The working group on the review of tax benefits, set up by the Ministry of Finance, has already received over 200 proposals from experts, business and the public on what needs a transformation in the country’s tax system. Albeit, the primary message from the Ministry and some representatives of the ruling majority is that there will be no urgency, a lot more discussions await, and the tax changes could take effect in 2023. Is there really nowhere to rush and what kind of reform does Lithuania need?
Indeed, the urgency of tax changes is intolerable when the tax amendment laws reach the Seimas together with the budget for the coming year. We have repeatedly been in a situation where, in December, residents and businesses watch a thriller with horror without understanding what taxation rate they will be burdened with starting from 1st of January the following year. However, this does not mean that comprehensive tax reform needs to be postponed and delayed once again, especially when its flaws are well known and distinguished by both local specialists and international institutions.
Perhaps many have no doubt that it is not easy to implement such a tax reform, so that “both the wolf is full and the sheep stays healthy.” The abolition of any benefits – including the most unjustified and harmful – and the increase in any tax rates, any new tax will always attract the dissatisfaction of one or another group of society. Even tax cuts, as we saw a few years ago, can be much criticised for reducing the state’s ability to finance public services.
Therefore, bearing in mind that the municipal council elections will take place in 2023 and together with Seimas’ elections – the presidential will take place in 2024, so delaying the reform reduces the likelihood that “more equal than equal” problem will be taken head-on. In other words, in the run-up to the elections and avoiding a sharper conflict with some sections of society, it may be difficult to erase the long-standing misdeeds and inefficient flaws in the tax system. Although many recognise that a tax “livestock farm” is not desirable, unfortunately, it continues to flourish for the fourth decade.
The tax reform is needed not because of the consequences of the pandemic
It is clear that the pandemic has opened a significant hole in the general government budget, which will result in public debt exceeding by 50% of GDP. However, such debt still remains one of the lowest in the Euro area and does not create any problems nor for today’s, neither for the future generations – Lithuania’s debt is sustainable, its credit rating has even improved this year, so the state borrowing is at zero or negative interest rates.
However, the reform cannot be delayed under the guise of the pandemic. Yes, some sectors are not at ease and some are in deep crisis, but they make up a small part of the country’s economy, and the end of the pandemic is around the corner. If tax changes have a negative impact on the most affected sectors, the changes can be gradually implemented or other support measures can be envisaged rather than delaying the reform itself.
The reform is needed not to balance the public finances in the near future, but in order for the state to have a more efficient and fairer tax system that ensures a sustainable source of financing for its long-term liabilities.
Three criteria for an optimal tax system
There is a consensus in the scientific literature that simplicity, fairness and efficiency are the main criteria for an optimal tax system.
Simplicity means that tax returns and their payment to residents and businesses should not be a time-consuming and costly process. The difference between the funds collected from the tax fee to the budget and the cost of its administration must not be despicably small, as is the case, for example, with the taxation of the real estate in Lithuania.
In addition, the tax system, which is complicated by exceptions and exemptions, often becomes regressive– the lowest tax rates can be paid by those with the highest incomes. This is because only those who can hire lawyers and tax advisors are able to benefit from ambiguities, benefits and exemptions. This problem is also particularly relevant in Lithuania – depending on which one of the many legal forms of economic activity will be chosen, the tax rate payable may vary several times.
The principle of justice requires that taxpayers are not discriminated against. Those with the higher income have to pay bigger taxes – this is called vertical justice. Meanwhile, equal tax rates must be applied to those on equal incomes who engage in different economic activities or who legitimise it differently, which is called horizontal justice.
It is horizontal justice in Lithuania that is the least, therefore income tax exemptions for different groups of society should not avoid the knife of reformers. Unfortunately, we find ourselves in an unpleasant situation of not being able to name the “more equal than equals” avoiding their fierce reaction.
Finally, the criterion of efficiency of the tax system means minimising incentives to hide in the shadows, registering activities in another country, and encouraging work, business and investment. Ideally, the tax system must have so-called positive externalities, not only to help raise funds for the budget, but also to change the behaviour of residents and businesses, for example by less polluting the environment or consuming products that harm them and those around them. Such taxes are called excise duties, or sin taxes – there are certainly not too many of them in Lithuania, so one could consider, for example, excise duties on unhealthy foods, which are gaining popularity in the more advanced countries.
Another aspect should not be forgotten when improving the efficiency of the tax system: tax avoidance by legal and illegal means should be difficult. In this regard, property taxes are more efficient than income and consumption taxes. For instance, the tax on polluting cars meets all three criteria of an optimal tax system.
It is not only preferences and exceptions that are important
It is important to note that not all tax advantages are bad and should be eliminated – there are also those that Lithuania could consider and apply. For example, all neighbouring countries apply corporate tax relief to reinvested profits– corporate tax is paid by companies only when the profits earned are paid to shareholders. As long as profits are employed for the development of an enterprise, job creation or salary increases, it is not taxed.
With such incentives, states not only try to stimulate investment, but also to compete in an attempt to attract large multinational companies. Here it can be noted that Lithuania is in last place in Central and Eastern Europe in terms of the ratio of accumulated foreign direct investment and GDP. Therefore, when discussing tax changes, it is necessary to consider not only the direct consequences, that is, how much money will be collected, who will pay and who won’t, but also the ‘second derivative’ – whether we can attract investment, create jobs and boost wage growth.
Finally, when it comes to agreeing that any reform of the tax system will receive criticism and the murmuring of the dissatisfied, it is important for the authorities not to forget an important factor that would raise tax morale and reduce tax avoidance, which is the efficient and transparent use of the taxes collected.
This requires structural reforms optimising the network of public bodies and public service institutions, improving the procurement process and constantly combating any form of corruption.
Celebrating the 31st day of the restoration of Lithuania’s independence would be the time to undertake a reform that has been delayed for decades and to give Lithuania a simpler, fairer and more efficient tax system.
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