The structure of the tax system, more than the tax rates themselves, is what makes it so attractive to citizens and businesses.
Lessons from one of the world’s most efficient and transparent tax regimes
E stonia may be a small country, but over the last few decades, its approach to digitalization and taxation has received considerable attention. For example, the U.S.-based Tax Foundation has ranked Estonia as having the best tax system of all OECD member states for nine consecutive years.
Sometimes, the focus is on both digitalization and tax at the same time. This was the case in a recent article for the Daily Telegraph in which James Warrington outlined the high-tech and tax lessons that Estonia could offer the United Kingdom. The headline for the piece (which is unlikely to have been written by Warrington) is “What [British Prime Minister Rishi] Sunak can learn from the low-tax, high-tech economies of Estonia and Latvia.” The high-tech part is right, but the emphasis placed on “low tax” is more questionable.
Nevertheless, this is a narrative that keeps surfacing occasionally. Steve Forbes has advocated an Estonian-style flat tax in the United States over the decades. Prominent think tanks such as the Cato Institute have portrayed Estonia as a flat-tax beacon (although, to be fair, that was in a report from 2007, and, to be fair, Estonia was a pioneer in introducing a flat tax in 1994). More recently, however, the tax has become less flat (if flatter than in many jurisdictions), and to focus on that is to ignore other important elements in the Estonian tax system.
In certain respects, Estonia remains a low-tax economy. There is no corporate-income tax on undistributed profits. Sometimes pundits describe this as meaning that profits reinvested in the business are tax-free. But that’s not the case. No tax is paid on any retained earnings. However, once profits are distributed, they are subject to individual-income tax, which is paid by companies on the behalf of individuals.
Historically, there were only two individual-income-tax brackets in Estonia (thus the talk of a flat tax) — zero on very low incomes and 20 percent on all incomes above that threshold. Capital gains were treated as ordinary income. However, the system became less flat in 2018: There are now many tax brackets between zero and 20 percent.
A maximum of 20 percent tax on any income exceeding 2,100 euros per month may seem a good deal, but, on top of that, employers have to pay social taxes of 33 percent on salaries, which can (even if there are no direct employee contributions) operate as an indirect tax on income. Dividend income is not subject to social taxes,s but 20 percent income tax on dividends is not insignificant either. Add to that a 20 percent value-added tax (VAT) that individuals have to pay on most transactions, and it is difficult to see how Estonia can be considered a low-tax country.
According to the OECD, Estonia had a tax-to-GDP ratio of 33.5 percent in 2021. This was slightly lower than the OECD average of 34.1 percent. However, Estonia ranked 22nd among the 38 OECD member countries in 2021 (the lower the ranking the lower the ratio). Estonia was a long way below Denmark with a 46.9 percent of tax-to-GDP ratio and France with 45.1 percent tax-to-GDP ratio, but it is far from being a tax haven. The U.S. tax-to-GDP ratio was 26.6 percent.
Estonia’s tax-to-GDP ratio has been fairly consistent for quite some time. It was 31.1 percent in 2000. The lowest tax-to-GDP ratio Estonia has experienced since then has been 29.8 percent in 2005 and the highest 35 percent in 2009.
The Estonian tax structure is characterized by lower property- and corporate- and individual-income taxes than the OECD average. But Estonia has higher social-security contributions and (like all EU member states) consumption taxes above the OECD average.
These high social-security contributions translate into a high effective tax on labor, which is an obstacle in the way of developing a competitive service sector. In particular, high labor taxes are a barrier for recruiting high-skilled professionals from other countries. For instance, IT professionals do not want to relocate into Estonia-based units even within the same IT firms because of the increased tax obligations in comparison with other locations.
These challenges have also been highlighted in the 2021 report by the Foresight Centre at the Estonian parliament (for which I am an affiliated expert and former head of research), which questioned the sustainability of relying heavily on social taxes while the working-age population continues to decline. The center has proposed a reduction in social taxes “paid for” by increasing other taxes. It’s perhaps worth noting that Estonia has traditionally operated its budget on a prudent basis. Estonia’s debt-to-GDP ratio in 2021 stood at a little under 18 percent.
Under the circumstances, therefore, Estonia’s No. 1 ranking from the Tax Foundation is not solely dependent on its relatively low tax rates. Indeed, it’s telling that, in discussing that ranking, the Tax Foundation also points out the simplicity of Estonian individual, corporate, and property taxes. The report highlights the benefits of the country’s territorial tax system that “exempts 100 percent of foreign profits earned by domestic corporations from domestic taxation, with few restrictions.”
France is ranked last in the Tax Foundation report because of its high wealth tax, financial-transaction tax, inheritance tax, and a narrow base for VAT collection (it covers less than 50 percent of final consumption). The United States ranks 22nd among the 38 OECD countries with the nature of its property taxes and complex cross-border tax rules being two factors among quite a few pulling down its rating.
In a nutshell, high marginal-tax rates and multiple layers of tax rules that contribute to complexity make tax systems less competitive. All too often, concentrated benefits are received by a few, while diffused costs are paid by many. The simplicity and transparency of Estonia’s tax regime, as well as its broad tax base, provide a good example of how a more neutral and competitive tax system can be designed.
The relative simplicity of Estonia’s tax system has not only facilitated digital tax collection but has also made it easy to file tax returns online. As a result, that’s what almost everybody does. For a person whose only income is his or her salary, it can take only a few seconds to submit pre-filled tax declarations online. For people whose income comes from multiple sources, this process takes a matter of minutes or some tens of minutes, something that is not exactly the experience in the U.S.
Simplicity combined with digitalization means lower transaction costs for both citizens and government. It enhances efficiency, but also transparency and trust. It is no coincidence that Estonia also ranks highly in Transparency International’s Corruption Perceptions Index, alongside countries such as Canada and Iceland. The fight against corruption has been central in the comprehensive reforms carried out by successive Estonian governments.
Contrary, perhaps, to the impression given by that Daily Telegraph headline, the writer of the piece below it clearly appreciates that it’s the structure and simplicity of the tax system that counts:
Carmen Raal, digital transformation adviser to the Estonian Government, says: “We’re not a tax haven, but something we can say quite proudly is that we are an administrative haven.”
Ms Sandra Särav [an official in Estonia’s Ministry of Economic Affairs and Communications] agrees that while the tax regime is undoubtedly attractive, the main pull for businesses is in fact convenience.
Tax policy has been an important ingredient in Estonia’s reform efforts that have been among the most radical and far-reaching of all those seen in Central and Eastern Europe since the breakup of the Soviet Union and the fall of communism in its satellite states. Estonia has implemented profound economic, trade, fiscal, and monetary reform, alongside an overhaul of governance designed to impose the rule of law and deliver efficiency. This has worked in sync with the approach taken to tax policy. Tax policy should not be seen in isolation; carried out well, it can be key to a sound economic environment. In Estonia, that has been the case.