Historical, Philosophical and Practical origins of the Estonia Tax System, Part II

William H. Cronenberg
Attorney at Law

In part I, I offered perspectives on Estonian tax policy from the fall of the Soviet Union through the early years of reform. While Estonia did well through this period, we should note that there were challenges along the way. The country endured a jarring stock market and credit crash in 1997, and the Russian banking crisis in 1998 and the dotcom implosion across the Atlantic a few years. All these events had significant negative impacts on the Estonian economy. Yet reforms powered ahead, and setbacks were followed by strong rebounds. The leading economic indicators through these years put Estonia at or near the top of all former East bloc countries in development. This was especially impressive considering that communism was most firmly entrenched in the former USSR. While there were many factors contributing to these results, the Estonian tax system was clearly a cornerstone of the successful transition.

While the Estonian approach to taxes met the overwhelming approval of taxpayers, at the dawn of the 21st century it would face a much tougher audience. Estonia was by then a serious candidate for EU membership. It was well understood that EU accession would move any new Eastern members into a higher class in the eyes of the world, with important economic implications. Beyond that, accession would to bring new members development aid and other transfer payments from the EU budget of roughly 4% of GDP per year. Obviously if some Eastern countries were admitted while others were left out, those outside would be at a major disadvantage. The risks of marginalization for a small, peripheral country such as Estonia were especially acute.

Overall Estonia had little difficulty meeting the requirements of EU candidacy. Indeed long before the serious membership drive began, Estonia and other East European countries were already major recipients of development aid from Brussels. A significant part of this aid supported reforms effectively preparing these countries for membership. As there was plenty of enthusiasm in Estonia to utilize the EU resources, membership preparations progressed very quickly. One of the few areas that raised serious potential questions was Estonia´s tax code.

While in principle EU countries retain the right to determine their internal tax policies, those hoping to join the club are subject to additional scrutiny. Most often the concerns raised about Eastern European applicants centered on things like budget deficits, public debt, tax administration, corruption, bloated public sector payrolls, excessive “gray” and “black” economic activity and so forth. Estonia compared very favorably or excelled in all of these areas. However, the conspicuous lack of corporate income tax drew attention. The left leaning members of the EU elite interpreted this as a sign that Estonia was not “taxing its rich”. Even more worrisome than the risk of weak tax collection or inequitable distribution of income was the prospect of Europeans taking advantage of Estonia as a “tax haven within the EU”.

Those having read my earlier post (hyperlink) Basic Elements of Estonian Tax Policy have heard me deny that Estonia has zero corporate taxation. While this is true today, it was not the case earlier. In its initial form, the Estonian tax code did not impose a corporate income tax per se. Rather, all income was in principle taxed only once at the level of the natural person receiving it. If a company paid dividends to a private owner for instance, the standard (flat) income tax was withheld by the company and remitted directly to the State. In theory the tax was collected for the State, by the company, for the account of the individual recipient.

EU officials evaluating Estonia´s candidacy were deeply divided about Estonia´s unorthodox approach. Those with a free market leaning philosophy tended to defend Estonia´s right to implement a tax system to suit its needs. In their view, there is no “one size fits all” European approach to income tax, and a country as small as Estonia might be justified in rejecting the approach of much larger countries with very different circumstances. They felt that as long as the system was administered neutrally, capable of raising the needed revenues and did not specifically violate existing EU norms, it should be permitted. Those with a more socialistic world view on the other hand, while having to concede that the Estonian system was in fact effective, regarded it as a transitional anomaly that would have to be abandoned for Estonia to mature into a modern European state. At or near the surface of this debate was the fear of Estonia creating “harmful tax competition” in Europe and setting a bad example with an “anti-social” taxation model.

The Estonians were adamantly opposed to scrapping their system. There is no room here to describe the long closed door negotiations that took place, but the Estonian representatives lobbied intensely for a compromise. After a period of uncertainty a deal was reached. The resulting amended tax code gives us the slightly modified system we have today. Now there IS a corporate tax, but a corresponding “reinvestment credit” in the same amount pertaining to “reinvested profits”. Happily for the business community, the definition and interpretation of reinvestment is so broad that in effect you can almost say that Estonia still has 0% corporate taxation, and that the other essential elements of the Estonian approach survive intact.

On May 1st, 2004 Estonia formally acceded to the EU. Since then, its tax system has continued to function commendably. There are no doubt those who still feel the Estonian approach is incompatible with “European values”. However, as Estonia has maintained stability (with no talk of bailouts) in the face of the recent financial crisis, it is hard to accept these criticisms. Considering the severe and deepening financial problems in other parts of Europe, where more conventional taxation and budgetary models have ruled, I think it is safe to assume Estonia will continue on its unique path for some time to come.  

It is always a bit tricky to compare the three Baltics, of which Estonia is the smallest and Northernmost. They are in many respects as different from each other as any other EU countries despite similar size, geography and historical experiences. However it is interesting to note a current comparison of the 3 in terms of their national budgets as a share of GDP, considering that they started from very similar economic conditions back in 1991. According to figures published by the Baltic News Service in January this year, the State budget for Estonia (population approx. 1.3 million) for 2013 is 7.69 Billion Euros, with a projected deficit of 0.7%, representing 42.5% of GDP. In Latvia with a population of 2.2 million, the corresponding numbers are 6.92 BEUR, representing 30.1% of GDP, with a projected deficit of 1.4%. In Lithuania, with 3 million inhabitants, the 2013 budget is 7.65 BEUR representing 30.2% of GDP, with a projected deficit of 2.84%. To briefly judge from these figures it is safe to say that since re-independence, the Estonian tax system has enabled Estonia to effectively raise tax revenues while simultaneously promoting solid economic growth and human development.