Equitable Growth, Finance, and Institutions Europe and Central Asia Region Equitable Growth, Finance, and Institutions Europe and Central Asia Region Latvia Tax Review Latvia Tax Review CONTENTS 3. Tobacco..............................................................................................................................................................231 4. Natural gas.........................................................................................................................................................232 5. Coffee and sweet drinks ....................................................................................................................................237 1. INTRODUCTION .......................................................................................................................................................24 TABLES 1.1 Context of review ..............................................................................................................................................24 Table 1. Survey measure of the shadow economy ......................................................................................................35 1.2 Objec ves of the review ....................................................................................................................................25 Table 2. Composi on of taxa on, 2015, in percent of total tax revenue ....................................................................46 1.3 Economic context ..............................................................................................................................................27 Table 3. Tax system characteris cs, Latvia and peers, 2016 ........................................................................................46 1.4 Grey economy ...................................................................................................................................................34 Table 4. Tax rate indicators in 2014 in the EU countries, in percent ............................................................................51 Previous es mates of the grey economy.................................................................................................................34 Table 5. Personal income tax and social contribu ons as a percent of GDP in 2013, and social contribu on Es mates of informality from the World Bank ........................................................................................................35 rates paid by insured persons and employers in 2013/2014 in EU countries, in percent ...........................................54 2. EVOLUTION OF TAX SYSTEM AND STRUCTURE........................................................................................................44 Table 6. Op mal top rates PIT Latvia ...........................................................................................................................58 2.1 Tax system developments ..................................................................................................................................44 Table 7. Fiscal and Distribu onal Impact of Alterna ve Policies: Simula ons............................................................58 2.2 Poten al areas for mobilizing revenue ..............................................................................................................48 Table 8. Taxes on capital income and wealth in Latvia, 2016, in percent ....................................................................62 3. PERSONAL INCOME TAX AND SOCIAL SECURITY CONTRIBUTIONS..........................................................................50 Table 9. Taxa on of business income in Latvia, January 2016 .....................................................................................72 3.1 Labor income and social security contribu ons ................................................................................................50 Table 10. Effec ve tax rates, Latvia and other EU Countries .......................................................................................74 3.2 Capital income taxa on .....................................................................................................................................60 Table 11. Tax rates MET-regime vs other legal forms, in percent ................................................................................82 4. CORPORATE INCOME TAXATION ..............................................................................................................................66 Table 12. Comparison self-employed and microenterprise .........................................................................................82 5. MICROENTERPRISE TAXATION .................................................................................................................................82 Table 13. Par cipants in the microenterprise tax regime, 2009–2015 ........................................................................86 6. VAT ...........................................................................................................................................................................96 Table 14. Microenterprise share in labor income and incidence of self-employment (2008-2015) among 7. EXCISE TAXATION ...................................................................................................................................................104 individuals who worked in microenterprises in 2015 ..................................................................................................92 8. RESIDENTIAL PROPERTY TAXATION .......................................................................................................................110 Table 15. Average microenterprise share in gross and net labor income among individuals with posi ve 9. TAX COMPLIANCE ..................................................................................................................................................116 microenterprise earnings in 2015, by tax regime group .............................................................................................93 10. CONCLUSIONS .....................................................................................................................................................136 Table 16. Individuals with posi ve microenterprise earnings in 2015, by tax regime group and total REFERENCES ..............................................................................................................................................................140 microenterprise work experience ...............................................................................................................................93 ANNEX A: VAT CONTRIBUTION TO INEQUALITY ........................................................................................................146 Table 17. Revenue loss due to reduced VAT regime, 2014 ..........................................................................................97 ANNEX B: MEASURING UNDECLARED EARNINGS WITH EU-SILC DATA .....................................................................147 Table 18. Selected OECD VAT indicators ......................................................................................................................98 ANNEX C: METHODOLOGY OF ESTIMATING REVENUE GENERATION POTENTIAL FOR LATVIA..................................151 Table 19. Sources of VAT GAP in Poland and the U.K., in percent .............................................................................101 ANNEX D: OPTIMAL TAX THEORY AND MARGINAL INCOME TAX RATES ...................................................................153 Table 20. Excise Du es and Consump on Taxes, Representa ve EU Countries, Percent of GDP..............................104 ANNEX E ELASTICITY OF TAXABLE INCOME OF HIGH-EARNERS IN LATVIA. ...............................................................156 Table 21. Prices of Du able Products, Latvia, Russia, and Belarus, 2016 ..................................................................105 ANNEX F SELECTED PIT REFORM SIMULATION RESULTS ...........................................................................................163 Table 22. Tax on diesel used in rail transport ............................................................................................................106 ANNEX G: IMPACT OF LABOR TAXES ON EMPLOYMENT AND WAGES.......................................................................169 Table 23. Total excise tax revenue (upper bound es mate), EUR million ..................................................................108 ANNEX H. OPTIONS FOR DIFFERENTIATED SOCIAL CONTRIBUTION RATES ...............................................................171 Table 24. Local Government Revenues, 2015............................................................................................................110 ANNEX I. SOCIAL PROTECTION OF THE SELF-EMPLOYED AND SOCIAL CONTRIBUTIONS ..........................................188 Table 25. Exis ng and proposed ra os of assessed value to market value adopted in 2015 ....................................111 ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACT.........................................................190 Table 26. Standard tax rate on residen al buildings..................................................................................................111 ANNEX K: AN ECONOMIC ANALYSIS OF THE MICROENTERPRISE TAX .......................................................................202 Table 27. Iden fica on of high-risk industry segments in selected OECD countries.................................................120 ANNEX L. ESTIMATES OF WORKERS MOST VULNARABLE TO PHASING OUT OF THE MET ........................................203 Table 28. Sweden: Supervision, inspec on visits and audits within the cash trading opera on in the first ANNEX M: SUMMARY OF TAX PROVISIONS FOR SMALL -AND MEDIUM-SIZED ENTERPRISES IN THE EU .................209 three years of compulsory cash register use .............................................................................................................121 ANNEX N: EXCISE TAX RATES: CURRENT STATUS AND RECOMMENDATIONS ............................................................216 Table 29. Incen ve schemes, selected European Union member countries .............................................................128 ANNEX O: INTERNATIONAL EXPERIENCE WITH PROPERTY TAX RATES AND EXEMPTION POLICIES ..........................217 Table 30. Personal and household services (PHS) as related to public policy instruments .......................................128 ANNEX P: HISTORY OF CHANGES IN LATVIAN TAX SYSTEM .......................................................................................219 Table 31. Latvia: Tax audit results ..............................................................................................................................130 1. PERSONAL INCOME TAX AND SOCIAL SECURITY CONTRIBUTIONS........................................................................220 Table 32. Verifica on and audit staff as a percentage of total tax administra on staff in selected countries ..........131 2. Value Added Tax ....................................................................................................................................................224 Table 33. Trade-offs between instruments for raising revenue 3. Electricity tax and subsidized electricity tax ..........................................................................................................226 Table 34. Es mates of revenue impact of tax measures ...........................................................................................136 4. Real estate tax .......................................................................................................................................................226 Table 35. Es ma on of employee earnings (in all jobs) during the last calendar year in the Latvian and Estonian 5. Lo ery and gambling tax .......................................................................................................................................227 na onal EU-SILC data, 2008-2013 .............................................................................................................................137 6. Company car tax and vehicle exploita on tax .......................................................................................................227 Table 36. Iden fica on of informal employees in the Latvian na onal EU-SILC data, 2008–2015 ...........................146 7. EXCISE DUTY ..........................................................................................................................................................229 Table 37. Es ma on of declared and undeclared gross earnings in the Latvian na onal 1. Energy products.................................................................................................................................................229 EU-SILC data, 2008-2015 ...........................................................................................................................................148 2. Alcoholic beverages ...........................................................................................................................................230 4 5 Latvia Tax Review Latvia Tax Review Table 38. Es ma on of declared earnings in the Latvian na onal EU-SILC data when survey-based Table 71. Microenterprise workers (ex. those with low risk of income loss) by group, turnover and earnings are recorded, 2008-2015 ............................................................................................................................150 legal form of the main microenterprise, 2015 ..........................................................................................................206 Table 39. Indicators of under-reported earnings .......................................................................................................150 Table 72. Profiling of MET workers by characteris cs ...............................................................................................207 Table 40. Selected studies aimed at assessing tax effort ...........................................................................................151 Table 73. Projected op mal ou lows from MET by group, 1000 of workers ............................................................208 Table 41. Regression results for the general model (dep. variable: total tax to GDP ra o) .......................................152 Table 74. SME incen ves and assistance measures, EU countries ............................................................................210 Table 42. Changes in marginal tax rates (including PIT, SSC and solidarity tax) .........................................................158 FIGURES Table 43. Comparison of control and treatment groups ...........................................................................................159 Figure 1. Poten al sources of revenue increases ........................................................................................................26 Table 44. Es ma on results.......................................................................................................................................160 Figure 2. Contribu on to GDP growth, percentage points, average over 2005-2015 .................................................27 Table 45. Changes in marginal tax rates (including PIT, and solidarity tax) ...............................................................161 Figure 3. Investment by company size in Latvia, in EUR million, 2015 ........................................................................28 Table 46. Es ma on results.......................................................................................................................................162 Figure 4. Structure of value added by size of the enterprise in Latvia and in benchmark countries, 2015 .................28 Table 47. Raising top PIT rate to 33%, simula on results ..........................................................................................164 Figure 5. Distribu on of monthly income earners, by EUR wage band, in percent, 2015 ...........................................29 Table 48. Introducing universal EITC and EITC targeted to families with children, simula on results .......................165 Figure 6. Distribu onal impact of the Latvian tax and benefit system ........................................................................30 Table 49. Introducing progressive PIT and progressive PIT combined with EITC targeted to families Figure 7. Es mated VAT, PIT and SSC as shares of household gross income, 2014, by quin les of equalized with children, simula on results ...............................................................................................................................166 disposable income .......................................................................................................................................................30 Table 50. Progressive PIT with and without joint taxa on of married couples: Impact on tax revenues Figure 8. Equalized direct and indirect taxes, contribu ons and benefits, by quin les of equalized disposable and inequality............................................................................................................................................................168 income, 2014 ...............................................................................................................................................................31 Table 51. Employment and wage effects of changes in payroll taxes ........................................................................169 Figure 9. Gini Coefficient Before and A er Taxes and Transfers, Selected Countries, 2014 ........................................31 Table 52. Insured and employer contribu on rates, by country and program type in selected EU28 countries, Figure 10. Role of Taxes and Benefits in Reducing Inequality, Percentage Point Reduc on in Gini of in percent, 2014 ........................................................................................................................................................174 Disposable Income, EU Countries................................................................................................................................32 Table 53. Social security contribu on arrangements in some of the EU28 and EFTA countries in 2016...................175 Figure 11. Difference in spending with comparator countries, 2014 ..........................................................................33 Table 54. Financing arrangements of social protec on benefits in the EU28 countries in 2016...............................178 Figure 12. Difference in spending with the OECD and the EU28 average, in percent of GDP, 2014 ............................33 Table 55. Part- me employment as percentage of the total employment, involuntary part- me employment Figure 13. Size of the shadow economy calculated using the es ma on procedure, 2013, in percent of GDP .........34 as percentage of the total part- me employment, and temporary employees as percentage of the total number Figure 14. Size of the shadow economy according to the survey data (% of GDP), 2009-2015 ..................................34 of employees in 2015 in the EU28 countries, in percent...........................................................................................187 Figure 15. Wage gap (in percent of total wage), 2014.................................................................................................35 Table 56. Number of tax payers, employees and revenue by tax type, from 2009-2015 ..........................................190 Figure 16. Incidence of complete informality and envelope earnings (in percent of employees with posi ve Table 57. Top 20 sectors with the largest shares of microenterprise workers in private employment, 2015 ...........191 earnings during the year), and average envelope wage share (in percent of total gross earnings), 2007-2014 .........36 Table 58. Propor on of microenterprise workers in sector’s private employment (2015), by labor Figure 17. Incidence of complete informality by category of workers (in percent of employees with posi ve taxes - turnover ra o in 2010, Percent ......................................................................................................................192 earnings), 2013-2014 ..................................................................................................................................................37 Table 59. Determinants of microenterprise share in sector’s private employment, 2015 ........................................192 Figure 18. Es mated envelope share in aggregate earnings (in percent), by worker income .....................................38 Table 60. Determinants of change in the burden of main taxes in sectors of Latvian economy Figure 19. Es mated envelope share in aggregate earnings (in percent), by quar le of gross between 2010 and 2014............................................................................................................................................193 monthly earnings of full- me employees ...................................................................................................................39 Table 61. Microenterprise workers’ impact on growth of labor cost and labor produc vity in sectors of Latvian Figure 20. Incidence of high envelope share, by worker income ................................................................................39 economy between 2010 and 2014 ............................................................................................................................194 Figure 21. Es mated total envelope earnings, million EUR, by worker income ..........................................................40 Table 62. Ou lows from microenterprise regime between 2014 and 2015..............................................................195 Figure 22. Wage gap (envelope share in percent of total wage bill) in selected sectors: World Bank Table 63. Change in annual average registered employment over 2010-2015 by sector, firm size and tax regime ..195 es mates compared to SRS es mates.........................................................................................................................41 Table 64. Determinants of the share of MET payers among employers by sector, 2015...........................................196 Figure 23. Total tax revenue, years before and a er reform, in percent of GDP .........................................................44 Table 65. Distribu on of monthly earnings in the main microenterprise job and in the main general regime Figure 24. Tax-to-GDP Ra os and GDP per capita, PPP, 2014 ......................................................................................45 job for individuals with posi ve microenterprise earnings in 2014 or 2015 .............................................................197 Figure 25. Tax revenues in Latvia and selected countries when they had similar GDP per capita ..............................45 Table 66. Individuals with posi ve microenterprise earnings in 2014 or 2015, by tax regime group and Figure 26. Difference between the level of tax-to-GDP in selected countries and Latvia, percentage points, 2015 ...45 economic ac vity of the microenterprise .................................................................................................................197 Figure 27. Difference between the level of tax-to-GDP in selected countries and Latvia, percentage points, 2015 ...45 Table 67. Profiling of individuals with posi ve microenterprise earnings in 2014 or 2015 by tax regime Figure 28. Tax-to-GDP Ra o, Latvia and Benchmark Countries, 2000–15 ...................................................................47 over 2014-2015 .........................................................................................................................................................203 Figure 29. Difference between the tax-to-GDP ra o in given year and 2015 (in percentage points) ..........................47 Table 68. Incidence of low risk of income loss among individuals with posi ve microenterprise earnings in Figure 30. Effec ve (implicit) tax rates, 2012 ..............................................................................................................48 2015, by tax regime group.........................................................................................................................................204 Figure 31. ITR on consump on, selected EU countries, 2012 .....................................................................................48 Table 69. MET-only and Unstable workers (ex. those with low risk of income loss) by gross general regime Figure 32. Revenue fron er, average revenue, and actual taxes collected in Latvia, 2006–13 ...................................49 earnings and MET share in net labor income, 2015 ..................................................................................................205 Figure 33. Changes in non-taxable minimum and allowances for dependents, 1994–2016 .......................................50 Table 70. Mixed and Mainly General workers (ex. those with low risk of income loss) by gross general Figure 34. Increase in net income as work effort increases for one earner couple with 2 children, selected regime earnings and MET share in net labor income, 2015 ......................................................................................205 countries......................................................................................................................................................................53 Figure 35. Es ma ng Pareto parameter in Latvia .......................................................................................................57 6 7 Latvia Tax Review Latvia Tax Review Figure 36. CIT difference between the level of the implicit tax rate on capital income in selected Figure 77. Scenario Progressive B: Effect of introduc on of progressive PIT and joint taxa on of married countries and Latvia (in percentage points), 2012 ......................................................................................................61 couples on the equalized disposable income, change vs baseline ............................................................................168 Figure 37. Housing wealth as a percentage of total household wealth in European Union in 2013 ...........................63 Figure 78. Individuals who worked in microenterprises in 2015: Distribu on of work and labor income across Figure 38. Components of capital taxa on as a percentage of opera ng surplus and mixed income, 2014 ..............63 tax regimes, by occupa on........................................................................................................................................198 Figure 39. CIT: Top Statutory Rates (Percent) and Revenue (Percent of GDP) .............................................................67 Figure 79. Microenterprise workers in 2014-2015, by source of earnings in Latvia over 2008-2015 .......................199 Figure 40. PIT and CIT and their Poten al Tax Bases, Latvia, Estonia, and Slovakia 2000-2014, EUR Million .............67 Figure 80. Average number of months with posi ve employee income, 2008-2015. Individuals with Figure 41. Losses carried forward to 2014 by year of genera on and sector .............................................................69 posi ve microenterprise earnings in 2014 or 2015, by tax regime group .................................................................199 Figure 42. Taxable profits before losses, losses deducted and losses transferred to the future, Figure 81. Average declared annual earnings of “MET-only” and “Mixed” workers as propor on of economy-wide in EUR million, 2014 ....................................................................................................................................................70 average annual earnings of general regime employees, 2008-2015 .........................................................................200 Figure 43. Effec ve marginal and average corporate tax rate, 2014, in percent .........................................................71 Figure 82. Average declared annual earnings of “Unstable” and “Mainly General” workers as propor on Figure 44. Cost of capital by financing method, 2014, in percent ...............................................................................74 of economy-wide average annual earnings of general regime employees, 2008-2015 ............................................200 Figure 45. Main inflows into microenterprise regime in 2011-2015, by tax regime in the previous year Figure 83. Individuals with posi ve microenterprise earnings in 2015, by tax regime group, gender and age group ....201 (restricted to workers with posi ve microenterprise earnings in 2014 or 2015) ........................................................83 Figure 84. Regional distribu on of individuals with posi ve microenterprise earnings in 2015, in comparison Figure 46. Microenterprise (MET) workers by economic ac vi es (2015, annual average)........................................84 with general regime employees ................................................................................................................................201 Figure 47. Firms appear to be manipula ng wage reports to qualify for the MET .....................................................85 Figure 85. Absence of declared earnings in 2008-2015 among individuals with posi ve microenterprise Figure 48. MET earnings have become an important source of personal income ......................................................86 earnings in 2014 or 2015, by tax regime group .........................................................................................................202 Figure 49. Growth in registered employment by tax regime, 2011–2015 ...................................................................87 BOXES Figure 50. Es mated shares of microenterprise workers without declared labor income during the previous year..88 Box 1. Calcula ng the op mal top rate for Latvia .......................................................................................................57 Figure 51. Annual earnings of MET-only and mixed workers vs. those of formal employees without Box 2. The Case for ‘Married, Filing Jointly’ ................................................................................................................59 microenterprise experience, 2009-2014: Evidence from EU-SILC microdata ..............................................................89 Box 3. Who should reap the windfall from progressive tax rates? ..............................................................................60 Figure 52. Number of taxpayers in the microenterprise regime and exi ng the regime, 2010-2015 .........................90 Box 4. Valida on of claims for R&D Tax Relief: Approach taken in Ireland..................................................................71 Figure 53. Individuals who worked in microenterprises in 2014-2015, by occupa on in “main” microenterprise ....92 Box 5. Overview of the Estonian Model of CIT ............................................................................................................76 Figure 54. Most microenterprise workers in the two most vulnerable groups have low-paying, manual jobs ...........93 Box 6. Local Government Finance in Latvia ...............................................................................................................110 Figure 55. Educa onal profile of employees by tax regime, 2014-2015 .....................................................................94 Box 7. Is the Property Tax Progressive? Regressive? Or Neither? .............................................................................112 Figure 56. Produc on taxes, in percent of total tax revenue, 2015.............................................................................96 Box 8. The Poli cal Economy of Property Taxa on....................................................................................................113 Figure 57. Revenue efficiency, Latvia, in percent.........................................................................................................96 Box 9. Examples of a taxpayer feedback survey: the U.S. IRS taxpayer a tude survey ............................................119 Figure 58. Ra o of VAT revenue to total tax revenue ..................................................................................................96 Box 10. Compliance survey analysis in Canada .........................................................................................................119 Figure 59. Share of household consump on (cash) by VAT rate category, 2014 .........................................................99 Box 11. The relevant contract tax in Ireland ..............................................................................................................121 Figure 60. Hotel/Restaurant consump on per capita by income decile, in euros, 2014.............................................99 Box 12. Tax withholding obliga ons in Australia .......................................................................................................121 Figure 61. Global hotel price index and country global ranking, 2014 ........................................................................99 Box 13. Surprise visits to cash businesses in Ireland .................................................................................................122 Figure 62. Distribu on of cost of reduced VAT rates in 2014 ....................................................................................100 Box 14. Requirement for Irish incorporated companies to have a director resident in an EEA state ........................125 Figure 63. VAT gap, in percent of VAT liability, 2013 .................................................................................................101 Box 15. Sweden: Impact of housework deduc on on tax formaliza on ...................................................................129 Figure 64. Compliance problems, percent of total liability, 2010-2014.....................................................................104 Box 16. The use of random audits for improving risk analysis in Denmark ...............................................................131 Figure 65. Trends in the tax gap development analyzed by the SRS..........................................................................116 Box 17. California: A Cau onary Tale.........................................................................................................................219 Figure 66. Twenty-two components of the tax gap analysis in Denmark ..................................................................117 Figure 67. Overall results of the tax gap analysis by customer group, tax type and behavior: the U.K. HMRC example .....................................................................................................................................................................118 Figure 68. The cash receipt check app in Russia........................................................................................................123 Figure 69. Issuing e-invoices: the Korean example ....................................................................................................126 Figure 70. Acceptability of different types of shadow work, average scores, Bal c States and EU8 .........................127 Figure 71. Op mal U-shape of EMTRs and the reasons for it ...................................................................................154 Figure 72. Income threshold and change in reported income, 2015-2016 ...............................................................157 Figure 73. Simulated effect of raising the top PIT rate, by household income deciles ..............................................164 Figure 74. Simulated effect of introducing EITC, by household income deciles ........................................................165 Figure 75. Impact of introducing a progressive income tax and a targeted EITC: Simulated effect, change in percent of income, by household income deciles .................................................................................................166 Figure 76. Scenario Progressive A: Effect of introduc on of progressive PIT and joint taxa on of married couples on the equalized disposable income, change vs baseline .........................................................................................167 8 9 Equitable Growth, Finance, and Institutions Europe and Central Asia Region ACKNOWLEDGEMENTS The report summarizes a thorough research on the Latvia’s tax system that the World Bank has undertaken over the past year. The report was prepared by the team of World Bank experts from the Equitable Growth, Finance, and Ins tu ons cluster, and Global Prac ces for: Poverty, Macroeconomics and Fiscal Management (MFM), and Governance. The core team was led by Emily Sinno (World Bank) and Emilia Skrok (World Bank), consis ng of Michael Engelschalk, Mihails Hazans (University of Latvia and IZA); John Fanning (former Irish Civil Service), William Dillinger (former World Bank) and Bas Jacobs (Erasmus University Rot- terdam). The team is greatly indebted to Jan Gąska, Paulina Hołda (World Bank), Māris Jurušs (Riga Technical University), Palma Mosberger (Central European University), Anna Pluta (Bal c Interna onal Centre for Economic Policy Studies and University of Latvia), Olga Rastrigina (University of Essex) and Joanna Tyrowicz (GRAPE) for their invaluable contribu on to the report. William Shaw and Anne Grant provided excellent editorial and produc on support. Special thanks are due to Olga Rastrigina (Ins tute for Social and Economic Research, University of Essex) for invaluable support in terms of ge ng access to EUROMOD so ware and EUROMOD-adjusted SILC data as well as Agnieszka Boratyńska, Aleksandra Ignaczak, Jason Victor and Indiana Taylor (all World Bank) for their excellent editorial support and research assistance. Many people contributed to the wri ng of the report. The main authors and contributors were: Introduc on was wri en by Bas Jacobs, Emily Sinno and Emilia Skrok; sec on „Es mates of informality from the World Bank” was wri en by Mihails Hazans. Chapter 2 (Evolu on of tax system and structure) was wri en by Emilia Skrok and Jan Gąska contribu on from with Paulina EXECUTIVE SUMMARY Hołda. Chapter 3 (Personal Income Tax and Social Security Contribu ons) was wri en by Bas Jacobs, Mihails Hazans and Emily Sinno with contribu ons from Palma Mosberger and Anna Pluta and guidance from Olga Rastrigina on the EUROMOD tax-benefit microsimula on model. Chapter 4 (Corporate Income Tax) was wri en by John Fanning and Emilia Skrok, with contribu on from Bas Jacobs. Chapter 5 (Microenterprise Tax) was wri en by Mihails Hazans and Emily Sinno . Chapter 6 (Value Added Tax) was wri en by Emilia Skrok with contribu on from Jan Gąska. Chapter 7 (Excise Tax) was wri en by Emilia Skrok with contribu ons from Māris Jurušs. Chapter 8 (Residen al Property taxa on) was wri en by William Dillinger with contribu ons from Emilia Skrok. Chapter 9 (Tax compliance) was wri en by Michael Engelschalk. This work benefi ed from the support, guidance and advice of Arup Banerji (Regional Director for Opera ons, European Union), Ivailo Izvorski (former Prac ce Manager in the Macroeconomics and Fiscal Management Global Prac ce), Luis-Felipe Lopez-Calva (Prac ce Manager in the Poverty Global Prac ce), Lalita Moorty (Prac ce Manager in the Macroeconomics and Fiscal Management Global Prac ce), Carolina Sanchez-Paramo (Senior Director in the Poverty Global Prac ce), Carlos Pinerua (Country Manager for Poland and the Bal c Countries) and Marina Wes (former Country Manager for Poland and the Bal c Countries). We par cularly thank our reviewers Alan Fuchs Tarlovsky (Senior Economist), Blanca Moreno-Dodson (Lead Economist), and Karlis Smits (Senior Economist) for their extensive and construc ve sugges ons. This report gained much also from workshops held in Riga in June, September and December 2016. Finally, the team wishes to thank senior officials from the Ministry of Finance and the State Revenue Service. The team is sin- cerely grateful for the prepara on and sharing of data, contribu ons, comments and sugges ons received from the counter- parts in Latvia during prepara on of the report. Latvia Tax Review Latvia Tax Review LATVIA TAX REVIEW – EXECUTIVE SUMMARY expenditure subsidies is a decision to spend scarce budgetary resources on the corporate sector, and as such, should be subject to cost-benefit analysis. • Reduce high labor tax burden, especially for lower income individuals. The effec ve tax rate on labor is significantly 