Profit tax repeal may not be Lithuania's pot of gold

  • 2001-03-15
  • BNS
VILNIUS - In its resolve to eliminate the corporate profit tax at the start of 2002, the Lithuanian government may find itself looking for an imaginary pot of gold.

Economists are not sure this radical move is the most effective way to stimulate economic activity. Moreover, there is a risk the tax repeal would be seen by the European Union as a form of dishonest competition, and by the International Monetary Fund as a retreat from fiscal discipline.

"At the Cabinet level this has already been decided, it is part of the government's policy program," said Vitas Vasiliauskas, director of the Finance Ministry's income tax department, asked about the seriousness of plans to eliminate the current 24 percent tax on corporate profits effective Jan. 1, 2002.

Vasiliauskas told BNS the government would complete a detailed study of tax reform as a whole by the end of March. It expected to send draft legislation to Parliament in July or August. "It is hard to predict how things will go in Parliament, since there seem to be conflicting opinions," the ministry official noted.

Tax cuts fit in well with the thinking of Prime Minister Rolandas Paksas' Liberal Union party. Proponents say the new scheme would encourage companies to reinvest profits, while state revenue losses on the profit-tax side would be compensated by increased revenue from personal income and consumption taxes.

They point to the booming economy in Estonia, which eliminated the classical profit tax from the start of last year, as proof of the theory.

"The corporate income tax is a very small part of total revenue to the national budget, and administration is very costly and inefficient," said Vytas Gruodis, general director of the Lithuanian Development Agency. "Some experts say the repeal is very desirable as a stimulant to the economy," Gruodis added.

However, most analysts say it's too early to judge the success of Estonia's new tax system, which has been dubbed by some as "the strangest in the world." It also seems doubtful that taxes are the main driver of Estonia's economic growth.

Lithuanian officials admit that competition for foreign investment is not a major issue behind plans to copy Estonia's tax policy. According to Gruodis, "People shop around, of course, but we are not aware of any specific project where an investor was drawn from Lithuania to Estonia. I don't think it's fair to say Estonia has drawn investments away from Lithuania."

The Finance Ministry's Vasiliauskas agreed that recent press reports of investment flight to Estonia were unfounded: "We have checked and there is certainly no boom, just 5 or 6 branches (of Lithuanian companies opened in Estonia). So it does not seem like there is any investment problem."

The IMF has not been enthusiastic about the current Lithuanian government's tax reform plans. The supplementary policy memorandum that the government signed with the fund in December refers to plans to eliminate the corporate profit tax. It says this should not be allowed to derail the key medium-term goal of balancing the national budget.

Hence, a study of potential alternative sources of tax revenues is called for. The memorandum also highlights "the need to preserve a balance between the taxation of capital and labor, in order to promote employment-creating growth."

"IMF officials are mostly concerned about the fiscal deficit and are rather conservative on the question of repealing the profit tax," Vasiliauskas said. "However, they are well-disposed and constructive, and if we resolve to keep to the agreed fiscal-gap limit, then this issue should not cause problems (in cooperation with the fund)."

The tax policy aide noted that the fund favored a more gradual reduction of the profit tax. It has proposed lowering the rate to 20 percent at first, and then by 5 percent steps bringing it down to 0 percent in 2005.

The Finance Ministry official said he himself was not fully convinced by the logic for eliminating the tax. "The Estonians have been very hesitant to release the data of the initial results from their tax repeal. But from what we know, tax collection dropped significantly. It doesn't seem like there was any surge in personal income tax revenues in 2000, though maybe the effect will show up later."

Vasiliauskas said that in some cases eliminating the profit tax might just mean letting other countries collect the tax revenues that Lithuania got until now.

"Suppose we do not tax a big international company, like IBM. They in any case will consolidate their finances for world operations and report to the U.S. tax authorities. If they have paid taxes in Lithuania, then their U.S. tax burden will be reduced by that amount. If they did not pay in Lithuania, then they will have to pay taxes on the income in the U.S.A. according to U.S. corporate tax law."

Asked if the tax change could affect EU integration, officials said it could have a slightly negative effect. "The EU has not directly expressed disapproval, but it has pointed to a political document, called the Code of Conduct, under which we pledged not to violate honest competition in the taxation of business," said one Lithuanian official close to the situation.

"Of course, they say the 0 percent rate in itself is not so important as long as it is not accompanied by things like lack of public disclosure and widespread tax avoidance that characterize classical off-shores," the official added. He said the EU was expected to clarify its position when it responds to the negotiation position that Lithuania has submitted on the matter.

Even as it contemplates copying its northern Baltic counterpart, Lithuania has joined Latvia in scolding Estonia's profit tax repeal as a violation of a double-taxation treaty the three countries have signed.

"Tax avoidance possibilities seem to have been opened up," said Albinas Zanavicius, an official at the Lithuanian Foreign Ministry's economics department. Zanavicius said Lithuania and Latvia were likely to stop applying the treaty as regards Estonia.

"So far the treaty is in force and we are awaiting more information from Estonia (which was not delivered by the agreed deadline of March 6), but based on what we know now, we see problems applying the double-taxation accord," the Foreign Ministry aide said. He said companies were able to arrange things, at times carrying out fictitious financial operations, so as not to have to pay taxes in either country.

However, Zanavicius was upbeat on Lithuania's plans to follow Estonia's lead. "This is linked to the government's desire to encourage more active economic activity. A competitive economy is a really big plus for integrating into the EU."