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.

"Too much math, too little history"

Author: Irakli Barbakadze
 

I want to continue the topic which Nino started some blogs before. Nobel Prize statistics but focus more on “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel” (There is no Nobel Prize in economics :)). 

It is interesting where the economics as a science is going to and how we, as students, should follow the trend. The actual topic nowadays in economics is the topic called “Too much math, too little history”. This means that economics is mostly based on math and data science and there is not sufficient history behind it. There are many sources of data and literature to find the answer this question but here we use the statistics about Nobel Prize Laureates in Economics.

The graph #1 shows the number of Nobel Prize Laureates in different fields of economics. We divided the data into two periods (before 2000 and after 2000). The graph represents that there are some disciplines in economics without Nobel Prize winners during 15 years and on the other hand, there are disciplines with Nobel Prize winners only after 2000. This means that we see a significant progress in some field of economics while the other disciplines are not progressing as much.

Graph #1. Number of Nobel Prize Laureates by field of economics

Source: www.nobelprize.org

Let me start analysing from the least progressing fields without Nobel laureates in the last 15 years.

•    Development economics, economic growth, economic growth theories, welfare economics and welfare theory – in the last 15 years there were no Nobel Prize winners from these fields. This means that there is no significant improvement of the growth and development theories. This means that everything is still based on the Solow/Classical/Neo-Classical growth models.  On the other hand, economic growth and development are very demanding topics nowadays.

Let’s have a look the number of publications which are published in these fields. We see that Economic growth theory is a field of economics which was one of the leading in the last century but after 2000 this field is not progressing at all. On the other hand, disciplines such as welfare economics and welfare theory progressing quite well in terms of a number of publications (we use google scholar statistics which is not very precise but give us the general picture).We can definitely say that these fields are still demanding among scholars.

Graph #2. Number of publications in each field of economics

Source: Google scholar

Short summary: So, it is interesting that such demanding topics in the 21st century, such as development economics, economic growth and welfare economics are without Nobel laureates after 2000. This means that there is no significant progress in these fields. We still use neo-classical growth models with some modification and try to explain why countries growing rates are not the same. The most noteworthy case is Economic growth theory. Here we observe a huge amount of publications which are mostly empirical but not the theory itself. Is it “lack of theories”?

 Graph #3. Number of publications

Source: Google scholar

Another very interesting insight from the graph 1 is that in the case of international economics we see no Nobel Prize laureates after 2000. While we are living in the interconnected world (age of globalisation) and everybody is talking about an export, import, foreign investment and other topics which are very connected to international economics. On the other hand, we have Nobel laureates in regional economics. This means that regional cooperation between/within countries is a much more actual topic among scholars than countries international cooperation.

The graph #3 presents that regional economics is progressing more rapidly than international economics in terms of a number of publications. This result makes sense because all the aspects of international economics such as export, import, FDI and other are mostly related to regional level. So, “gravity aspect” matters.

Let’s switch to most progressive disciplines of economics

•    Labour economics, experimental economic, economic psychology and economic governance – all these fields are strongly connected to human psychology. So, we see a high collaboration of two science: psychology and economics. The logic of such link goes through the human behaviour. We know that in economics one of the main subjects are households. Their decisions affect both labour and goods market. On the other hand, households behaviour is mostly coming from their individual psychology.

So,  economic science is behaviour science and all the factors which affect humans’ behaviour also affect economics in general.

We should analyse also the following disciplines: microeconomics, econometrics, the economics of information, financial economics, game theory, and macroeconomics. These are the disciplines of economics which are progressing permanently. We observe many Nobel Prize laureates during the history (before and after 2000).

The most logical conclusion of the blog will be to ask yourself in which direct economic science is going to... (Check your master topics, best measure :))

Do not forget to watch this video as well following video.

Olympic Games

Author: Irakli Barbakadze

Economists see economics everywhere. If we take Olympic Games, it is a huge sport event with lots of emotions, anthems, tears and everything related to patriotic spirit but on the other hand it is a good research topic for economists to explore some interesting behind the "Medals". 