1. INTRODUCTION higher than on consump on and capital. For low-income earners, par cularly the unemployed, there is a high par cipa on tax, which equals total taxes paid when working (in the formal sector) plus the non-employment benefits that a worker foregoes Latvia’s Ministry of Finance requested the World Bank to collaborate on a review of the country’s tax system as input for when the individuals start working. High labor taxes reduce the incen ve for hiring into and par cipa ng in the formal labor the design a medium-term tax strategy. The mo va on behind the tax review is to find op ons to increase tax revenues by market. In addi on, they encourage the underrepor ng of wages. Reducing the rela vely high tax on low-income labor would three percentage points of GDP to reach a target tax-to-GDP ra o of 33 percent in the medium term.1 In Latvia, tax revenues encourage employment and formality. Decreasing the reliance of the tax system on labor taxes should be an aim of the tax are lower than predicted for its income level and ins tu onal development. The addi onal revenues would be used to cover system in the longer term given the low effec ve tax rate on capital and the shrinking and aging of the labor force. growing spending needs in the following areas: • Increase the rela vely low impact of tax and benefit system on inequality. The tax and benefit system has a rela vely Defense spending. The Government aims to increase defense spending to the NATO guideline target of 2 percent of GDP by small impact on income inequality in Latvia. Latvia’s Gini is the second highest for (a er-tax) disposable income in the European 2018 (from 1 percent of GDP in 2015 and an es mated 1.5 percent of GDP in 2016).2 Union (EU); Estonia’s Gini is just 0.1 percentage points higher. The tax/benefit system does result in some redistribu on of Investment in human capital. Health, educa on and social protec on are addi onal areas that the Government has iden fied income from high-income to low-income households (Figure 1). However, fiscal policy has a lower impact on inequality in as requiring further investments. In par cular, public health spending is low and health outcomes are lagging compared with Latvia than in most developed countries. Not only is income taxa on in Latvia not progressive, it is also horizontally inequitable: much of the European Union (EU). different income sources are taxed unevenly, favoring some forms of income e.g. from dividend income. Latvia’s tax policy needs to be restructured to support economic development and raise living standards. The speed of • Confront informality. The large shadow economy and widespread informality result in high tax evasion across income convergence in Latvia to average income levels in the European Union (EU) was impressive un l the 2008-2009 crisis, but since groups and economic ac vity. Increased formality improves inclusion and increases produc vity: it enables workers to access then output recovery has been fast but not rapid enough for real GDP to return to pre-crisis level. A cri cal challenge then is health and pension insurance, improve their financial security, results in more opportuni es for on-the-job training, and allows to boost produc vity growth in the economy: the level of produc vity is low rela ve to OECD economies and its growth has businesses to expand, modernize, innovate and become more produc ve. slowed notably since the crisis. Increasing labor produc vity is par cularly important if overall produc vity is to rise: informality • Base future adjustments to the tax system on a system-wide view of its direc on. There have been many ad hoc—and and inac vity reduce both labor ac vity and produc vity. Increased investment in skills and good health are an important part o en substan al—changes to system, par cularly in response to fiscal pressures due to the 2008-2009 economic crisis. Any of the labor produc vity and par cipa on story—par cularly as Latvia rapidly ages. But reducing the reliance of the tax system tax system changes must take into account interdependencies between different taxes to ensure the expected impact of the on low-skilled labor is also a key policy challenge. Latvia’s tax system puts substan ally more of a burden on labor compared to reform, for instance any changes to personal income tax have to be consistent with reform of the microenterprise regime, to capital or consump on. This is all the more concerning given that wages for much of the popula on are low and so the current limit income shi ing between tax regimes. flat income tax structure has implica ons for social inclusion and poverty. Inequality of (a er-tax) disposable income in Latvia is one of the highest in the EU, with only Bulgaria, Romania and Lithuania having higher inequality.3 There are mul ple dimensions to be taken into account in examining tax reform op ons apart from increased revenue 2. LEVEL AND COMPOSITION OF TAXATION Latvia has considerable poten al to raise tax revenues. Latvia’s tax share of GDP is one of the lowest in the EU in 2015 genera on. Tax systems as a whole should be efficiently designed to meet revenue targets and distribu onal goals with (Figure 1). Tax revenues to GDP in Latvia has been rela vely stable since 2000, at around 29 percent of GDP, about 5 percentage the lowest possible distor ons on economic ac vity. Taxes entail economic costs by affec ng people’s and firm’s behaviors: points below the OECD average and 10 percentage points below the EU average. Not only is the tax revenue share of Latvia’s decisions on working, saving/consuming, inves ng and employing workers. A tax system that relies too heavily on inefficient GDP the fourth lowest in the EU, it is also one of the lowest in the world for countries at a similar level of development. taxes, uncompe ve tax rates and poorly targeted or ineffec ve concessions will impose significant economic costs on the Globally, controlling for degree of development, only small islands or resource-rich economies have lower taxes than Latvia. economy. This “excess burden” of taxa on is the economic cost of taxa on. Such economic distor ons entail costs over and Compared to Estonia, Lithuania, Poland, Slovakia, and the Czech Republic, only Lithuania has lower tax revenues. A comparison above the income that individuals and firms pay in taxa on. It is also important who actually bears the economic costs of with countries facing similar structural characteris cs and ins tu ons suggests that Latvia could increase its tax revenues by taxa on—commonly referred to as the ‘incidence’ of a tax. Here it is important to look at tax neutrality—the degree to which about five percentage points of GDP if it would collect the same taxes as its average country peer in terms of the countries’ levels taxes favor one type of economic ac vity over another and the distribu on of the economic incidence. of ins tu onal development. The tax system entails distribu onal choices and one of the objec ves of the review is to look at op ons to improve the The average effec ve taxa on on labor income is significantly higher than on consump on and capital. Implicit tax rates equity of the system. Here both ver cal equity, i.e. taxing less those of lower income, and horizontal equity, i.e. taxing the same measure the actual or effec ve tax burden on different types of economic income or ac vi es by compu ng the ra o of tax those in economically similar situa ons, are of importance. Governments are inevitably confronted with an equity-efficiency revenue for each type of ac vity with the poten al tax base.4 Statutory tax rates o en do not reflect the actual rates paid and trade-off: higher taxes on the richer parts of the popula on—to raise revenue and to finance benefits for poorer groups—can so it is useful to look at the effec ve tax burden for different ac vi es in the economy. Despite some decline since 2000, the distort the economic incen ves for work, entrepreneurship, saving and risk-taking of middle- and higher-income individuals. At effec ve taxa on on labor remains significantly higher than on consump on and capital (Figure 2).5 In Latvia, the implicit tax the same me, redistribu on to low-income individuals, through tax credits or benefits, could weaken labor supply incen ves. rate on labor dropped from 36.5 to 33 percent over 2000-2012 due to a fall in personal income tax (PIT) revenues. It is below the On the other hand, fairness, or equity is an important considera on for widespread acceptance and sustainability of the tax EU average of 36.1 percent. The effec ve tax rate on consump on at 17.4 percent in 2012 is rela vely low for the EU for which system. the average if 19.9 percent. It did not change much between 2000 and 2012 despite an increase in VAT rates. Latvia’s implicit tax To reduce economic distor ons created by the current tax system, increase equity and meet increased revenue goals, the rate on capital is now one of the lowest in the EU, having declined by about two percentage points from 12.3 percent in 2000 following features of the current tax system of Latvia are important to address in a medium-term tax strategy: to 9.9 percent in 2012. • Restore tax neutrality across firm types and economic ac vity. The most pressing need is to rebalance tax treatment across enterprises. There are large incen ves for firms to remain small in terms of turnover and the number of employees due to the microenterprise taxa on regime. Depending on their legal form, size or produc on mix, firms face different possibili es to benefit from tax relief, allowances, exemp ons and deduc ons. The lack of neutrality contributes to economic efficiency losses (e.g. small firms in Latvia have low export intensity), tax avoidance and forgone revenues. Inves ng government resources to promote certain segments of corporate sector whether done through tax allowances, exemp ons and deduc ons, or 1 See Declara on of the Intended Ac vi es of the Cabinet of Ministers Headed by Māris Kučinskis, February 2016, Riga h p://www.mk.gov.lv/sites/default/ 4 For consump on, the implicit tax rate is the ra o of taxes (mostly VAT and excise) on the final consump on of households in the country. The implicit tax files/editor/deklaracija_en.pdf rate on labor is the ra o of taxes on employed labor to the total compensa on of employees including payroll taxes. Regarding capital, the implicit tax rate is 2 Defense expenditure as a share of GDP for 2015 and 2016 is sourced from NATO (2016). the ra o of capital taxes to the worldwide capital and business income of domes c residents. 3 Based on Eurostat data for the Gini coefficient in 2015 (latest available as of May 2017). 5 The latest available data is for 2012. 12 13 Latvia Tax Review Latvia Tax Review 6 Figure 1. Tax-to-GDP Ra os and GDP per capita, PPP in current US$, 2013 countries. Latvia has a rela vely high statutory PIT rate, with a rela vely small non-taxable personal allowance. Other peers have either a higher untaxed personal allowance or a lower tax rate, at least at the lower end of income distribu on. Latvia collects more VAT revenues as a percent of GDP than its regional peers, except for Estonia. Finally, Latvia’s revenues from corporate income taxes (CIT) as a percentage of GDP are similar to those of Lithuania, Estonia, and Poland, but lower than in Slovakia and the Czech Republic. Figure 3. Difference between the level of tax-to-GDP in selected countries and Latvia, percentage points, 2014 Source: World Bank’s World Development Indicators and IMF. Figure 2. Average effec ve (implicit) tax rates, 2012 Note: A nega ve value indicates that a country collects lower revenues from a tax than Latvia; a higher value shows that a country has higher revenues from a tax compared to Latvia. Source: World Bank staff calcula ons based on Eurostat. Fiscal policy has a lower impact on inequality in Latvia than in many EU and OECD countries (Figure 4). Market income inequality in Latvia is not par cularly high, but the combined impact of direct taxes and government transfers is lower than in other EU countries. Latvia’s Gini is the second highest for (a er-tax) disposable income in the European Union (EU); Estonia’s Gini is just 0.1 percentage points higher. Benefits, especially means-tested benefits, play li le role in reducing inequality, direct taxes have only a small impact and pensions play a lower role than on average in the EU. To achieve a higher reduc on in inequality of disposable income, a broad mix of redistribu on across benefits and taxes is important. However, various combina ons can be used. Ireland for example, with a rela vely low corporate profits tax, achieves a large reduc on in inequality through a progressive PIT and substan al means-tested benefits targeted at low-income groups. Source: Eurostat. Personal income taxes (PIT) and social security contribu ons (SSC) account for the bulk of the difference between tax collec ons (as a share of GDP) in Latvia and the EU average (Figure 3). The share of revenues from capital taxa on is also lower than the EU average. The picture looks somewhat different if compared to regional peers (the Czech Republic, Estonia, Lithuania, Poland and Slovakia). Latvia’s revenues from social security contribu ons are s ll lower by 2.5 to 6 percentage points of GDP, which could be explained by a lower standard rate for SSCs, but the PIT-to-GDP ra o is higher than in all the selected comparison 6 Based on the Gini coefficient of equalized disposable income from the EU-SILC. 14 15 Latvia Tax Review Latvia Tax Review Figure 4. Gini Coefficient Before and A er Taxes and Transfers, Selected Countries, 2014 weaken incen ves for work and entrepreneurship, and increase avoidance and evasion. The solidarity tax introduces a small element of redistribu on in the system, and in the absence of other changes to make labor taxes more progressive, it should be maintained. The tax rate on capital income is well below that of most EU countries, reflec ng both low nominal rates and various exclusions from income. Since large parts of capital income remain untaxed, taxes on labor income and consump on need to be higher than they otherwise would have to be. The tax rate on capital income is not uniform, which enables tax avoidance by transforming capital income from one source into capital income from another source. For example, capital gains are subject to a 15 percent rate, but this income stream could instead be converted into dividends, which are subject to a lower 10 percent rate (both dividends and capital gains are zero-rated if held by corpora ons). The system also provides a strong incen ve to overinvest in real estate and to issue debt rather than equity. Non-uniform tax treatment of capital income is inefficient, generates inequi es and provokes tax arbitrage. Latvia should increase the share of taxes on capital income in total tax revenue along with making tax rates on various forms of capital income more uniform. 4. TAXATION FOR FIRMS Corporate income tax revenue in 2014 equaled only 1.5 percent of GDP 2014, compared to the EU average of 2.6 percent. The CIT statutory rate is 15 percent, well below the EU average of 23 percent, and tax incen ves for investments, tax credits (for farmers), deduc ons and loopholes further reduce the effec ve rate. Average and marginal effec ve corporate tax rates (EATRs and EMTRs), which take into account both the rates and the tax base, are rela vely low by EU standards. This suggests that suggest that Latvia’s CIT system imposes rela vely low marginal investment distor ons. There may be some scope for broadening the CIT base by reducing specific tax expenditures, par cularly accelerated deprecia on, provisions for the carrying forward of losses incurred in the past, and various deduc ons designed to encourage investment and R&D, which may not be providing sufficient benefits rela ve to the tax revenues foregone. Low CIT revenues are due to a narrow and eroded tax base. The 2008/2009 economic crisis reduced the income tax base for both corpora ons and households, leading to lower income tax revenues. Unlike Estonia and Slovakia, personal and corporate Notes: The OECD assumes that pensions are a government transfer (and social insurance contribu ons are a tax). In-kind spending income tax revenue in Latvia remained below the pre-crisis peak in 2014. CIT revenues stayed below the level corporate profits on educa on and health is not included in the calcula ons for OECD countries. Countries are ordered by Gini coefficient a er developments would have suggested, partly as a result of the introduc on of a microenterprise tax, as well as other policy taxes and social transfers from low to high values. changes that also increased tax avoidance (see Figure 5). PIT revenues in Latvia increased by more than the recovery in the wage bill implied, probably with the assistance of a broadening of the tax base in 2010 to cover capital income. Sources: Gini before and a er taxes and transfers are from OECD for all OECD countries and from the Commitment to Equity country papers for the remaining countries. Russia’s data is for 2014. Government spending as a share of GDP is from the World Figure 5. Latvia: PIT and CIT and their Poten al Tax Bases, 2000-2014, EUR Million Bank’s World Development Indicator 3. PERSONAL INCOME TAXATION Moving away from the flat tax system would improve the efficiency and equity of the tax system. Marginal tax rates at the bo om of the income distribu on are too high (in some cases 100 percent) and personal income tax rates are flat at 33.5 percent for all incomes above the minimum non-taxable threshold. A differen ated non-taxable minimum whereby lower income earners receive higher tax-free thresholds was introduced in 2016. Together with increased allowances for dependents, the structure of the personal income tax has become somewhat more progressive over me. Nevertheless, flat taxes are sub- op mal compared to non-linear tax regimes because all individuals, including middle- and high-income earners, benefit from the non-taxable minimum income. Hence, in order to raise the (a er-tax) disposable incomes for low-income earners via a higher non-taxable minimum income, marginal tax rates on average need to be much higher than if redistribu on was done through a progressive income tax rate. Consequently, a flat tax causes more distor ons for the same income redistribu on, or can redistribute less income for the same degree of economic distor on. In The Latvian government could consider adjus ng the structure of effec ve marginal tax rates by (i) making the tax system more progressive; (ii) reducing the welfare loss of the tax system; (iii) raising revenue, or by a combina on of all three. There is a case for increasing the rate on higher incomes in Latvia. Given that PIT accounted for about 20 percent of total tax Source: Eurostat na onal accounts data, OECD data on income from taxes. revenues (see chapter 2) and the regressivity of other major tax instruments (e.g., the VAT),7 there is a strong case for increasing the rate on higher incomes. Whether to introduce a higher tax bracket for higher incomes, however, fundamentally is a poli cal The CIT system in Latvia may distort corporate financial decisions. In Latvia interest is taxed only once, since it is deduc ble choice regarding how much redistribu on should be undertaken through the tax system versus the social value placed on the at the corporate level. Hence, the effec ve tax rate on interest equals the 10 percent rate of the PIT. However, dividends and income of higher income earners. Simula ons suggest that an increase in the current top rate of 23 percent is feasible and capital gains are subject to higher effec ve marginal tax rates of, respec vely, 23.5 percent and 27.75 percent. The deduc bility would result in more income redistribu on and public revenue. Such an increase carries risks, of course. A higher top rate could against the CIT of interest payments, but not, in general, on equity may offer an incen ve for corpora ons to use debt rather 7 VAT is effec vely regressive: the es mated share of the VAT in household gross income falls steadily from 14.1 percent in the first quin le to 6.8 percent in than equity financing. The asymmetric tax treatment of debt and equity should be reviewed to remove or reduce distor ons the top quin le. in the financing of investment. It could be eliminated through an Allowance for Corporate Equity, a Comprehensive Business 16 17 Latvia Tax Review Latvia Tax Review Income Tax, or a combina on of both where costs of equity and debt are both par ally deduc ble for the CIT. A CIT approach efficiency and distribu onal impact of preferen al VAT rates on goods and services. that taxes distributed earnings as adopted in Estonia exempts the costs of equity in the form of retained earnings, but given that The most significant challenge for VAT is to combat the substan al amount of revenues that are lost due to tax evasion it does not provide an exemp on for all types of equity costs it does not address financing bias completely. and avoidance. The VAT compliance gap—the difference between expected VAT revenues and VAT actual revenues collected due to tax fraud, tax evasion and tax avoidance as well as because of bankruptcy, insolvency and poor calcula ons—is high. Latvia’s microenterprise tax was introduced in 2010 to increase employment and encourage business start-ups. In 2016 Latvia has close to EU average VAT revenue ra os, but a very high VAT gap (see Figure 8).8 Failure to comply explains a major part the regime enabled small firms to pay a tax rate of 9 percent of sales volume in lieu of PIT, CIT, and social security contribu ons. of this gap. The State Revenue Service (SRS) es mates that there has been a gradual but persistent decline in the gap since the The number of par cipa ng microenterprises and employees have increased sharply since its introduc on, and tax losses due to crisis, closing the gap could s ll increase VAT revenues significantly—there is room to adopt more efficient tax administra on the movement from the general regime are substan al. There has been a steady and large inflow of tax payers from the general methods to tackle tax fraud, evasion of VAT arrears, underrepor ng, and the shadow economy (Figure 9). Because the gap may regime into the MET regime. By contrast, there is li le evidence of a significant number of firms leaving the MET regime to enter have a variety of sources, knowledge of VAT gap structure could make it easier to design efficient methods to tackle it. The size the general tax regime (Figure 6). While the MET may have reduced undeclared wage payments and VAT fraud, there is strong of the gap in Latvia suggests that it would be advisable to adopt methods to tackle tax fraud, evasion of collec on of past debts, evidence of manipula on of wage repor ng to qualify for the MET regime. Moreover, measures are not adequate to prevent underrepor ng, and the shadow economy. avoidance of taxa on through the MET regime, for example by establishing mul ple microenterprises owned and controlled by connected persons. The MET regime also may inhibit the growth of innova ve firms, and reduce contribu ons to and coverage Figure 8. VAT gap, in percent of VAT liability, 2013 Figure 9. Compliance problems, percent of total of the social security system. Finally, tax revenue from MET is very low compared to the number of MET taxpayers and their liability, 2010-2014 earnings (Figure 7). The es mated tax revenue foregone due to MET amounted to 60 million EUR or 0.2 percent of GDP annually (in 2014-2015. Figure 6. Number of taxpayers in the microenterprise Figure 7. Changes in the share of MET tax revenue/earners in regime and exi ng the regime, 2010-2015 labor taxes/taxpayers in Latvia, 2010-2015 Source: CASE 2015. Source: Latvia’s State Revenue Service. VAT thresholds should be evaluated. The cutoff for firms exempt from the VAT due to small size is higher than in most EU countries, which while easing administra on can increase tax avoidance (exis ng firms can split up into smaller companies to gain the exemp on). Gains from reducing tax administra on and compliance costs need to be carefully assessed against the compe ve distor ons stemming from the difference in treatment among taxpayers on both sides of the VAT threshold. 6. EXCISE TAXES Source: Calcula ons based on State Revenue Source: Calcula ons based on State Revenue The rela vely high excise tax in Latvia imposes a burden on domes c consumers and a racts illegal trade making it harder Service data. Service data. to increase taxes. There might be a case, however, for changing the applica on of excise du es to different products. When designing the excise tax system the government should seek to minimize the distor ng effects of the tax on consumer behavior, The MET should be phased out and replaced with an alterna ve programs to support new innova ve and lifestyle use it to correct socially costly behavior, or both. In Latvia, there is a clear case for reform in how driving and alcohol are taxed. businesses in the new regime only genuine new business start-ups would be covered, with various forms of tax relief focused Fuel excise du es do not target the primary externality, CO2 emissions, associated with driving. The government should consider on micro/small enterprises and linked to new jobs created. The lifestyle scheme should be offered only for small traders / basing the tax on fuel on CO2 emissions. Taxa on of fuel needs to be carefully redesigned so as not to harm the transport proprietors with a low turnover e.g. less than EUR 20,000 per year, combined with the number of employees and the possibly sector and Latvia’s compe veness. Reform of alcohol taxa on should target alcohol products systema cally, because a society loca on of business premises (e.g. Tax Card regime in Poland). However, the phase-out of the MET would have to be gradual consumes dispropor onately more of the low alcohol content products such as beer. Changing the balance between the specific and well designed to ensure transi on to the general tax regime and accompanied by assistance to vulnerable workers who rely and ad valorem components of the tax on cigare es will be er target public health and may lead to higher revenues. These principally on microenterprise employment. changes in excise taxes could bring addi onal revenues (up to 1 percent of GDP) but only if accompanied by improvements in tax administra on to reduce tax fraud and evasion. 5. VALUE-ADDED TAXES Latvia’s value-added tax (VAT) is fairly broad-based, with a standard rate of 21 percent (close to the EU average) and a reduced rate that covers rela vely few goods and services. Some por on of consump on is excluded from, or enjoys a reduced 7. PROPERTY TAXES rate under, the VAT, similar to most economies. The reduced rates and exemp ons in VAT are costly in terms of public revenue. There have been frequent calls for increasing property taxes to generate addi onal revenues in Latvia. Latvia has modern, The VAT exemp ons in 2014 amounted to EUR 945 million, or 3.9 percent of GDP. Increased revenues could be realized from rela vely sophis cated value-based model of taxing property. Genera ng support for increased property taxa on is likely to broadening the VAT base to eliminate unnecessary exemp ons or raise reduced rates that no longer achieve policy aims in the most efficient way (taxa on of energy or hotel accommoda on). This decision needs to be based on a careful review of the 8 The VAT gap arises not only from fraud or tax evasion but also from errors, failure to take reasonable care, and nonpayment due to bankruptcy or insolvency. 18 19 Latvia Tax Review Latvia Tax Review be challenging: a empts to make the system of residen al tax assessment be closer to the market value have met with and environment-related taxes, should grow. considerable poli cal resistance given the implied large tax increase on certain categories of residen al property. The resistance • Reduc on in tax evasion/avoidance is a priority. However, the gains from improved compliance, while poten ally comes from the fact that in Latvia, as in other economies in Central and Eastern Europe, the value of property is not always substan al, are uncertain. Thus, planned increases in revenues that are ed to increases in spending should mainly rely on tax closely linked with financial situa on of tax payer. Nonetheless, the Government should keep to the planned schedule for raising design measures aimed at broadening the tax base or raising tax rates. But in order to reach the increased revenues goal, a the assessment average ra o to 85 percent in 2018, with no compensa ng changes in tax rates or exemp on policies. It may con nued reduc on in the VAT tax compliance gap and a fall in the underrepor ng of wages will be necessary. be desirable to extend the 90 percent tax abatement for low-income households to households with slightly higher incomes, • Decreasing inequality of (a er-tax) disposable income. The most appropriate instruments for tackling inequality are perhaps with a reduced percentage of relief. However, proposals to impose lower assessment ra os or lower tax rates on lower direct personal income taxes and benefits. Apart from introducing more progressivity in the personal income tax system, benefit value property, or to raise the maximum property value subject to a lower assessment ra o, would not necessarily benefit changes would also be necessary to decrease inequality: benefits, especially means-tested social assistance, play li le role in low-income renters. In general, it is preferable to address income distribu on concerns through direct income tax and benefits reducing inequality compared to other EU countries. rather than through measures in the property tax system. Table 1. Es mates of revenue impact of tax measures 8. TAX ADMINISTRATION Measures Revenue impact ( % of GDP) Despite considerable improvements in tax enforcement in recent years, the underground economy remains large. The 1. Personal income tax (wages) 0.09-0.3 difference between expected VAT revenues and actual collec ons has fallen since 2010 but remains above one-fi h of VAT 1.1. Non-linear tax schedule, lower tax for low-income workers* revenues. Key steps to strengthen VAT compliance include: (i) the devo on of more staff resources and increased availability 3-rates PIT (19%/23%/33%) 0.31 of data for the analysis of VAT compliance; (ii) stricter review of firms before they are permi ed to enter the VAT net; (iii) introduc on of an e-invoicing system for business-to-business transac ons; (iv) withholding tax requirements for payments 3-rates PIT (19%/23%/29%) 0.10 made to sub-contractors (either in high-risk sectors or to all sub-contractors lacking a tax registra on number); and (v) requiring 3-rates PIT (19%/23%/29%) + EITC 0.00 use of cer fied cash registers to record sales in cash-dominated sectors. 1.2. 19% PIT rate for self-employed -0.01 Improving voluntary compliance with the tax system is a key challenge. Allowing consumers of household services to 2. Personal income tax (capital) 0.11 deduct part of the costs of such services when documented through a tax invoice could improve tax compliance by service 2.1. Uniform tax rate (15%) on capital income 0.11 providers, but could also significantly reduce revenues from consumers. Key steps to promote voluntary tax compliance could include the use of outreach and communica on to promote voluntary compliance in high-risk areas, innova ve approaches to 3. Corporate income tax 0.06-0.68 promote both the SRS and voluntary compliance (e.g. web-based presenta ons distributed via YouTube or tax-related TV spots), 3.1. Changes to tax deprecia on broadening the SRS program to honor the most compliant and biggest taxpayers in the country to small- and medium-sized Remove accelerated deprecia on of fixed assets 0.22 businesses, and dissemina ng informa on on the penal es imposed on major tax evaders. Remove enhanced deprecia on for new technological equipment 0.29 SRS tax administra on and access to data could be strengthened. The use of audits could be improved by comparing risk- 3.2. Limit on the offset of losses carried forward based audit results with other audit approaches to evaluate the risk parameters used, increasing staff with audit exper se, and increasing specializa on in audit tasks, for example by size of business, sector, and high net-wealth individuals. Increased access Limit loss relies to 80% of profit before taxa on 0.06 to credit card and bank account informa on would improve the checking of income tax data. Measures to a ract and retain Limit loss relies up to 5 years 0.17 highly-qualified staff could include special compensa on levels or bonus systems for key expert posi ons and improved working 4. Microenterprise tax regime 0.21 condi ons (e.g. flexibility in working hours or possibility for part- me work, job security, and in-kind benefits like kindergarten 5. VAT 0.13 facili es). 5.1 Elimina ng reduced VAT rates 9. POLICY RECOMMENDATIONS Standard rate for accommoda on services in tourism 0.04 Collec ng an addi onal three percentage points of GDP in revenues involves substan al tax changes and will be Standard rate for district heat supply and firewood 0.08 challenging. Even if interna onal benchmarking indicates that there is room to increase tax pressure, when a package of taxes 5.2 Reduce VAT threshold 0.01 that is es mated to yield the government target is put together it shows that large policy modifica ons are needed. The following 6. Excise tax 0.37-1.0 illustra ve changes outlined in Table 1 would at a maximum bring revenues close to the goal, which would be shared between Alcoholic beverages 0.30 central and local governments. The proposed changes rely primary on: redesigning tax burden within income taxa on (from Cigare es 0.20 low-skilled labor towards capital), shi ing tax burden from income to consump on taxa on and improving tax compliance, with poten al benefits for economic growth and equality.9 These broadly are reforms aimed at: Fuel 0.50 • Broadening the tax base. For corporate income tax, given the low statutory and effec ve tax rates in an EU context, this 7. Property tax* 0.10 will involve decreasing costly tax expenditures, such as generous accelerated deprecia on rates for fixed assets and enhanced 8. Compliance 0.56 depreca on for new technological equipment, and limi ng loss relief. Gradually moving taxpayers who belong—given their VAT gap (20%) 0.24 overall ac vity level—to the general tax regime from the microenterprise regime will also contribute. Tax expenditures on Underrepor ng of wages (20%) 0.32 reduced- and zero-rate VAT provisions are lower than in many EU countries, but s ll should be reviewed for poten al sources of increased revenues. TOTAL MAX 3.09 • Changing tax structure. Distor ons due to taxa on could be reduced and equity improved by raising more revenues from capital income taxa on through a uniform treatment of different types of capital income involving a rise in tax rates for some Note: * Denotes that local government would benefit from the proposed tax change. income sources (par cularly to reduce the bias for inves ng in real estate and issuing debt rather than equity), introducing a Source: World Bank staff es mates. progressive personal income tax and changes to the way excise rates are designed. Over me, the role of property/wealth taxes 9The report did not use a general equilibrium model to assess the economic impact of the proposed package. Instead, it uses a review of the theore cal and empirical tax literature and par al equilibrium tools to design key elements of the reform and asses their impact. 20 21 Equitable Growth, Finance, and Institutions Europe and Central Asia Region INTRODUCTION Latvia Tax Review Latvia Tax Review 1. INTRODUCTION The government target is to increase tax revenues by three percentage points of GDP to reach a target tax-to-GDP ra o of 33 percent in the medium term.7 This is to cover growing spending needs in Latvia. Latvia has one of the smallest governments 1.1 Context of review in the EU—Latvia ranks third lowest in the EU in government revenues and spending: general government revenues equaled 35.8 percent of GDP and government expenditures 37.1 percent of GDP in 2015. In addi on, Latvia’s tax share of GDP is one of Since the introduc on of the flat personal income tax (PIT) in the mid-1990s Latvia has made several changes to the tax the lowest when compared with countries of a similar level of development. As the economy grows and converges toward the system that moved away from the original uniform PIT and corporate income tax (CIT) rates. In 2016, a series of measures higher-income EU economies, there may be an increasing need for social spending both to invest in human capital and provide were put in place aimed at reducing income inequality by making the tax system less regressive: the non-taxable minimum a be er safety net. The Government has iden fied na onal security—defined as social protec on and military spending—as was increased and is set to be differen ated in favor of lower income groups in future years.1 A solidarity tax on higher income a cri cal area that needs more fiscal resources. Spending and coverage of the Guaranteed Minimum Income program (the last earners came into effect on January 1, 2016.2 Looking forward the Ministry of Finance intends to draw up a medium-term tax resort social assistance program) is low rela ve to needs (Strokova and Damerau, 2013b). The Government aims to increase strategy to put in place a more permanent change to the design of the system and asked the World Bank to do a review of the defense spending (currently at 1.4 per cent of GDP). Educa on and health are addi onal areas that the Government has iden fied tax system as a basis for the reform. as requiring further investments. In par cular, public health spending is low and health outcomes are lagging compared to the Latvia was among the first wave of adopters in the recent episode of flat-tax directed reforms with a flat tax of 25 percent EU (Levin and Sinno , 2015). introduced in 1997. Latvia’s flat tax reform followed on from the introduc on of a flat tax in Estonia and in Lithuania in 1994. The flat tax replaced a degressive3 personal income tax (PIT) regime with a general marginal tax rate of 25 percent and a 10 percent Any shi in taxa on and expenditure policy will take place within a framework of commitment to fiscal sustainability. marginal tax rate for high incomes. The corporate income tax (CIT) rate remained unchanged at 25 percent, and capital income Latvia ins tu onalized a framework to maintain fiscal sustainability—hard won in the crisis period—with a Fiscal Discipline remained tax exempt. Latvia’s flat tax system differed from that of later adopters, such as Russia or Romania, as in Latvia the flat Law in 2013 and the crea on of an independent Fiscal Discipline Council to monitor compliance with the Law in 2014. The tax rate was set at the highest rather than lowest marginal income tax rate, and capital income was exempt. Addi onally, the country joined the Eurozone in 2014. Public debt is among the lowest in the EU. The general government structural deficit target non-taxable minimum was only slightly increased in Latvia compared to the larger increases seen in many other countries with (taking into account permissible devia ons and structural reforms in the health sector) is 1.7 percent of GDP for 2017 and 2018, the aim of reducing the average income tax imposed on lower-income earners through a flat tax. with a reduc on in the deficit planned therea er. The policy remains broadly compliant with the principles of fiscal discipline, both according to the IMF and Fiscal Discipline Council. However, the IMF8 called for further moves to improve tax compliance Over me the parameters of the tax system were altered, moving away from the ini al flat tax concept and introducing and shrink the shadow economy, while the FDC noted that budget deficits exceeded the targets approved in budget law in a lower CIT rate; further changes put in place during the stabiliza on program following the financial crisis of 2008-09 have recent years. At the same me, the FDC argued that achieving the Government’s objec ve of increasing the tax-to-GDP ra o made the PIT system more regressive. In 2002, the CIT rate was reduced to 15 percent, below the current PIT rate of 23 percent. to one-third by 2020 will require coordinated efforts to build a reliable and sustainable revenue flow and coherent tax policy Modifica ons were made to the tax system following the 2008-09 financial crisis, including a reduc on in the non-taxable framework.9 minimum, the introduc on of a 10 percent tax on interest and dividends, a 15 percent tax on capital gains, and a reduc on in tax expenditures through a ghtening of tax exemp ons, deduc ons and credits targeted to selected groups or specific ac vi es. In The Government is working to achieve consensus support for tax system reform from its social partners. There was response to the crisis a new tax regime for microenterprises was adopted in 2010, which reduced taxa on and social insurance widespread cri cism of the introduc on of the solidarity tax by the business community and across media outlets. Partly this contribu ons.4 It is es mated that 19.2 percent of private sector employees5 reported at least part of their income through was related to compe veness concerns, but also objec ons were again raised on the imposi on of new taxes when tax evasion the microenterprise regime in 2015. In addi on to poten al tax avoidance, for example through the shi ing of ac vi es to is high. The business community and media most o en focus on “envelope wages” as the big tax fraud issue, whereby a formal microenterprises, a concern is that some microenterprise workers may accrue lower en tlements for pensions as well as other employee receives not only a declared wage but also an undeclared “envelope wage”. Further efforts to raise compliance under social insurance benefits such as unemployment. the exis ng tax system is thus an important element of building support for tax reforms. In addi on, the Government wants to make sure that addi onal spending is efficient and achieves the intended benefits. With this in view, the Government has been Latvia’s recent tax changes were prompted by concerns over high inequality, and the Government intends to implement inves ng in detailed sector strategy and spending reviews, including in the areas of health and social protec on. further tax design changes to enhance the equity of the system. Inequality is high; Latvia’s Gini is the second highest for (a er- tax) disposable income in the European Union (EU) (with Estonia just 0.1 percentage points ahead).6 Aside from the recent PIT 1.2 Objec ves of the review tax changes, there is a large agenda to address equity concerns of the current tax system. Labor taxes make up a large share There are mul ple dimensions to be taken into account in examining tax reform op ons, and it is useful to set out a brief of overall revenues and are rela vely high at 34.09 percent, made up of 10.5 percent (employee’s part) and 23.59 percent set of principles to be focused on in reviewing the Latvia’s tax system. First, the Government requested that the tax review (employer’s part). The labor tax wedge for low-income workers is par cularly high, raising concerns on incen ves for labor iden fy op ons to increase government revenues to finance higher spending on security (par cularly health, social protec on supply (Strokova and Damerau, 2013a and OECD, 2015). and defense). Second, the Government aims to improve the design of the tax system to enhance produc vity and employment, and to help posi on Latvia businesses to be flexible, compe ve and robust in the face of dynamic global condi ons. Finally, the government would like to improve the equity of the tax system, both by taxing lower-income households less than upper- income households (par cularly by reducing the high labor tax wedge faced by low-income workers) and by trea ng equally 1 See the October 7, 2015 statement of the Minister of Finance, Janis Reirs, on the equity objec ve of the 2016 budget h p://www.fm.gov.lv/en/ those of equal income. news/51418-minister-of-finance-janis-reirs-next-years-budget-focuses-on-solitaire-reduc on-of-income-inequality 2 The solidarity tax will be levied on annual incomes above EUR 48,600 and the solidarity tax rate is equal to the state social insurance contribu on of 34.09 The efficiency and welfare implica ons of the tax system are cri cal to the review. Tax systems should meet distribu onal percent (23.59 percent paid by the employer and 10.5 percent by the employee). In essence, the new solidarity tax removes the cap on social insurance con- goals and revenue targets with the lowest possible distor ons on economic ac vity. Taxes entail economic costs by affec ng tribu ons, but its proceeds will go to general revenues and it will not en tle contributors to increased social insurance benefits. The solidarity tax came into people’s and firms’ behavior: decisions on working, saving/consuming, inves ng and employing. These ‘excess burdens’ of taxes effect on January 1, 2016. The Ministry of Finance (2015a) es mates that 4,700 individuals will be affected by the tax or 0.6 percent of the employed (Source: are the economic costs of taxa on. They arise over and above the income that individuals and firms pay in taxa on, since the h p://www.fm.gov.lv/lv/aktualitates/jaunumi/nodokli/51253-solidaritates-nodokli-maksas- kai-personas-ar-alguvirs-48-600-eiro-gada). 