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Estonia: Novel Corporate Taxation Plan Causes Stir

Estonia has come up with a plan to abolish all corporate taxation in cases where companies re-invest their profits in the country. RFE/RL correspondent Breffni O'Rourke examines the advantages and possible problems of this innovative tax scheme:

Prague, 26 August 1999 (RFE/RL) -- The Baltic republic of Estonia is drawing international attention with a radical taxation scheme designed to increase investment.

The scheme, which will be considered by the Estonian Parliament next month, would remove all corporate tax from that proportion of a company's profits which is re-invested in further development inside the country. Tax will only be applied to the profits which are used for other purposes.

This plan, which will bite deeply into government tax revenues, is viewed by some analysts as a bold innovation in keeping with Estonia's track record as a leading economic reformer among the transition states. But others see it as impractical and unlikely to be viable in the long run.

The pro-business Wall Street Journal Europe (Aug. 25/F529) expresses enthusiasm, saying the government concludes the move will bring growth to the enterprise sector and generate wealth in the economy as a whole.

Estonian analyst Anvar Samost, the head of business news at the Baltic News Service in Tallin, told RFE/RL:

"The scrapping of the corporate income tax is just another example of Estonian unconventionality in decision-making".

He says that Estonia has in the past made similarly unconventional moves which paid-off. He cites the successful currency reform of 1992, which created a currency board and pegged the Kroon to the German mark. Samost says that at the time, the International Monetary Fund had reservations, but the model was subsequently copied in several other transition states.

Samost says that in the case of corporate tax, the government is aware of the heavy revenue loss it will suffer, and is taking measures to cope:

"The Ministry of Finance is working very hard to cut spending in next year's budget and I understand they have the full support of the whole government, so many of the ministries are very willing to cut their spending next year".

The projected revenue for next year under the present flat rate of 26 percent for corporate tax is estimated at 1,500 million Kroons, or just over $100 million. What proportion of that revenue would be lost under the new scheme depends on what profit companies decide to reinvest, and to what to withdraw.

But the loss to the state budget would be severe, and Samost says the government's cost cutting will not be able to make up the entire shortfall. The government is not planning to raise other taxes, however, and is hoping to raise extra revenue through projected income growth plus from the new resource of customs tariffs.

A senior analyst at Deutsche Bank Research, Bernd Klett, has reservations about all this. Speaking to RFE/RL from Frankfurt, Klett said that the move is courageous and will create a positive investment climate:

"But I cannot imagine the country can live without corporate tax for a long period of time, because there will not be enough money in the budget on the revenue side".

He says that even with careful budgeting, the usual scenario would be that other taxes would have to be raised in the long run to make up any shortfall. Klett and other analysts also say there is some doubt about whether the European Union, which is conservative in its thinking on tax matters, would approve of such an innovation. Estonia is courting EU membership, and should be admitted within the next five years.

One present EU member which has been able to innovate most in tax matters is Ireland, which for years has had the liveliest economy in Europe with annual growth of 8 percent. Senior researcher at the Economic and Social Research Institute in Dublin, Terry Baker, told RFE/RL that Ireland for many years has had a very low corporate tax rate of 10 percent on manufacturing industry. And this has worked very well:

"It's been an immense factor in attracting companies, particularly the very profitable high tech companies in information technology and in pharmaceuticals, which have very high profit margins indeed".

Baker says lack of revenue resulting from the low tax rate has not been an issue. That's because sufficient numbers of dynamic companies have been attracted to Ireland, and, as he puts it, 10 percent of their very high profits is better than having 50 percent tax on a very narrow base.