THE TAX SYSTEM OF THE BALTIC STATES AND ITS CHANGES 1

The Tax System of the Baltic States and its Changes Karolis Iliukas Principles of Macro Economics Charles Milliken 04/16/2012

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The Baltic States were one of the first countries to declare independence from Soviet Union and to start a transition from planned economy to open market system. The adoption of flat tax system that happened in Lithuania, Latvia and Estonia at the beginning of 1990s, aided this transition and helped the countrys to emerge as one of the fastest developing countries in Europe. In order to understand this development, this paper will overview the fiscal policies of the three Baltic States, analyze the changes within taxation systems and their effects to economic growth. All of the three Baltic States currently adopt flat tax rate, which has been in the effect since early 1990s. However, the taxes themselves slightly vary from country to country. Lithuania, for instance, uses seven main types of taxes: direct taxes including the corporate income tax, personal income tax, real estate tax of enterprises and organizations, land tax and inheritance and gift tax; and indirect taxes including the value added tax, excise duty and lottery and gaming tax. (Baltic Legal, 2012). The taxes slightly differ in Latvia, where the government also taxes natural resources, cars and motorcycles, and customs duty. Taxes in Estonia do not differ very much from Lithuanian, except Estonian government imposes heavy duty automobile tax. (Baltic Legal, 2012). According to 2011 data, Lithuania and Latvia ran a budget deficit of 1,800 million and 1,480 million respectively, whereas Estonia managed to have a budget surplus of 35 million. (Economy Watch, 2012). The current flat tax system that Baltic States are utilizing has been in use since 1994 in Lithuania and Estonia, and 1995 in Latvia. Previously, the three countries were still using the old and obsolete tax system that they had inherited from Soviet Union. However, this Soviet style tax system included turnover and enterprise profit taxes and was generally inefficient under the newly liberalized and privatized economies. Thus, as these countries

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began to transition into a market economy and a private sector emerged, the creation of new tax laws became increasingly necessary. (Greenberg, 2009). Estonia was the first to adopt flat tax system. The change was much anticipated and needed, as the country faced major economic problems upon their departure from USSR. According to Greenberg, In 1992, industrial production declined by more than 30 percent a decline more severe than the Great Depression price inflation ran at more than 1,000 percent, and fuel prices rose by more than 10,000 percent. (Greenberg, 2009). One of the factors for such problems was Estonias dependence on Russia, which accounted for around 92 percent of international trade. Hence, when Russia ceased all trade with Baltic States, Estonia had very little to provide for trade with other countries. The troubles in the country were so severe, that prices rose twenty two times, and banks soon ran out of currency. After the parliamentary elections of 1992, newly elected government was in a rush to introduce radical changes to ensure macro-economic stability. Thus, Estonia underwent several changes, such as introduction of Estonian kroon as the countrys main currency in 1992, kroons connection to German mark, and finally the privatization of national assets. Together, all these changes helped to reduce the inflation, as By 1993, the inflation rate dropped to 89.8 percent from 1,000 percent in 1992. (Greenberg, 2009). However, the biggest change, which was the introduction of flat tax system, came only in 1994. On January 1, 1994, Estonia introduced a flat-rate personal income tax of 26 percent, thereby becoming the first European country to adopt a flat personal income tax. Previously, Estonia followed a progressive tax system with the top personal income tax rate in 1993 held at 33 percent. (Greenberg, 2009). The change in tax system, as illustrated in Chart 1, helped to boost Estonias GDP from 67.8 billion EEK in 1994, to 71.2 billion EEK in 1995, and also secured the subsequent growth of GDP. Just in five year span, Estonias GDP increased by 30 billion EEK and totaled to 95.5 billion EEK in 2000.

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Source: Greenberg, 2009 Flat income tax of 26 percent also provided more tax revenue for the government. In 1995, a year after the implementation of flat tax system, the revenue from Personal Income Tax amounted 8.7 percent of total Estonias GDP (Chart 2a). Compared to the previous year, the Personal Income Tax Revenue increased by 0.9 percent in 1995. Furthermore, flat tax system boosted Total Government Revenue in Estonia, as it went from 30 percent of GDP in 1993, prior adopting flat tax, to 41.3 percent of GDP in 1994, the year when Estonia officially switched to flat tax system (Chart 2b).