3 Under a degressive tax, the tax rate decreases as the taxable amount increases. It should be noted that the degressive PIT system was in place only since la er are compensated by larger public revenues. Governments inevitably confront trade-offs between 1996; prior to 1995, the PIT system was progressive with five rates ranging from 15 to 35 percent. 4 The microenterprise tax rate was 9 percent from turnover ll the end of 2016. The tax replaces state social contribu ons both for employers and employees as well as PIT and CIT depending on the legal form of taxpayer. To qualify for status of microenterprise taxpayer the employee’s income should not exceed EUR 7 See Declara on of the Intended Ac vi es of the Cabinet of Ministers Headed by Māris Kučinskis, February 2016, Riga h p://www.mk.gov.lv/sites/default/ 700 per month, turnover should not exceed EUR 100,000 per year, and the number of employees may not exceed five. Source: h p://www.fm.gov.lv/en/s/ files/editor/deklaracija_en.pdf taxes/ 8 Staff Concluding Statement of an IMF Staff Visit, December 9, 2016 h p://www.imf.org/en/News/Ar cles/2016/12/09/MS120916-Latvia-Staff-Concluding- 5 The es mate was given in discussions by the Ministry of Welfare in 2015. Statement-of-an-IMF-Staff-Visit. 6 Based on the Gini coefficient of equalized disposable income from the EU-SILC. 9 Fiscal discipline surveillance report (No 1-08/1186) h p://fiscalcouncil.lv/05-10-2016-surveillance-report. 24 25 Latvia Tax Review Latvia Tax Review equity and efficiency: higher taxes on richer groups—to raise revenue and to finance benefits for poorer groups—can distort 1.3 Economic context the economic incen ves for work, entrepreneurship, saving and risk-taking of middle- and higher-income individuals. At the Latvia has achieved rapid income growth over the last 20 years, although the process was marked by significant vola lity. same me, redistribu on to low-income individuals, through tax credits or benefits, could weaken labor supply incen ves. The Latvia is a small open economy that has made significant progress in catching-up to the income and produc vity levels of tax review will aim to es mate the magnitude of these types of efficiency effects. the richer EU economies since regaining independence. Rapid income convergence has been supported by market-oriented Apart from the revenue mobiliza on and equity objec ves of the tax review, the review will consider policy changes to reforms, an openness to foreign capital inflows and technology transfer from abroad, with a significant boost coming from achieve the following objec ves: market integra on with the EU. Similar to other countries in the region such as Estonia, Lithuania or Poland, strong economic  Raise the efficiency of the tax system and iden fy poten ally welfare-improving tax reforms. Efficiency considera ons growth was based primarily on capital deepening (Figure 2). At the same me, growth was rela vely vola le, with a par cularly aim at minimizing the tax distor ons and administra ve burdens to meet given equity or revenue objec ves. By removing marked boom star ng around the EU accession in 2004 (GDP growth averaged 10 percent over 2003-07), mostly based on the inefficiencies, the Government can raise more revenue, redistribute more income, or lower tax rates. In addi on, some credit-fueled domes c demand. The overhea ng economy experienced an infla onary spiral and a loss of compe veness, features of the tax system are neither equitable, nor efficient. In such cases reforms can be iden fied that raise efficiency, with a doubling of unit labor costs and a real estate bubble. The burs ng of the domes c demand bubble coincided with the equity or both. interna onal financial crisis, leading to a major economic downturn with GDP shrinking by about a quarter.  Reduce avoidance, evasion and the grey economy. An important concern is the impact of tax policy and administra on on informality and the size of the grey economy. Neutrality in the tax treatment of various sources of income is important Figure 2. Contribu on to GDP growth, percentage points, average 2005-2015 to combat tax avoidance. The different tax regimes applied on goods, inputs, and various forms of income and asset types should avoid genera ng strong incen ves for individuals or firms to shi income across tax bases, between people and over me.  Improve compe veness. Taxes affect the compe veness of firms, which helps determine overall levels of produc vity and living standards. Latvia is a small open economy that faces tax compe on on tax rates, tax bases, and tax burdens from other countries in the EU, and in par cular its Bal c neighbors. Changes in tax policy should take into account the impact on the compe veness posi on of Latvian firms and the level of the interna onal playing field. Thus, comparisons with the tax systems of neighboring countries (in par cular Estonia and Lithuania) are important to analyze the implica ons for the mobility of labor and capital, including a rac ng inward foreign direct investment (FDI).  Reduce administra ve and compliance costs. Simplicity is a cri cal feature of a tax system that aims at minimizing tax collec on costs for the government and compliance costs for individuals/firms. In addi on, the parameters of the tax system should be transparent and easy to grasp. The tax review looks at the tax structure in its en rety and examines its general evolu on over me. The study aims to inform the Government’s formula on of its medium-term tax strategy, and to support dialogue aimed at reaching agreement in society on reforms to the tax system by presen ng the analysis and policy recommenda ons for public discussion. The framework used for evalua ng op ons to increase revenues takes into account possible behavioral responses to tax changes (where possible). The report considers changes to both the tax system rules (e.g. rates, deduc ons) and tax administra on policies, such as enforcement tools (audits, evasion penal es, public disclosure) (see Figure 1). Indirect ways to Source: Groningen Growth and Development Centre, Total Economy Database. increase tax revenues through policies that boost economic ac vity, income and wealth are not discussed in the review. The review, however, pays a en on to how individuals and firms respond to taxa on. To the extent possible, it considers not only how behavioral responses affect labor supply and investment, but also tax avoidance and evasion. Investment and value added in Latvia have been driven by large firms. Firms with more than 20 employees accounted for about 70 percent of total investment, while micro companies made up 23 percent (Figure 3), in itself a significant increase from Figure 1. Poten al sources of revenue increases the previous year. Similarly, around 70 percent of value added is generated by firms employing more than 20 people (Figure 4). Large enterprises play a similar role in Slovakia, Czech Republic or Lithuania, but a somewhat smaller role in Estonia. However, small companies (up to 20 employees) are cri cal for employment. In the Bal c States as well as peers from Central Europe, small (and micro) companies account for at least 40 percent of employment. 26 27 Latvia Tax Review Latvia Tax Review Figure 3. Investment by company size in Latvia, in Figure 4. Structure of value added by size of the enterprise force in 2015, compared to 1.6 percent in 2007 (Eurostat). The unemployment rate for workers aged between 15 and 74 with no EUR million, 2015 in Latvia and in benchmark countries, 2015 more than a lower secondary educa on was 22 percent, much higher than in 2007 (10.6 percent) and the rate of unemployment for workers with a ter ary educa on qualifica on (5 percent in 2015). Labor demand has yet to fully recover. Although vacancies have increased from 0.4 percent of total posts at the end of 2015 (the lowest in the EU) to 1.6 percent in the last quarter of 2016 (compared to 1.8 percent for the EU average). Older groups are more likely to spend a long me out of work, and there is a concern that the cyclical unemployment caused by the crisis becomes structural over me as people’s skills deteriorate and those without long unemployment spells are preferred in the labor market. Labor force par cipa on rates in Latvia are high and have increased in recent years. Latvia’s labor force par cipa on rate is 68 percent for those aged 15–74, higher than the EU15 average (65 percent) but below that of Denmark (70 percent) and significantly below Estonia and Sweden (72 percent) (2016 Q3 data). Labor force par cipa on rates (for workers older than 25) are higher for more educated workers, with the biggest differences between the lowest-educated group (with less than upper- secondary educa on) and those with secondary and above educa on. For women, these differences occur over their whole working life, but for men, they emerge in the mid-40s. Educa on becomes very important in terms of exit from the labor force for both sexes: the more educated are much more likely to stay in the labor market around re rement age. Figure 5. Distribu on of monthly income earners, by EUR wage band, in percent, 2015 Source: Eurostat, SBS. The economic adjustment of 2009-2010—achieved through internal devalua on and fiscal austerity that reduced domes c demand by about one third—was rapid and impressive, but also came at a cost. The economy adapted swi ly, and most of the imbalances accumulated during the boom years (including the excessive increase in private sector indebtedness, unsustainable current account deficits and oversized public spending programs) were addressed, backed by an interna onal financial assistance program (EUR 7.5 billion, i.e. 30 percent of GDP, of which 4.5 billion was used). Latvia maintained the currency peg with a view to joining the euro area, so adjustment was achieved through a significant internal devalua on, in part driven by produc vity increases stemming from labor shedding. Unit labor costs decreased, restoring external compe veness and suppor ng an export-led recovery. The budget deficit was reduced by cu ng expenditures and raising revenues (including a 20 percent decrease in public sector wages and an increase in VAT rates), with the total austerity package amoun ng to 17 percent of GDP over four years. In addi on to the hardships faced by Latvian workers, the adjustment also led to massive emigra on flows. Ten percent of the working age popula on le the country during 2008-2013, and emigrants were dispropor onally young and rela vely well educated—the share of university graduates among Latvian emigrants is higher than among their age Source: Central Bureau of Sta s cs. group that stayed in Latvia (Hazans, 2015). Latvia will need structural reforms and investment to support produc vity improvements and achieve rapid convergence The real adjusted gross disposable income of households per capita is just recovering to the high of 2008. According to with richer EU countries. Despite major reform efforts in response to the crisis, some structural vulnerabili es s ll remain to be Eurostat, the real adjusted gross disposable income of households per capita10 was EUR 12,756 in 2015 compared to EUR 9,974 addressed to maintain a high and sustainable pace of convergence and to make the economy more resilient. Latvia can further in 2009 and EUR 11,947 in 2008. Households with workers younger than re rement age rely mostly on labor income, while its integra on into global-value chains, and increase investment in knowledge-based capital and innova ve capaci es. Latvia’s pensions rise in importance for households with older workers (World Bank, 2015). Social assistance is small for all age groups, exports are dominated by goods with a low technological content (agricultural, food, wood, metals products), and produc vity and substan ally contributes to income only for short episodes of need for a low propor on of the popula on. The majority of gains will be essen al to move up the value chain (OECD, 2015). A sector-level analysis also points to the importance of investment workers (77 percent) earned under 1,000 EUR a month in 2015, with 42 percent earning 500 euros or less a month (up from 30 in addi on to structural reforms (IMF, 2015). Some sectors lack “intrinsic” convergence and their produc vity growth is quite percent in 2014), which is close to the minimum wage of 370 EUR a month (Figure 5). sensi ve to investment. A prominent example is the manufacturing sector, where during the last few years investment has fallen The tax and benefit system does redistribute from high-income to low-income households (Figure 6). Households in the short of the level needed to achieve the historical average labor produc vity growth. One reason for the low level of investment lowest income decile receive more benefits than they pay in taxes, and higher income deciles pay a larger share of income in could be the weak credit environment, as the stock of bank credit has declined for many years. taxes. However, redistribu on through benefits (social insurance and social assistance transfers) is limited beyond the poorest At the same me, economic growth will need to be more inclusive to address significant income inequality and high levels 10 percent of the popula on, and the redistribu on that occurs through the tax-benefit system is much smaller than in most of informality. Despite impressive economic growth over the past two decades, growth has not been inclusive and a high share other EU economies. For example, in the U.K., the increase in disposable income due to the impact of the tax-benefit system for of the popula on (19.4 percent in 2014) are at risk of poverty. Income inequality in Latvia is among the highest among OECD the poorest decile is close to 40 percent (Mirrlees et al. 2011) compared to 15 percent in Latvia. countries and second highest in the EU a er Estonia. The Gini coefficient for incomes a er social transfers and pensions was 35.5 in 2014 compared to 25 in Slovenia, which is the most equal country in the EU. Low earners is Latvia are among the lowest earners in the EU: only in Bulgaria and Romania do the bo om 20 percent of income earners have lower incomes than in Latvia. The labor market recovery is con nuing, and unemployment among individuals aged 15-74 has fallen from its crisis peak 10 Real adjusted gross disposable income of households per capita in PPS is calculated as the adjusted gross disposable income of households and Non-Profit of 19.5 percent in 2010 to 9.6 percent in 2016. A major concern is that long-term and low-skilled unemployment remains high Ins tu ons Serving Households (NPISH) divided by the purchasing power pari es (PPP) of the actual individual consump on of households and by the total compared to before the crisis. Long-term unemployment (unemployed for more than one year) equaled 4.5 percent of the labor resident popula on. 28 29 Latvia Tax Review Latvia Tax Review Figure 6. Distribu onal impact of the Latvian tax and benefit system Figure 8. Equalized direct and indirect taxes, contribu ons and benefits, by quin les of equalized disposable income, 2014 Tax and benefit share of disposable income, by income decile group, in percent, 2014 Notes: Deciles are based on adult equalized disposable income. Nega ve values of incomes are removed and incomes more than +4 standard devia ons from the mean are top-coded. Notes: Quin les ordered from poorest to richest in terms of disposable income. Source: Calcula on based on Na onal EU–SILC 2015 (income 2014). Sources: Calcula on with EU-SILC 2015 and HBS 2014 microdata. Benefits have been simulated using EUROMOD (i.e. assuming The impact of the tax-benefit system is more regressive if the value-added tax (VAT) is considered. The es mated share full take-up of benefits based on eligibility). of the VAT in household gross income falls steadily from 14.1 percent in the first quin le to 6.8 percent in the top quin le. The distribu onal impact of VAT is es mated by using EU-SILC 2015 household survey data as the main income source, and Fiscal policy has a lower impact on inequality in Latvia than in many EU and OECD countries (Figure 9). Market income assigning annual spending on VAT to each EU-SILC household using informa on imputed from HBS 2014 as described in inequality in Latvia is not par cularly high, but the combined impact of direct taxes and government transfers is lower than in ANNEX A: VAT CONTRIBUTION TO INEQUALITY. Figure 7 presents the shares of VAT spending in household gross income by other EU countries. Benefits, especially means-tested benefits, play li le role in reducing inequality, direct taxes have only a quin le, in comparison with PIT and social security insurance contribu on (SSC) spending. small impact and pensions play a lower role than on average in the EU (Figure 12). To achieve a higher reduc on in inequality of disposable income, a broad mix of redistribu on across benefits and taxes is important. However, various combina ons can While effec ve total rate of PIT and SSC is progressive (as it grows from less than 10 percent for the first quin le to almost be used. Ireland for example, with a rela vely low tax-to-GDP ra o, achieves a large reduc on in inequality through substan al 27 percent for the fi h quin le), it appears that VAT is regressive, with lower income households paying a greater share of means-tested benefits targeted at low-income groups. their income on VAT than higher income households. This finding should be treated with some cau on, due to data limita ons Figure 9. Gini Coefficient Before and A er Taxes and Transfers, Selected Countries, 2014 (purchases made abroad or in the unofficial sector have not been iden fied and excluded from assigning VAT). However, this is unlikely to change the conclusion qualita vely. Figure 10 compares VAT spending in absolute terms with PIT and SSC spending, as well as with benefits (excluding old-age benefits) received. It appears that in each quin le households pay more in VAT that they receive in benefits. Figure 7. Es mated VAT, PIT and SSC as shares of household gross income, 2014, by quin les of equalized disposable income Notes: The OECD assumes that pensions are a government transfer (and social insurance contribu ons are a tax). In-kind spending on educa on and health is not included in the calcula ons for OECD countries. Sources: Gini before and a er taxes and transfers are from OECD for all OECD countries and from the Commitment to Equity country papers for the remaining countries. Russia’s data is for 2014. Government spending as a share of GDP is from the World Bank’s World Notes: Quin les ordered from poorest to richest in terms of disposable income. Development Indicators. Sources: Calcula on with EU-SILC 2015 and HBS 2014 microdata. 30 31 Latvia Tax Review Latvia Tax Review Figure 10. Role of Taxes and Benefits in Reducing Inequality, Percentage Point Reduc on in Gini health in par cular is lower than the EU or OECD average (Figure 12). Health outcomes lag behind not just the EU but also many of Disposable Income, EU Countries middle-income countries, and there are large inequali es in access to health care (Levin and Sinno , 2015). Figure 11. Difference in spending with comparator countries, 2014 Source: OECD Stat database. Figure 12. Difference in spending with the OECD and the EU28 average, in percent of GDP, 2014 Source: Extracted from Table 4 in Leven and Vujackov (2016). Government spending is lower than on average in OECD and EU countries, but also compared to Latvia’s peers. Latvia has a rela vely strong fiscal posi on. The deficit is projected to improve to below 1 percent of GDP by 2017, and government debt was only around 40 percent of GDP in 2014, one of the lowest ra os in the OECD. However, spending pressures are emerging. The ra o of public expenditures to GDP in Latvia was 11 percentage points below the EU average and 9 percentage points below the OECD average in 2014. Situa on has not change much since then. The spending level in Latvia is also lower than in all peer countries—Estonia, Slovakia, the Czech Republic, and Poland—except Lithuania (Figure 11). Spending on social protec on and 32 33 Latvia Tax Review Latvia Tax Review 1.4 Grey economy Table 1. Survey measure of the shadow economy Previous es mates of the grey economy Business profits Number of employees Salaries Level of bribery The shadow economy in Latvia is es mated at close to a quarter of the official GDP level, compared with an OECD average of 14.4 percent. The share of the informal sector has fallen over the past decade, but remains very large albeit similar to the size (% of actual (% of actual (% of revenue spent on payments ‘to (% of actual profits) of the informal sector in the other Bal c States. According to surveys, the tolerance of tax evasion is more entrenched in Latvia employees) salaries) get things done’) than in Estonia or Lithuania, and firms are more dissa sfied with the tax system and the government, which is a factor behind Estonia 6.7 7.6 13.6 3.4 high informality (Putnins and Sauka, 2015). It is more socially acceptable for firms and individuals to operate in the shadow economy in Latvia than in Estonia, Lithuania and on average in the EU (Williams and Horodnic, 2015). Lithuania 9.4 5.4 12.2 9.8 Es mates of unreported ac vity are difficult to make and tend to vary depending on the source and the method used. Latvia 21.7 9.6 20.3 10.2 According to es mates using cross-county macro data (calculated for 36 OECD countries, including 31 EU countries), Latvia, Source: Putnins and Sauka, 2015. along with Lithuania and Estonia, are among the EU countries with the largest shadow economy (Figure 13), exceeding 25 percent of GDP in 2013 (Schneider, 2013). There is some concern that macro model es mates are too high; detailed na onal More recently, es mates of informal employment and envelope wages in Latvia have been provided by OECD(2016: p.83). accoun ng imputa on procedures are preferred and o en yield much lower es mates of underground economy ac vity.11 Es mates of envelope wages presented below in this report are based on an approach similar to that used in OECD (2016) Similarly, a survey of company managers shows that informal ac vity accounted for 21.3 percent of GDP in Latvia in 2015. While and Hazans et al (forthcoming), but the methodology of the analysis has been further developed (for details, see Annex B: the size of the shadow economy according to this survey decreased by 2.5 p.p. of GDP over last 2 years, it remains considerably MEASURING UNDECLARED EARNINGS WITH EU-SILC DATA), the EU-SILC datasets have been amended (for this Review) with higher than in neighboring Estonia and Lithuania (Putnins and Sauka, 2016). The survey data indicates that unreported business addi onal indicators, and more recent data have been used. income, i.e. tax evasion, accounted for about 44 percent of the shadow economy in 2015. Unreported salaries remain the second largest item, although the share has been declining (Table 1). It should be noted that such survey responses may give an inaccurate representa on of the size of the shadow economy, being subjec ve in nature. It is important to have na onal Figure 15. Wage gap (in percent of total wage), 2014 sta s cal agency and tax administra on es mates using detailed na onal accounts or tax administra on data as a check on these macro model or survey es mates. Figure 13. Size of the shadow economy calculated Figure 14. Size of the shadow economy according to the survey using the es ma on procedure, 2013, in data (% of GDP), 2009-2015 percent of GDP Source: Latvia’s State Revenue Service. * Simple average for 27 EU countries. Note: The calcula on of the size and development of the shadow economy with the MIMIC (Mul ple Indicators and Mul ple Courses) es ma on procedure. Source: Schneider (2013). Source: Putnins and Sauka (2016). Es mates of informality from the World Bank The share of workers who receive their en re employee income in the form of envelope wages (complete informality) and the average (across workers) envelope share in earnings dropped in 2011 with the introduc on of the microenterprise regime, based on EU-SILC microdata (see ANNEX B: MEASURING UNDECLARED EARNINGS WITH EU-SILC DATA )Since then, the share of complete informality among all employees has declined slowly, but the incidence of par al informality (envelope earnings account for a por on of wages), as well as the average share of envelope wages in total gross earnings has remained rela vely stable (Figure 16). 11 See h p://www.oecd.org/ctp/administra on/reducingopportuni esfortaxnon-complianceintheundergroundeconomy.htm for a discussion. 34 35 Latvia Tax Review Latvia Tax Review Figure 16. Incidence of complete informality and envelope earnings (in percent of employees with posi ve earnings during Figure 17. Incidence of complete informality by category of workers the year), and average envelope wage share (in percent of total gross earnings), 2007-2014 (in percent of employees with posi ve earnings), 2013-2014 Note: The sample includes individuals with posi ve earnings in respec ve year. Source: Calcula ons based on na onal EU-SILC 2008-2015 and SRS data for 2007-2014. As expected, the share of informality is high (23 percent) among workers with temporary contracts or without contracts. Figure 17 presents the incidence of complete informality among different categories of employees in 2013-2014. The highest incidence of informality is among skilled agricultural workers (19 percent) and individuals employed in elementary occupa ons (11 percent); informality is above average (5 to 6 percent) also among skilled non-agricultural manual workers. The share of informal employees is high in forestry (20 percent), agriculture and fishing (13 percent), and other services (12 percent), followed by administra ve and support ac vi es (8 percent), construc on, warehousing and transport support (5 to 6 percent), and accommoda on and food service (about 5 percent). In other sectors, the share of informal workers varies from 2 to 4 percent. The level of informality falls with the size of the firm (from 7 percent in establishments with up to 10 employees to 2 percent in units with 20+ workers) and with educa onal a ainment (from 9 percent among low-educated to less than 2 percent among ter ary-educated employees). However, informality is not restricted to only very small enterprises or only low-educated workers: establishments with 11 to 19 workers have an above-average level of informality (5.5 percent), as do workers with secondary educa on. Informality differs by region and gender. Informality levels in Latgale and Kurzeme regions (about 7 percent of workers) are higher than in Zemgale, Pieriga and Vidzeme (about 5 percent), but among workers living in Riga less than 3 percent are informal. The share of male employees who are informal is 5.7 percent, compared to 3.6 percent for female employees (the difference is sta s cally significant). Note: The sample includes individuals with posi ve earnings in respec ve year. Source: Calcula ons based on na onal EU-SILC 2014-2015 and SRS data for 2013–2014. 36 37 Latvia Tax Review Latvia Tax Review The share of envelope wages in the economy-wide wage bill is es mated at 15.7 percent in 2014 (Figure 18). Official data Figure 19. Es mated envelope share in aggregate earnings (in percent), by quar le of gross on average earnings and number of employees in the public and private sectors suggest that the official wage bill in the private monthly earnings of full- me employees sector was twice as big as in the public sector. Assuming that there are no envelope wages in the public sector, our es mate implies that envelope wages accounted to 21.8 percent of the private sector wage bill in 2014. This is close to the es mate by Putnins and Sauka (2015) (20.3 percent of the private sector wage bill), which was obtained by a very different methodology (opinion survey, see above). The envelope share in the wage bill is higher for low-income workers, but the total amount of undeclared earnings is larger among high-income employees. Figure 18 compares the envelope share in total earnings (in the context of shadow economy a.k.a. wage gap) for four categories of workers, which roughly correspond to earnings quar les:12 low-income (annual gross earnings less than 12 minimum monthly wages), middle-low income (annual earnings between 12 and 18 minimum monthly wages), middle-high income (annual earnings between 18 and 30 minimum monthly wages) and high-income (annual gross earnings at least 30 minimum monthly wages). The envelope share in the wage bill falls with the level of earnings: since 2008, it was three to four mes higher among low-income workers than among high-income ones. The difference between middle- low and middle-high income groups is smaller and disappears in the last year of observa on (2014). The same rela onship is found in classifying data in terms of full- me monthly earnings (rather than annual earnings, which depend not only on monthly earnings but also on the number of months spent in employment), which may be more useful from a policy perspec ve (Figure 19). A comparison of Figure 18 and Figure 19 suggests that envelope wages are somewhat more widespread among workers who work part- me or are employed for less than a full year, compared to full- me workers. Figure 20 compares the incidence of envelope wage shares of at least 25 percent and at least 50 percent across the same income groups as used in Figure 18. High envelope wage shares are more o en found among low-income workers. Recently, however, these shares have increased among high-earners. Note: The sample includes individuals with posi ve earnings who spent 12 months in full- me work in respec ve year. Figure 18. Es mated envelope share in aggregate earnings (in percent), by worker income Source: Calcula ons based on na onal EU-SILC 2008-2015 and SRS data for 2007-2014. Figure 20. Incidence of high envelope share, by worker income Top panel: envelope share ≥ 25% Bo om panel: envelope share ≥ 50% Note: The sample includes individuals with posi ve earnings in respec ve year. Source: Calcula ons based on na onal EU-SILC 2008-2015 and SRS data for 2007-2014. Note: The sample includes individuals with posi ve earnings in respec ve year. Source: Calcula ons based on na onal EU-SILC 2008-2015 and SRS data for 2007–2014. 12 Results for quar les are similar. 38 39 Latvia Tax Review Latvia Tax Review Figure 22. Wage gap (envelope share in percent of total wage bill) in selected sectors: World Bank es mates compared to SRS es mates Finally, although high envelope wage shares are more o en found among low-income workers, the total amount of undeclared earnings (and hence unpaid taxes) is larger among high-income employees (see Figure 21). Figure 21. Es mated total envelope earnings, million EUR, by worker income Note: The sample includes individuals with posi ve earnings in respec ve year. Source: Calcula ons based on na onal EU-SILC 2014-2015 and SRS data for 2013-2014. Note: The sample includes individuals with posi ve earnings in respec ve year. Source: Calcula ons based on na onal EU-SILC 2008-2015 and SRS data for 2007-2014 The total amount of envelope wages is es mated to be EUR 1.3 billion in 2014, of which 40.5 percent (EUR 528 million) went to those earning at least 30 minimum monthly wages per year, while the share of this group among all employees was just 30.4 percent. High- and middle-high income workers together (those earning at least 18 minimum monthly wages per year, or 55.8 percent of all workers) received 71.5 percent of envelope wages. The envelope wage share differs across sectors, as shown in Figure 22. It stands very high (between 23 and 27 per cent of wage bill) in construc on, manufacturing of furniture and wearing apparel, agriculture, security services, trade and repair of motor vehicles, and hotels and restaurants, and reaches one-third of the wage bill in other individual services and forestry. Our microdata-based es mates are generally well in line with those obtained by SRS using different (macro) methodology. In some sectors (trade; manufacturing of food, wood products and metal products; real estate), however, the SRS es mates are higher. Our es mate is higher for forestry; in addi on we iden fy some high-risk sectors not covered by SRS es mates. 40 41 Equitable Growth, Finance, and Institutions Europe and Central Asia Region EWOLUTION OF TAX SYSTEM AND STRUCTURE Latvia Tax Review Latvia Tax Review 2. EVOLUTION OF TAX SYSTEM AND STRUCTURE Figure 24. Tax-to-GDP Ra os and GDP per capita, PPP, Figure 25. Tax revenues in Latvia and selected 2013 countries when they had similar GDP per capita 2.1 Tax system developments Latvia needs to re-design the tax system to confront future challenges. The transforma on of the world economy in recent decades through financial deregula on, the growth of mul na onal companies using global supply chains and increasing digi za on have been very posi ve developments for Latvian economy, but they also pose challenges to the tax system, including by driving global tax avoidance ac vi es. Likewise, with the opening of borders people become very mobile which impacts employment, human capital and social protec on systems. The tax system needs to adapt to these challenges. Concerns about the regressive nature of the tax system and about tax compliance further underline the need for a review of the design of the tax system and the priori es for strengthening tax administra on. Tax revenues rose only slightly a er the flat tax rate was introduced in 1997 (see Figure 23). PIT revenues increased by a similar amount as in Estonia a er introduc on of a flat tax, as to be expected given that the marginal tax rates remained unchanged or increased, and CIT also increased. In a survey of the lessons to be learned on the impact of the latest wave of flat taxes, Varsano, Kim and Keen (2006) find that there is no evidence of Laffer-type behavioral responses due to tax cuts, and that the theore cal basis for the impact of flat taxes on compliance is ambiguous. Russia is the one country where revenues strongly increased following introduc on of a flat tax regime (PIT revenues rose by almost a quarter a er the flat tax reform in 2001), due mainly to improved tax compliance (Ivanova, Keen and Klemm, 2005).13 The rise in revenues in Latvia may have been par ally due to a series of reforms aimed at reducing tax avoidance and tax arrears. In gauging the impact, an assessment also should be Source: World Bank’s World Development Indicators and IMF. made of the impact of the move toward a flat PIT tax in 1994, when the 25 percent tax rate was introduced with the 10 percent tax rate for high incomes. Latvia’s ra o of consump on taxes (VAT) to output is slightly higher, but the ra o of PIT and CIT revenues lower, than the average of OECD countries (Figure 26 and Figure 27). Lower PIT revenues and social security contribu ons explain almost 80 Figure 23. Total tax revenue, years before and a er reform, in percent of GDP percent of the difference with the EU average and about 72 percent of the difference with the OECD average. The sum of PIT revenues and social security contribu ons in Latvia is the lowest among regional peers (the Czech Republic, Estonia, Poland and Slovakia) except Slovakia, due to a lower standard rate for SSCs (Table 3), despite a high PIT rate and a small non-taxable personal allowance. Similarly, Latvia’s revenues from CIT as a percentage of GDP are the lowest in the group. On the other hand, Latvia collects more VAT revenues as a percent of GDP than its regional peers, except for Estonia. Figure 26. Difference between the level of tax-to- Figure 27. Difference between the level of tax-to-GDP in GDP in selected countries and Latvia, percentage selected countries and Latvia, percentage points, 2015 points, 2015 Source: Varsano, Kim and Keen (2006). Latvia has scope to raise more revenue from taxes. Latvia’s tax-to-GDP ra o was 29.3 percent in 2014 (and 29.5 in 2015), fourth lowest in the EU and far below the 40 percent EU average and the 34.2 percent OECD average. Controlling for the level of development, only small islands (like the Bahamas, Mauri us, and An gua and Barbuda) or resource-rich economies have lower tax ra os than Latvia. The tax-to-GDP ra o in Latvia is below what Ireland, Denmark, Austria, and Finland had when they were at the same point in their development (Figure 25). Compared to Estonia, Lithuania, Poland, Slovakia, and the Czech Republic, only Lithuania has lower tax revenues. Source: Eurostat. Source: OECD, SRS. 13 This may have been due to efforts to raise tax compliance, but also because of the reduc on of incen ves against incorpora on at higher income levels following the removal of the 10 percent marginal tax rate on higher incomes. 