So, every 4 years the topic of Olympics is always actual but not only for sportsmen. Scientists try to predict countries performance. The most common method is to predict number of medals if we control country’s GDP per capita and the number of population. Larger and wealthier countries have more chance to be in top of ranking, such as: US, China, Russia, UK and others. This topic does not need more investigation but to find other sources of success is still interesting. Pwc reports economic briefing paper about modelling Olympic performance before starting  every Olympic Games. They found that together with GDP per capita and population, countries from the former Soviet Union have significant advantage factor to get medals. This shows that sport is one area where state planning and intervention can produce results.

The graph below also supports our notion. If we take, for example Ukraine we can see that with its 20 medals in 2012 it is in top 11 countries in the world. Their performance is better than the following developed countries, such as: Sweden, Denmark, Canada, Finland and many others. In case of Russia, the situation is much more better, they are the third top medalist countries, together with china and unites states.

Chart 1. Relationship between number of medals and GDP per capita (log)

Source: http://www.sports-reference.com

So, we know that post societ countries perform well in sport other than more developed countries but let’s check the dynamics of the performance. We start from 1988 because previous two Olympic Games were kind of different because in 1984 Soviet Union boycott this games which was the response to United States decision which boycott in 1980, Moscow Games. In 1988 was the last Olympics for the Soviet Union and they gathered 132 medals. In 1992 after ruined Soviet Union 12 countries out of 15 (Latvia, Lithuania and Estonia participated separately) created Unified team. It is obvious that for all the countries these period was so dramatic after independent and in overall the total performance was not as good as in 1988 but they collected 119 medals.



Chart 2. Total number of medals in Post Soviet countries

Source: http://www.sports-reference.com

 

As we mentioned above Olympic Games is kind of patriotic spirit. So countries after Soviet Union had more such patriotic emotions so in 2000 the number of total medals increased dramatically and the progress is still the case. It is difficult to explore the exact reason why sum of individual countries is better than the union but one logical reason is that sport is more than economics and politics it is a national and patriotic event.

Estonia as an Emer"land"

Authors: Nino Kokashvili, Irakli Barbakadze

Time: 18:00pm, 19^th of June, 2016. Location: Narva 25, 9^th floor, Tartu, Estonia.

Irakli: We need to start writing the first blog post, let’s choose the topic.

Nino: It should be related to Estonia in some way, but what is it famous for?

Irakli: Long winter, white nights, sauna …

Nino:  Hold on! Look through the window, how green Estonia is.

Irakli (googling): the greenest countries in the world… Hmm.

Nino: What is it?

Irakli: I guess I have found the exact topic.

The view from our window

The phase of economic development and technological progress coincides with environmental degradation. Nowadays environmental issues are widely discussed. This year marks a new era of the cooperation and partnership for international environmental policy. With 10 years’ experience EPI provides a baseline analysis to inform national-level metrics that gauge progress towards global environmental goals.

Based on the Environmental Performance Index (EPI) data, which measures countries’ performance of environmental issues in two areas: human health and protection of ecosystems, Estonia is ranked as 8^th most environment protecting country in the world. The 1st four cleanest nations are Scandinavian countries. Estonia’s ranking is not as high as Nordic world, but it exceeds other Baltic states. Latvia is ranked as 22^nd and Lithuania – 23^rd.

Chart 1. Environmental Performance Index ranking, 2016



Source: Environmental Performance Index 2016 

The environment is not static, but dynamic. In the last decade Estonia has significantly progressed EPI score (by 5.9%) which is mostly due to improvements in following factors:

• Air quality;
• Water resources;
• Agriculture. 

EPI air quality subindex is a combination of air pollution and household air quality. With the household air quality, which measures indoor air cleanliness, Estonia is the number 1 country in the world. This is not unusual for them who have been in Estonia (The first thing that surprised me here is wooden houses and wood heating).

Chart 2. EPI sub indexes in 2006 and 2016 


Source: Environmental Performance Index 2016 

“Chronic exposure to air pollution produced by the combustion of cooking fuels is among the world’s most significant and most silent killers. The most recent Global Burden of Disease (GBD) project found household air pollution from solid fuel responsible for approximately 2.8 million premature deaths worldwide.”

