Lessons from Tax Competitiveness Index – How to Get On Pedestal?

William Daniels: Title A Girl Standing by a Pedestal // Public domain

Lithuania ranked ninth in the International Tax Competitiveness Index 2023. This country ranked eighth last year and fourth in 2019. Why is it sliding down instead of finally rising up the pedestal?

The International Tax Competitiveness Index assesses tax systems on their simplicity, transparency, neutrality – i.e., fairness to specific activities and income levels – and stability. Lithuania, once faithful to these principles, is now moving further and further away from them – toward exceptions, prejudices, preferences and the complex bureaucratic burdens that accompany them.

Its position in the individual tax categories perfectly illustrates this. Even when it gets a good rating for a relatively low corporate income tax (CIT) rate, complex procedures and exemptions ruin it. Personal income tax (PIT) is again seemingly low, but it is dragged down by the introduction of a progressive rate and the taxation of capital gains and dividends. New? – The Index’s authors point out that the model used in Lithuania means double taxation of capital income.

Estonia and Latvia score highest on the International Tax Competitiveness Index because profits are taxed only when distributed as dividends, with them not being taxed a second time. Some countries use more sophisticated methods to combat double taxation, such as tax credits or various offsets. The index compilers note that, given the double taxation of capital, many countries have lower rates on capital gains and dividends, as this is a susceptible area that can undermine capital formation and economic growth.

Lithuania’s value-added tax (VAT) is viewed less favorably than direct taxes because of the high base rate, many exemptions and administrative challenges. Countries that apply the same (and relatively low) VAT or sales tax to all products score best here. Interestingly, countries where everyone is registered as a VAT payer (there is no threshold for registering for VAT) also score higher. These countries include Spain, Mexico, Turkey, and the USA. The absence of a VAT threshold is probably linked to the simplicity of this tax administration, which we still need to improve on.

An essential lesson which Index gives us is that the deterioration of the tax system over the last four years (including the introduction of the progressive 32% PIT) has reduced Lithuania’s competitiveness. More importantly, it shows that doing nothing is not a panacea. After all, while we are muddling through, other countries are improving their position. For example, Turkey has overtaken Lithuania by reducing its CIT rate from 23% to 20%. Global competition is only intensifying; while we do nothing, others are looking for ways to improve. It is like in human life – if you are not going up, you are going down.

Inflation could also adjust the Index’s assessment, as it notably increases the tax burden in countries with different rates, rules, and taxation based on specific fixed amounts. This is where the advantage of neutral and one-size-fits-all taxes becomes apparent! Inflation has shifted the Index’s compilers’ focus towards the procedures of recognizing corporate costs. They point out that inflation is particularly damaging to companies’ fixed asset base.

We have seen much of this in Lithuania: high inflation prevents companies from restoring their fixed asset base, and only a fraction of the money invested is recovered through depreciation. We have prepared an excellent instrument that would immediately improve the situation of companies and thus Lithuania’s position in the Index – instant depreciation of fixed assets. It is good that it is included in the tax package, but it should be adopted in line with the budget.

Countries that apply instant or accelerated depreciation score better in the International Tax Competitiveness Index. The authors point out that Chile’s position has worsened because it abandoned the instant depreciation of fixed assets introduced at the beginning of the COVID-19 pandemic, which has significantly improved corporate investment conditions.

The Index also provides more concrete insights and indicates what policies would allow Lithuania to regain its status as an attractive tax jurisdiction. As we are still procrastinating on the brink of tax reform, the Index shows the paths worth taking to get on the pedestal finally.

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