44 45 Latvia Tax Review Latvia Tax Review Table 2. Composi on of taxa on, 2015, in percent of total tax revenue Cap (percentage of AW) 694% - - 589.3% 250.0% 400.0% Self-employed social security 28.2% 33.0% 37.5% 47.2% 29.0% 21.4% Czech contribu on rates Latvia Estonia Slovakia Poland OECD Average R. Employer health care - - 6% 14% 9% 9% Personal income tax 20.6 17.3 21.3 27.4 10.8 40.8 contribu on ***) Corporate income tax 5.5 6.2 9.2 11.9 10.7 8.3 Employee health care - - 3% 4% - 4.5% contribu on Social security contribu ons 28.9 33.5 26.2 27.4 43.5 23.7 Self-employed health care - - 9% 18% 9% 13.5% Payroll taxes 0.0 0.0 0.0 0.0 0.0 0.0 contribu on ***) Property taxes 3.4 0.8 3.8 2.9 1.1 10.4 Taxes on good and services General consump on taxes 27.1 27.4 24.9 21.5 22.0 7.7 VAT standard rate 21% 20% 21% 20% 23% 21% Specific consump on taxes 12.0 13.5 11.9 7.3 10.2 6.7 Tax base (consump on), per €7,974 €8,754 €8,620 €9,230 €7,252 €8,737 Other taxes 2.4 1.3 1.8 1.6 1.7 2.4 capita, EUR Tax base (% of GDP) 67.7% 57.7% 69.6% 66.2% 67.1% 59.4% Labor taxa on 49.5 50.8 47.5 54.8 54.4 64.4 Notes: *) addi onal solidarity taxes in Latvia (from 2016) and the Czech Republic since 2013; **) Opera ng surplus = 104284, Capital taxa on 9.0 7.1 13.0 14.8 11.8 18.7 but the tax base for Estonia is not based on corporate income but on corporate distribu ons ***) paid by employee, 86 percent Consump on taxa on 41.6 42.2 38.6 30.4 33.8 16.8 (7.75 percent out of 9 percent) of health-care contribu on is deduc ble from Personal Income tax, MET: microenterprise tax. Tax base is the theore cal amount on the basis of which tax liability should be calculated—it is equal to wage bill for personal Source: OECD, SRS. income tax and social security contribu ons (as these taxes are, by defini on, levied on wages), gross opera ng surplus for corporate tax and consump on for VAT (as VAT is, ideally, meant to act as consump on tax). Tax credit is the lump-sum amount Table 3. Tax system characteris cs, Latvia and peers, 2016 that is deducted from the total tax liability paid by tax payer. Basic allowance is the income that is exempted from tax. In the table, tax credit was divided by the minimal tax rate such that tax credit and basic allowance are comparable between countries. Latvia Estonia Lithuania Slovakia Poland Czech R. Sources: OECD, KPMG. Personal Income tax The ra o of tax revenues to GDP in Latvia has been rela vely stable since 2000, fluctua ng at around 29 percent of GDP, Top/bo om PIT rate 23% * 20% 15% 19%/25% 18%/32% 15% *) about 5 percentage points below the OECD average and 10 percentage points below the EU average. The tax-to-GDP ra o dropped from 31.8 percent of GDP in 1998 to 27.4 percent in 2003, as revenues from SSCs and VAT fell, but then reversed Tax credit/basic allowance 13.7% 13.9% 31.6% 32.3% 7.2% 40.0% direc on as revenues from CIT and consump on taxes went up (Figure 29). The economic and financial crisis caused Latvian tax (% of Average Wage, AW) revenues to fall again, to 27.2 percent, led by consump on taxa on, followed by a gradual recovery to the levels registered in Top PIT rate threshold mid-2000. Similarly, the ra o in the OECD and the EU15 as a whole were rela vely stable between 2000 and 2008 (Figure 28 and (expressed as a mul ple of 0.1 0.1 0.3 3.9 2.4 0.4 Figure 29). By 2013 almost all OECD and EU countries had managed to recover from the crisis-related drops in 2008 and 2009: AW) the average tax-to-GDP ra o in OECD countries was 34.4 percent in 2015 compared with 34.2 percent in 2000. Tax base (wage bill), per Figure 28. Tax-to-GDP Ra o, Latvia and Benchmark Figure 29. Difference between the tax-to-GDP ra o €11,141 €14,754 €10,995 €12,076 €9,687 €12,501 employed person, EUR Countries, 2000–2015 in given year and 2015 (in percentage points) Tax base (% of GDP) 42% 46% 40% 38% 37% 40% Corporate Income tax 22%/mini 19% 15%/9% Top/bo om CIT rate 20% 15%/5% (MET) value (EUR (lump sum 19% (MET) 480) PIT) Tax base (opera ng surplus of €114,447 - **) €115,375 €100,366 €104,511 €81,694 firms), per firm, EUR Tax base (% of GDP) 47% 41% 50% 53% 51% 51% Social Security Contribu ons Employee social security 10.5% 2.0% 3.0% 9.4% 19.1% 8.5%/6.5% contribu on rate Employer social security 23.6% 34.0% 27.98%/29.6% 25.2% 21.0% 25.0% contribu on rate Source: Eurostat. Source: Eurostat. 46 47 Latvia Tax Review Latvia Tax Review Despite some decline since 2000, the effec ve taxa on on labor remains significantly higher than on consump on and Figure 32. Revenue fron er, average revenue, and actual taxes collected in Latvia, 2006–13 capital (Figure 30). In Latvia, the implicit tax rate on labor dropped from 36.5 to 33 percent, compared to an average decline of about 2.5 percentage points in the neighboring countries and less than 1 percentage point in the EU. The decline in Latvia was driven by the reduc on in PIT revenues, as SSCs increased. The effec ve tax rate on consump on in Latvia did not change much between 2000 and 2012 (similar to the EU average) despite an increase in VAT rates, perhaps due to changes in consump on pa erns, introduc on of a new system of VAT returns, and some VAT base erosion. By contrast, effec ve taxa on of consump on for both Poland and Estonia surged in response to the rate increases (Figure 31). Finally, Latvia’s implicit tax rate on capital is now one of the lowest in the EU, having declined by about 2 percentage points from 12.3 percent in 2000. The drop came because the reduc on in the CIT rate for microenterprises during the crisis was not compensated for by the broadening of the tax base and the higher tax rates for dividends, interest income, and capital gains. Figure 30. Effec ve (implicit) tax rates, 2012 Figure 31. ITR on consump on, selected EU countries, 2012 Note: The end date for es mate is determined by the data availability for countries in global sample. Source: World Bank staff calcula ons based on data from Eurostat, the IMF’s Global Finance Sta s cs, and the World Bank’s WDI, World Governance Indicators and Doing Business databases. Source: Eurostat. 2.1 Poten al areas for mobilizing revenue A country’s poten al for raising addi onal revenue may be measured in terms of distance to its peers, taking into account a range of characteris cs likely to affect revenue-raising capacity. The appropriate level of taxa on depends on country characteris cs—economic (level of development, openness to external partners, sectoral structure, size and structure of the firms), poli cal (the choices and preferences of the society), ins tu onal (the effec veness of government, the efficiency of tax administra on, labor market ins tu ons and types of contracts), and even geographical (long and leaky borders, extent of territory, popula on density). That is why it is hard to derive an “op mal” size of government. It is useful, nonetheless, to have some sense of the poten al for raising revenues. For this, two complementary approaches are adopted. The first compares Latvia’s tax revenues with the average for its peers, controlling for a range of characteris cs likely to affect revenue raising. The second compares a country’s tax ra o with the maximum achieved by others with similar characteris cs (see ANNEX B: MEASURING UNDECLARED EARNINGS WITH EU-SILC DATA). Both approaches are simply indica ve; they need to be interpreted with cau on. The calcula ons indicate how much more can be done but the decision about whether to do more is up to the authori es. In Latvia, tax receipts are lower than predicted for its income level—not surprisingly, given that the tax-to-GDP ra o is low compared to peers. Latvia would increase its tax revenues by about 5 percentage points of GDP if it collected the same level of taxes as its average country peer (see the black-do ed line in Figure 32). The blue line shows the actual tax collected in Latvia. The red-do ed line in the figure below shows the maximum revenue generated by a country with the same level of ins tu onal development as Latvia. These es ma ons are in line with previous results that found that tax revenues in Latvia were 6 to 10 percentage points of GDP below the predicted level based on income (Torres 2013, Minh Le, Moreno-Dodson, and Bayraktar 2012). 48 49 Latvia Tax Review Latvia Tax Review 3. PERSONAL INCOME TAX AND SOCIAL SECURITY CONTRIBUTIONS the wages of employees, underreport the formal wage (e.g. only report the minimum wage), or go informal. The tax wedge be- tween total labor costs to the employer and the corresponding net take-home pay for average single workers without children 3.1 Labor income and social security contribu ons in EU28 countries varied between Belgium (49.9 percent) and Malta (18.8 percent) in 2015. Latvia is on the higher end with a Latvia’s personal income tax (PIT) is imposed at a flat rate of 23 percent. In addi on, there are flat-rate social-security tax wedge of 42.3 percent (Table 4). It should be noted that the tax wedge is a so-called synthe c measurement, meaning it is contribu ons (SSCs). Employers pay a SSC rate of 23.59 percent of gross earnings and employees pay a SSC rate of 10.5 percent purely based on legisla on and therefore measures what individuals are supposed to pay, not what they actually pay, in taxes of gross earnings. Some degree of progressivity is nevertheless achieved, in several ways. First, incomes below a minimum and social security contribu ons. In the case of Latvia, the social contribu on as a percent of GDP at 6.0 percent in Latvia is less threshold level are en rely exempt from the PIT. Second, there are allowances for dependents, persons with disabili es, than countries with a lower tax wedge (for example, compared to 11.1 percent of GDP in Estonia).14 Social security tax collec on poli cally repressed persons and par cipants of the na onal resistance movement, and expenses for educa on and medical depends on the wage bill, employment rates, exemp ons and compliance and so the effec ve tax rate may diverge from the services. These are all uniform; i.e., they are independent of earned income. As a result, they have a propor onately greater statutory rates set. impact on the taxable income of lower-income taxpayers. There is no consensus in the empirical literature on whether it is the employee or the employer who bears the burden of In recent years, the government has altered the PIT structure in ways that affected its progressivity. In 2009, it lowered the labor taxa on. A range of results have been found using within-country varia on, i.e. differences in tax and social contribu on non-taxable minimum (the minimum level of income subject to the PIT) thus increasing the number of lower-income households schedules for different individuals or firms in a country, to es mate the incidence of labor taxa on. By contrast, es mates using subject to the tax. Since then, it has gradually increased the non-taxable minimum. It has also increased the amount of the cross-country or me series varia on in the labor tax burden ini ally mostly found that the burden falls largely on workers, but allowance for dependents. As a result, the structure of the PIT has become slightly more progressive (Figure 33). more recent studies using updated es ma on strategies have found more mixed evidence (Hofer et al 2015). High employer contribu ons to social security leads to high wage costs, especially for low-skilled workers and the youth, and reduces their job Figure 33. Changes in non-taxable minimum and allowances for dependents, 1994–2016 opportuni es in the formal sector. In Latvia, a concern is that high employer contribu ons to social security leads to high wage costs, especially for low-skilled workers and the youth, and reduces their job opportuni es in the formal sector. Table 4. Tax rate indicators in 2014 in the EU countries, in percent Tax wedge on labor Unemployment trap Low wage trap— Low wage trap - one costs single person earner couple with without children two children EU28 34.9 73.8 47.3 61.8 Belgium 49.9 93.0 60.7 48.8 Bulgaria 33.6 81.6 30.1 40.8 Czech Republic 39.6 80.2 48.9 91.4 Denmark 34.1 90.0 77.3 89.5 Germany 45.1 73.0 56.2 89.5 Estonia 39.0 63.7 24.2 33.7 Ireland 22.0 73.2 46.5 72.6 Greece 35.8 50.3 21.9 19.0 Spain 37.3 81.7 30.3 14.8 France 45.1 77.4 51.8 83.8 Croa a 36.1 81.0 29.9 23.8 Italy 42.3 79.5 37.8 0.3 Source: Ministry of Finance, Latvia. Cyprus* 11.9 61.5 6.3 114.5 Latvia 42.3 88.7 32.0 50.7 For policy-making purposes, the progressivity of the income tax should be analyzed in terms not only of the tax structure, Lithuania 38.9 61.5 26.8 84.6 but also the system of social benefits. Apart from through the tax structure, income distribu on objec ves are achieved in Latvia through two social assistance programs: housing assistance and a guaranteed minimum income (GMI). Both are means Luxembourg 30.5 86.7 57.9 107.7 tested; benefits are dropped en rely when gross income crosses the relevant threshold. Hungary 49.0 78.5 37.4 39.4 Taxes on labor—personal income taxes and social security contribu ons—directly reduce labor demand by driving up Malta 18.8 57.7 22.1 22.3 labor costs for employers and reduce labor supply by lowering a er-tax wages. As such labor taxes create a “tax wedge” be- tween labor cost to the employer and the worker’s take-home pay and thereby reduce both employment and economic growth Netherlands 31.4 82.2 71.9 63.8 (see ANNEX G: IMPACT OF LABOR TAXES ON EMPLOYMENT AND WAGES) on the impact of labor taxes on growth). The higher the Austria 44.9 67.9 42.8 97.1 marginal effec ve tax rate, the lower the incen ves for the employee to look for work or to work addi onal hours. In the face of higher labor costs, due to their share of the payroll taxes, employers can reduce employment, reduce working me, reduce 14 Source: The IMF’s World Revenue Longitudinal Data set 2015 (WoRLD). In: h p://data.imf.org/?sk=77413F1D-1525-450A-A23A-47AEED40FE78 50 51 Latvia Tax Review Latvia Tax Review Poland 33.6 77.6 61.0 44.9 Figure 34. Increase in net income as work effort increases for one earner couple with 2 children, selected countries Portugal 34.9 79.9 27.7 24.3 Increase in net income vs non-work income Romania 41.0 50.6 31.1 34.7 Slovenia 38.6 89.7 48.5 58.2 Slovakia 38.7 44.5 26.2 51.4 Finland 38.2 81.5 55.8 100.0 Sweden 40.5 69.5 38.7 69.3 United Kingdom 26.2 62.4 48.1 80.5 Iceland 29.3 84.8 47.4 61.2 Norway 33.8 75.6 34.0 96.2 Switzerland 19.4 … … … United States 29.5 69.7 28.5 70.7 *-2007 Source: Eurostat Sta s cs Explained (2016). Wages and labor costs. h p://ec.europa.eu/eurostat/sta s cs-explained/ index.php/Wages_and_labour_costs. Low-income workers in Latvia can face a rela vely high effec ve marginal tax rate (EMTR). The EMTR is the percentage of an addi onal euro of income that the individual loses due to personal income taxes, social security contribu ons, and a fall in Note: In-Work Benefits: United Kingdom (Working Tax Credit), United States (Earned Income Tax Credit); Tapered social assistance and other benefits. The loss of unemployment and other social benefits coupled with labor taxes can create withdrawal of Social Assistance in France, Australia. Latvia baseline is the situa on in 2013 and Latvia sim represents a unemployment traps. These are situa ons where unemployed or informally employed people have a financial disincen ve to reform scenario simulated in 2013. seek formal sector employment since the level of social benefits they receive as registered unemployed are higher than their Source: Strokova and Damerau (2013) based on OECD tax-benefit model for 2013. net earnings would be if employed formally and losing those benefits. In other words, when unemployed workers go back to work, they do lose unemployment benefits, all or some of the social assistance and other benefits paid to the family of the High marginal tax rates can have a substan al impact on employment. High statutory taxes on labor can reduce labor de- unemployed, while having to pay social security contribu ons and income taxes. In Latvia, low-income workers face extremely mand and reduce incen ves for individuals to seek employment or work longer hours, thus reducing tax compliance, increasing high EMTRs at the point at which their incomes cross the threshold for social assistance eligibility. Because benefits drop to zero informality and reducing economic growth (see ANNEX G: IMPACT OF LABOR TAXES ON EMPLOYMENT AND WAGES). Most stud- at that point, earners face an EMTR of 100 percent. An unemployed worker who secures a job faces an EMTR (referred to as the ies from developing and transi on countries es mate the rela onship between a change in labor taxes and a change in employ- “unemployment trap”) of 88.7 percent, one of the highest in the EU (Table 1). Thus, unemployed workers have li le incen ve ment in the -0.20 to -0.60 range, i.e., a 10 percent decrease in the cost of labor would cause employment to rise by between 2 to return to the (formal) labor market. Latvia’s employment services par ally address this issue by encouraging the unemployed and 6 percent (see ANNEX A: VAT CONTRIBUTION TO INEQUALITY). Thus, reduc ons in employer social security contribu ons to look for work and to par cipate in training programs. More funding for these programs could improve their coverage and can be effec ve in raising employment of low-skilled workers (Gill et al, 2013), par cularly where the link with benefits is weak increase the intensity of case management (OECD, 2016). (e.g., for health expenditures). Austria, Belgium, France, the Netherlands, Spain, and the United Kingdom have cut social secu- rity contribu ons by low-paid workers by about 1.5 percentage points since 1997 (IMF, 2011). Encouraging labor force par cipa- Marginal tax rates on increases in earnings by employed, low-income workers (the “low wage trap”) are more moderate on, in turn, can have wider social benefits, through increasing social cohesion (Kanbur et al. 2006). than those faced by the unemployed. The share of gross earnings taxed away by the combined effect of the levied taxes, social contribu ons, and the withdrawal of social benefits, when an employee’s gross earnings increase from a third to two-thirds of While the statutory tax rates on labor are high in Latvia, the effec ve tax rate is low. The difference between total labor the average wage, was 32 percent in 2015. This is below the EU average of 47.3 percent (Table 1). These rates vary by household costs to employers and net take-home pay to workers is 42.3 percent in Latvia, compared to an average of 34.9 percent in the characteris cs that are taken into account by the tax rules. For example, the low wage trap for one earner couple with two chil- EU28 countries and 29.5 percent in the United States (Table 5). However, these high statutory tax rates have not succeeded in dren was 50.7 percent in Latvia compared to the average of 61.8 percent in EU28. genera ng large revenues, due to exemp ons and compliance issues. PIT and social security contribu on tax collec on as a share of GDP in Latvia is one of the lowest in the EU28 countries (Table 5).15 In Latvia, addi onal earnings generate no increase in net income un l they exceed 40 percent of the average wage (Figure 36). In the UK, addi onal earnings begin to generate significant addi onal net income when they surpass ten percent of the average The current pa ern of EMTRs in Latvia does not sa sfy the criteria for an op mal tax system. A discussion of op mal tax wage. In France and Australia, addi onal earnings increase net incomes almost immediately, although at modest levels. In the theory and its insights for se ng marginal tax rates is given in ANNEX C: METHODOLOGY OF ESTIMATING REVENUE GENERATION United States, the earned income credit generates significant increases in net income immediately. POTENTIAL FOR LATVIA. An op mal income tax system should feature marginal tax rates that start out high at the bo om, because income-dependent support (e.g. GMI) is phased out. Then, taxes should decline towards the mode of the earnings distribu on, since distor ons imposed by high marginal tax rates increase while distribu onal benefits decrease. A er the mode, depending on the empirical distribu on of earnings, the marginal tax rate may increase un l it reaches the top rate. Currently, marginal tax rates at the bo om are too high (in some cases 100 percent) and tax rates are flat at 33.5 percent for all incomes above the minimum income. The Latvian government could consider adjus ng the structure of EMTRs to a stronger U-shape by (i) making the tax system more progressive; (ii) reducing the welfare loss of the tax system; (iii) raising revenue, or by a combina on of all three. Efforts to reduce evasion of social security contribu ons can impose high taxes on low-income workers. Some countries 15 The IMF’s World Revenue Longitudinal Data set 2015 (WoRLD). In: h p://data.imf.org/?sk=77413F1D-1525-450A-A23A-47AEED40FE78 52 53 Latvia Tax Review Latvia Tax Review impose a minimum level of social security contribu ons per worker, to improve compliance. Social contribu on payments tend Sweden 12.26 9.80 7 31.42 38.42 to accrue around the level of minimum contribu on, sugges ng that many firms report only wages that are close to the nego - ated minimum contribu on threshold. Hungary addressed this issue by se ng the employer’s social contribu on base at twice U n i t e d 9.16 6.22 11.1 13.8 24.9 the minimum wage, unless the employer declares that workers are indeed earning the minimum wage (which, in turn, raises the Kingdom risks of a tax audit). In Latvia, the government decided not to impose a mandatory minimum state social insurance contribu on *- 2012 based on the minimum wage, which had been due to come into effect on January 1, 2017.16 The objec ve had been to reduce Source: SSA and ISSA (2014); The IMF’s World Revenue Longitudinal Data set 2015. underrepor ng of income. The mandatory minimum social insurance contribu on scheme could have reduced the employment prospects of low-wage, par cularly part- me,17 workers who would have had to pay dispropor onally higher taxes on earned Establishing different social contribu on rates can reduce the marginal tax rate faced by low-income households while incomes. It also would have limited the capacity of employers to respond to economic condi ons by reducing working hours. minimizing the loss in social security contribu ons. Income taxes and social security contribu ons may be subject to a floor, Table 5. Personal income tax and social contribu ons as a percent of GDP in 2013, and social contribu on rates paid by a ceiling, tax brackets, tax exemp ons, personal basic exemp ons, and tax credits (see ANNEX G: IMPACT OF LABOR TAXES ON insured persons and employers in 2013/2014 in EU countries, in percent EMPLOYMENT AND WAGES) for a detailed list of experiences from European countries). Some countries set a lower minimum level of social contribu ons for certain categories of workers (e.g. self-employed workers or farmers, or differen ated by Social Contributors occupa on and industrial branch, as in Bulgaria, or for youths, as in Switzerland, or for the disabled, as in Slovakia). Some PIT as % of GDP contribu on as countries have established lower contribu on requirements for employers or workers if earnings are below a benchmark, or % of GDP Insured persons Employers Total contribu on rates generally vary according to the level of taxable earnings (e.g., U.K. and Austria). Lower contribu on rates also have been provided for small enterprises (e.g. in France),18 and differen ated rates have been assigned to ac vi es that Austria 9.77 14.59 17.2 25.15 42.35 are associated with higher risk of accident or disease. Finally, some social insurance benefits can be financed by general tax Belgium 12.73 14.16 13.07 24.8 37.87 revenues rather than taxes specific to labor. Bulgaria 2.95* 7.02* 12.9 17.8 30.7 Increasing the ceiling on income subject to social security contribu ons can raise resources without increasing the Croa a 2.99* 11.45* 20 15.2 35.2 marginal tax rate facing low-income workers. Virtually all countries set a maximum to the base used to determine social security contribu ons, in part because without a ceiling contribu ons from the highest earnings brackets would be much Cyprus 3.64* 8.35* 7.8 7.8 15.6 greater than the eventual benefits. However, most countries introduce some progressivity in the tax system by se ng higher Czech R. 3.66 14.76 11 34 45 personal income tax rates for higher income levels. Progressivity is limited in Latvia, where personal income is taxed at a flat Denmark 26.37 0.79 8 0 8 rate, regardless of income. Moreover, ceilings introduce some discon nuity in the effec ve marginal tax rates as income rises, which is at odds with the goal of fla er and smoother schedules aimed for under flat tax regimes. On the other hand, ceilings can Estonia 5.50 11.09 4 34 38 reduce incen ves for tax avoidance among high earners, and may help reduce the incidence of high-income workers emigra ng Finland 12.91 12.73 8.41 22.19 30.6 to reduce their tax burden. In Latvia star ng in 2016, workers were required to pay contribu ons on income exceeding the France 8.35 16.75 13.2 37.5 50.7 former maximum of EUR 48,600 (the solidarity tax). Germany 9.55 13.98 20.175 20.575 40.75 Financing of social protec on for the self-employed is a difficult issue, due to on the one hand the poten al for evasion and on the other the desire to avoid imposing high labor taxes on poor workers. The number of self-employed in Latvia rose Greece 6.95* 10.62 12.05 23.6 35.65 from 87,400 in 2008 to 100,500 in 2015 (11.6 percent of the total employment), of which 36,500 were self-employed persons Hungary 5.05 12.86 16 27 43 with employees (employers), and 64,000 were self-employed persons without employees (own-account workers). Similar to Ireland 9.27 4.40 4 4.25 8.25 many other EU countries (see ANNEX H. OPTIONS FOR DIFFERENTIATED SOCIAL CONTRIBUTION RATES), Latvia sets a minimum amount of earnings subject to contribu ons (EUR 4,440 per year in 2016). Self-employed persons are insured if their income Italy 11.57 12.98 9.19 33.68 42.87 exceeds the minimum amount of the base for compulsory contribu ons defined by the Cabinet of Ministers. Social insurance Latvia 3.95* 6.01* 10.5 23.59 34.09 contribu on rates differ among categories of self-employed, and were the following in 2016: (i) self-employed persons (also Lithuania 12.02 … 9 31.17 40.17 those with disabili es of group I or II) insured for risks of old-age, death, sickness, parental leave, maternity, and disability: 30.58 Luxembourg 8.98 11.27 12.7 11.95 24.65 percent; (ii) self-employed persons over re rement age and persons who receive old-age pension (including pre-re rement pension) insured for risks of old-age, death, parental leave, maternity, and sickness: 28.21 percent; (iii) individuals carrying out Malta 6.43* 6.98* 10 10 20 management of real estate and registered as tax payers for income gained from economic ac vity who are insured for risks of Netherlands 7.34* 14.95* 22.7 19.07 41.77 old-age and disability: 26.19 percent. In Latvia, self-employed persons do not make social insurance contribu on payments Poland 4.52* 12.11* 22.71 19.38 42.09 concerning insurance against occupa onal accidents and insurance against unemployment, as they employ themselves and bear responsibility for their working condi ons and safety (some EU countries do require self-employed persons to contribute Portugal 7.68 8.93 11 23.75 34.75 to unemployment insurance—see ANNEX A: VAT CONTRIBUTION TO INEQUALITY). Romania 3.57* 8.87* 16.5 28 44.5 Slovakia 2.55 13.29 13.4 33.2 46.6 Some countries have used ‘income disregards’ or tax credits to improve progressivity and reduce the marginal tax rate faced by low-income workers. Under an income disregard, a certain percentage of income over the threshold is disregarded Slovenia 5.32 14.75 22.1 16.63 38.73 in calcula ng a worker’s tax liability or eligibility for social assistance payments. Many OECD countries, for example, disregard Spain 7.32 11.28 6.25 31.13 37.38 a certain percentage of earned income for the purposes of calcula ng social assistance benefit eligibility or amounts. Under a tax credit, workers receive a matching grant for each addi onal unit of income, up to a ceiling. Under the U.S. Earned Income 16 In 2016, a minimum amount for voluntary contribu ons was not set for the employees of micro-enterprises, who could join the state social insurance volun- Credit (EIC), for example, the matching level starts at 21 percent (for a family with more than one child). In other words, the first tarily. Contribu ons were made from freely selected income that did not exceed 720 euro a month. h p://www.vsaa.lv/en/services/employees/contribu ons. A change has been made whereby an employer, who has the status of a payer of the micro-enterprise tax, has to pay social insurance contribu ons based on the 18 There is no evidence that targeted tax relief for small firms is more effec ve in increasing aggregate employment than general tax relief for businesses. In minimum wage for each employed. In 2017, a transi on period is planned and the taxable amount is 75 percent from the minimum salary. fact, special relief may reduce employment by lowering incen ves for firm growth. Also, small firms tend to pay lower wages, offer more modest benefits, and 17 From Eurostat data, in 2015, there were 63,000 part- me workers in Latvia, or 7.2 percent of the total employed popula on aged 15-64. provide poorer working condi ons than large firms do (Brown et al, 1990; IMF, 2012). 54 55 Latvia Tax Review Latvia Tax Review dollar of earned income is matched by a grant of 21 cents. The matching propor on increases gradually as income rises and then Box 1. Calcula ng the op mal top rate for Latvia declines. Families with incomes over US$ 52,000 are ineligible for the EIC. An income disregard could significantly increase the coverage of the GMI—at a very low addi onal cost. Based on 2013 Saez (2001) has shown that the welfare-op mal top tax rate can be calculated using only three sta s cs: the Pareto calcula ons, assuming a 25 percent earned income disregard, GMI coverage would increase to 25 percent of the popula on, parameter for the top of the earnings distribu on, the elas city of taxable income (ETI), and the social welfare weight for top- climbing to 63 percent for those at risk of poverty.19 Despite such an increase in coverage, the total cost of the program would income earners. The welfare-maximizing marginal top rate T’(y) can be computed as T’(y) = (1—g)/(1—g + αε), where g is the rise to just 0.6 percent of GDP (Strokova and Damerau 2013). Alterna vely, an earned income tax credit could be introduced. It social welfare weight of top-income earners, α is the Pareto parameter, and ε is the ETI.1 The revenue-maximizing or ‘Laffer should be noted that either of these measures can be administra vely costly. With this in view, Latvia might consider the recent rate’ is obtained by se ng the welfare weight of top-income earners at zero (g = 0). Tax policy then only ‘soaks the rich’. It reforms in the U.K., which consolidated its means-tested benefits and tax credits into one program administered through the tax is generally not desirable to set the top rate beyond the Laffer rate. If top tax rates are higher than the Laffer rate, reducing system—the Universal Tax Credit (UTC). the top rate cons tutes a Pareto improvement: it raises more revenue and imposes fewer distor ons, while no one is worse There is a case for increasing the rate on higher incomes in Latvia. As noted above, the PIT rate is a flat 23 percent for off. The revenue-maximizing rate increases when the top tail of the earnings distribu on is ‘fa er’, i.e., when the Pareto all incomes above the minimum. Given that PIT accounted for about 20 percent of total tax revenues (see chapter 2) and the parameter α is lower. The revenue-maximizing top rate decreases when the ETI (ε) is higher. A higher top rate then causes regressivity of other major tax instruments (e.g., the VAT),20 there is a strong case for increasing the rate on higher incomes. more economic distor ons, avoidance and evasion. The revenue-maximizing top rate is not equal to the welfare-op mal top Whether to introduce a separate top bracket, or increase its rate, fundamentally rests on poli cal valua ons regarding the rate, since it is impossible to calculate the op mal top rate without making an intrinsically poli cal judgment regarding the social value of income for top-income earners (Box 1). Preliminary calcula ons suggest that an increase in the current top rate social welfare weight of top-income earners. A Rawlsian government only cares for the poor, and thus a aches a zero welfare of 23 percent is feasible and would contribute to more income redistribu on or public revenue. Such an increase carries risks, weight to the top-income earners (g = 0). Consequently, it sets the top rate at the revenue-maximizing rate. For any posi ve of course. A higher top rate could weaken incen ves for work and entrepreneurship and increase avoidance and evasion. These social welfare weight for the top-income earners (g > 0), op mal top rates are below the revenue-maximizing rate. behavioral responses can be taken into account by using quite conserva ve es mates for the elas city of taxable income (ETI) of top-income earners21 (see also ANNEX E ELASTICITY OF TAXABLE INCOME OF HIGH-EARNERS IN LATVIA.). Nevertheless, some The top of the income distribu on can be characterized well by a Pareto distribu on in most countries in the world increase in the rate on higher incomes should be considered. (Atkinson, Pike y and Saez, 2011). By using data on income percen les from Eurostat we calculate a provisionary es mate of the Pareto-parameter for the top of the Latvian earnings distribu on.2 Let earnings be denoted by y. And let the cumula ve distribu on be Pareto and denoted by F(y). When the income distribu on is Pareto, there exists a linear rela onship between ln(1-F(y)) and ln(y).3In Figure 37, we plot this rela onship for the 90-99 percen les of the earnings distribu on. Strikingly, the rela onship is indeed nearly linear (R2 = 99 percent), hence the Pareto distribu on provides a good fit. The implied Pareto parameter equals 3.3, which is among the highest in the world (Atkinson et al., 2011)4. However, given that there is large income inequality according to the Gini coefficient, we expect the Pareto-parameter to be biased upwards considerably due to (possible) top coding in the tax data and tax evasion/avoidance, which result in underrepor ng of top incomes. We use a baseline value of 3.0 and values between 2.5 and 3.5 as robustness checks given that there is large uncertainty in this parameter. For our computa ons, we use a range of values of the ETI between 0.2 and 0.5, which is in line with our review of es mates and our own ETI es mate for high income tax payers. Based on our es mate (see ANNEX E ELASTICITY OF TAXABLE INCOME OF HIGH-EARNERS IN LATVIA.) the elas city of high-income taxpayers to tax rates, es mated based on the introduc on of the solidarity tax in 2016, is around 0.13 and 0.2 depending on the sample selec on. Figure 35. Es ma ng Pareto parameter in Latvia 19 At present, only three percent of the popula on receives GMI, due to the low ceiling on eligibility and its strict enforcement. (Gotcheva and Sinno , 2013). 20 As noted in Chapter 1, the VAT (which accounts for 27 percent of total tax revenue) is effec vely regressive: the es mated share of the VAT in household Source: Calcula ons based on Eurostat data. gross income falls steadily from 14.1 percent in the first quin le to 6.8 percent in the top quin le. 21 Behavioral economics has given a number of reasons why op mal marginal taxes could be useful to correct externali es or internali es. Op mal top rates can be increased to stop status or rat races when consump on is a status good, causes rivalry or induces keeping-up-with-the-Joneses’ effects (Akerlof, 1976; Layard, 1980; Kanbur et al. 2006). However, also leisure can be a status good (Alesina et al., 2005) or high leisure consump on could erode work ethic (Lindbeck and Nyberg, 2006). In that case, op mal labor taxes should be lowered to internalize these externali es and internali es. The net effect of these behavioral-economic aspects is unclear and should be weighed by poli cians. 56 57 Latvia Tax Review Latvia Tax Review Table 6. Op mal top rates PIT Latvia 1. 3- er +1.6% -.316 Table 6 gives the calcula ons for the op mal effec ve top rate for Latvia. The ‘op mal effec ve top rate’ includes both progressive rates indirect taxes and SSCs, and corresponds to the op mal top rate according to the Saez-formula above. The row ‘op mal top rate 2.1 Earned income -5.0% -.216 incl. SSC’ corrects the op mal effec ve top rates for indirect taxes indicated at the bo om of the table. The ‘op mal top rate credit PIT’ excludes the SSCs from the ‘op mal top rate incl. SSC’. Baseline values are indicated in bold. These calcula ons need to be 2.2. EIC limited to -1.4% -.096 interpreted with cau on, given the high level of uncertainty regarding the parameters. families 3. Combined 1+2.2 +0.2% -.406 Scenario 1. Introducing a progressive PIT with three rates (19 percent, 23 percent and 29 percent) would increase PIT revenues by 1.6 percent and significantly reduce the gap between the rich and the poor: the decile dispersion ra o (DDR--the ra o of the average income of the top ten percent of the income distribu on to the average income of the bo om ten percent) would fall by .316 percentage points, from 10.27 to 9.95. A more radical measure—raising the PIT rate to 33 percent on the top 20 percent of taxpayers—would increase PIT revenues by 16 percent and reduce the decile dispersion ra o to 9.54 (Table 7). Scenario 2. Introducing a modest EITC (with a maximum benefit of €227 per year) in isola on would cost the government €73 million--equivalent to five percent of 2014 PIT revenues--and would have a somewhat smaller impact on the distribu on of income. The decile dispersion ra o would fall by only .216 percentage points. Interes ngly, the fiscal cost of this measure would fall substan ally if the EITC were targeted only to families with dependent children. This variant (labeled 2.2 in Table above) would cost the government only €20 million, 1.4 percent of PIT revenues. Scenario 3. The fiscal impact of a combined scenario would be essen ally nil: the costs of the EITC would be offset by the increase in PIT revenues. The distribu onal impact would be substan al, with the DDR falling by 0.406 percentage points. Box 2. The Case for ‘Married, Filing Jointly’ The Government should consider introducing the joint taxa on of married couples. There are a number of arguments for doing so. First, married couples typically have a common budget and are therefore single economic units. Second, the labor supply decisions of members of a couple are in fact joint decisions. Third, joint taxa on is a family-friendly policy, which is par cularly important in the Latvian demographic context. The theory of household produc on suggests that it is ra onal for Our calcula ons suggest that an increase in the current top rate in the PIT of 23 percent seems feasible and would contribute a couple to reduce the labor supply of the partner whose marginal produc vity in household produc on (e.g. in child care) to more income redistribu on or public revenue. Introducing a separate top bracket for incomes poten ally raises more revenue is higher than in the market and to increase the labor supply of the other partner. Progressive taxa on that does not treat at baseline values for the ETI (0.35) and Pareto parameter (3.0). Top rates can be increased from 23 percent to about 33 percent. couples jointly punishes such behavior if the income of the second partner exceeds the threshold for the top rate. In this case the MTR including SSCs equals 43 percent (it equals 49 percent when we include indirect taxes of 11 percent).26 With greater inequality, and the Pareto-parameter of the earnings distribu on assumed to be 2.5 rather than 3.0, the revenue- The shi could be costly for the Government, however. As described in ANNEX F SELECTED PIT REFORM SIMULATION maximizing top rate in the PIT is 38 percent, or 15 percentage points higher than the current top PIT rate. However, the current RESULTS, permi ng couples to file joint returns, assuming a simultaneous shi to a three er (progressive) tax structure), top rate in the PIT of 23 percent would be revenue maximizing if we assume that the ETI is higher than in the baseline (0.50). would reduce PIT revenues by nearly €30 million over what they would otherwise have been. Clearly, the ETI is a cri cal parameter to judge the desirability of raising the top rate in Latvia. Another cri cal element is the poli cal valua on of the income of top-income earners. The table shows that with a low social welfare weight for top- Conclusions income earners, op mal tax rates are higher than current ones. However, with a high social welfare weight for top-income earners, op mal tax rates are es mated to be lower than current ones. Indeed, current top rates of 23 percent in the PIT can  The high EMTR on incomes at- or just above- the minimum threshold should be reduced, in order to be ra onalized with a social welfare weight of the top-income earners around 0.3. Thus, a final proposal for the changes to PIT increase (formal sector) labor force par cipa on and encourage workers within the formal sector to pursue rates are dependent on two cri cal parameters: ETI and the welfare weight for top income earners. higher earnings. This could be accomplished either through: (1) a system of earned income tax credits or (2) income disregards in the calcula on of eligibility for the GMI and housing allowances. At the same me, the Any such reforms will have fiscal and distribu onal impacts. A range of simula ons were run, using data from 2014, to Government should consider raising the PIT rate on higher incomes, in order to improve the progressivity of es mate the magnitude of these effects (The simula ons are described in detail in ANNEX F SELECTED PIT REFORM SIMULATION the tax system as a whole and generate addi onal revenues. According to the simula ons, both measures RESULTS). The simula ons examine three basic scenarios: (1) the introduc on of a progressive rate structure (i.e., higher rates could be accomplished simultaneously at li le net cost to the government. More radical increases in the PIT on higher incomes); (2) the introduc on of an earned income tax credit (EITC); and (3) both together. As described in ANNEX F rate on higher incomes, or more parsimonious tax credits would, of course, increase the net revenue yields to SELECTED PIT REFORM SIMULATION RESULTS, the results of the analysis depend on the precise parameters of each scenario. the government. The addi onal revenues from the introduc on of progressivity could be kept at the central government level (see Box 3). Table 7. Fiscal and Distribu onal Impact of Alterna ve Policies: Simula ons  The government should con nue with the removal of the ceiling on social contribu ons. Given the flat tax Scenario Fiscal Impact Distribu onal impact (change in DDR) rate, the solidarity tax introduces a small element of redistribu on in the system and in the absence of other (% of PIT) changes to make labor taxes more progressive, it should be maintained. 