The competitiveness of a country’s tax system is instrumental in creating a favorable environment for foreign direct investment, stimulating business, and advancing societal well-being. Competition based on endogenous factors (e.g. taxation and the level of bureaucracy) should not be perceived as unjust or unnatural.
Differences in tax regimes have real effects on the economy: international competitiveness indices commend Estonia for the most attractive business environment in the Baltic States. Ranked 12th in the World Bank‘s Doing Business Index, Estonia outperforms Lithuania (16th) and Latvia (19th) (European Chamber, 2018).
In 2016, foreign direct investment (FDI) accounted for 87.1 percent of gross domestic products (GDP) in Estonia, as compared to 36 percent in Lithuania and 54 percent in Latvia (Eurostat, 2016).
Tax regimes play a key role in attracting foreign investment. According to the 2017-2018 Global Competitiveness Report by the World Economic Forum, Estonia ranks 31st out of 137 economies in terms of the effect of taxation on investment incentives, while Lithuania and Latvia are ranked 99th and 118th, respectively.
Similarly, Estonia ranks 9th in terms of the impact of FDI regulation on business development and 59th in terms of the effect of taxation on incentives to work. In these areas, Estonia again outperforms Lithuania (63rd and 121st respectively) and Latvia (53rd and 117th respectively) (World Economic Forum, 2017).
For the past four consecutive years, Estonia’s tax code has been named the best among OECD member countries. It is widely recognized for its four biggest assets. First, Estonia applies a 20 percent corporate income tax (CIT) on distributed profits.
Second, a flat personal income tax of 20 percent does not apply to dividends.
Third, property taxes are calculated on the basis of the value of land rather than real estate or capital value.
Fourth, Estonia has a territorial tax system whereby all foreign profits generated by domestic corporations are exempt, with some exceptions, from domestic taxation (Tax Foundation, 2017).
A corporate income tax regime like this is attractive to foreign investment and effective in terms of budget revenues. Even though the corporate income tax is charged on distributed profits only, revenues from the corporate income tax per capita are higher by 25 percent in Estonia than in Lithuania. Latvia has followed suit and applies the same regime from 2018.
In Estonia foreign direct investment from EU member states amounts to €19.7 billion (Estonian Bank, 2018), as compared to €12.6 billion in Lithuania (Statistics Lithuania, 2018). If calculated per capita (1.3 million in Estonia (Statistics Estonia, 2018) v. 2.8 million in Lithuania (Statistics Lithuania, 2018), the difference in FDI is even more striking. Such disparities in business performance are partly due to differences in tax regimes.
This paper analyses the corporate tax regimes in Lithuania, Latvia and Estonia and offers policy recommendations for improving business conditions. We use a traffic light model to display assessment of the applicable tax provisions. The countries are color coded with Green = the most favorable, Red = the least favorable, and Yellow = moderate.