Fiscal Discipline Council (the Council) is to ensure that the government's fiscal policy ensures sustainable and balanced economic growth. Therefore, the planned changes in the tax system in 2021 and the medium-term directions of tax reform are evaluated mainly from the perspective of fiscal discipline. The Council does not evaluate individual proposals to improve tax policy, but instead offers criteria that the government should consider. The main criteria are the following:
- Achieve an increase in tax revenues as share of GDP,
- Reduce tax burden on labor, especially for low income groups,
- Reduce number of ineffective tax allowances,
- Ensure fair competition for enterprises, with equal tax burden, and equal social protection for all employees.
The Council has analyzed recent experiences and trends in tax reforms in the world and in particular in EU Member States. The global economy is currently undergoing radical transformation, reinforcing the role of fiscal policy in stabilizing the economy, promoting inclusive growth and reducing inequalities. World experience shows that the tax burden is relatively high in wealthy countries.
The Council warns that because of insufficient increase in budget revenues, the amount of public funding does not meet citizens' demands for public services and social assistance. In the medium term, even greater demand for public funding is expected- which may put pressure on political decision-makers to increase budget deficits and breach the legal conditions for fiscal discipline. Future tax reform should ensure higher tax revenues to finance the growing demand for public services, pensions and social assistance. Ensuring the growth of tax revenues is one of the important criteria for improving the tax system.
Looking at the results of the 2018 reform, the Council concludes that the 2018 tax reform has failed to achieve one of its main objectives, which is to raise share of tax revenues to GDP, as well as a sufficiently robust growth of the tax base. At the same time, it is positive that the government has kept its promise and has not changed its tax rates drastically in the three post-reform years. In order to reduce inequalities, the tax burden on low-wage earners has been reduced, but it remains significant and higher than in Lithuania and Estonia. The reform has improved the capitalization of companies and profit margins; however, no significant increase in fixed capital formation and corresponding economic growth has been achieved. There are signs that the share of the shadow economy has slightly decreased, and the State revenue service performance has improved.
By international standards, Latvia has a relatively low tax burden, which has further decreased as a result of the 2018 reform. According to the Council's estimates, the reform resulted in a decrease in tax revenue of about 0.8% of GDP in 2018 and 1.4% of GDP in 2019.
As a result of the reform, the tax burden was slightly shifted from capital to consumption and from lower wages to higher wages. Entrepreneurs are the main beneficiaries of the 2018 reform. The tax burden on labor should be further reduced by transferring it to capital, consumption and environmental taxes, thus continuing policies to reduce inequalities and increase competitiveness, as recommended by the European Council.
The reform should include a comprehensive, data-driven and objective analysis of the usefulness and effectiveness of the tax allowances. Ineffective ones should be abandoned or replaced. In the future tax policymaking process tax allowances should be avoided where possible, in order to keep the tax system simple and to avoid tax base reduction.
Measures to reduce the number of workers in the Micro-enterprise tax regime should be continued in order to ensure fair competition, fair taxation and social protection for workers. Further efforts are needed to reduce the informal economy as well as to reduce the tax gap.
The council opinion on the directions of tax reform was broadly approved in a discussion, with high-level participants from academic, private and public sectors.
Conclusions and recommendations
The global economy is undergoing radical transformation, which increases the role of fiscal policy in promoting inclusive growth and reducing inequality. When planning tax reform, government must take into account the reform trends in the developed world and draw conclusions from the results of the previous reform.
The previous tax reform has failed to achieve one of its main objectives, which is to increase share of tax revenues to GDP. The tax burden on low-income people has been reduced, but it is still significant and higher than in Lithuania and Estonia. The reform has improved the capitalization and profits of companies, but has not led to a significant increase in fixed capital formation and a corresponding economic acceleration that could generate higher tax revenues. There are signs that the share of the shadow economy has declined slightly, and the performance of the State revenue service has improved, however, this has not resulted in a significant increase in tax revenue.
The Council concludes that the level of public funding is insufficient to meet the basic requirements of citizens for public services and social assistance. In the medium term, even greater demand for public funding is expected, which could put pressure on politicians to increase budget deficits and breach fiscal regulation requirements. For this reason, the Council recommends that the tax reform of 2021 should ensure greater tax revenues for ever-increasing public services and social benefits.
In an international context, Latvia has a relatively low tax burden. Although there is no universally defined optimal tax burden, there is a correlation between higher personal income and higher tax burden. Increasing overall amount of tax revenues, also by reducing the gray economy and tax gaps, is one of the benchmarks for tax reform.
The Council recommends further reducing the tax burden on labor by transferring it to capital, consumption and environmental taxes, thus continuing policies to reduce inequalities and increase competitiveness, as emphasized by the European Council.
The Council recommends assessing the usefulness of tax allowances and eliminating tax allowances with low or unproven effectiveness in future tax policy-making, and avoiding introducing new ones.
The Council recommends further measures to reduce the number of workers in the micro-enterprise tax regime in order to ensure fair competition, fair tax payments and social protection for workers.
To summarize the written above, the Council proposes found criteria, which should be used to assess the prospective elements of the reform:
- Does it achieve an increase in tax revenues as share of GDP,
Does it reduce tax burden on labor, especially for low-income groups,
- Does it reduce number of ineffective tax allowances,
- Does it ensure fair competition for enterprises, with equal tax burden, and equal social protection for all employees?
The Council organized a tax reform discussion with high-level experts from academic, private and public sectors. There were wide range of opinions and ideas, but in general the participants agreed that short term target of the tax system could be to achieve tax burden as percentage of GDP in range 33-35%. In the medium term, the target could be to approach, but not exceed the average level of EU countries (currently 40.3% of GDP).
By better tacking of grey economy (around 20% of GDP), decreasing tax allowances (2.5 billion euros or 9.5% of GDP), rationalizing alternative tax paying regimes (microenterprises), the tax burden could be increased in Latvia to 33-55%.
Coordination with Estonia and Lithuania is essential to avoid tax arbitration, when desiging the tax system.