58 59 Latvia Tax Review Latvia Tax Review  Apart from tax-benefit policies, the policy agenda to support an increase in the number of higher produc vity Figure 36. CIT difference between the level of the implicit tax rate on capital income in selected formal sector jobs is cri cal for reducing informality and increasing the adequacy of social protec on countries and Latvia (in percentage points), 2012 contribu ons. Tax policy is just one component of the policy agenda to combat informality. Box 3. Who should reap the windfall from progressive tax rates? At present, the majority of PIT revenues are transferred to local governments. The sharing percentage is adjusted in the annual budget law. Revenues are distributed among individual jurisdic ons on the basis of origin, and are then subject to an equaliza on mechanism. If a progressive tax rate structure is adopted, this arrangement will have to be modified. It is the central, not the local, governments that should reap any increase in revenues arising from the introduc on of progressive tax rates. One solu on would be to have local governments con nue to receive the amount they would have received under the flat rate, with the central government retaining the difference. From a technical and administra ve standpoint, there appear to be no obstacles to doing so. 3.2 Capital income taxa on The aggregate burden of capital taxes in Latvia is low. Latvia has a low effec ve tax rate (Figure 36) and raises rela vely li le revenue from taxing capital income. In par cular, the implicit tax rate on capital and business income of corpora ons and self-employed is below the level in nine of ten comparator countries, the excep on being Estonia. Source: Eurostat. Taxing capital income at very low or zero rates is not socially desirable. Op mal tax theory points to good reasons for the taxa on of capital income for both equity and efficiency reasons (Diamond and Banks, 2010; Diamond and Saez, 2011; Jacobs, In Latvia, different forms of capital income are taxed at different rates (Table 8). Interest and dividends received by 2013). It is op mal to tax capital income for redistribu ve reasons, since not all income inequality originates from differences individuals are taxed at a rate of 10 percent. Capital gains received by individuals are taxed at a rate of 15 percent. Dividends and in labor earnings. Individuals inherit different amounts of wealth (Pike y and Saez, 2013). Individuals with higher earnings capital gains received by corpora ons, on the other hand, are en rely exempt from taxa on.22 Given that there is no correc on capaci es also have stronger preferences to save (Banks and Diamond, 2010; Diamond and Spinnewijn, 2011; Gordon and of accrued interest in unrealized capital gains, a good case can be made for se ng a somewhat higher tax on capital gains Kopczuk, 2014). And, individuals with high earnings ability not only earn more labor income, but also more capital income to avoid arbitrage by conver ng dividends into lower taxed capital gains using, for example, stock op ons (Auerbach, 1991a, (Gerritsen, Jacobs, Rusu and Spiritus, 2016). It is also op mal to tax capital income for efficiency reasons. Taxa on of capital 1991b). There is no taxa on of imputed rent on home ownership, although income from ren ng out property is taxed. Such income helps to alleviate the distor ons of labor and consump on taxes in the labor market by boos ng labor supply (Blundell income can be reported as a private ac vity (subject to PIT) or as a business ac vity, liable to the corporate income tax (the CIT) and MaCurdy, 1999; Meghir and Phillips, 2010; Pir lä and Suoniemi, 2014; Erosa and Gervais, 2002; Conesa et al. 2011), or the microenterprise tax (MET). Capital gains on the sale of real estate are taxed at a rate of 15 percent, although important promo ng later re rement (Gruber and Wise, 1999, 2002) and s mula ng investments in human capital (Jacobs and Bovenberg, exemp ons exist. In par cular, capital gains on the sale of owner-occupied housing is not taxable, as long as the capital gain is 2010). Moreover, capital taxes can alleviate the distor ons from borrowing constraints (Hubbard and Judd, 1986; Aiyagari, reinvested into a new residence.23 Corporate income is normally taxed at a rate of 15 percent.24 There is a local property tax, 1994, 1995) and missing insurance markets (Diamond and Mirrlees, 1978, 1986; Golosov et al., 2003; Jacobs and Schindler, ranging from 0.2-3 percent of the value of the property, depending on the jurisdic on. Immovable property is also subject to a 2012). Taxing capital income is also desirable when capital income contains unearned income, i.e. capital income for which no stamp duty of 2 percent of the property value. There is no inheritance taxa on.25 economic sacrifice has been made in the form of postponing consump on or bearing risk, such as rents on land and housing The pension system is subject to a variety of tax provisions, but differences between the tax treatment of ordinary savings, or the profits from market power or loca on advantages. Finally, taxes on capital income are needed to combat tax avoidance second-pillar pension savings and third-pillar pension savings are small. Pension benefits from first-pillar, PAYG state pensions and maintain the integrity of the PIT (Chris ansen and Tuomala, 2007). The separa on between capital and labor income is are taxed at the 23 percent rate of the PIT, while they are funded from SSCs (EC, 2014). The second-pillar of pension savings— the Achilles heel of any dual income tax system, such as the tax system in Latvia. Without taxa on of capital income individuals occupa onal pensions—is a funded system. Second-pillar pension benefits are taxed under the 23 percent rate of the PIT. Its would have a strong incen ve to transform taxed labor income into untaxed capital income (Fuest and Weichenrieder, 2002; De tax treatment can be characterized as an ETT system (Exempt contribu ons, Taxed accrual, Taxed benefits). Contribu ons by Mooij and Nicodème, 2008). employees for third-pillar, occupa onal pensions are tax deduc ble up to a maximum of 20 percent of gross earnings. However, The Latvian tax system is a dual tax system where labor incomes and capital incomes are taxed separately. From an op mal- contribu ons for employers to occupa onal pensions are not tax deduc ble. Accrual of pension wealth in occupa onal tax perspec ve it is probably most desirable to have a dual-income tax system where labor incomes are taxed at progressive pension schemes is taxed at 10 percent, the rate at which dividends and interest income is taxed (Latvian Revenue Service, rates, and capital incomes are taxed at lower, flat rates (Jacobs, 2013). Most Scandinavian countries have a dual tax system. The 2016). In addi on, individuals can make voluntary pension savings in the third pillar via pension products with a favorable tax consensus in the economics literature suggests that capital income should be taxed at lower rates than labor income, given the treatment. The tax treatment of the third pillar differs from the second pillar and can be characterized as an ETE system (Exempt high interna onal mobility of capital. However, while taxes on capital income are generally considered more distor onary, they contribu ons, Taxed accrual, Exempt benefits). Premiums for life-insurance and pension contribu ons are deduc ble from the could also yield larger distribu onal benefits in view of the skewed distribu on of capital income and wealth holdings. labor income tax up to a maximum of 20 percent of taxable income. Voluntary pension savings into private pension funds under licensed pension plans are not taxed when the employee contributes to the pension plan. However, when employers contribute to the pension plan of the employee, the tax advantage disappears since pension benefits are then taxed at the PIT rate of 23 percent (Latvian Revenue Service, 2016). Pension accrual in private pension savings in the third pillar are taxed at a rate of 10 22 Corporate dividends are taxable if the corpora on is located in a country listed in Latvia’s list of low- tax or no-tax jurisdic ons. 23 Capital gains on houses are not taxed when home ownership before aliena on lasted more than 60 months; it was the place of residence for at least 12 months or it was the only house for the last 60 months; it has been replaced with an owner-occupied house 12 months before or a er the aliena on; capital gains on the house have been divided in the case of a divorce provided that it was the residence of both spouses at least 12 months un l the aliena on; an aliena on of the real estate is realized in accordance with the Law On Aliena on of Immovable Property for the Public Needs, provided that ownership lasted more than 60 months or the capital gain is invested in a func onally similar property within 12 months a er aliena on. 24 If a corpora on is classified as a microenterprise, the rate is nine percent of turnover, plus ten percent on dividends. 25 However, there is a provision for the taxa on of inheritance of copyrights, which are taxed at 23 percent. 60 61 Latvia Tax Review Latvia Tax Review percent. Only about 25,000 people make use of the tax advantages for third-pillar private pension savings. The reasons are Figure 37. Housing wealth as a percentage of total household wealth in European Union in 2013 unclear; it may be due to inadequate income to contribute to third pillar savings or perhaps due to a preference for other forms of savings. Fees on third pillar savings also may act as implicit taxes on pension saving and ul mately soak up most of the explicit tax advantages. Consequently, there appears to be no substan al private gain from saving for pensions using these products compared to private savings or home ownership. Table 8. Taxes on capital income and wealth in Latvia, 2016, in percent Rate Rate Personal capital income Corpora ons Interest 10 Interest (effec ve) 15 (10) Dividend 10 Dividend (effec ve) 0 (23.5) Capital gains on assets 15 Capital gains (effec ve) 0 (27.75) Housing Microenterprises Imputed rental income - Interest (effec ve) 9 (9) Realized rental income 10 Dividend (effec ve) 9 (18.1) Deduc on mortgage rent - Wealth taxes Source: Eurostat, ECB. Capital gains housing 0, 15 Property 0.2-3 Occupa onal pensions (second pillar) Stamp duty immovable property 2 Latvia should raise the share of capital taxes in the tax mix. Revenues from capital income taxes in Latvia are low compared to income (see Figure 38) and account for a small share of total tax revenue. Thus, a good economic case can be made that Pension benefits 23 Inheritance - Latvia should shi the aggregate tax burden from labor (i.e. consump on and taxes on labor earnings) towards capital income. Deduc on contribu ons employer/ Note that this is not a plea for raising the aggregate tax burden, only a shi in the mix of taxes from labor towards capital. Such a 0/23 employee shi can help raise the efficiency or equity (or both) of the Latvian tax system. One obvious step is to tax imputed rental income Pension accrual 10 from owner-occupied housing at the same rate as taxes on dividends from other assets, and to tax capital gains on housing Private pension saving (third pillar) assets at the same rate as capital gains on other assets. Another proposal is to tax inheritances. In principle, if incomes from the underlying assets are taxed, then there would be no jus fica on for introducing a tax on inheritances. This is similar to the Pension benefits 0/23 argument that a wealth tax is redundant if all capital incomes are taxed. However, as many forms of capital income are under- Deduc on contribu ons employer/ taxed, introducing an inheritance tax may be desirable. 0/23 employee Pension accrual 10 Figure 38. Components of capital taxa on as a percentage of opera ng surplus and mixed income, 2014 Non-uniform tax treatment of capital income is inefficient, generates inequi es and provokes tax arbitrage. A uniform tax on capital income is needed to avoid tax arbitrage between people, across bases and over me. Capital income from one source can easily be transformed into capital income from another source. For example, dividends can be converted into capital gains, ordinary assets can be transformed into pension plans, and savings can be converted into equity of closely-held companies. Low or zero taxes on housing assets (see Table 8) provides strong incen ves to save in the form of housing assets, since other forms of capital income are taxed at a higher rate. As a result, the share of housing wealth in total household wealth is higher in Latvia than in all EU countries (with adequate data), except Slovakia (see Figure 37). The microenterprise regime provides advantages in capital income taxa on for some firms over the standard CIT-regime.26 Thus, Latvians are able to lower their average and marginal tax rates on their assets to very low levels, possibly close to zero, by making suitable por olio choices (save in the form of housing and microenterprises). Since large parts of capital income remain untaxed, taxes on labor income and consump on need to be higher than they otherwise would have to be, which severely distorts labor and other markets. Moreover, given that there is typically much larger inequality in wealth holdings, the tax system does not op mally address distribu onal concerns by largely exemp ng capital income and wealth holdings from taxa on. For all these reasons, the Latvian tax system does not meet the criteria for an op mal tax treatment of capital income. Source: Eurostat. 26The MET is beneficial to avoid CIT and SSC. However, no deduc on for interest costs or intermediate goods is provided in the MET. Thus firms with high debt or intermediate goods use need not be be er off. 62 63 Main conclusions:  The share of taxes on capital income in total tax revenue should be raised to create a more efficient and equitable balance between taxes on labor/consump on and taxes on capital. Equitable Growth, Finance, and Institutions  Tax rates on capital income should be made more uniform, par cularly by increasing taxes on owner-occupied housing. The government should also consider taxing inheritances. Europe and Central Asia Region CORPORATE INCOME TAXATION Latvia Tax Review Latvia Tax Review 4. CORPORATE INCOME TAXATION Figure 39. CIT: Top Statutory Rates (Percent) and Revenue (Percent of GDP) While Latvia’s CIT regime contains many of the ingredients that are required for a well-func oning system of corporate income taxa on, there are areas where the effec veness of the regime could be enhanced and tax-related distor ons reduced. As with all taxes, the design and determina on of appropriate policies for corporate income taxa on needs to be considered in the context of the well-established principles of neutrality (as respects various forms of business ac vi es), efficiency (in minimizing compliance costs), certainty and simplicity (with tax rules that are clear and easy to understand), effec veness and fairness (in the imposi on and collec on of tax) and flexibility (in adap ng to changes in technology and economic ac vity). At the same me, countries around the world are having to frame their corporate income tax policies against a background of ever- increasing globaliza on and compe on for mobile investment, and Latvia is no different in this regard. There is also widespread acceptance interna onally of the need for effec ve measures to counter base erosion and profit shi ing (BEPS) and a range of ac ons have been agreed at OECD and EU to deal with BEPS and limit the scope for interna onal tax avoidance by mul na onal enterprises. Within this context, it is desirable that CIT policies are designed and developed to deliver a tax regime which:  facilitates enterprise and minimizes distor ons in rela on to loca on of economic ac vity, legal form of business en es, investment and investment financing,  is stable and sustainable, with predictability and certainty for businesses making investment decisions—too many or too frequent changes in the regime does not provide confidence for investors,  provides a broad tax base with targeted incen ves, where appropriate, for investment in R&D and innova ve enterprises,  provides a sufficient revenue yield from the corporate sector on a year to year basis that contributes to equity and Sources: OECD, KPMG, Latvia MoF. fairness of the overall tax system,  is open and transparent in the opera on and administra on of the tax rules (e.g. in rela on to eligibility for tax Figure 40. PIT and CIT and their Poten al Tax Bases, Latvia, Estonia, and Slovakia 2000-2014, EUR Million reliefs)—this also helps to enhance equity and fairness of the tax system, as well as public confidence and interna onal acceptance,  restricts, as far as possible, the opportuni es for tax avoidance and aggressive tax planning (e.g. through measures to A. Latvia counter profit and manipula on of financial structures),  promotes compliance and provides effec ve deterrents to counter evasion and limit the scope for opera ng in the shadow economy,  is compliant with EU law and State Aid rules and aligned with tax policy principles agreed within EU (e.g. Code of Conduct on Business Taxa on) and OECD (e.g. transfer pricing guidelines and policies to deal with BEPS), and  is complemented by an efficient tax treaty network to eliminate double taxa on while providing for effec ve taxa on of corporate income. While the Latvian CIT regime exhibits many of these features in varying degrees (e.g. it has a rela vely low headline rate that has remained in place since it was introduced in 2002), there are areas where the effec veness of the regime could be enhanced (e.g. broadening the tax base by re-focusing tax allowances), where distor ons in investment financing could be removed or reduced (e.g. ensuring equal treatment of debt and equity costs) and where revenue leakage could be curtailed (e.g. through reform of micro-enterprise tax). Corporate income tax revenue in Latvia is low by both EU and OECD standards. In 2014, Latvia’s CIT revenue as a percent of GDP was about 1.5 percent, compared to the EU average of 2.6 percent and the OECD average of 2.8 percent. One reason for Latvia’s CIT shor all is the low tax rates, both statutory and effec ve (Figure 39). The low effec ve rates are caused by tax incen ves for investments (the possibility to carry forward losses, accelerated deprecia on of fixed assets, enhanced B. Estonia deprecia on for new technological equipment for produc on, tax relief for R&D expenditure) and tax credits (for farmers), deduc ons and loopholes. As a result of these provisions, the produc vity of CIT27 in Latvia is below the EU average and also lags behind Slovakia, the Czech Republic, and Ireland. Although the CIT revenue-to-GDP ra o in Latvia has averaged about the same since 2000, it has been quite vola le. A rise in revenues to 3 percent of GDP in 2008 (caused by a surge in profits and the lowering of the statutory rate, see Figure 39, second panel) was followed by a rapid drop during the crisis and a slow recovery therea er, which was limited by the introduc on of the micro-enterprise regime (see Figure 39, second panel). 27 Produc vity is measured by CIT revenue as a percent of GDP divided by the CIT rate. 66 67 Latvia Tax Review Latvia Tax Review These rates are then doubled for the purposes of determining the amount of deprecia on for tax purposes, so the effec ve C. Slovakia rates of deprecia on are twice those set out above (with the excep on of certain vehicles, e.g. motor cars, where a mul ple of 1.5 applies). Applying these effec ve rates on a reducing balance basis provides for rela vely high levels of deprecia on in the early years with deprecia on levels gradually declining in later years. Some adjustments to the deprecia on regime may be appropriate, with a view to limi ng accelerated deprecia on and aligning tax deprecia on more closely with economic deprecia on. Given the wide range of assets with differing economic lifespans, it would be very difficult to achieve a precise alignment with economic deprecia on for every case without having very complex and detailed rules, with lengthy lists of various asset categories and descrip ons. Of course, tax deprecia on could be allowed to follow accoun ng deprecia on, leaving it up to each company to determine the appropriate deprecia on for assets in use based on the applica on of generally accepted accoun ng principles. However, this would give a lot of discre on to companies, leading perhaps to significant differences in the amount of tax deprecia on claimed by companies for similar assets; it is not an approach that would generally be favored by tax authori es. For prac cal purposes, some simplifica on is required in se ng deprecia on rules and certainly this has been the approach taken by most countries. The Government could consider various op ons, including a re-classifica on/ simplifica on of asset categories, a switch over to straight line deprecia on for some or all assets (e.g. buildings and other long-life assets), a revision of rates for the different asset categories, and removing or reducing the mul ple by which rates are doubled/increased. Loss Relief Tax expenditures associated with loss relief are high due to an accumula on of losses during the recent economic crisis, Source: Eurostat na onal accounts data, OECD data on income from taxes. as well as excess deprecia on allowances carried forward from previous years. The sectors that report the highest losses are those most affected by the crisis (see Figure 41). Tax expenditures are likely to stay high in the years to come, as these losses are The crisis reduced the income tax base for both corpora ons and households, leading to lower income tax revenues. But large compared to companies’ profitability and thus are absorbed only slowly (see Figure 42). unlike Estonia and Slovakia, personal and corporate income tax revenue in Latvia remained below the pre-crisis peak in 2014 (see Figure 40). CIT revenues stayed below the level corporate profits developments would have suggested, partly as a result of the introduc on of a microenterprise tax, as well as other policy changes that also increased tax avoidance. PIT revenues in Figure 41. Losses carried forward to 2014 by year of genera on and sector Latvia increased by more than the recovery in the wage bill implied, probably with the assistance of a broadening of the tax base in 2010 to cover capital income. Low CIT revenues are due to a narrow and eroded tax base. The Ministry of Finance Report on tax expenditures for 2014 reveals that the CIT revenue foregone (tax expenditures) in 2014 as reported by the State Revenue Service was about 1.5 percent of GDP, with the promo on of investment accoun ng for about 80 percent of the total amount. Most of the incen ves involve generous deprecia on and loss-carry-forward schemes—which all conform to the rules set out in EU law on State Aid. Accelerated deprecia on of fixed assets was used by 51,583 commercial operators at a total cost of EUR 52.7 million in 2014, while relief for losses incurred in current and previous tax periods were used by 16,661 commercial operators at a total cost of EUR 122 million in 2014. The Ministry of Finance Report notes that these two relief measures are related, which would suggest that claims for loss relief arise in part from losses created by expenditure qualifying for accelerated deprecia on (i.e. as dis nct from commercial losses). Less typical for the EU are Latvia’s incen ves for selected sectors (such as shipping, agriculture or financial sector). The main avoidance vehicles arise from the use of tax incen ves by domes c firms, e.g. via micro-enterprise tax. There may be some scope for broadening the CIT base by reducing tax expenditures that are not providing sufficient benefits rela ve to their cost in tax revenues foregone. At the same me, due account should be taken of the poten al impact of any base broadening measures on economic ac vity and employment. A number of changes were made in 2014 based on an analysis of the effec veness of CIT relief provisions in the Ministry of Finance Report on tax expenditures. The main changes included amendments to the relief for R&D (with effect from 1 July 2014), aboli on of group relief for losses (from 1 January 2014) and aboli on of the rebate for investment in fixed assets in territories of special support (for assets acquired a er 2012). Source: State Revenue Service. S ll, there may be further scope for broadening the CIT base by reducing tax expenditures. Deprecia on Sec on 13 of the Law on Enterprise Income Tax sets out the rules for deprecia on. Assets are depreciated on a reducing balance basis (i.e. based on tax wri en down values) at specified rates depending on the category of asset. There are five asset categories and the rates of deprecia on range from:  5 percent for buildings and structures,  10 percent for railway rolling stock and technological equipment, ships, power equipment,  35 percent for computer equipment and so ware  7.5 percent for oil explora on pla orms and equipment  20 percent for other fixed assets. 68 69 Latvia Tax Review Latvia Tax Review Figure 42. Taxable profits before losses, losses deducted and losses transferred to the future,  Holding company regime. A holding company regime was introduced in 2013 and provides a tax exemp on for in EUR million, 2014 dividend income and capital gains earned by a company in respect of shares held in subsidiaries and other companies. Many other countries provide such a regime and generally the objec ve is to encourage companies to locate their headquarter opera ons and related func ons in the jurisdic on. There is no minimum shareholding requirement in the Latvian regime, so that dividend income and capital gains from small por olio shareholdings (e.g. quoted shares) are exempt; there may not be a significant tax cost associated with this measure, but some limita ons in the relief might be worth considering, e.g. to exclude shareholdings below 10 per cent.  Triple deduc on for R&D expenditure. This measure, which provides an enhanced deduc on for qualifying R&D expenditure, was introduced in 2014 and could play an important role in the promo on of innova on and high-value enterprises with growth poten al. There are good economic reasons to provide tax relief for investment in R&D, given the considerable risks associated with such investment and the large externali es arising from R&D. At the same me, it is desirable to ensure that the measure is focused on genuine R&D ac vi es and that provision is made for effec ve oversight of the relief, including assessment and valida on of R&D expenditure in specific cases, where appropriate (see Box 4 for the experience from Ireland). Box 4. Valida on of claims for R&D Tax Relief: Approach taken in Ireland Many developed countries provide tax relief for companies engaged in R&D ac vi es, as Latvia does through the enhanced deduc on for R&D expenditure. Tax relief granted under these provisions can be substan al, so appropriate arrangements to evaluate claims, as well as requirements that companies maintain detailed documentary evidence in support of their claims, are important. Source: State Revenue Service. In Ireland, companies can claim on their annual tax return a credit of 25 percent of qualifying R&D expenditures made within the EU. The claim must sa sfy two tests: Loss relief is a standard feature of corporate tax systems in most countries, although the rules vary from country to country. Such rules may include me limits and an -avoidance provisions (e.g. to prevent loss buying). As companies can make  The science test. Qualifying R&D ac vi es involve basic research, applied research or experimental development which profits and incur losses in different tax periods over the business cycle, taxing profits while not allowing relief for losses would aims to achieve scien fic or technological advancement and to resolve scien fic or technological uncertainty. be unbalanced and unfair. Latvia used to apply an eight-year me limit on the carry forward of losses, but losses incurred from 2008 onwards are not subject to any me limit. On the other hand, Latvia has recently abolished group relief for losses, which  The accoun ng test. Detailed records should be maintained demonstra ng that the correct amount of expenditure on is a significant change (the measure was introduced to offset the cost of a new provision for R&D). qualifying R&D ac vi es has been claimed. Claims are subject to audit. Some further restric on of loss relief could be considered to limit the impact of losses on CIT revenues. For example, limi ng the aggregate amount of deduc ons for losses carried forward in any tax period to a specified percentage (e.g. 80 Records required to sa sfy the science test include: (i) a descrip on of the goals and methods to be used, including the percent) of net taxable profits (before such deduc ons) could ensure that a minimum percentage (e.g. 20 percent) of profits hypothesis advanced and how it is to be tested; (ii) a jus fica on of the necessity for each major step and indicators used to remain subject to tax. (Lithuania and France have a similar provision). The other op on would be re-introduc on of a me limit determine whether goals are met; (iii) informa on on work progress and conclusions; and (iv) evidence that the research has on the carry forward of losses. For example, in Poland, losses incurred by a taxpayer may be carried forward and set off against not already been undertaken, perhaps including a comprehensive literature review. income over the five following tax years from the year the loss is incurred, but only up to 50 percent of the loss suffered in a given tax year may be deducted at once. A cap (e.g. 20%) on the amount of losses that can be carried forward in a tax period The legisla on provides that Revenue may enlist the help of experts with specialized knowledge to determine whether an would spread the offset of losses over a longer period of me, while a me limit on the carry-forward of losses could result in ac vity qualifies for relief. Experts are required to sign a confiden ality agreement with Revenue, and Revenue has to no fy the forfeiture of some losses due, for example, to insufficient profits to absorb all losses within the relevant me period. The claimant of the expert’s iden ty and the informa on that will be disclosed. A company can object to an expert if it believes there former op on may be preferable from the perspec ve of providing a tax revenue cash-flow benefit while allowing for all losses is a conflict of interest, and has the right to appeal Revenue’s decision. An expert may be required to give evidence before an to be relieved in the longer term. appeals board or a law court if his or her opinion is disputed by the claimant. Other areas of tax expenditure Other measures which might be reviewed in rela on to their overall effec veness and value for tax expenditures include the Records required to meet the accoun ng test include details of the alloca on of resources and associated costs for each following: stage of a project. Detailed targets and deliverables that are clearly related to the project goals should be directly associated  Enhanced deduc on for the acquisi on of new technological equipment. This measure, which provides for the amount with relevant accoun ng records. Records containing the following informa on, if relevant, are required: of deprecia on to be enhanced by a mul ple of 1.5, is currently available for new technological equipment acquired in the period 2009-2020. Although withdrawing this relief now in the context of its intended applica on to 2020 might  The dates of commencement and termina on of the project. Costs incurred a er the R&D phase is completed do not undermine confidence in the tax regime for investment in the technology sector, a review of the effec veness of the qualify for the relief; measure may be appropriate.  Tax rebates on investment. The tax rebate for investments in supported investment projects is 25 percent for amounts  A project plan with appropriate milestones and deliverables for management of the project; up to EUR 50m and 15 percent for amounts from EUR 50m to EUR 100m. Projects are given this support based on an assessment by the Ministry of Economics and approval by the Cabinet. To apply a tax rebate for amounts exceeding  Details of progress made against the project plan; EUR 100m (the maximum tax rebate applied is 11.9 percent), approval from the Cabinet and European Commission is necessary. Again, the costs and benefits of this program are worth reviewing.  Details of the personnel involved in the project, their qualifica ons and the amounts of their me allocated to the project; 70 71 Latvia Tax Review Latvia Tax Review  The loca on where the R&D ac vi es took place and a breakdown of costs associated with the loca on (e.g. Micro enterprise Regular regime Lump sum appor onment of light, heat etc.); Small capital Individual Small capital Individual Purchase of a Legal form Self employed Self employed  Details of any amounts paid to ins tu ons of higher educa on or non-academic subcontractors, and the qualifying R&D LTD merchant LTD merchant patent ac vity carried out by them on behalf of the company; and Criteria Criteria Annual Annual Annual Annual Certain  Details of the methods and bases of appor onment of all expenditure associated with the R&D. Income turnover < turnover < turnover < Turnover Net income turnover < economic EUR 100,000 EUR 100,000 EUR 100,000z EUR 284,600 ac vi es The required records should generally be available within a company for its own internal purposes. Companies may consult <5 (all are with their local tax office or case manager if they are uncertain about the adequacy or suitability of their records. No of natural per- - - - 1 >5 person - The complexity of Latvia’s taxa on of business income creates distor ons and inequali es. Like most countries, Latvia employees son) applies a single rate to all businesses subject to the corporate income tax regime. However, with the introduc on of the microenterprise tax, the tax rate varies by firm size and income, leading to a prolifera on of differing rates (Table 9; see the Monthly 1000 (top panel) and up to 1000 (bo om panel) MET workers and MET regime workers below 700 euros, underlining the likelihood that the drama c difference between the two regimes in the share of workers with earnings just below the maximum threshold for MET par cipa on represents wage manipula on. Figure 47. Firms appear to be manipula ng wage reports to qualify for the MET Notes: Min. wage refers to minimum monthly wage (€320 in 2014 and €360 in 2015). Source: Calcula ons based on State Revenue Service data (monthly records). The MET regime may also create long-term challenges for the social security system. While 65 percent of MET proceeds goes to mandatory state social insurance contribu ons (planned to be increased to 74.5 percent from 2017), workers who rely mainly on microenterprises for wages pay lower social security contribu ons, and hence, accrue lower en tlements for pensions as well as other social insurance benefits such as unemployment insurance. This may undermine the sustainability of the social security system by lowering benefit coverage and adequacy.40 Notes: The Figure reports annual average number of workers with posi ve microenterprise earnings. For Arts & entertainment, Employment under the MET regime has increased substan ally (Figure 11 and addi onally for more detail, see ANNEX J. this number exceeds total number of employees with main job in the private sector, and MET share of private sector workers MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACT, Table 52). The number of registered taxpayers using the (144%) is not shown. Source: Latvia’s State Revenue Service data, CSB data and staff calcula on. MET regime increased from around 7 thousand in January 2011 to around 47 thousand in January 2016, while the number of employees at microenterprises rose from around 14 thousand in January 2011 (5 percent of private sector employees) to The availability of the MET regime may have reduced revenues. In 2015 the MET regime generated only 0.8 percent of around 85 thousand (14 percent of private sector employees) in December 2015.41 In total, almost 104 thousand workers had total tax revenues. It is es mated that the MET regime resulted in 60 million euros in taxes foregone in both 2014 and 2015. posi ve microenterprise earnings in 2015. As a result, earnings under the MET regime have become an increasingly important This tax loss largely reflects firms switching to the MET regime to lower their tax burden. Econometric evidence shows that the source of personal income (Figure 48). And the MET regime accounted for most of the rise in [registered] employment in Latvia share of MET payers is higher in sectors where the burden of labor taxes and profit taxes (each measured as a share of turnover from 2011 to 2015. The increase in the number of workers employed only under the general tax regime accounts for much less in 2010) was higher prior to inaugura on of the MET (ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS than a half of the total increase in employment in 2011-2013, less than a quarter in 2014, and becomes nega ve in 2015 (see IMPACT, Table 60). Also, sectors with larger shares of MET-only workers in 2014 experienced larger cuts (or smaller increases) ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACT, Table 52). ).42 in the burden of main taxes (labor taxes, profit taxes, VAT, and MET) between 2010 and 2014 (ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACT, Table 56). On the other hand, the MET may have encouraged some firms to report wages formerly provided in cash. Other things equal, the share of microenterprise workers is higher in sectors where the share of employees earning no wages in 2010 was higher (ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACT, Table 55). Manipula on of wage repor ng under the MET regime may have contributed to a reduc on in revenues. A large share of firms par cipa ng in the MET regime report workers who earn just below the maximum of EUR 720 per month, providing strong evidence of wage manipula on. About one-quarter of monthly earnings records of MET-only workers (one-third of mixed workers) show exactly EUR 720, while the narrow band from EUR 700 to EUR 720 contains about 38 percent of MET-only (50 regimes, only the job with the largest pay packet in the given month is considered. percent of mixed) records (Figure 47).39 By contrast, general regime earnings of mixed workers fall in the interval from EUR 700 40 The stark reduction in social security contributions separates the Latvian regime from other small business regimes across the OECD (OECD, 2015). 41 State Social Insurance Agency data prepared on request. 39 This is based on monthly earnings records of 123 thousand individuals with posi ve microenterprise earnings in 2014 or 2015. For each of the two tax 42 This is true whether total employees or employees with posi ve earnings are considered. 