Estonian corporate tax system in North Carolina

The Fraser Institute hosted annual student essay contests last year. The topic for the 2016 was: Small Change, Big Impact: Improving Quality of Life One Policy Change at a Time. Students were asked to identify a single, specific, practical policy change that would have a big impact on the quality of life (the social and/or economic well-being) for citizens. We are happy to announce that among 340 entries Quantiative Economics program alumnis: Nino Kokashvili and Irakli Barbakadze recieved 3rd place in graduate category. You can read the winning essay below. 

Estonian corporate tax system in North Carolina

Abstract

The aim of the article is to evaluate the suitability of Estonian CIT model in North Carolina, USA. We studied the effect of Estonian CIT model in Estonia (ex-post) and in Georgia (ex-post) and concluded that Estonian CIT model will have an investment favoring effect in North Carolina as a state which is on the way of improvement business environment.

Broadening linkages of national economies into a worldwide market of goods, services and especially capital is one of the key features of globalization. Mobile capital and labor has created competitive environment among countries. In this process taxes are vital components of countries’ international competitiveness (Janeba (1995), Devereux et al. (2008)). The evidence shows that countries with effective tax system together with other country level factors, such as, access to row material, cheap labor force and infrastructure, attract new businesses and leads to higher economic growth (De Mooij and Ederveen (2003)).

In last decades many countries have recognized the importance of the simplicity of tax system and implemented different reforms to improve tax code. However, some countries have experienced difficulties in reforming process and as a result have fallen behind the global trend. International tax competitiveness index (ITCI) measures the business attractiveness of national tax systems. The index is based on several tax policy variables including corporate income tax which is the crucial determinant to attract new businesses and encourage higher economic growth. According to the latest data (2015) of ITCI in OECD countries (Chart 1), Estonia is evaluated as the most competitive country based on the overall tax system, which is partly explained by Estonia’s unique corporate tax code.

Source: Authors’ own elaboration based on International Tax Competitiveness Index 2015 data

The Estonian corporate income tax system is unique as it does not mean a traditional tax nullification on retained earnings, but postpones the tax payments until the distribution of dividends. The idea of the Estonian CIT system is not new in economics. It is originated from Irving Fisher’s capital theory (Fisher (1906)), which argues about double taxation on savings. Retained earnings which are reinvested in capital provides income that will be taxed later. Taxation of retained earnings reduce the potentially highly productive investment ability of constrained firms since it reduces internal funds, therefore, reduces investment capacity by the amount of taxation. Additionally, the Estonian corporate income tax system provides the opportunity for firms to be more flexible in changing environments, which means that firms can individually decide whether reinvest retained earnings or distribute it as dividends.

In 2000 Estonia has modified the tax system and abolished the retained earnings from taxation. The results of reform after 10 years showed (Masso et al. (2003)):

• Share of liabilities in total assets have decreased by 7 percentage points.
• The share of cash and equivalent in assets (which has been used as liquidity indicator) has increased by 2-3 percentage points.
• The share of undistributed profits and reserves in total capital has grown by 11 percentage points.

The most noticeable result of this reform is that post reform capital structure of the firm helped Estonian companies to survive from the economic crises in 2008, because they had less debt financing and more liquid assets.

The Estonian corporate income tax system is successful not only in Estonia but it has also gained attention of different countries from all over the world. With support of USAID, Georgian government has evaluated possible effects of Estonian CIT model implementation. Based on the ex-ante study(Regulatory impact assessment of Estonian CIT model implementation in Georgia) the reform will have investment favoring effect in Georgia. The results for future 1.5 years are the following:

• The stock of capital will increase by 3.2%.
• The real GDP will increase by 1.4%.
• Aggregated private consumption will increase by 0.8%.

Ex-ante and ex-post analysis of Estonian CIT model show the positive effect on overall business climate. The main difference between Estonian CIT model and traditional systems is that Estonian model is not just tax reduction but it is unique because of its neutrality and simplicity.