Global Metrics For Environment, 2016

Even though Estonia uses woods as a main material for both:  heating and production, still it ranks as one of the leading countries with forest resources. Thus, while other nations lose forests, Estonia uses its renew-ability factor and makes it one of the most reliable and healthy energy source. 

Environmental aspect in Agriculture has experienced dramatic change in last 10 years in Estonia. The roots of the progress come from the efficient use of Nitrogen. As a result in this period the production of crop have increased significantly, around 98% and reached 4382 kg per ha.

Chart 3. Production of field crop per ha by year

Source: Estonian Statistics office


The next sub index which caused Estonia's such progress in EPI ranking is water resources. In Estonia around 88% of water is extracted from the surface water and 93% of water is used in Energy industry. It is clear from the graph that starting from 2009 the net supply of water (supply - demand) decreases every year which might be explained by the less wasted water. Moreover Estonia is 25th country in the world according to wastewater treatment.

Chart 4. Water supply and consumption by year

Source: Estonian Statistics office

To sum up, there is no doubt that Estonia is an environmental friendly country but on the other hand "A nation’s environment is not its own but is shared with its neighbors and the rest of the world. Pollution is not one country’s problem – everyone bears its burden".

Global Metrics For Environment, 2016

If we want to live in a healthy environment we should work together. I want to end the post with Georgian motto:

"Strength is in Unity"

Political instability as an impediment of FDI. Case of the South Caucasus region

 Author: Irakli Barbakadze

Broadening linkages of national economies into a worldwide market of goods, services and especially capital is one of the key features of globalization. Growth of Foreign Direct Investment (FDI) is the most visible consequence of this process. On the other hand, FDI as a source of economic growth for transition countries seems to have recently acquired the status of stylized fact. Positive interdependence between FDI and economic performance arises the following important question, what countries can do to attract more FDI.


This paper focuses on the host country characteristics, in particular on political instability as an impediment of FDI in the South Caucasus region. South Caucasus is a strategically located region, on the border of Europe and Asia, with heterogeneous countries (Georgia, Armenia and Azerbaijan). Region has all possibilities, such as oil resource, cheap labor force, good location to become a hub of investment in SEE (South East Europe) region while political stability still remains as a main obstacle for foreign investors. This makes it a good case for identifying the role of political stability in attracting FDI.

The main contribution of this paper is not just filling the research gap in FDI literature in case of the South Caucasus region, but also analyzing business environment based on the perception data. Despite skepticism among economists about reliability of subjective perception data, it has been used in various studies across disciplines and provides useful information. There is a growing interest of using such subjective measure in the area of economics, especially in firm level analysis.

This paper assesses the relationship between affiliate firms’ perception of political instability and their headquarters’ investment decision in the South Caucasus region. Results based on the BEEPS (Business Environment and Enterprise Performance Survey 2009) data suggest that affiliate firms’ perception of political instability do not have a significant effect on the headquarters’ decision to invest or not (propensity of FDI) in this region. On the other hand, headquarters which have already made an investment prefer to reduce the volume of FDI (intensity of FDI) if their affiliate firms face the problem of political instability. This negative effect disappears when affiliate firms perceive high corruption together with political instability. Presence of oil resources is a significant determinant of FDI in the South Caucasus region but there is no significant difference between non-oil and oil industry in case of sensitivity to political instability.

Irakli Barbakadze

Nationality: Georgian
Previous education: BSc Economics, Tbilisi State University

What did you get from MA Quantitative Economics?

MA Quantitative Economics is the program which provides students all possibilities to be successful.  Qualified lecturers and well organized study process create good study environment. The most important and visible fact is that all staff of this program is very friendly. They are always ready to help you which increase the motivation of student to study.

During this two years we had opportunities to have the lectures form the famous visiting lecturers. On the other hand with a huge support of our program manager all students had the chance to start internship.

Current position: Researcher at PMC Research Center, Tbilisi, Georgia.
Contact: iraklibarbaqadze1@yahoo.com