84 85 Latvia Tax Review Latvia Tax Review Table 13. Par cipants in the microenterprise tax regime, 2009–2015 Figure 49. Growth in registered employment by tax regime, 2011–2015 2009 2010 2011 2012 2013 2014 2015 a Number of microenterprise taxpayers - 7,194 17,820 25,164 31,978 40,007 47,169 Number of taxpayers under general 241,772 257,334 279,924 304,861 330,395 345,255 350,924 regime Number of microenterprise employees b - 25,530 45,288 60,784 74,239 83,063 Share of total employment 3.3% 5.6w% 7.4% 8.8% 9.8% Microenterprise tax revenue (millions - 0.04 13.01 26.16 40.53 51.07 58.85 of euros) Note: a Number of taxpayers is for the first day of the calendar year. b Includes self-employed, i.e. microenterprise owners. Source: Latvia’s State Revenue Service and State Social Insurance Agency data and staff calcula on. Figure 48. MET earnings have become an important source of personal income (Business, labor and interest income of physical persons by source, 2008 and 2010-2015) Source: Calcula ons based on State Revenue Service and State Social Insurance Agency data. The rise in employment under the MET regime mostly reflects shi s from the general tax regime rather than a reduc on in unemployment. In 2015, 22 thousand workers switched from working in firms under the general tax regime to working at least part of their me in firms under the MET regime, accoun ng for about half of the increase in microenterprise workers with posi ve earnings (Figure 45). Nevertheless, the inflows from non-employment and informal employment were significant (Figure 50): 14 percent of microenterprise workers in 2011 did not have any labor income in 2010, and 7 percent had only informal (undeclared) labor income. By 2014, these shares fell to 9 and 3 percent, respec vely. In absolute numbers, however, inflows of non-employed and informally employed individuals to the MET regime rose from 7.2 thousand in 2011 to 11.4 thousand in 2014. Source: Calcula ons based on State Revenue Service and State Social Insurance Agency data. 86 87 Latvia Tax Review Latvia Tax Review Figure 50. Es mated shares of microenterprise workers without declared labor income during the previous year Figure 51. Annual earnings of MET-only and mixed workers vs. those of formal employees without microenterprise experience, 2009-2014: Evidence from EU-SILC microdata Notes: Administra ve (SRS) data do not dis nguish informal workers from non-employed. Es mates presented in the figure are based on EU-SILC 2012-2015 panel microdata, which contain 1484 observa ons of microenterprise workers, including 1002 observa ons for which were observed also in the previous year. For 2014, the es mated number of MET workers without declared labor income during the previous year differs from exact number available from SRS data by just 1.4 percent. Notes: The figure reports the results from (log) annual earnings regressions controlling for the year; gender; educa on; total Source: Calcula ons based on microdata of EU-SILC and SRS data. work experience; age; living with a partner; presence of children below age of 15; ethnicity and ci zenship; limita ons in daily ac vi es; region and level of urbaniza on; number of months worked full- me and part- me; presence of self-employment The MET regime may impair produc vity. Controlling for other determinants of earnings, workers who only worked in income; tax regime as employee during the income reference year (only general, mixed, only MET or informal); being informal, microenterprises from 2011–14 earned 20 percent less from 2009–10 (before the MET era) than workers without microenterprise MET-only or mixed employee in another year; size (7 categories) and economic ac vity (23 categories) of local unit the main (or informal employment) experience in the earlier period (Figure 51).43 This suggests that MET-only workers are, on average, job; contract type; occupa on (2-digit ISCO code); supervisory responsibili es; and job change since the previous year46. For significantly less produc ve than others (note that under the general regime gross earnings are propor onal to labor costs and each year, the sample consists of all individuals whose gross annuals earnings were no less than one monthly minimum wage, hence to produc vity). This produc vity gap (which persists also in 2011–12) is larger than in the case of informal employees. excluding those who received part of the income reference year earnings abroad. The number of observa ons for each of the 3 However, MET-only workers’ net earnings exceeded that of otherwise similar general regime employees by about 40 percent es mated models is between 12 and 13 thousand, while the R-squared varies from 0.65 to 0.68. ** and *** refer to coefficients from 2011–14, while labor costs to microenterprise employers were lower.44 In other words, MET-only workers, despite significant at 5% and 1% level, respec vely. Source: Calcula ons with microdata of na onal rota ng panel versions of cross- objec vely being less produc ve (based on their earnings before the MET era) than general regime workers, are now paid more. sec onal EU-SILC 2008-2015 amended with a number of addi onal indicators (including microenterprise earnings if any); these Similarly, the net earnings of mixed workers are 30 to 40 above that of otherwise similar general regime employees without data have been provided by CSB. Data for 2012-2015 include 1484 observa ons on microenterprise workers, while data for microenterprise experience. Thus mixed workers are overpaid as well.45 In short, lower taxes on labor have enabled less- 2008-2015 include more than 1000 observa ons on persons who had microenterprise earnings in a year different from the produc ve firms to raise wages and a ract workers from more-produc ve firms, perhaps reducing overall produc vity. survey year (but not in the survey year). The MET regime may not be fulfilling one of its goals of increasing innova on. The amount of innova on in firms is difficult to measure. However, as innova on is inherently risky, many innova ve firms tend to fail, while others expand rapidly. By contrast, there is li le evidence of a significant number of firms leaving the MET regime to enter the general tax regime (Figure 52). Instead, there has been a steady and large inflow over me of tax payers from the general regime into the MET regime. 43 See notes to Figure 53 for the list of control variables. Models that do not control for any job a ributes give qualita vely similar results with smaller effects. 44 Annex J, Figure 79 reports MET-only workers’ gross earnings being by 10 percent above those of general regime employees, but labor costs under the gen- eral regime include also employer SSC of 23.59 percent. 45 Plausibly, in the case of mixed workers part of this overpayment is due to working more hours. However, models similar to those presented in Annex J, Figure 79 but controlling also for hours worked (the sample being restricted to full-year, full- me employees for which informa on on hours worked during the income reference year is available) suggest that mixed workers are s ll overpaid by 19 percent. 46 Together with the panel structure, the job change indicator has been used to address me mismatch between earnings and job a ributes data. 88 89 Latvia Tax Review Latvia Tax Review Figure 52. Number of taxpayers in the microenterprise regime and exi ng the regime, 2010-2015 who sell the business a er a specified period, perhaps with a requirement that proceeds from the sale be invested in another business. Several condi ons on the gran ng of tax relief would be necessary:  The tax relief would be available for only a limited period of me (e.g. the first three years of opera on). However, if the tax relief is not used during this period (for example, because the firm had limited profits or losses in the first three years, which is not uncommon among start-ups), then the relief could be carried forward.  The amount of tax relief should be focused on micro/small enterprises, with relief declining as enterprises exceed specified levels of income or profits.  A meframe for commencing the new business could be set to enhance the short-term impact, e.g. relief could be available for new business start-ups commenced within a three to five-year period, with provision for extension if necessary.  If appropriate, tax relief to facilitate/encourage risk investment by individual investors in new start-up businesses could be included as an addi onal incen ve, e.g. through PIT or capital gains tax relief for the amounts invested.  Restric ons, supported by monitoring, should ensure that the tax relief is focused on genuine new business start-ups and does not apply to any exis ng business that may be restructured or recons tuted as a qualifying new business. Source: Calcula ons based on State Revenue Service data. In the case of tax relief for equity investment in SMEs by individual investors, relief should only be available for the investment of risk capital (i.e. ordinary shares) which is used for the purposes of the business. The tax relief should be In summary, the MET regime may have impaired government finances and produc vity. Introduc on of the MET regime withdrawn if the moneys invested are subsequently repaid to the investor by way of a loan, debt repayment, transfer has resulted in significant foregone tax revenues, due to the lower tax rates imposed on firms that genuinely qualify, and the of asset or provision of any other benefit. manipula on of wage reports by firms who otherwise might not qualify. The a rac on of workers to less-produc ve firms and the incen ve to avoid expansion (and thus capture economies of scale) may have reduced overall produc vity. Lower social  Relief should be generally available and be State Aid compliant. There should be no preferen al treatment or selec ve security contribu ons implies reduced pension benefits in the future for MET regime employees, perhaps undermining the advantage provided to par cular undertakings or sectors; it may be desirable to ensure that relief is provided within sustainability of Latvia’s social protec on system. The regime does not appear to be encouraging the expansion of start-ups. de minimis State Aid limits. Introduc on of the MET may have led to some expansion of employment and reduced informality, although most of the growth  Terms and condi ons should be clear, easy to understand and apply, and should not leave any room for ambiguity. The of employment under the MET regime has reflected inflows from the general tax regime. same rules should apply for all enterprises, regardless of sector or business type (e.g. high tech/ high growth vis-à-vis A recent amendment to the MET regime, effec ve January 2017, is designed to address some of these concerns.47 In 2017, life-style businesses). microenterprises that have a sales volume below EUR 7000 will pay a 12 percent tax, and microenterprises with sales volume between EUR 7000 and EUR 100000 will pay 15 percent. Star ng from 2018, all microenterprises with sales volume up to EUR  Relief could be made subject to a claim/applica on being made to the tax authority, with relevant informa on to be 100000 will pay 15 percent of their sales volume as the microenterprise tax. Employees of microenterprises will have to pay provided by the claimant/ applicant. Such a claim could be included in the annual tax return, which also would facilitate MSSIC contribu ons on incomes up to 75 percent of the minimum wage in 2017, and on incomes up to the full minimum wage evalua ons of the program. star ng from 2018.48 Services sectors, as well as forestry and logging (the sectors with most microenterprises), are likely to be explicitly excluded from the regime.49 Finally, if any employee is employed for over three years the enterprise is excluded from The phasing out of the MET regime should take into account the vulnerability of the microenterprise workers, whose the MET regime. While these amendments do not address all of the concerns raised by the MET, it will be important to monitor income levels are quite diverse. Some microenterprise workers are very poor. The share of microenterprises repor ng zero the impact of these changes on par cipants before moving forward with a more thorough reform of the MET. earnings averaged 15 percent per month in 2015, perhaps due to leave during the repor ng period or sales being close to Once the impact of the recent changes are more fully understood, considera on should be given to phasing out the MET zero. By comparison, the monthly average incidence of zero earnings among general regime employees in 2015 was just 6 regime. A more efficient tax regime for microenterprises would minimize distor ons in the tax regime while addressing the percent.50 While a large share of microenterprise workers had some other source of income (about a third were also employed market failures facing microenterprises. This approach would ensure that workers and firms with the same earnings faced the by a firm in the general tax regime), microenterprise earnings s ll accounted for three-fourths of the labor income of workers same tax rates, unless there is a compelling public purpose to do otherwise. One possible market failure is that business start- in microenterprises (Figure 12). Together with low mandatory social security contribu ons (and thus reduced future benefits), ups cannot secure the financing required to exploit innova ve, poten ally profitable ideas. This may occur because financiers the high incidence of zero earnings makes many microenterprise workers without other income sources vulnerable to economic cannot reliably predict the profitability of new ideas, so must secure their loans through collateral requirements that many small shocks. On the other hand, more than 50 percent of microenterprise employees work in highly skilled non-manual occupa ons businesses cannot meet. The government could support such innovators through narrowly-targeted tax relief, provided only to (Figure 53), implying that many higher-paid individuals are covered by the MET regime. This is consistent with the fact that high companies/sole traders commencing a new business/trade not previously carried out by anyone. shares of microenterprise workers are found in service sectors with a highly-qualified workforce (see ANNEX J. MICROENTERPRISE Tax relief could be provided in various forms, and subject to strict condi ons (see ANNEX M: SUMMARY OF TAX PROVISIONS TAXATION: FURTHER EVIDNECE ON ITS IMPACTTable 53). FOR SMALL -AND MEDIUM-SIZED ENTERPRISES IN THE EU). For a discussion of tax relief for small- and medium-sized enterprises in the EU). Businesses carrying on new ac vi es might be provided a credit for their corporate income taxes or their SSC contribu ons, subject to maximums per employee and per enterprise. Individuals star ng their own businesses (and working full- me in the business) could be given relief from personal income taxes on income up to a specified level (e.g. amount of capital invested) or for a limited number of years (a similar measure could be considered for returned emigrants). Rebates could be given on taxes paid in a specified number of prior years, up the amount of capital invested, for workers who leave employment to establish a new business. Finally, an exemp on on a por on of capital gains taxes could be given full- me entrepreneurs 47 See state revenue service (2016) for more details. 48 Those employed by more than one microenterprise would have to pay such MSSIC from each microenterprise they work for. Unlike for the general regime employees, these payments will not be cumula ve. 49 For more detail see company taxes (2015). 50 State Revenue Service data. 90 91 Latvia Tax Review Latvia Tax Review Table 14. Microenterprise share in labor income and incidence of self-employment (2008-2015) among individuals who substan al shares of MET-only and unstable workers recently stayed outside formal employment for extended periods ( ANNEX worked in microenterprises in 2015 J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACT, Figure 85 provides details), which is likely to make it difficult to find stable jobs under the general regime. Mainly general workers, or whose income sources were roughly equal 2008 2009 2010 2011 2012 2013 2014 2015 between the two regimes (Mixed in Table 15) are likely to be less affected, in part because a very low share of workers in these Average microenterprise share in gross two groups had more than one year of microenterprise work experience (Table 16). ANNEX J. MICROENTERPRISE TAXATION: 0.0 0.0 1.2 19.5 31.6 44.2 59.5 74.9 FURTHER EVIDNECE ON ITS IMPACTprovides a more detailed analysis iden fying the workers most vulnerable to a phasing out labor income, % of the MET regime. Average self-employment share in 2.4 2.4 2.7 1.5 1.2 0.8 0.5 0.2 gross labor income, % Table 15. Average microenterprise share in gross and net labor income among individuals with posi ve microenterprise Propor on of persons with self-employment income: earnings in 2015, by tax regime group - among those with some labor income, Percent 3.9 3.7 3.9 2.3 2.0 1.5 1.2 0.6 % MET-only Mixed Mainly Unstable Total - among all group members aged 15+, General 2.7 2.3 2.3 1.5 1.4 1.2 1.0 0.6 % Gross Net Gross Net Gross Net Gross Net Gross Net N obs with labor income, 1000 70.5 63.5 61.1 68.1 75.2 82.4 91.4 103.8 2015 98.1 98.4 46.7 51.8 29.0 33.5 71.7 74.3 74.9 77.2 N obs. 53,247 28,107 8,634 13,799 103,787 Notes: For 2008-2014, average microenterprise share in labor income (shown in the Table) differs very li le from microenterprise Source: Calcula ons based on State Revenue Service data. share in aggregate labor income of the group; in 2015, however, the la er is substan ally smaller (just 64 percent), indica ng that MET share tends to be lower for high-income earners. Table 16. Individuals with posi ve microenterprise earnings in 2015, by tax regime group and total microenterprise work Source: Calcula ons based on State Revenue Service data. experience Figure 53. Individuals who worked in microenterprises in 2014-2015, by occupa on in “main” microenterprise Percent MET-only Mixed Mainly Unstable Total General 1 -12 months 30.7 21.9 94.7 84.1 40.7 13-36 months 44.0 45.1 5.0 12.5 36.9 > 36 months 25.3 33.0 0.3 3.3 22.4 Total 100 100 100 100 100 Notes: Experience as of the end of 2015. Source: Calcula ons based on State Revenue Service data. Figure 54. Most microenterprise workers in the two most vulnerable groups have low-paying, manual jobs Notes: The figure covers only individuals with posi ve microenterprise earnings in respec ve year. The results should be treated with care, as informa on on occupa on was not available for 37% of observa ons in 2014 and for 30 percent of observa ons in 2015. These observa ons are excluded. N = 75,548 for 2014 and 86,469 for 2015. Source: Calcula ons based on State Revenue Service data Workers likely to suffer the most from a phasing out of the MET regime are those most dependent on microenterprises for their incomes. Workers who worked only for microenterprises (MET-only in Table 15) or who had substan al income from microenterprises but their sources of income varied sharply over me (Unstable in Table 15) accounted for 78 percent of the 103.8 thousand individuals with posi ve microenterprise earnings in 2015 (Table 15). Most workers in these two groups (55 and 65 percent, respec vely) are concentrated in sectors dominated by manual work (Table 57 and ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACTTable 62) and have significantly lower average earnings (ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS IMPACTFigure 81 and Figure 82) and educa on (Figure 55) than workers who received most of their income from firms in the general tax regime (Mainly general in Table 15). Moreover, Source: Calcula ons based on State Revenue Service data. 92 93 Latvia Tax Review Figure 55. Educa onal profile of employees by tax regime, 2014-2015 Equitable Growth, Finance, and Institutions Europe and Central Asia Region Notes: Defini on of groups is consistent with Table 29. LFS data contain 1984 observa ons on employees with posi ve microenterprise earnings in 2014 or 2015. To have enough observa ons in Mainly general group, workers without microenterprise earnings in 2015 are not excluded (this does not affect results for other groups). Source: Calcula ons based on State Revenue Service and LFS microdata. Main conclusions  The MET regime has many defects. A substan al number of enterprises and self-employed individuals have switched from the general tax regime to the MET regime, leading to a significant loss of tax revenues. Basing the tax on turnover rather than profits, designed to reduce bookkeeping costs for small enterprises, is par cularly a rac ve to sectors with high labor costs (e.g. professional service companies) rather than retail or manufacturing, where materials represent a higher share of costs. Thus, companies with similar levels of profitability are subject to different levels of taxa on. VAT One implica on is that less-produc ve firms may be able to pay wages that a ract workers from more-produc ve firms, thus reducing average produc vity in the economy. Safeguards are not adequate to prevent abuse, for example the manipula on of wage repor ng to maintain eligibility or par cipa on in the MET by several enterprises controlled by connected individuals (to evade the eligibility limits on the size of par cipa ng firms). The reduced employee contribu ons to the social security system under the MET regime may undermine the social protec on system by lowering current social security receipts and reducing the future protec on of workers once they reach re rement age. And finally, the MET regime has had li le role in encouraging innova on and growth, as few firms report achieving the expansion that would require shi ing to the general tax regime. Indeed, the MET may inhibit growth, as firms remain small to maintain eligibility.51  Alterna ve tax provisions could achieve some of the objec ves of the MET while limi ng the impact on the poor of elimina ng the regime. Alterna ve tax regimes for small firms are used in many OECD countries to encourage innova ve start-ups and boost the employment of low-income workers. It would be advisable to redefine criteria for firms par cipa ng in Latvia’s MET regime, for instance by lowering the maximum turnover allowed for par cipa ng firms (to EUR 20,0000), limi ng the number of employees and excluding certain professions. This would focus the MET on suppor ng small, life style companies that have low poten al to grow, in order to provide opportuni es for low- skilled workers who find it difficult to secure employment in firms par cipa ng in the general tax regime due to the high taxes on labor. At the same me, the professional services firms where salaries are high could be moved to the general tax regime. Independent from the life style regime, the government may consider introducing me-limited tax relief focused on start-ups involved in new businesses, with stringent monitoring to prevent abuse and ensure exit, to encourage innova on while limi ng foregone tax revenues. 51However, the vast majority of enterprises registered for the MET regime report turnover levels of EUR 40,000, which is well below the maximum turnover (EUR 100,000) level eligible for the 9 percent tax rate. 94 Latvia Tax Review Latvia Tax Review 6. VAT Latvia’s VAT is fairly broad-based with a standard and reduced rate, though rela vely few goods and services are taxed at the lower rate. The standard rate of 21 percent is close to the EU average (21.6 percent) and somewhat above the OECD A large share—about 39 percent—of total tax revenue in Latvia comes from taxes on goods and services, far above the average (19.1 percent). The rela vely high reduced rate (12 percent; see Table 18) applies to medical supplies and equipment, OECD and EU15 average (see Figure 56). Of these, the value-added tax (VAT) brings in more than 60 percent: VAT is more books, newspapers and periodicals, baby food products, firewood, central hea ng, thermal energy, hotel accommoda on, and efficient than some other taxes in Latvia (Figure 57) as it has a much broader base. During the global crisis EU countries on public passenger transport. However, some of these products are neither essen al nor are considered socially desirable. Goods average experienced a decline in VAT efficiency of about 3 percentage points, but the drop was much steeper in Latvia, as it was and services that are zero rated include items common for all EU countries, such as exports of goods and related services, intra- in Ireland, the Netherlands, and the U.K. This is probably due mainly to a shi in consump on pa erns, as o en happens during Community supply of goods, and interna onal transport, but the category also includes tourism services provided outside Latvia recessions when both incomes and expecta ons worsen and tax compliance slackens. The efficiency of Latvia’s VAT has recently (which is more difficult to defend). During the crisis, the government raised the top VAT rate from 18 to 22 percent and the returned to the pre-crisis level, though it is s ll below its peak of 0.45 in 1995. Although Latvia’s VAT revenue efficiency is now reduced rate from 5 to 10 percent—at that point s ll one of the lowest rates in the EU. The reduc on of the gap between the close to the EU average, it is s ll far below its efficiency in Estonia or the Czech Republic, perhaps because Latvia has a higher top and the reduced rate was regressive, although it also diminished the incen ve for businesses to lobby for reclassifica on of VAT threshold that exempts SMEs from VAT payments, and also due to tax compliance and enforcement issues. their products and increased VAT efficiency. Figure 56. Produc on taxes, in percent of total tax Figure 57. Revenue efficiency, Latvia, in percent Some por on of consump on is excluded from the VAT, as is true for most EU and OECD economies. In Latvia the rela vely revenue, 2015 short list of exemp ons is limited to such basic items as health, educa on, social, cultural, postal, and financial services. Less standard exemp ons are those that apply to gambling, sale of real estate, and rental housing, which are poten al candidates for moving from the exempt to the standard VAT category. Reduced VAT rate regimes cost 0.65 percent of GDP in Latvia in 2014 in terms of revenue foregone (see Table 17 for a decomposi on of cost by category of good and service). The standard VAT exemp ons are o en jus fied on prac cal grounds, e.g., output is hard to define and tax, such as financial and insurance services or gambling, or has distribu onal objec ves, such as basic health and educa on. Postal services are public services, which are non-taxed or exempt in most EU countries. Table 17. Revenue loss due to reduced VAT regime, 2014 Cost of reduced VAT rate thsd. EUR in percent of GDP Total cost 152,638 0.65 of which: Pharmaceu cals 103,168 0.44 Medical devices 2,744 0.01 Specialized food for infants 719 0.00 Note: Efficiency is calculated for each tax as the ra o of tax revenue to the product of the standard rate and Regular inland passenger transport and carriage of passenger luggage 10,422 0.04 the tax base (consump on). Source: Eurostat, OECD (for New Zealand) Source: World Bank staff calcula ons. Text books and original literature 3,164 0.01 Figure 58. Ra o of VAT revenue to total tax revenue Newspapers, magazines, bulle ns and other periodicals* 3,745 0.02 Tourist accommoda on services 9,642 0.04 Residen al heat supply 18,985 0.08 Supply of firewood to residents 51 0.00 Source: Latvian Ministry of Finance. Latvia offers a rela vely generous VAT exemp on for small firms: those grossing less than EUR 50,000 in the preceding 12 months are not required to charge and collect the tax. Such thresholds vary significantly in EU and OECD countries; Latvia’s is higher than in all benchmark countries except the U.K. (Table 18). It is triple Estonia’s. Though the objec ve of the high threshold is to help ease administra on, it can also discourage firms from par cipa ng in the formal economy. It promotes tax avoidance among exis ng firms by crea ng an incen ve for them to split up and start a new company to benefit from the 12-month VAT exemp on. Moreover, it creates a very uneven playing field between new and exis ng firms: new firms can sell goods at much lower VAT-exempt prices. Source: OECD.Stat database. 96 97 Latvia Tax Review Latvia Tax Review Table 18. Selected OECD VAT indicators compe veness. Estonia with a lower VAT rate of 9 percent on hotels is less compe ve than Latvia (12 percent) on hotel pricing, while Lithuania with a 21 percent VAT rate on hotel accommoda on in 2014 was more compe ve (see Figure 61). 52 VAT Rates (in percent) Another example is that central hea ng, thermal and wood fuel supply are subject to a low VAT rate, while gas and electricity Threshold (EUR), 2015 used for hea ng are subject to the standard rate. In general, goods or services that are close subs tutes (for instance all of the 2005 2015 above commodi es) should be uniformly taxed. Standard Other Standard Other Figure 59. Share of household consump on (cash) by Figure 60. Hotel/Restaurant consump on per capita by Latvia 18 5 0 21 12 0 50,000 VAT rate category, 2014 income decile, in euros, 2014 Lithuania 18 9 5 0 21 9 5 0 45,000 Estonia 18 5 0 20 9 0 16,000 Slovakia 19 0 20 10 0 49,790 Poland 22 7 3 0 23 8 5 0 ca 35,000 Czech Republic 19 5 0 21 15 10 0 ca 37,000 Austria 20 16 12 10 20 12 10 0 30,000 Ireland 21 13.5 4.8 0 23 13.5 9 4.8 75,000 (37,500 for services) Finland 22 17 8 0 24 14 10 0 8,500 New Zealand 12.5 0 15 0 ca 36,000 UK 17.5 5 0 20 5 0 ca 104,000 Germany 16 7 - 19 7 None Source: EC 2015, Ernst 2015. Op mal tax theory holds that differen ated VAT rates should be used only to reduce labor-market distor ons or improve income distribu on. Taxing goods and services that are complementary to leisure (e.g. travel and tourism) at higher VAT rates Source: World Bank calcula ons based on Household Budget Survey, 2014. can raise labor supply, desirable because labor supply is reduced by the income tax (Jacobs and Boadway, 2014). Conversely, goods that are complementary to work (e.g. work-related cost of travel, child-care facili es, or goods that are close subs tutes Figure 61. Global hotel price index and country global ranking, 2014 for home produc on) should be taxed less. When the demand for goods and services does not vary with labor supply, the famous Atkinson-S glitz (1976) theorem indicates the VAT should be uniform. The welfare losses from differen ated VAT-rates in goods markets need to be traded off against the poten al welfare gains in labor markets. There is not much empirical evidence es ma ng the degree of complementarity of various commodi es with labor supply. Available research does not provide par cularly strong evidence in favor of differen ated VAT rates to reduce labor-market distor ons. Crawford et al. (2010) find that for the UK, food, energy, tobacco and public transport are complementary to leisure, whereas restaurant dinners, alcohol, and fuel are complementary to work. Pir lä and Suoniemi (2010) show that in Finland capital income and expenditures on housing are complementary to leisure, whereas child-care facili es are complementary to labor. Most expenditure categories in both studies, however, show no significant associa on with labor supply. Whether VAT rates should be used to improve income redistribu on depends on whether a differen ated VAT-structure can redistribute more income over and above that which can be achieved through a progressive tax on income. That is, when all differences in the demand for goods and services are perfectly predictable by labor incomes alone, then a differen ated VAT-structure cannot redistribute any more income than the government can achieve through the income tax, but it in addi on distorts commodity demand. Consequently, differen ated VAT-rates are not desirable even if the poor spend a larger frac on of their income on certain commodi es. Differen ated VAT-rates are only desirable for income redistribu on when, condi onal on observing (and taxing) labor earnings, demand for goods and services s ll vary with earnings (Mirrlees, 1976; Saez, 2002). In this case, the trade-off between equity and efficiency can be improved through differen ated VAT-rates. For example, Gordon and Kopczuk (2010) present empirical evidence that home-ownership (and capital income) strongly correlates with earnings ability. Differen ated VAT rates are not an effec ve means of reducing poverty or redistribu ng income in Latvia. Survey data do Source: The Travel and Tourism Compe veness Index Dataset © 2015 World Economic Forum. not indicate a concentra on of expenditures by lower-income households on goods and services subject to reduced VAT rates. Thus, moving some of the 12-percent or 0-percent VAT commodi es to the 21-percent group, while offse ng any distribu onal In general, VAT rules that apply to Latvia’s public sector, unlike in many other EU countries, do not undermine VAT consequences through income tax adjustments, could reduce distor ons in goods markets, as well as administra ve and neutrality. The VAT rules that exempt such public services as health, educa on, and cultural services also apply to the private compliance costs, without worsening income distribu on. sector. The only excep on is specific postal services that are only VAT-exempt for the public sector. Some differen ated VAT rates have par cularly poor economic jus fica on in Latvia. For instance, Latvia introduced the The reduced rates and exemp ons in VAT are costly in terms of public revenue. The VAT expenditures in 2014 amounted reduced VAT rate for hotel accommoda on in 2010 to help the sector recover from the crisis. Since then, the economic situa on 52 As of January 1, 2015, Lithuania has reduced the VAT rate of Hotel Accommoda on Services to 9 percent. But the compe ve calcula ons were done prior of the hotel sector has improved and the argument for the reduced rate for this sector has weakened. In addi on, a lower VAT to that change—for the 2015 Travel & Tourism Compe veness Report. Estonia plans from January 2017 to increase the VAT rate for hotel accommoda on rate on hotel accommoda on benefits visitors and richer residents (see Figure 59 and Figure 60) but does not necessarily drive services from 9 percent to 14 percent. 98 99 Latvia Tax Review Latvia Tax Review to EUR 945 million, or 3.9 percent of GDP and 52 percent of VAT revenues. In Latvia, the VAT exemp ons are responsible for the Figure 63. VAT gap, in percent of VAT Figure 64. Compliance problems, percent of total bulk of the VAT expenditures (about 3.2 percent of GDPThe budgetary cost of reduced tax rates is es mated at 0.65 percent of liability, 2013 liability, 2010-2014 GDP, of which about 60 percent results from the reduced VAT rate for medicines and medical equipment (see Figure 62). The cost of reduced VAT rates for hea ng, public transport and hotel accommoda on is also non-negligible. Figure 62. Distribu on of cost of reduced VAT rates in 2014 Source: CASE 2015. Source: Latvia SRS. Table 19. Sources of VAT GAP in Poland and the U.K., in percent Source: Ministry of Finance. U.K. (2013-14) Poland (2013) The bank levy Latvia introduced in 2011 is a first step to addressing the undertaxa on of the financial sector caused by the Missing trader intra community 3.8-7.6 10.8 VAT exemp on. Exemp ng the financial sector from VAT can distort both consumer and business decisions. On the other hand, Shadow economy 18 above 6.3 applying the VAT to financial services is difficult, largely because defining the price for financial opera ons is challenging.53 As a result, most financial and insurance services are exempted in the EU. Therefore, while the financial sector does not charge VAT Tax evasion 14 above 35 on most of its output, it cannot deduct the VAT charged on its inputs (the “irrecoverable VAT” problem). This creates cascading Mistakes 8 7.7 tax effects, since the irrecoverable VAT embedded in the charges that banks make to their business customers will be carried through to final prices for domes c consump on (OECD 2014). As a result, the price of financial services for business users Source: Poniatowski (2016). is higher than what it would be with a deduc ble output VAT, while the price of financial services for final individual users is lower than if VAT were applied. The exemp on also distorts compe on between domes c services (exempt with no right of deduc on/inputs taxed) and services imported from a VAT country (where export of such services is free of VAT) or from a non- VAT country (e.g., the USA). Given these problems, Latvia in 2011 introduced a “stability fee” of 0.036 percent on the adjusted Main conclusions: liabili es of banks, which is economically equivalent to a VAT. This is similar to the bank levy imposed by Sweden and the UK.  Authori es could broaden the VAT base to eliminate unnecessary exemp ons or raise reduced rates that no A significant amount of VAT revenue is lost due to tax evasion and avoidance. Evidence of entrenched tax evasion can also longer achieve policy aims in the most efficient way (taxa on of energy or hotel accommoda on). This decision be found in the high VAT compliance gap54. Latvia has close to EU average VAT revenue ra os (VRR) but a very high VAT gap (see needs to be based on a careful review of the efficiency and distribu onal impact of preferen al VAT rates on goods Figure 63).55 An independent study by the European Commission (2014b) found that the VAT gap in Latvia had grown from 15 and services. percent of poten al liabili es in 2005 to 30 percent in 2013. Failure to comply explains a major part of this gap. Although the  VAT thresholds should be evaluated. Gains from reducing tax administra on and compliance costs need to be State Revenue Service es mated a smaller gap than the EC (Figure 64) and found a gradual but persistent decline in the gap since carefully assessed against the compe ve distor ons stemming from the difference in treatment among taxpayers the crisis, closing the gap could s ll increase VAT revenues significantly—there is room to adopt more efficient tax administra on on both sides of the VAT threshold. methods to tackle tax fraud, evasion of VAT arrears, underrepor ng, and the shadow economy. Because the gap may have a  Efforts should be made to reduce the VAT gap. An analysis of the causes of the gap should be used to target tax variety of sources, knowledge of VAT gap structure could make it easier to design efficient methods to tackle it. For instance, administra on measures on major areas of noncompliance. analysis for Poland (Poniatowski 2016) found that the shadow economy, tax evasion, and VAT fraud (in par cular missing trader intra community) are responsible for more than 50 percent of the gap (see Table 19). The size of the gap in Latvia suggests that it would be advisable to adopt methods to tackle tax fraud, evasion of collec on of past debts, underrepor ng, and the shadow economy. 53 Actually, the main difficulty in taxing financial services does not lie in the VAT per se but in the applica on of the invoice-credit system to services priced on the basis of margin spreads rather than explicit fees (Zee 2013). 54 VAT gap is the difference between poten al collec ons and actual collec ons. Incorporates the impact on collec ons of both compliance issues and the policy structure. Compliance gap is difference between poten al collec ons and actual collec ons given the current policy framework. Policy gap is difference between the poten al collec ons given the current policy framework and some norma ve policy framework (i.e. single rate, broad base) given the current composi on of GDP. 55 The VAT gap arises not only from fraud or tax evasion but also from errors, failure to take reasonable care, and nonpayment due to bankruptcy or insolvency. 