Source: Greenberg, 2009

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Lithuania after the declaration of independence in 1990 also faced similar problems as Estonia. The inflation rate was high, and budget revenues were minimum, because the majority of economic transactions happened in underground economies. In 1992, Lithuania saw its lowest revenue collection, when tax revenue fell to 26 percent. (Greenberg, 2009). Lithuania switched to flat tax system the same year as Estonia, in 1994. However, before that, Lithuania had hundreds of different types of taxes, which served as its main sources of budget revenues, as well as progressive tax system, with taxes ranging from 18 to 34 percent. However, contrary to Estonia, Lithuanian government did not concentrate on flat tax as much as their Baltic fellow. Instead, Lithuania tried to revamp their taxation system by introducing general turnover tax and VAT in 1994. The main motivation behind these indirect taxes was to adopt a market-friendly tax system that was compatible with EU requirements and to meet revenue needs. (Greenberg, 2009). Due to the fact that it is mo re efficient to administer indirect taxes than direct, the adoption of VAT and general turnover tax helped to elevate governmental revenue. The VAT was introduced at 18 percent, and its share of the national budget has risen from 29.5% in 1994 to 40% in 1998. Revenues in excise tax grew as well, going from accounting for 1.1% of GDP in 1994 to 3.1 percent in 1998. (Greenberg, 2009). Furthermore, the research of Greenberg states that in 1992 more than 40 percent of Lithuanias economic transactions took place in underground economy. Thus, changes were needed in tax administration as well. As a result, legislation changes were made to increase the efficiency in tax administration and collection. The result of reforms within the taxation system helped to increase the production, boost government income from taxes and reduce the effects of underground economy. The 33 percent flat tax rate was the highest tax rate the country had seen ever before helped the

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transition to modern, free market economic system. The graph bellow illustrates the growth of Lithuanian economy after tax reforms.

Source: Economy Watch, 2012 Latvia was the last of the three Baltic Countries to implement flat tax system, as the country did that in 1995. The main reason why Latvia wanted to introduce this system was to make tax administration simpler and more efficient. Thus, in 1995 Latvian government adopted 35 percent flat tax rate on annual income. Since Latvia tried to integrate into EU from the beginning, they followed the role of Lithuania and introduced value added tax that was used in modern European countries. Since the introduction of flat tax system, Latvian GDP saw a gradual increase, increasing by a small fraction each year. The year Latvia introduced this taxation system their GDP equaled 3.7 billion LVL. After eleven years, in 2006, the countrys GDP doubled and totaled 7.6 billion LVL. After Latvia officially switched to flat tax, the revenue government received significantly increased. As shown in the chart below, in 1995 compared to 1994 saw the increase of government tax revenue from 4.6 percent of total GDP to 5.1 percent. The numbers dropped in 1997 when government reduced tax rates, but again continued to grow in following years.

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Source: Greenberg, 2009

Of course, the change in taxation system did not increase the GDP and strengthen the economies of Baltic States alone. However, there is no doubt that such reforms helped the transition of the three countries from planned economy to open market, and allowed to develop much faster. In fact, due to rapid growth, the three Baltic States were called Baltic Tigers and often compared to their Asian counterparts. As Greenberg suggests, to better imagine the positive effects of flat tax, comparisons can be made between Baltic States and other former Soviet countries which did not adopt flat tax.

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Source: Greenberg, 2009 Based on this table, it is evident that the implementation of flat tax allowed the governments of Baltic States to receive more tax revenue and contributed to overall growth of the economy. The tremendous economic growth that Baltic Countries have seen from the implementation of flat tax rates was compromised by recession in 2009. Thus, several concerns were expressed regarding the efficiency of such tax system. The opponents of flat tax system suggested to get rid of this system in favor of progressive taxes. The argument was that progressive taxes would increase tax revenue for the governments as well as provide fairer outcome for lower income households. Therefore, generating higher revenue would have helped to get the economies of recession faster. The proponents of flat tax say that seeing how Baltic Countries managed to recover from the crisis in just two years and are continuing to increase their GDP to match the levels that were before the recession, no changes within current tax systems are needed. However, the reality is that something has to be changed. In order to recover from the recession, tax rates were lifted and there were newly introduced ones. For instance, since 2008 Lithuanian government has increased the VAT by 3 percent, rising it up from 18 to 21. Also, property tax was introduced in 2012. (Baltic Legal, 2012). These recent changes became a burden for the citizens of the country, especially for people who do not get high income. Therefore, the progressive tax system would lessen the financial burden of such people. In conclusion, flat taxes have worked for Baltic Countries very well in the past, but the governments cannot rely on flat taxes for ever, and the reformation of fiscal policies of Lithuania, Latvia and Estonia must be considered.

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References Economy watch. (2011, August 1). Retrieved from http://www.economywatch.com/economic-statistics/country/ Greenberg, D. (2009). The flat tax: An examination of the Baltic States. (Bachelors thesis, University of Pennsylvania) Retrieved from http://repository.upenn.edu/cgi/viewcontent.cgi?article=1158&context=curej Taxes in Estonia. (2012), Baltic-legal.com. Retrieved from http://www.balticlegal.com/useful-information/additional-services/taxes-in-estonia/ Taxes in Latvia. (2012), Baltic-legal.com. Retrieved from http://www.balticlegal.com/useful-information/additional-services/taxes-in-latvia/ Taxes in Lithuania. (2012), Baltic-legal.com. Retrieved from http://www.balticlegal.com/useful-information/additional-services/taxes-in-lithuania/