The recent parliamentary elections in Lithuania have sparked hope that after 18 years the country will revisit its decision to give up a zero-tax rate on reinvested profits, a regime that gave an immense impetus to the country’s investment and economic growth while in effect from 1997 until 2002. Lithuania’s new coalition government comprised of the conservative Homeland Union-Christian Democrats, the Freedom Party, and the Lithuanian Liberal Movement has put this reform option back on Lithuania’s agenda.
In recent years, Lithuania has enjoyed record high FDI flows, along with strong growth in the fin-tech sector and startup ecosystem, as well as in industry and export development. The country’s tax system has played no small part in this. Lithuania boasts one of the most competitive and neutral tax systems in the OECD, ranking 6th in the International Tax Competitiveness Index 2020. A 15-percent corporate income tax, compared to the OECD average of 23.59 percent, and a relatively neutral treatment of capital investment cost have made Lithuania an attractive place for investment.
However, Lithuania’s tax system is not as attractive as those in neighboring Estonia and Latvia, which top the global tax competitiveness rankings. Lithuania taxes business profits twice, once at 15 percent (or a reduced rate of 5 percent) when earned, and again at 20 percent when distributed as dividends. Lithuania’s effective corporate and personal income tax burden stands at 27.75 percent. At the same time, its Baltic neighbors both apply a more competitive and neutral cash-flow tax on business, taxing profits only once when they are distributed to shareholders. Their tax rate is 20 percent.
As ineffective as the corporate income tax is, the double taxation of profits is insidious and damaging to all parties. It disguises the actual tax burden and creates the illusion that taxation of dividends is not that important. The disproportionate tax burden derails business decisions and resource allocation, inhibits investment, and undermines economic growth. It also imposes onerous administrative and compliance costs on businesses, while being a rather insignificant source of government revenues.
Since the abolition of the zero-tax rate on reinvested profits in 2002, Lithuania has seen a gradual expansion of profit tax breaks. This trend reflects a continuous search for ways to boost investments and confirms the fact that this requires a more favorable tax regime.
Lithuania is facing growing regional competition for FDI. The country needs more high value-added jobs, better conditions for domestic business to grow, and a bigger productivity boost. Domestic firms continue to suffer from a severe lack of access to credit, while the level of reinvested profits is among the lowest in the EU, standing at 20 percent compared to the EU average of 24 percent. Net capital stock per employer is 2.7-times lower than the EU average.
A zero-tax rate on retained profits could do the trick. Eliminating double taxation of business earnings would put Lithuania on the same footing with Estonia and Latvia in the regional race for investment, while retained profits would provide an inherent source of investment capital for domestic firms. The reform would also facilitate a faster and deeper economic recovery for Lithuania from the COVID-19 crisis.
Estonia has applied a zero-tax rate on retained profits since 2000, reaping the benefits of growing investments, technological innovation, productivity, employment, and budget revenues ever since. In 2018 Latvia followed suit. But the penny dropped when Poland decided this past November to usher in the Estonian model starting in January 2021.
Lithuania is under the pump. It needs to reclaim its own model.
The article is syndicated by 4Liberty.eu Network