100 101 Equitable Growth, Finance, and Institutions Europe and Central Asia Region EXCISE TAXATION Latvia Tax Review Latvia Tax Review 7. EXCISE TAXATION Table 21. Prices of Du able Products, Latvia, Russia, and Belarus, 2016 Excise du es make a significant and stable contribu on to Latvia government revenues. In 2013–2015, the du es levied on fuel, tobacco, so drinks, coffee, and alcohol56 raised 7.2 percent of total tax receipts—3.2 percent of GDP (Table 20). However, Cigare es, Alcoholic Beverages, Eur/1 liter Fuel, Eur/1 liter despite increases in excise rates (to the EU required minimum) over the past decade, excise revenues have not increased EUR /20 cig compared to GDP. For example, the rate on alcoholic beverages has almost doubled since 2004, and the increase on cigare es57 Geo Beer Wine Spirits Petrol Diesel LPG has been even higher. On the other hand, the duty for petrol is now about 25–80 percent of its 2004 level and for diesel 60–130 percent, depending on its content. Diesel that is 100 percent bio is not taxed and the tax on that used in agriculture is very low. Latvia 1.70 11.50 28.30 2.60 1.03 0.91 0.48 Russia 2.10 4.40 11.70 1.31 0.47 0.45 0.22 Table 20. Excise Du es and Consump on Taxes, Representa ve EU Countries, Percent of GDP Belarus 1.20 3.20 9.60 0.64 0.51 0.53 0.26 GEO/TIME 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Euromonitor, Globalpetrolprices, 2016. Belgium 2.1 1.9 1.9 1.9 1.9 1.9 1.8 1.8 1.8 1.8 1.8 Czech Republic 2.6 2.6 2.8 2.4 2.5 2.5 2.7 2.7 2.8 2.3 2.5 The high excise tax in Latvia that burdens domes c consumers and a racts illegal trade makes it harder to increase taxes. There might be a case, however, for changing the applica on of excise du es to different products. When designing the Germany 2.2 2.2 2.0 2.0 2.0 1.9 1.8 1.7 1.6 1.6 1.5 excise tax system the government should seek to minimize the distor ng effects of the tax on consumer behavior, use it to Estonia 3.7 3.4 3.6 3.3 5.0 4.2 4.3 4.4 4.2 4.3 4.3 correct socially costly behavior, or both. Consump on of certain goods can impose costs on others (“externali es”) or costs on Ireland 0.8 0.7 0.7 0.7 0.7 0.6 0.5 0.5 0.5 0.4 0.3 consumers in the future (“internali es”) that they may not fully take into account when making consump on decisions. In these circumstances, taxa on can discourage the excessive consump on that would occur without it. There is some evidence that in Latvia 3.4 3.1 2.7 3.0 3.6 3.6 3.4 3.2 3.2 3.2 3.3 Latvia the excise du es could be er target the externali es and internali es associated with smoking, driving, and drinking. Lithuania 2.9 2.9 2.8 3.0 3.4 3.1 2.9 2.8 2.8 2.8 3.1 The current structure of alcohol du es could be improved to be er target poten ally harmful consump on. Alcohol Austria 2.6 2.4 2.4 2.3 2.3 2.3 2.4 2.4 2.3 2.3 2.3 consump on not only imposes costs directly on people who drink but also on others, such as vic ms of accidents, property Poland 3.9 3.8 3.9 4.1 3.5 4.1 3.9 3.8 3.7 3.5 3.5 damage, and violence. Moreover, the social harm from alcohol consump on is likely to be nonlinear: consuming a bo le of wine in an evening is likely to cause much more harm than the first glass. Finally, for a given level of consump on, the magnitude of Slovakia 3.6 2.8 3.4 2.6 2.8 2.9 2.8 2.7 2.7 2.7 2.7 harm is likely to vary across people. This creates challenges in quan fying both the marginal external or internal costs of alcohol Finland 3.6 3.5 3.2 3.2 3.3 3.4 3.7 3.8 3.7 3.6 3.7 consump on and the appropriate tax level. Nevertheless, many countries design excise taxes on alcohol consump on by taxing United the unit of alcohol regardless of the form of the drink. The Latvian excise tax burden on spirits is already significantly higher 3.1 3.0 3.0 3.0 3.2 3.3 3.3 3.3 3.2 3.2 3.1 than on beer, even without taking into account the planned rate increases for the former60. Excise tax burden on strong alcohol Kingdom Source: Eurostat 2016. beverages is already significantly higher than on beer, more than 4-5 mes, based on beverage impact on human health (alcohol does). Given that consump on of beer dominates in total consump on of alcoholic beverages in Latvia, it might be desirable to suspend the planned increase in the excise duty on strong alcohol and raise du es on beer and wine (see table in the ANNEX N: Latvia has much higher excise rates than its regional peers, especially when corrected for purchasing power. In 2014, its EXCISE TAX RATES: CURRENT STATUS AND RECOMMENDATIONS). alcohol du es, though s ll below the EU average, were among the highest in the region. Moreover, it had the highest duty in Changing the balance between the specific and ad valorem components of the tax on cigare es will be er target public the EU for spirits and wine, and the sixth-highest (behind Malta, Croa a, Bulgaria, Portugal, and Slovenia) rate on beer, in PPP- health and may lead to higher revenues. Increases in Latvia’s excise tax rates were necessary to meet EU requirements, and had adjusted terms. Latvia also had the second-highest PPP-adjusted duty on tobacco in the EU, though it was s ll below the EU the effect of reducing the difference in price between the cheapest and most expensive cigare es. S ll, each EU member state average in euro terms.58 Finally, Latvia has one of the lowest retail fuel prices in the EU, but when adjusted for PPP it has the has flexibility in determining the balance between the specific and ad valorem excise components. Lowering the ad valorem rate fourth-highest duty on all types of fuel59 (see ANNEX K: AN ECONOMIC ANALYSIS OF THE MICROENTERPRISE TAX). and raising the specific rate, combined with an increase in the minimal excise tax, could increase revenue from tobacco excise by Differences in prices, resul ng from higher excise rates in Latvia than in neighbouring Lithuania, Belarus and Russia, up to EUR 3 million. It would also help to improve public health: (1) it would likely raise prices, causing price-sensi ve consumers encourage tax avoidance and evasion. The higher the du es, the larger the incen ve for consumers to avoid the tax by cross- to reduce their consump on; and (2) it would reduce incen ves for consumers to subs tute higher-priced for lower-priced border shopping or evade it by purchasing in an illegal segment of the market where tax is not levied. Prices of spirits, wine, fuel brands, especially when consumers find it difficult to reduce consump on a er a tax increase. This would have a greater impact of all types, and cigare es are much higher in Latvia than in Belarus and Russia (see Table 21), which encourages cross-border on reducing smoking by individuals who are poor or young. This change would need to be combined with CPI adjustments to shopping and smuggling despite exchange rate risk, border control and visa requirements to cross the border. The scale of tax keep pace with infla on, but since infla on is low in Latvia, that will not be immediately necessary. avoidance in the tobacco and fuel markets appears to be a ma er of high concern. Latvia is one of the countries with the highest Changes to the excise taxa on on fuel require much thought. Current fuel prices in Latvia already a ract cross-border trade consump on of smuggled cigare es (more than 20 percent of total cigare e consump on is illegal) in the European Union and smuggling from Russia and Belarus. When PPP is taken into account, the excise also imposes a high tax burden on Latvian (KPMG 2013). Legal and illegal import of fuel has a significant impact on the fuel market in Latvia, too. consumers. Nevertheless, fuel excises could be restructured to more effec vely tax driving externali es (e.g., CO2 emissions, conges on). For instance, the fuel excise could be redesigned to take into account the harmful impact of transport fuel on the environment (Brizga, Juruss 2016). One way to do this would be to base the tax rate on the unit of CO2 emission, because emissions are directly propor onal to fuel use. For Latvia that would imply reducing the rate on gasoline but raising it on diesel 56 In accordance with the law, the excise tax is applied to alcoholic beverages, tobacco products, oil and natural gas, so drinks, and coffee. The tax on oil is ap- and other products. Even this change, however, would need to be designed carefully so as not to harm compe veness and plied to transport fuel and hea ng oil (despite several reliefs and reduced rates such as the rate for diesel used in agriculture). the development of infrastructure. For instance, commercial use of diesel may need special treatment such as a rate reduc on 57 The tax rate on cigare es has gone up significantly, from EUR 11.95 per 1,000 cigare es + ad valorem 19.2 percent on January 1, 2007, to EUR 39.84 + ad (through reimbursement of the tax difference) to encourage transport companies to purchase fuel legally in Latvia rather than valorem 33.5 percent on January 1, 2014. 58 In Latvia cigare e taxa on has both a specific (€60 for 1,000 cigare es in 2016) and an ad-valorem component (25 percent of the retail pack price). in neighbouring countries. Revenues from a higher excise tax on diesel could be also earmarked to support the railway system, 59 In 2014 the cost of 60 liters of petrol (average daily per capita consump on) cons tuted 12.76 percent of a worker’s average net salary (EU average: 7.88 percent), and expenditure on 60 liters of diesel 11.81 percent of the average net salary (EU average: 7.25 percent). 60 EUR 1,450 per 100 liters as of January 3, 2017, EUR 1,500 as of January 3, 2018. 104 105 Latvia Tax Review Latvia Tax Review which is much more environmental friendly than road transport.61 Finally, total or par al exemp ons or tax reduc on for energy Conclusions products used for the carriage of goods and passenger by rail can be considered. Several EU countries allow for par al or total excise tax exemp on for diesel used in rail transport (see Table 22). In Latvia, the excise tax on fuel used by railway transport is  The main economic jus fica on for excise taxes is to correct behavior that has social costs that individuals do not taken paid in full despite for the importance of the transit and logis cs sector.62 into account when deciding what and how much to consume. These costs may be borne by others, the society at large, or the consumer in the future. There is considerable evidence that consump on of tobacco, fuel, and alcohol generates Table 22. Tax on diesel used in rail transport such costs, although their extent can vary in complex ways related to the amount consumed and the consumer. Such social costs are a ra onale for levying excise du es on these goods. However, it is important that any tax is designed to Country EUR/1000 l target effec vely externali es or internali es associated with consump on. Belgium 0 Denmark 60.99  There is a clear case for reform in how driving and alcohol are taxed. Fuel and alcohol excise du es do not target the France 128.3 primary externality, CO2 emissions, associated with driving. The government should consider basing the tax on fuel on CO2 emissions. Taxa on of fuel needs to be carefully redesigned so as not to harm the transport sector and Latvia’s Estonia 110.95 compe veness. Reform of alcohol taxa on should target alcohol products systema cally, because society consumes Italy 185.22 dispropor onately more of the low-tax products. Ireland 108.28  The main goal of levying excise du es is to correct socially costly behavior, not to generate revenue. Indeed, reducing Luxemburg 0 consump on of tobacco, fuel and alcohol could improve their net contribu on to the public purse if it leads to Portugal 90.11 sufficiently large falls in the health, environmental, and public safety costs associated with their consump on. Slovenia 253.66  Future excise policy might consider levying taxes on other forms of consump on that generate externali es and internali es. Finland 214 Spain 0 Hungary 0 Sweden 0 Source: TAXUD 2016. Impact on Tax Revenue The proposed changes in excise taxes (see for details) would raise between EUR 100 and 400 million (up to 1.8 percent of GDP, see Table 23) in the next two years. The upper bound es mate assumes that improvements in tax administra on reduce tax fraud and evasion. The addi onal revenues will come from:  Alcoholic beverages. The changes in the tax burden would raise taxes on beer and wine but not on spirits.  Cigare es. The proposal to increase the specific excise component of excise while reducing the ad valorem part will result in addi onal revenues if the government intensifies the fight against smuggling. However, without a more determined a ack on smuggling, the revenue effect could be zero or even nega ve.  Fuel. It is proposed to increase excise tax rate on fuel (see ANNEX N: EXCISE TAX RATES: CURRENT STATUS AND RECOMMENDATIONS), in par cular the tax rate on diesel used for private purposes, mainly for environmental reasons. The revenue impact of proposed changes is dependent on tax policy changes in other Bal c States (harmoniza on of excise policy), introduc on of tax relief for commercial diesel fuel and the effec veness of tax administra on. Table 23. Total excise tax revenue (upper bound es mate), EUR million 2018–19 Alcoholic beverages 90 Cigare es 100 Fuel 220 Note: The table indicates upper end of es mates. 61 This is also in line with one of the EU transport policy priori es spelled out in Europe 2020– making make rail freight more compe ve than road transport. 62 Carriage of goods by rail is more developed in Latvia than in other countries. Transit and the logis c sector had a significant impact on economic development in Latvia, now genera ng about 12 percent of GDP. The railway industry pays at least EUR 100 million in taxes each year, and transport and logis cs employ than 70,000 people. 106 107 Equitable Growth, Finance, and Institutions Europe and Central Asia Region RESIDENTIAL PROPERTY TAXATION Latvia Tax Review Latvia Tax Review 8. RESIDENTIAL PROPERTY TAXATION Table 25. Exis ng and proposed ra os of assessed value to market value adopted in 2015 There have been frequent calls for increasing property taxes to generate addi onal revenues in Latvia. The Latvian Exis ng tax rate, percent Proposed tax rate, percent Government is currently considering a reform of its property tax system. Genera ng support for increased property taxa on is likely to be challenging. For example, a empts to make the system of residen al tax assessment more uniform have met with New residen al apartments 38 81 considerable poli cal resistance, because it would imply a large tax increase on certain categories of residen al property. Old residen al apartments 72 86 Box 6. Local Government Finance in Latvia Single family homes 65 79 Local governments account for about 27 percent of general government spending in Latvia, slightly above the average for the EU28.* The largest source of local government revenues is the personal income tax, which generated 52 percent of local government revenues in 2015. One third of local revenues were derived from transfers, and only nine percent from property Table 26. Standard tax rate on residen al buildings taxes. Of this amount, about half was generated from taxes on land and the remainder from taxes on buildings. The majority of taxes on buildings, in turn, were derived from industrial and commercial proper es. As shown in the table below, taxes on Value of Building, EUR Property tax rate, percent residen al buildings generated only EUR 24.2 million in 2015; twelve percent of total property taxes and only one percent of total local revenues. User charges and other non-tax revenues accounted for the remaining 6 percent of total revenue. Up to €56,915 0.20 Table 24. Local Government Revenues, 2015 €56,915 -106,715; 0.40 Over €106,715 0.60 EUR million In percent of total Taxes 1362.8 60 Latvia’s system of mass appraisal is quite sophis cated. In the case of mul -family residen al proper es, for example, separate calcula ons are made for the building and the land under it (this is conven onal prac ce). The calcula on of the PIT 1148.1 51 land component takes into account not only the loca on and size of the parcel, but also its environmental status (whether Property 197.1 9 it is considered polluted), cultural significance, and any liens or other encumbrances on tle. If a parcel is located within the Of which: Bal c Sea and the Gulf of Riga coastal protec on zone, for example, its value is reduced by 20 percent. The calcula on of the building component takes into account the square footage of the structure and its use (e.g., whether the building is used for - Land 100.4 4 residen al, commercial or industrial purposes). In the case of residen al property, further dis nc ons are made among types - Buildings 96.6 4 of buildings (e.g., single family homes, small mul -family buildings, large mul -family buildings, etc.) along with the condi on of -- Residen al 24.2 1 the structure and its access to u li es.64 Transfers 738.3 32 As in many countries, the resul ng es mate of market value is then reduced by a fixed percentage to yield an ‘assessed value’; i.e., the value to which the tax rate will be applied. In Latvia, these vary among various types of residen al property. Fees, other 172.3 8 As shown in Table 25, new apartments are currently assessed at only 38 percent of their market value, while old apartments TOTAL 2273.4 100 are assessed at 72 percent of their market value. For single family homes, the ra o is 65 percent. 65 As discussed below, the *General government includes social security. Data is for 2015. EU 28 average is 24 percent. Government and Parliament are considering an increase in the assessment ra o. In August 2015, the Cabinet adopted a Source: Eurostat. regula on66 raising the assessment average ra o to 85 percent, effec ve in 2017 (the ra o would con nue to dis nguish among types of residen al property, but with far less varia on than at present—Table 2). In May, 2016, however, Parliament adopted Background: the residen al property tax in Latvia amendments to the Na onal Real Estate Cadaster Law postponing the change to 2018. As shown in Table 2, the ra o would The property tax is exclusively assigned to local governments in Latvia. However, property tax receipts equal only 9 percent con nue to dis nguish among types of residen al property, but with far less varia on than at present. of total local government revenues (Box 6). The legal framework for property taxa on is set out in the Law on Immovable Rates. Prior to 2013, the central government fixed the rate of the property tax. Since that date, local governments have been Property (as amended through April 2014) and a series of cabinet resolu ons. According to the current property tax law, the permi ed to set the rate within a range of 0.2 to 3.0 percent. However, the rate may only exceed 1.5 percent if the property is property tax is imposed on land and buildings (including residen al buildings owned by local governments which are rented out, ‘not maintained in accordance with the procedures laid down in laws and regula ons’. If a local government declines to set its in which case tax is imposed on the tenant). The tax is assessed on the basis of the property’s cadastral value on January 1 of own rate, a standard rate schedule is applied. This standard rate is 1.5 per cent of the assessed value of the land and building, each year. According to the law, that value is to be determined by the State Land Service in compliance with the requirements except in the case of residen al buildings, where the rate is ranges from 0.2 percent to 0.6 percent (see Table 26). of the Immovable Property State Cadaster Law, using data from the Immovable Property State Cadaster Informa on System and Exemp ons and Abatements. The property tax law sets out several exemp ons and abatements that local government other sources, as required. are required to observe. These include a 90 percent tax reduc on for ‘deprived and low income persons’ as determined by Assessment Methodology. Cadastral values are, in most cases, determined through mass appraisal. Under this approach, state informa on system and a 50 percent reduc on for residen al property if the taxpayer has 3 or more children under data on recent property sales is analyzed to determine the contribu on of various property characteris cs (including the use, 18 years of age or qualifies as poli cally repressed (and has owned the property for at least five years). The law also permits loca on, and size of the land parcel, and the square footage and other characteris cs of the building) to the sales price of each local governments to provide addi onal abatements of 25-90 percent at their own discre on, provided the abatements apply property. This yields a formula assigning a value to each parameter (e.g., a value per square meter of floor area for residen al uniformly to objec vely defined groups. A local council, for example, may provide for a deferment of property tax liabili es for buildings in a par cular zone) which is then applied to all proper es on the tax rolls.63 taxpayers mee ng certain socio-economic criteria. The deferred amount is then due when the property is sold. At the same me, the law allows local government to provide abatements to support ‘the compe veness of local entrepreneurs’ consistent with the principle of social responsibility, par cularly to take into account the impact of the tax on ‘the groups of socially disadvantaged and poor inhabitants’. ANNEX N: EXCISE TAX RATES: CURRENT STATUS AND RECOMMENDATIONSdiscusses the 64 Whether the system in fact succeeds in predic ng the future sales price of proper es is not known. 65 D.Reizniece-Ozola, Ministry of Finance, Informa on Report: On exemp ng the only property owned from immovable property tax (IPT). 2016. 63 See Land Service website h p://kadastralaver ba.lv/vienkarsi-par-kadastralo-ver bu/ 66 Resolu on No 456, amending Cabinet Resolu on No 305 of April 18, 2006 “Regula ons regarding Cadastral Evalua on” 110 111 Latvia Tax Review Latvia Tax Review experience with property tax relief in four OECD countries. There are of, course, other ways of targe ng the poor through the property tax. All of them have serious drawbacks, however. The Cabinet’s decision to increase average assessment ra os to 85 percent set off a poli cal firestorm. As shown in Table One approach is to impose lower assessment ra os or lower tax rates on lower value property. In theory, this would lower the tax 25, above, this reform would substan ally increase the property tax burden on residen al proper es, par cularly on new on people living in modest dwellings. Latvia already uses this approach in se ng the rates on residen al buildings. As noted earlier, residen al apartment buildings. In response, the government is examining ways to ameliorate the impact of these increases. that rate range from 0.2 to 0.6 percent. The Ministry of Finance is considering a proposal to increase the number of households The remainder of this note evaluates a variety of op ons, based on interna onal experience (see ANNEX O: INTERNATIONAL benefi ng from the lower rates by raising the thresholds: the 0.2 percent rate would apply to proper es with values of up to EUR EXPERIENCE WITH PROPERTY TAX RATES AND EXEMPTION POLICIES) for a discussion of prac ces in four comparator countries). 150,000 (or EUR 100,000) rather than EUR 56,915 as at present. In principle, it might make sense to increase the threshold s ll further or lower the rate on the lowest bracket. Property tax policy op ons for Latvia There are a number of drawbacks to this approach, however. To begin with, it would not necessarily benefit low income First principles. In evalua ng the op ons for Latvia, it is useful to begin with first principles. In theory, the burden of the renters. At present, the progressive rate on buildings applies to en re structures, rather than the individual housing units within property tax should be distributed on the basis of ability to pay. This is true of all taxes (except so-called sin taxes, whose them. Thus a large structure would be considered high value (and therefore subject to the maximum tax rate) even if the units objec ve is to discourage the behavior that is taxed). The problem, in the case of the property tax, is that property values do not within it were very modest. As landlords can be assumed to pass the burden of property taxes onto their tenants in the form of reflect a taxpayer’s ability to pay out of current income. At best, property values reflect a taxpayer’s wealth, which may only be higher rents, tenants would ul mately pay the higher rate. It should be noted that this is not as important an issue in Latvia as it realized (i.e., turned into cash) when the property is sold.67 would be in New York City, for example. The most recent published census data (from the 2011 census) shows that only that 14 percent of private households in Latvia occupy rental units.69 (Even in Riga, the propor on is only 15 percent.) But if no provision is This fundamental disconnect between the value of a property and its owner’s ability to pay out of current income is made to reduce the tax rate on low value rental units, this 14 percent would be excluded from the benefit of progressive tax rates. a common source of problems in developed countries with aging popula ons. There, older people on fixed incomes are Another op on—one that is much discussed in Latvia--would be to reduce the tax rate on housing units that are occupied confronted with rising tax bills arising from rapidly increasing property values. A similar problem exists in countries of the by their owners. (Such abatements typically apply only to the owner’s primary residence, ensuring that second homes are taxed former Soviet realm, due to the manner in which the housing stock was priva zed. Under the former regime, housing units were at normal rates.) According to the Minister of Finance (see D.Reizniece-Ozola, op.cit.) there is presently a public ini a ve to either typically allocated by state enterprises--without regard to the occupants’ income. At transi on, these residen al units were exempt owner-occupied residen al property en rely or reduce the rate on owner-occupied housing to 0.1 percent. But again, transferred to the persons occupying them at the me. As a result, low wage workers could find themselves the owners of high owner occupancy is no indicator of ability to pay. If anything, there is a nega ve correla on between income and tenure: richer value units and vice versa. The economic disrup on that accompanied the transi on worsened the problem, as even formerly people are more likely to own; poorer people are more likely to rent. As a result, an exemp on for owner-occupied proper es high income workers in high value proper es could find themselves unemployed and unable to afford the taxes on their units. would be grossly inequitable: the owner of a mansion worth several million euros would qualify for the exemp on while a low- Rising property values have compounded the problem, as tax bills that might have been affordable at the me of transi on income renter would not. 70 became less so. Given the difficul es of targe ng property tax reduc ons on those less able to pay, one has to wonder if it is worth the effort. Nevertheless, the first-best op on for Latvia would be to proceed with the adjustment in assessment ra os as planned, The fact is that the burden of residen al property taxes in Latvia is not very great. As shown earlier in Table 1, the tax on residen al with no compensa ng changes in tax rates or exemp on policies. Under the ability-to-pay principle, assessment ra os should buildings generated only EUR 24 million in 2015. The level of revenue generated by taxes on residen al land cannot be determined be the same for all residen al proper es. This ensures that individual property tax liabili es are uniformly associated with the from the sources at hand. But even assuming that it is twice the level of the tax on buildings, the average tax burden in Latvia works value of the property owned or occupied by the taxpayer.68 The fact that proposed assessment ra os would rise most rapidly out to only EUR 84 per household, or 0.6 percent of median household income. Even the most carefully targeted property tax on new apartment buildings represents a step forward, as it can be assumed that the people who purchase or rent units in new exemp on would not have any impact on the distribu on of income in Latvia. buildings are rela vely well off. More broadly, there is considerable uncertainty as to whether property taxes are progressive or regressive, which depends on the ul mate incidence of the tax (Box 8). Box 8. The Poli cal Economy of Property Taxa on Box 7. Is the Property Tax Progressive? Regressive? Or Neither? Throughout the world, the property tax—par cularly the tax on residen al property—arouses poli cal opposi on that is dispropor onate to the revenues it generates. Much of the popular resistance to the property tax appears to arise from Analysts disagree on the property tax’s progressivity—or lack of it. The dispute centers on the ques on of where the ul mate its visibility. Unlike the income tax, the property tax is not withheld at source. Unlike the VAT, it is not paid in small amounts incidence of the property tax falls. Some analysts believe that the incidence of taxes on residen al property ul mately falls with each daily purchase (or, in fact, hidden in the price of the good itself). Instead, the property tax generally is paid directly on occupants: owners, in the case of owner-occupied housing and tenants in the case of property that is rented out. On this by taxpayers in lump sum payments. As a result, it tends to raise hackles among taxpayers, par cularly those (such as owner basis they conclude that residen al property taxes are inherently regressive, since housing usually cons tutes a larger share occupants) who do not associate the tax with a flow of revenues. In consequence, governments tend to avoid it. Of the 75 of the spending of poor people. Others see the property tax as essen ally a tax on capital and conclude that it is inherently major countries tracked by the IMF Government Finance Sta s cs data base, only four generate more than 2.6 percent of GDP progressive, since income from capital cons tutes a rela vely higher share of income for richer people. Then, there are those from property taxes. The average yield of property taxes (including taxes on agricultural land and ta on the sale of property) who view the property tax as essen ally a charge for local public services. To them, the issue of incidence does not arise at among the 75 coun es is only one percent of GDP. all. They see no more sense in asking if the ‘price’ of local public services is regressive than in asking if the price charged for anything else is. See Enid Slack and Richard Bird, The Poli cal Economy of Property Tax Reform. 2014. Opposi on to the proposed increase in assessment ra os presumably arises from the high visibility of the property tax. As discussed in Box 4, throughout the world, the residen al property tax arouses poli cal opposi on that is dispropor onate to the Should Latvia provide addi onal relief to certain taxpayers? In principle, further reduc ons could be jus fied as a means revenues it generates. It is reasonable to assume that most of the abatements and exemp ons that accompany the property tax in of assis ng the poor. But if that is the jus fica on, then the best approach would be to base the reduc on not on the value (or the places reviewed for this note were not intended to achieve some desirable social result. Instead, they were intended to mollify other characteris cs) of the property, but rather on the income of the taxpayer. Latvia, of course, already has a mandatory 90% tax certain cons tuencies who were incensed. Unless and un l Latvia raises the level of residen al property tax to (for example) French abatement for low income households. Eligibility could be extended to households with slightly higher incomes, perhaps with a levels, the country would be be er off confining the proposed reform to the adop on of uniform assessment ra os, and minimizing reduced percentage of relief. If the problem is liquidity—e.g., re red couples living on modest means in substan al homes acquired any expansion of exemp ons and abatements. when they were working, local councils have the op on of adop ng the tax deferral program authorized by the current law. 69 This may understate the number of household who rent. Although 67 percent of household are classified as ‘owner-occupiers’, the remaining 18 percent 67 Even then, property value may be a poor indicator of ability to pay. There are two reasons. First, property assessments do not typically consider the value of are classified, without further explana on, as ‘other’. mortgages or other liens against the property. If a property is heavily mortgaged, the wealth of its owner may be considerably less than the assessment would 70 The MOF ar cle also argues that confining the exemp on to an owner’s primary residence would generate insuperable administra ve problems. Its author indicate. Second, and more broadly, property is not a primary source of income in modern economies. In the pre-industrial world, property values (par cu- predicts that owners with several homes would evade the tax by transferring tle of each one to other family members. This does not appear to have been a larly the value of agricultural land) were reasonably good indicators of ability to pay. This is no longer the case. 68 Assuming, of course, that owners of mul -family residen al buildings will pass any increase in property tax burden onto their tenants major problem in places reviewed for this report, perhaps because transferring tle to family members has downside risks of its own. 112 113 Latvia Tax Review Conclusions  The Government should keep to the schedule for raising the assessment average ra o to 85 percent in 2018, with no compensa ng changes in tax rates or exemp on policies. Equitable Growth, Finance, and Institutions  The property tax system is a poor vehicle for improving income distribu on. It may be desirable to extend the 90% tax abatement for low-income households to households with slightly higher incomes, perhaps with a reduced Europe and Central Asia Region percentage of relief. However, proposals to impose lower assessment ra os or lower tax rates on lower value property, or to raise the maximum property value subject to a lower assessment ra o, would not necessarily benefit low income renters. Moreover, even a generous es mate of the burden of property taxes equals only 0.6 percent of median household income. In general, it is preferable to address income distribu on through the income tax system. TAX COMPLIANCE 114 Latvia Tax Review Latvia Tax Review 9. TAX COMPLIANCE type and by business / taxpayer segment, as well as research on the reasons for low or non-compliance. Key ques ons are: which business types or taxpayer segments are less compliant than others? What are the main areas of non-compliance (fraud, This sec on of the report provides a number of proposals for strengthening compliance management. The State Revenue evasion, avoidance, errors)? What are the reasons for non-compliant behavior? What measures could increase the level of Service (SRS) has made considerable efforts in recent years to introduce a proac ve compliance management program, to voluntary tax compliance? The overall benchmark of a well-developed gap analysis system is the ability to calculate the tax gap strengthen compliance enforcement in key risk areas, and to improve its analy cal capacity to determine compliance gaps and by tax regime, taxpayer segment, taxpayer group and behavioral approach. However, this is a long-term process, which requires trends. The SRS should be commended for these ini a ves, which generally reflect modern compliance management trends and significant resources and data availability. Countries such as Australia, Canada, the U.K., Denmark, Sweden and the United correspond with interna onal good prac ce. Nevertheless, a high level of underground economy ac vi es remains a challenge States are examples of a well-developed gap analysis process. Denmark is a typical example of such a gradual refinement of the for revenue management, and compliance remains below target in core areas such as VAT and correct declara on of salaries for gap analysis approach. Following the first step of an overall analysis of the tax gap by tax type, the tax administra on has now income tax purposes. embarked on a decomposi on of the gap es mates into 22 more specific components (Figure 66). The tax administra on has Analyzing compliance levels yet to determine the methods that will be used to measure each of these segments, but it is clear that a number of different Reducing the tax compliance gap and counterac ng tax evasion resul ng from underground economy ac vi es is a major methods will have to be developed to address the various analy cal challenges. The gap analysis prac ced in the U.K. by HMRC focus of revenue mobiliza on in Latvia, but the capacity to deepen the analysis of compliance gaps and risk remains limited. is an example of a more precise es ma on of the extent of the tax gap by customer group and behavior in addi on to a mere tax- The SRS has successfully started to build tax compliance gap analysis capacity. A regular monitoring process has been launched type analysis (see Figure 67). This then becomes a basis for the development of targeted compliance improvement measures. in par cular for VAT, personal income tax, social contribu ons and excises on tobacco, petroleum products and alcohol (see, for example, Figure 65). In line with interna onal prac ce, the VAT gap analysis is based on a macro-analysis approach, while for Figure 66. Twenty-two components of the tax gap analysis in Denmark PIT and social contribu ons a combina on of a micro- and a macro-analysis approach is adopted. Tax gap analysis s ll is in the process of development, and the lack of resources in SRS headquarters unfortunately slows down the analysis process. The SRS con nues its efforts to recruit qualified analy cal experts, but with limited success so far. Should the efforts to build addi onal analy cal capacity in-house not succeed, considera on will have to be given to outsourcing part of the gap modelling work, as advancing and deepening the gap analysis work is of crucial importance for strategic planning and compliance management. Figure 65. Trends in the tax gap development analyzed by the SRS Source: SRS annual reports. VAT gap data for 2015 are not yet available. Source: IMF country report 16/59: Denmark: The Value-Added Tax Gap (2015). A comprehensive compliance gap analysis has not been done yet, but there is evidence that the VAT gap is high and there are large tax evasion losses from underrepor ng of business ac vity and envelope wages. Latvia was part of the EU- wide compara ve VAT gap analysis study carried out in 2013. The study found that as a percentage of GDP Latvia (similar to Lithuania) has one of the highest gaps in VAT revenue collec on in the EU. Although VAT policy contributes a substan al part to the shor all in VAT revenue collec on, the administra ve gap (VAT gap) remains high in an EU-wide comparison and is, different from the situa on in most EU countries, higher than the gap resul ng from preferen al treatment and exemp ons in VAT policy. The analysis ini ated by the EU Commission does not a empt to disaggregate the compliance gap, however. A more detailed analysis of the tax gap has been a empted by some studies. Putnins and Sauka (2015) es mate the level of underrepor ng of business income and salaries: their findings suggest that unreported business income (45.5 percent) comprises the largest share of unreported ac vity; envelope wages come second (36.1 percent), and unreported employees cons tute the remaining share (18.4 percent). The SRS is aware of the situa on and has put in place a number of measures to confront such tax evasion. Building the capacity to regularly monitor the tax gap not only on an overall basis, but separately by tax type and by gap category should be a key priority for further developing the compliance management strategy. The overall gap monitoring process introduced by the SRS provides important ini al informa on on general compliance trends and the overall soundness of the revenue management system. However, the analysis is not detailed enough to provide a direct input into compliance management; in order to ensure the maximum benefits from the gap analysis process the development of a more detailed picture of compliance levels and trends will be needed. This requires an in-depth analysis of the level of the tax gap by tax- 116 117 Latvia Tax Review Latvia Tax Review Figure 67. Overall results of the tax gap analysis by customer group, tax type and behavior: the U.K. HMRC example Box 9. Examples of a taxpayer feedback survey: the U.S. IRS taxpayer a tude survey Ques on 1: How much, if any, do you think it is an acceptable amount to cheat on your income taxes: (i) a li le here and there; (ii) as much as possible; (iii) Not at all. Ques on 2: Do you completely agree, mostly agree, mostly disagree, or completely disagree with the following statements: (i) it is every America’s civic duty to pay their fair share of taxes; (ii) Everyone who cheats on their taxes should be held accountable; (iii) it is everyone’s personal responsibility to report anyone who cheats on their taxes; (iv) taxpayers should just have to pay what they consider is a fair amount; (v) the more informa on and guidance the IRS provides, the more likely people are to correctly file their returns; (vi) I trust the IRS to help me understand my tax obliga on; (vii) I trust the IRS to fairly enforce the tax laws. Ques on 3: How important is it to you, as a taxpayer, that the IRS does each of the following to ensure that all taxpayers honestly pay what they owe: (i) ensure that low income taxpayers are repor ng and paying their taxes honestly; (ii) ensure that small businesses are repor ng and paying their taxes honestly; (iii) ensure that high income taxpayers are repor ng and paying their taxes honestly; (iv) ensure that corpora ons are repor ng and paying their taxes honestly. Ques on 4: How much influence does each of the following factors have on whether you report and pay your taxes honestly: (i) fear of an audit; (ii) belief that your neighbors are repor ng and paying honestly; (iii) third party repor ng to the IRS; (iv) your personal integrity; (v) belief that your friends and associates are repor ng and paying their taxes correctly. The SRS is already conduc ng taxpayer percep on surveys in order to collect informa on on client sa sfac on with the SRS services and performance. Such survey work should be supplemented by specific ques ons on tax compliance a tudes and views. However, feedback surveys only provide reliable and objec ve results if the anonymity of respondents is guaranteed. Introducing a limited random audit program and a regular taxpayer compliance percep on survey could help deepen Therefore, they are generally contracted out and carried out by a university or research ins tute or by a survey company. To the understanding of the areas and drivers of non-compliance. Two addi onal data collec