Tax Benefits: Search for System in Maze of Exceptions

Marinus van Reymerswaele: Two tax collectors // Public domain

The Lithuanian Ministry of Finance has undertaken a systematic review of tax benefits. This job will not be easy but it makes sense to look at tax benefits in difficult situations. At first glance, it might seem that there are not many tax benefits, so they can be examined and sorted in one sitting. Sadly, this is not the case.

There are many different benefits which are advantageous to some citizen groups but annoy the others. They are liked by politicians because they help to attract more voters but they hinder the collection of the budget.

However, not all rules of taxation, which are commonly referred to as “benefits”, are advantageous in the economic sense. There are simply a lot of different phenomena of taxation among them.

At the time being, the income tax (RIT) does not apply, to a certain extent, to funds saved for pension and education. Corporate income tax does not apply to expenses for the employee’s health insurance. Such a tax regime is purposeful – the aim of the regime is to supplement public services or allowances with funds accumulated by people themselves and the private sector. This is an implementation of the principle of subsidiarity.

It is much more efficient to tax private income or expenditure, rather than to provide allowances or various services to the state from the public funds. Based on the demographic situation, this form of taxation is more sustainable. It is especially relevant to savings dedicated to the older age groups, when the demographic situation is unfavorable for the “Sodra” type pension systems, and the population is much more dependent on them than in any other country of the European Union.

Society benefits from the fact that people are buying health insurance or have dedicated savings for nursing care, thus it is expedient to exempt personal contributions for supplementary health insurance from the RIT and to raise the tax-free limit.

There are fundamental differences between official employment and self-employment, which is why they constitute different forms of legal activity. Self-earned income and income that comes from capital is not guaranteed and non-periodical. A person bears the risk for the process and the product. An employee’s liability is limited to their job instructions and their salary does not depend directly on the company’s profit or loss.

Critics point out, and rightly so, that cases of misuse of minimum form of taxation are not uncommon, when not all income is accounted for. However, these, just like other cases of misuse, can be prevented by control measures.

If these forms of activity were abolished based on external equality, not all people working under them would register companies. Incentives for shadow activities would increase, and given the post-pandemic difficulties, this would be a step towards increasing hostility among social groups.

The current taxation regime in Lithuania for the income of self-employed citizens has an impact on the government’s goal of enabling everyone to participate in economic activities and thus reduce social exclusion.

The procedure, by which 15% RIT rate was increased to 20% by transferring the payment of pension from The State Social Insurance Fund Board to the state budget, was allocated exclusively to employment income. Now there are several ideas suggesting that other types of income must be taxed because they are benefits.

The 15% income tax rate is not a benefit but a long-standing and competitive RIT threshold in Lithuania which could serve as a guideline for achieving the previously set goals: more investments, development, favorable conditions to create value and earn more money.

A waiver of taxation on reinvested earnings should replace the existing tax benefits and the ongoing problems with deductible expenses. At the time being, earned profits are taxed twice – at a company level and by dividends. Despite the relatively low 15% income tax rate in Lithuania, effective corporate taxation is as high as 27,75%.

If only distributed profits were taxed, companies would have more funds for investment and development, and their need to borrow money would be reduced. Tax accounting would be significantly simplified, and administrative burdens would be reduced. It would also reduce incentives to engage in shadow activities, and artificially reduce taxable profits.

As we can see, a few directions of systemization can be found in the chaos of different processes of taxation:

  1. identify what is considered a benefit when, in fact, it is not;
  2. check the existing regimes of taxation and how they meet the long-term goals of Lithuania;
  3.  implement horizontal measures to reduce the need for benefits.

Tax policy is a political rather than economic phenomenon. There is no tax system that is best objectively and economically, simply because all taxes reduce the taxpayers’ incentive to act.

From an economic perspective, we can only assess how one or another tax will affect one or another person and how will it impact their behavior as a result. What goals should be achieved by certain taxes is the a decision of the politicians.

For now, the declared goals are to achieve a breakthrough in the transition to a higher value-added economy, reduce social fragmentation and exclusion, and create a business-friendly environment. It is only natural to expect taxes that would support these goals.

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