While international tax competitiveness index (ITCI) evaluated Estonia as the most competitive country based on corporate tax system, USA, in contrast, is a good example of the most noncompetitive tax code in OECD countries with one of the highest marginal corporate income tax rate. The higher marginal tax rates are not the only reason why US is on the bottom of the ranking. The problem is strengthened because of cost recovery difficulties and complexity of the system (Chart 2).

Source: Authors’ own elaboration based on 2016 State Business Tax Climate Index data

The complexity of US corporate income taxation is partly explained by two level of taxation, state and local level. On the other hand, tax competition between countries is similar to competition between states and the tax reductive policies are often discussed in different parts of United States as well (Hines (1993)). Every state tries to reduce taxes relative to their immediate neighbors to create attractive business environment. In USA corporate income taxes are levy in 44 states, rates range from 4% (North Carolina) to 12% (Iowa). Different states have implemented various corporate income tax reduction policies in 2015-16. Notable reforms in 2016 were in North Carolina, Indiana, Nevada, New York, New Mexico and Arizona (2016 State Business Tax Climate Index report).

North Carolina is a good example of a tax reduction process. The reform, started in 2013, had a dramatic improvement in State Business Tax Climate Index. The reform is still in progress and the corporate income tax is expected to reach its lowest level (3%) in 2017.

Besides tax reduction, additional structural reforms are also essential to create attractive business environment. The Estonian CIT model with above mentioned benefits on business climate is a suitable model for North Carolina as it not only reduces taxes, but also provides systematical improvements of business environment in a long term. Compared to traditional tax credits, which are used in many states to reduce effective tax rates in specific industries and investment, Estonian CIT model is preferable system. The advantages of the model are the following:

• Easy to administrate

The idea of a tax credit is that government collects tax revenue and then distributes it. So, we have double administrative cost which makes this system more expensive. In case of Estonian CIT model the administrative burden is minimal.

• Objective selection of reinvestment

Investment tax credit is the support of government if the company invests in new property, plants, equipment, or machinery. The crucial thing is that new investment have to be approved by the state’s government. So which investment is qualified as a reinvestment depends on government’s decision. In contrast, the Estonian CIT model gives the firms opportunity to make the decision about reinvestment individually.

•  Free market oriented

As we discussed above in case of traditional tax credit system government is the main actor. It decides which industry to be subsidized and how much. The principle of self-regulated free market is rejected. Such a huge role of government in market regulation process creates an additional deadweight loss because firms focus resources on influencing the tax code, such as lobby, instead of producing products. Such kind of deadweight losses in the United States attributed to lobbying were estimated to be between $215 and $987 billion in 2012. These expenditures for lobbying are assumed as an impediment of economic growth by crowding out potential economic activity. On the other hand, Estonian CIT model is based on the free market condition means that firms’ decision about investment is made by the firms.

If we sum up the advantages and limitations of Estonian CIT model we can conclude that this system works and is recognized not only by Estonia but also by other countries. International organizations rank this CIT model as a number one in OECD based on flexibility and neutrality of the system. USA as a country with leading economy in OECD but noncompetitive tax system should take steps toward to liberalization of tax code especially on the state level. But the most important is that just reducing CIT is not a solution, more structural reform is needed. Estonian tax reform is the best case for such structural changes.

Reference

De Mooij, R. A., & Ederveen, S. (2003). Taxation and foreign direct investment: a synthesis of empirical research. International tax and public finance, 10(6), 673-693.

Devereux, M. P., Lockwood, B., & Redoano, M. (2008). Do countries compete over corporate tax rates?. Journal of Public Economics, 92(5), 1210-1235.

Fisher, I. (1906). The nature of capital and income. The Macmillan Company.

Hines Jr, J. R. (1993). Altered states: Taxes and the location of foreign direct investment in America (No. w4397). National Bureau of Economic Research.

Janeba, E. (1995). Corporate income tax competition, double taxation treaties, and foreign direct investment. Journal of Public Economics, 56(2), 311-325.

Masso, J., Meriküll, J., & Vahter, P. (2013). Shift from gross profit taxation to distributed profit taxation: Are there effects on firms?. Journal of Comparative Economics, 41(4), 1092-1105.