on ini a ves would complement a certain extent, the data collected through the SSE Riga shadow economy index for the Bal c countries can also be used as the exis ng gap analysis work. First, a more systema c analysis of audit data is needed to determine types of non-compliance. input into the compliance a tude analysis. However, the survey was targeted at only a small number of entrepreneurs and Ideally this would include introducing a random audit approach and conduc ng a certain (small) percentage of tax audits as the ques ons covered only a few aspects of tax compliance (such as the percep on about the probability of ge ng caught for random audits instead of risk-based targeted audits (see also below the sec on on risk analysis). Such random audits would be underrepor ng of business profits), so it is not a subs tute for a real compliance a tude analysis. less thorough and in-depth than risk-based audits, but would have a wider scope and assess all kinds of errors and behavioral aspects. As a recent IMF research highlights “random audits can be costly, but provide direct intelligence on the nature of Box 10. Compliance survey analysis in Canada noncompliance” (IMF, 2015). The SRS tax gap analysis work currently is not even at a stage where findings from regular audits are used as an input into closer examina on of the factors contribu ng to the tax gap. SRS management will have to The Canadian Revenue Agency (CRA) contracts private firms to conduct taxpayer a tudinal research. The CRA uses a elaborate an approach for strengthening both the capacity and the scope of tax gap analysis. Second, the data analysis should representa ve survey to periodically inves gate a tudes toward tax compliance (names the CROP 3SC Monitor Survey). be supplemented by an analysis of the reasons for non-compliance, the percep on of taxpayers with regard to complying with The usefulness of the survey is that it gives informa on on how the a tudes of taxpayers to tax compliance vary by socio- tax obliga ons, and the effec veness of the tax administra on in enforcing compliance. Such addi onal percep on analysis economic characteris cs, trends and underlying values. It helps the CRA to monitor shi s in expecta ons/a tudes and provides extremely useful informa on for the strengthening of the compliance management strategy. Input into tax gap analysis behavior, and allows a more detailed profiling of tax payers than simple division into those that evade and those who do not. work through taxpayer percep on surveys was first introduced in Australia by the Australian Taxa on Office (ATO) in the 1990s; For example, recent cluster analysis showed: 31 percent of the taxpayer popula on is fully compliant (risk averse and opposed it has now become standard prac ce in many OECD countries. Percep on surveys include ques ons about a tudes towards tax to tax evasion), 18 percent are altruis c compliers (strongly opposed to tax chea ng), 15 percent are over-taxed opportunists chea ng, things that might encourage taxpayers to pay their full share of taxes, and more general ques ons about the a tude (higher-income taxpayer who view it acceptable to cheat, and state that they have done so when given the opportunity), 12 of taxpayers towards risk-taking, law-abiding behavior, and importance or reputa on (see, for example Box 10 on the U.S. percent are ra onalizers, 12 percent are underground economists, while 13 percent are outlaws (admit to tax evasion openly). experience and Box 11 on that of Canada). The CRA uses research findings to help develop communica ons and marke ng ini a ves to improve voluntary compliance, including the development of a strategy to target different subgroups. Developing a segment-specific approach for compliance management The grey economy generally is not equally distributed between business segments. Based on the analysis of tax audit results and economic data, many OECD country tax administra ons have developed a compliance heat map, priori zing compliance management in business segments with a presumed high level of undeclared income and transac ons. Studies on the composi on of the shadow economy show that major sectoral differences also exist in Latvia. The SRS has also embarked on a sector-specific approach to inves ga ng tax evasion, commencing with an in-depth analysis of business compliance in the car maintenance and repair sector in 2014, followed by the den stry industry and the beauty care sector. Such an approach is a useful and welcome ini a ve in principle. The SRS ini a ve is well designed insofar 118 119 Latvia Tax Review Latvia Tax Review as it combines targeted enforcement measures with steps to encourage a voluntary move to higher compliance levels. Also, Box 11. The relevant contract tax in Ireland the ac ve outreach to and coopera on with business associa ons by SRS reflects best interna onal prac ce. In 2015, a total of 2,135 new taxpayers were registered in the three sectors and the declared income in the sectors increased by around EUR10.5 All payments made by a principal contractor in the construc on industry to a sub-contractor are subject to tax withholding million. The overall impact of the ini a ve can only be evaluated once the longer-term compliance trend in the targeted sectors (the Relevant Contract Tax or RCT). Principals must no fy the tax administra on of all payments made on relevant contracts is known. Pu ng these sectors under constant closer supervision would consume considerable resources and probably not be through an online informa on system. The sub-contractor is also required to register for RCT, and sub-contractors which are cost-efficient. General prac ce in other countries therefore has been to focus on one specific sector for a limited period of me, not in the RCT database already will be registered automa cally a er the first contract no fica on by a principal contractor. generally one year. This me period is used to build be er voluntary compliance and collect data and informa on to improve The principal has to enter each payment to a sub-contractor in the online informa on system before the payment is made, risk management in the sector and develop specific risk analysis tools to permanently achieve a higher level of sector-specific and has to deduct withholding tax in accordance with the deduc on authoriza on issued by the tax administra on. There compliance monitoring capacity (see Table 27 for examples of sectors of focus of selected OECD economies). This should also are three RCT rates (0 percent, 20 percent and 35 percent), and the applicable rate depends on the compliance records of be the approach followed by SRS. the sub-contractor, with the zero rate applying to sub-contractors that were fully tax compliant for the last three years, the 20 percent rate applying to sub-contractors with a record of substan al tax compliance, and the 35 percent rate applying to Table 27. Iden fica on of high-risk industry segments in selected OECD countries all other sub-contractors. In addi on, if the tax administra on forms the opinion that deduc ons from relevant payments at the standard 20 percent rate of tax for the year of assessment will be insufficient to fully sa sfy the income tax liability of the Australia Belgium Canada Sweden USA sub-contractor for that year, the 35 percent rate may be applied. This provision can be used, for example, where there is a risk of the enterprise going out of business before its tax debt has been cleared. Construc on Construc on Construc on Construc on Car sales Box 12. Tax withholding obliga ons in Australia Transport Gambling Hospitality Restaurants Construc on Restaurants Transport Agriculture Hairdressers Healthcare A business dealing with another business that does not quote its iden fica on number must withhold taxes from any payment made at the rate of 48.5 percent. The high rate means the revenue is not at risk in rela on to those transac ons, Hairdressing/beauty Car sales Real-estate agents Taxi companies Medical professions since the withholding rate equals the maximum amount of income tax and social levy payable by an individual. The paying salons business must also complete a payment summary at the me of the withholding giving full details of the payee and the Cleaning services Diamond industry Taxis Scrap metals Restaurants transac on and send an annual withholding report to the Tax Office detailing the transac ons. This informa on enables the Clothing and tex les Den sts Hair Stylists E-commerce Real-estate agents Tax Office to conduct income-matching checks on businesses that have not quoted an iden fica on number. Motor vehicle retailers E-commerce Labor agents For businesses opera ng in sectors dominated by cash transac ons, the obliga on to use cer fied cash registers for Art and an que Hea ng-oil recording their sales can be a useful support tool to improve repor ng of turnover and income. But a special cash register dealing distributors control program will have to be designed. Latvia is currently strengthening its cash register system by introducing a direct electronic link between the register and the SRS database. The obliga on to use cash registers is not respected automa cally, however, as can be seen from the cases of cash register manipula on detected in many countries, including in Latvia. A close In sectors with a high risk of informal ac vi es and a widespread prac ce to delegate tasks to sub-contractors, the monitoring of the proper use and correct func oning of the registers is essen al, par cularly in the ini al phase of register introduc on of withholding taxes on payments to such sub-contractors could be an effec ve instrument to reduce tax evasion. introduc on. Countries with a posi ve experience in the opera on of cash registers, such as Sweden (Table 28), have invested Sub-contrac ng is widespread in the construc on industry, with more than 6,000 businesses registered in Latvia. Tax compliance considerable resources in such supervisory work. of the small number of principal contractors is easier to monitor and enforce than managing tax compliance of a large number of sub-contractors, which generally are smaller businesses and may have a rather short ac vity period on a construc on site. Table 28. Sweden: Supervision, inspec on visits and audits within the cash trading opera on in the Requiring the principal contractor to withhold income tax on the payments to such sub-contractors reduces evasion possibili es first three years of compulsory cash register use and contributes to higher compliance levels in the industry. The level of tax withholding can even be influenced by the compliance level of the sub-contractor, as the example of the Irish Relevant Contract Tax shows (see Box 12). A withholding tax scheme can also be applied to other industry segments in which a high level of sub-contrac ng takes 2010 2011 2012 Total place. An alterna ve approach is to require principal contractors in all business segments to withhold income tax on all payments Supervisory visits 50,353 20,782 10,308 81,443 made to other businesses which do not present a valid tax registra on number. An example of this type of withholding tax is s12- Inspec on visits 3,100 7,198 11,900 22,198 190 of the 1st Schedule to the Taxa on Administra on Act 1953 in Australia (see Box 13). The Australian approach has proven Audits 319 257 306 882 to be rela vely successful. Taxes withheld in its first year amounted to US$ 16.1 million, in the second year US$ 32.2 million, and in the third year US$ 54.8 million. Ul mately, more than 40 percent of the businesses that had tax withheld as a result of not presen ng their registra on number ini ated business registra on. The withholding tax approach on the income tax side can be Source: Ska everket, Impact evalua on: Requirements of cash registers (2013). combined with the opera on of a reverse charge mechanism on the VAT side. Supervision of the proper use and func oning of cash registers needs to con nue a er the introductory phase with a special cash register control program. Introducing this program in Latvia will be essen al to achieve the maximum impact of the registers on compliance. The Irish program of unannounced control visits to cash businesses is a model for such an ini a ve (see Box 14). 120 121 Latvia Tax Review Latvia Tax Review Box 13. Surprise visits to cash businesses in Ireland Figure 68. The cash receipt check app in Russia Behavior in respect of trades under-declaring income can be detected more successfully through real- me, unannounced interven ons or “cold calls” than through retroac ve reviews of books and records. Accordingly, a strategy was put in place involving unannounced visits to all cash businesses in a town, street, market or at an event (e.g. concerts, trade shows etc.) to check on the controls and procedures in effect for handling cash transac ons. The methodology employed in inves ga ng cash businesses can include the following:  Surveillance (including covert) and use of intelligence;  Test purchases;  Examina on of cash registers and electronic point of sale systems;  Ensuring all equipment is connected as appropriate;  Examina on of books and records;  Interviews with proprietors, managers and employees;  Ensuring all employees are on the books;  Stock checks; and Dealing with envelop wages  Follow-up visits. Ensuring accurate repor ng of wages remains difficult. However, taxpayer surveys seem to indicate that the level of underrepor ng of salaries con nues to decrease and is now not very different from the level in Estonia and Lithuania. This may Streetscape opera ons have proven to very successful –not only have compliance issues in the cash business been be due to be er compliance enforcement, or the increase in the minimum wage level may have reduced the prevalence of iden fied and addressed but the profile of Revenue has been raised in the towns concerned. Follow-up ac ons have confirmed envelop wages.71 The SRS has made considerable efforts to collect informa on on the actual level of salary payments, including that the majority of businesses who had issues with their books and records have corrected the situa on. through an ac ve coopera on with business associa ons. This enabled the SRS to develop par al data on average salary levels in industry segments, as benchmarks for selec ng cases with major devia ons from the averages for closer examina on. The Source: OECD (2012). development of risk indicators for audit selec on, typically being the difference between the salary levels declared by the employer and the average salary level in the business segments, or the difference of the turnover/salary payment ra o from the Control of cash register use only is effec ve, however, if viola ons of the obliga on to record a business transac ons industry average, generally is the main tool to iden fy cases which require an audit. Efforts also could be increased to promote or—even more severe—systema c manipula ons of a cash register result in severe penal es and fines. A sufficiently high voluntary compliance, in par cular with social contribu on payments, by highligh ng the reduc on in social benefits resul ng monetary penalty is required for not issuing a cash receipt for a transac on; an example is the new legisla on in Austria, where from the non-payment of MSSIC contribu ons. However, a voluntary compliance campaign in this area is likely to achieve only the obliga on to operate cash registers has been introduced from 2017, and which imposes a fine up to EUR 5,000 for not using limited results, as taxpayers seem to prefer a reduc on in their current tax burden to a higher level of future social benefits. So the cash register. More severe penal es are required for cash register manipula on, including imprisonment of the offender in the major emphasis of an ini a ve to reduce the level of envelop wages will have to remain on the enforcement side. One issue case of systema c installa on of electronic sales suppression tools. is if, similar to the prac ce in a number of OECD countries, a special audit focus should be built on audi ng wage withholding The usefulness of the tax lo ery scheme to promote the issuance of tax invoices should be reviewed. While tax lo eries tax compliance. In addi on, assuming that a substan al por on of envelop wage payments are made in cash, the current efforts are becoming increasingly popular in the region (less so in OECD countries overall), this does not necessarily mean that they are of SRS to be er monitor business income received in cash should facilitate the control of cash spending and the detec on of an effec ve tool to support tax compliance in the cash economy sector. Indeed, some countries, such as Georgia or Korea, have regular cash payments to employees. discon nued their lo ery schemes. The risk of the lo ery scheme is reduced in Latvia because no lo ery prizes are awarded, so Managing VAT compliance the costs of the scheme are limited. Nevertheless, administra on of the scheme consumes SRS resources, which may be be er VAT compliance could be strengthened by improving the control of the VAT chain and taking measures to reduce the risk of invested in other compliance management ac vi es. In any case, the tax receipt control mechanism should be facilitated as fake companies entering the VAT net. Latvia is one of the best performers in the area of business registra on, according to the much as possible. An app-based control mechanism, such as recently introduced in the Russian Federa on (see Figure 68), is a World Bank’s Doing Business indicators. The en re business registra on process takes only 5.5 days, compared to an average of typical example of a customer invoice checking mechanism based on modern technology and avoiding interac on with the tax 10 days in the Europe and Central Asia region and 8.3 days in high-income OECD countries. This impressive result is not without administra on by sending copies of paper invoices. risks for VAT compliance management, however. Avoiding the VAT registra on of bogus companies is a high priority for enforcing VAT compliance. This requires an ini al existence and sustainability check as a precondi on for accep ng a business into the VAT net. The fact that a business gets a business registra on number should not automa cally imply that it also should be VAT registered without ‘business reality scru nizing’ by SRS. Reducing the risk of VAT registra on by a fly-by-night company may require a site visit to check if the business actually exists and has installa ons, such as office space, employees, and machinery, which indicate a more permanent conduct of business ac vi es. Such ini al existence checks could in prac ce be combined with advisory services to the newly registered businesses, to inform the business manager of the services SRS can provide and 71 European Commission, Country report Latvia 2015, COM(2015) 85 final 122 123 Latvia Tax Review Latvia Tax Review check if the books and records are maintained in a sa sfactory way and if the business operator is aware of the tax filing and Box 14. Requirement for Irish incorporated companies to have a director resident in an EEA state payment obliga ons. Such rou ne visits to business start-ups are regularly provided by OECD country tax administra ons and appear effec ve, as business operators know that they are on the tax administra on radar screen and the tax administra on can Under Irish company law, every company incorporated in Ireland is required to have at least one director who proac vely iden fy weaknesses in the organiza on of tax compliance work in the business (‘Right-from-the-start’–approach). is resident in a member state of the European Economic Area (EEA)—i.e. resident in an EU member state or one The ini al business reliability and sustainability check should include a cross-checking of names and addresses of business of the three non-EU countries which are part of the EEA (Norway, Iceland and Liechtenstein). This requirement is owners and managers. Firms where the owners or managers had been involved in the opera on of a fake or non-compliant subject to two excep ons as follows: business should be selected for further inves ga on. The current prac ce of preven ng the enforcement of tax debt collec on by se ng up companies with managing directors resident in countries that do not provide administra ve assistance in debt - It does not apply where the company provides a bond to the value of EUR 25,000 which may be called upon collec on, such as Uzbekistan or Afghanistan, could at least partly be addressed by requiring by law the nomina on of an EU- to discharge liability of the company in respect of any fine that may be imposed under the Companies Act 2014 country resident company director. The Irish example can serve as a model for such an approach (see Box 15). as well as certain fines or penal es under specific provisions of the Taxes Consolida on Act 1997. A period of two The introduc on of an e-invoicing system could facilitate the opera on of a real- me VAT cross-checking mechanism. years is prescribed as the minimum period of validity of the bond, commencing no earlier than the event giving rise The SRS requires VAT-registered businesses to a ach a list of invoices issued to their monthly VAT return. This list is then to the requirement for the bond. For newly incorporated companies, the bond must be effec ve from the date of used for cross-checking the seller and buyer data in the VAT returns. This is a useful approach to detect inconsistencies in VAT incorpora on. The surety under the bond must be a bank, building society or credit ins tu on. returns. However, the cross-checking can only be launched a er a VAT return has been filed, and the approach implies both administra ve and compliance costs for the prepara on and processing of the VAT invoice list. A more efficient approach, which - The requirement does not apply where a company applies for and is granted a cer ficate from the Registrar would facilitate a be er, real- me monitoring of VAT-registered businesses, would be to introduce an obliga on for issuing of Companies that the company has a real and con nuous link with one or more economic ac vi es carried on e-invoices for B2B transac ons. This approach is now used increasingly in OECD as well as in developing countries to detect in Ireland. Such a link is considered to be established where one of more of the following condi ons are sa sfied: irregulari es in business behavior, such as businesses stopping transac ons or businesses with major input invoices but not issuing any output invoices. An early warning system can be introduced, which ini ates same-day follow-up ac ons in case (i) the affairs of the company are managed from a place of business in Ireland by a person or persons authorized the system detects irregulari es. Technically the e-invoicing system requires the business to install required so ware and a by the company to act for the company, data connec on with the respec ve tax administra on server. With the direct connec on to the tax administra on server the tax invoice of the seller is registered and gets an automated invoice number before it is even received by the buyer. The tax (ii) the company carries on a trade in Ireland, or administra on therefore has constant real- me access to the transac on level and behavior of all VAT registered businesses. (iii) the company is related to a company which sa sfies the condi ons in subparagraphs i or ii. Applica on for a cer ficate is made to the Registrar on a prescribed form and the Registrar shall not grant a cer ficate unless the company concerned provides proof that it has such a link. To ensure the necessary proof is provided, the Registrar generally requires any company applying for a cer ficate to obtain a statement from the Irish Revenue authori es, made within two months of the date of applica on, which Revenue has reasonable grounds to believe that the company has a real and con nuous link with one or more ac vi es in Ireland. A cer ficate issued to a company will be revoked where the Registrar forms the opinion that the company has ceased to have a real and con nuous link with any economic ac vity carried on in Ireland or is advised of this by the Revenue authori es. The relevant legisla on also provides that, where a person who is resident in an EEA state ceases to be a director of a company and to the best of his or her knowledge no other director of the company is so resident at the me of such cessa on, the person is required to no fy the Registrar of Companies to that effect. A person who fails to provide such no fica on will be jointly and severally liable with the company for any fine imposed under company law following cessa on as a director. The above-men oned provisions are part of a range of measures under Irish company law aimed at ensuring that companies incorpora ng in Ireland have a real and demonstrable business presence in the country and an iden fiable person authorized to act on the company’s behalf. 124 125 Latvia Tax Review Latvia Tax Review Figure 69. Issuing e-invoices: the Korean example Internal Revenue Code. The provision requires issuing companies to file informa on returns to the tax administra on and report payment card transac ons, including debit, credit and gi cards. All such transac ons have to be captured on a gross basis and accumulated monthly for each payee. Given that non-recorded cash income will be deposited and spent somehow and some me, the informa on on the volume of deposits and spending of a taxpayer allows the verifica on of his income declara on. The monitoring of credit and debit card spending therefore should also be introduced in Latvia. Developing a proac ve compliance management approach A key challenge for compliance management is to address the high tolerance level for informal ac vi es. Such a tolerance exists in Latvia in par cular with regard to undeclared work for private households and par al concealment of income (see Figure 70 for an es mate of a tudes to different types of benefit fraud/tax evasion across the Bal cs). SRS has implemented a number of ini a ves to promote voluntary tax compliance, including lectures to school children on the importance of paying taxes. However, tax morale remains a challenge and far below expecta ons. In such an environment efforts to convince taxpayers of the importance of tax compliance need to con nue. Figure 70. Acceptability of different types of shadow work, average scores, Bal c States and EU8 Source: Lee, Can electronic tax invoicing improve tax compliance, World Bank 2015. The downside of an e-invoicing ini a ve is the expected resistance from the business community. This resistance is due to the poten al costs of so ware and data connec on and the extended control possibili es of the tax administra on. A phased introduc on of e-invoicing, star ng with certain priority segments, might therefore be appropriate. Mandatory e-invoicing has in many countries started for specific business segments or transac ons. A first area of mandatory e-invoicing has o en been business to government (B2G) transac ons, manda ng suppliers to send invoices electronically to public sector clients (e.g. in Denmark, Norway, Finland, Italy, Austria, Singapore), while some countries made e-invoicing compulsory for specific business sectors (e.g. financial ins tu ons and exporters in Ecuador, the telecom sector in Turkey, and large businesses in Chile and Uruguay). Comprehensive mandatory e-invoicing s ll is an excep on; it is applied e.g. in Korea since 2011 (see Figure 69), in Guatemala since 2013, in Indonesia from 2016, and in Chile from 2017. In addi on, certain incen ves such as advantageous deprecia on possibili es for investments in e-invoice installa on, could be offered to businesses. Moreover, the reduc on in overall VAT compliance costs through e-invoicing could be highlighted, as the monthly prepara on of VAT returns is made much Source: Williams and Horodnic, Explaining and tackling the shadow economy in Estonia, Latvia and Lithuania: easier. A tax morale approach (2015). SRS, in coopera on with the private sector, has also started to implement an online documenta on system for the transporta on of goods. Several mee ngs have taken place between the Revenue Service and the private sector to discuss One approach to improving compliance in household services is the design of special and well-targeted tax incen ves. development of a single electronic data standard for invoice and delivery documenta on. This system is expected to improve There are various ways countries have tried to improve voluntary compliance for this segment (see Table 29 and 30). One widely- control of the actual delivery of goods and the detec on of fake transac ons. used tax policy approach is to offer targeted tax incen ves for business to consumer transac ons in service segments that are Providing access to financial sector data known for a high level of cash transac ons and tax evasion. This is generally done by allowing an expense deduc on for at least Access to credit and debit card data could greatly facilitate the checking of income tax data. The SRS already has access to part of the costs of such services if the expenses are properly documented through a tax invoice. a large volume of data from various government and non-government sources. According to informa on received from SRS the matching of these data is managed without problems, as issues of a ribu ng data to specific taxpayers do not occur, and the data While such incen ves schemes may contribute to a higher degree of formaliza on of ac vi es in the segments targeted, matching capacity is adequate. The major gap in the scope of access to third-party informa on is in the area of financial data, in they come at high cost. The addi onal tax revenue collected from the service provider has to be balanced against the tax par cular bank account data and informa on on credit or debit card use. SRS has informa on on the number of bank accounts reduc on on the consumer side due to the incen ve. The German Ministry of Finance, for example, es mated reduced income held by incorporated businesses (and possibly in the future also on bank accounts held by non-incorporated businesses), but tax collec on on the consumer side of EUR 410 million (US$ 435 million) in 2014. Prac cal experience with the applica on no informa on on the amount of funds deposited in such accounts or the transac ons made is available, except for cases of of incen ve schemes therefore has been mixed. In France, the Ministry of Employment has es mated the number of legally a tax audit. While this is not a major devia on from standard interna onal prac ce, as access to banking data con nues to be provided hours to have increased from 530 million hours in 1998 to 800 million in 2008; according to the Na onal Ins tute rather limited in many countries, some countries nevertheless have managed to require banks to provide financial data about of Sta s cs around two thirds of these hours legally paid on the market result from a “whitening” of previous undeclared their customers to the tax administra on on a rou ne basis. In India, annual informa on reports to be prepared by financial ac vi es.72 Survey evidence in Sweden indicates a posi ve impact of housework deduc on on tax formaliza on (see Box 16). ins tu ons include informa on on cash deposits, bank account numbers as well as credit card transac ons. Norway has one of In Germany, the incen ve system caused considerable loss of revenue from personal income taxa on, and the Federal Court of the most extensive repor ng requirements for banks in Europe; The Tax Assessment Act S. 6-4 requires “all financial ins tu ons, Auditors es mates that in only 30 percent of claims for tax credits for household services would the services have been cash- including banks, insurance companies and securi es firms, to report, unsolicited, to the tax authori es details of their clients’ based and not declared for tax purposes without the incen ve scheme; 70 percent of credits are claimed for payments made by economic standing, for example the amount of debit and credit balances for each account, capital invested, debt incurred bank transfer before the incen ve scheme was introduced. The Court of Auditors therefore has recommended that the scheme and interest accrued”. Similarly, Denmark and the Netherlands require banks to report to the tax administra on the account be abolished. Experience in Italy73 has shown that the majority of claims for bonus payments came from Northern Italy, which balance for each account at the end of each year or at the date the account was closed. More frequent is the introduc on 72 ORSEU (2013). of repor ng requirements for credit and debit card issuing companies. A model example here is sec on 6050W of the US 73 Marchese, A Chinese Recipe for Curbing the Evasion of Commodity Taxes, in CESifo DICE Report 3/2007, p. 38, referring to a study by Di Lorenzo et al. 126 127 Latvia Tax Review Latvia Tax Review is expected to have a lower level of tax evasion than the southern regions of the country. This shows that the costs and benefits Cleaning X X X X X X X X X of such incen ve schemes must be carefully monitored. Gardening X X X X X X X X X Table 29. Incen ve schemes, selected European Union member countries Cooking, meal X X X X X X X X X prepara on Country Incen ve Scheme Domiciliary No precise Tax reduc ons are linked to the use of vouchers used to hire household services. Two types of vouchers, the X X X private tui on defini on Belgium cheque L’Agence locale pour l’emploi (ALE) and the Titre-services, are eligible for tax deduc on, the former IT support X X program at 30 percent, the la er at 30 to 40 percent. The ceiling of tax deduc on for vouchers is EUR 2,400 (the sum of both vouchers). Small repairs X X X X In 1994 Denmark became was the first country to offer a subsidy, 50 percent of the cost, for such household Renova on X X X services as garden work, snow clearance, shopping for daily goods, cooking, cleaning, laundry, and window services Denmark cleaning. However, the benefit was reduced in 2004 and is now available only to people aged 65 or more. Source: ORSEU, Developing Personal and Household Services in the EU, 2013. In 2011 a tax credit was allowed to all private persons. While briefly abolished in 2014 the scheme was Note: BE: Belgium; DE: Germany; DK: Denmark; FI: Finland; FR: France; HU: Hungary; IT: Italy; NL: Netherlands; SE: Sweden; reintroduced with some modifica ons in 2015. SP: Spain; UK: United Kingdom. A tax deduc on was introduced in 1997 for household services within the taxpayer’s own home or the homes of elder rela ves. If the deduc on is larger than the amount of central government income tax, local Box 15. Sweden: Impact of housework deduc on on tax formaliza on government taxes can also be reduced. Since 2009 eligible services have been household work, caregiving In an interview survey from 2011, the Swedish Tax Agency inves gated how the housework deduc ons have affected Finland and day-care work at home, repair work, a leisure house, and IT services. The deduc on is 40 percent of the undeclared work. The result is compared with an interview survey conducted in the previous men oned report ‘Purchasing expenses paid to a company, small entrepreneur, or nonprofit organiza on (60 percent up to 2011) and 15 and performing undeclared work in Sweden’ from 2006 (data collected in 2005).The result shows that the occurrence of percent of the wages paid an employee. When an individual is employed, the employer is exempt from the undeclared work decreased by about 10 percent between 2005 and 2011, within the categories of jobs covered by the ROT social contribu on. and RUT deduc on. Moreover, 6 percent of the buyers of ROT indicated that the work would not have been performed unless France allows a tax deduc on of 50 percent of expenses for cleaning, ironing, IT assistance, or private they had access to the deduc on. This corresponds to 44,000 jobs, or 2.6 million working hours (Swedish Tax Agency, 2011). lessons. The deduc on is given to households that either directly employ an individual service supplier The general level of acceptance within the society of buying undeclared domes c services also has decreased, according to France at home or hire a service company. The deduc on ceiling is EUR 12,000 a year, but it can be increased the report. Nine out of 10 respondents indicated that it is wrong to buy repair, maintenance and cleaning services undeclared. depending on the number of children, people 64 and older, and disabled persons. Since 2007, if the eligible This result is similar to a survey among the general public by the Employer and Trade Organiza on for the Swedish Service tax deduc on surpasses the income tax, the difference is reimbursed to help low-income households. Sector (Almega) (2009) which shows a decline in individuals’ percep on that undeclared household services are legi mate A tax credit is allowed up to 20 percent of the costs for household-related services, such as gardening, (Swedish Tax Agency, 2011). In the autumn of 2011, the Swedish Federa on of Business Owners (Företagarna) conducted a Germany survey among 2,447 member companies in the construc on sector. Nearly 90 percent of the surveyed companies felt that the cleaning, laundry services, or childcare. Another 20 percent of the wage costs for cra services, such as repairs and refurbishing, can be used to offset income tax. ROT-deduc on had a posi ve impact on reducing undeclared work in the sector, compared to 78 percent in 2009 (Swedish Federa on of Business Owners, 2011). Italy Tax incen ves are linked to the purchase of vouchers. However, the scope of work covered is very inclusive: Source: European Monitoring Center on Change (EMCC), 2013. maintenance of buildings, seasonal and agricultural ac vi es, organiza on of spor ng events, etc. Luxembourg Tax is reduced by the expense of housework services, care for dependent persons or childcare. The The introduc on of an incen ve scheme for the voluntary declara on of personal service payments is no subs tute for the maximum tax rebate is EUR 3,600 a year or EUR 300 a month. implementa on of a more general voluntary compliance promo on plan, which should also increase the awareness on the Invoices issued in certain hard-to-tax sectors (restaurants, hotels, car repair, hairdressers) en tle the nega ve consequences of informal sector ac vi es. Feedback the mission received from various private sector representa ves Portugal customer to a 15% refund of the VAT charged against his PIT tax liability. The refund amount is deducted demonstrates that the percep on that tax money is not well spent and risks being wasted is an important reason for non- from the PIT liability in the following year. A ceiling of 250 Euros applies. compliant behavior. The SRS already operates a well-developed taxpayer informa on and outreach program. Taxpayers can The tax reduc on system in Sweden has two components; RUT (cleaning, maintenance, servicing) and ask ques ons electronically, access client service centers and contact the call center to get answers to ques ons. The SRS also Sweden ROT (home renova on services). A tax credit is allowed for 50 percent of the labor costs (including VAT) is ac vely using social media such as Facebook and Draugiem.lv. to communicate with taxpayers. Key areas for improving the of household services. The sum of the tax credit for RUT and ROT must not exceed about EUR 5,500 per outreach and communica on strategy would be to carry out a deeper analysis of taxpayer service and informa on demands person per year. and the preferred channels for the delivery of such services, the design of a communica ons program to improve the public percep on of the SRS, and the use of outreach and communica on to promote voluntary compliance in high-risk areas. While SRS has done some ini al work on collec ng taxpayer feedback, and is monitoring the sa sfac on of taxpayers with Table 30. Personal and household services (PHS) as related to public policy instruments certain services offered, a broader and more systema c survey of service expecta ons and preferences could help increase BE DE DK FI FR HU IT NL SE SP UK the efficiency and effec veness of taxpayer services. Changing the public percep on of SRS, improving the trust of taxpayers in the fairness of revenue collec on, and promo ng an image of SRS as a client- and service-oriented ins tu on instead of a Financial Regula on Tax Main Public Mini Tax Tax Act Buoni mere enforcement body will be crucial for improving voluntary tax compliance. This will require developing a special outreach Services Incen ve on Home Dedica on - - Scheme Jobs Deduc on Deduc on XC Lavoro program, including exploring opportuni es to improve the dialogue with special segments of the taxpayer community, such as Service- Services (RIT, ROT) tax consultants or large businesses. Also, innova ve approaches to promote both the SRS and voluntary compliance should be considered, such as, e.g., the design of web-based presenta ons distributed via YouTube, or tax-related TV spots. If designed well, such instruments can become highly popular. A par cular focus on explaining the use of tax revenues and the comple on of projects with taxpayer money would be another component of a refined outreach and communica on program. There are 128 129 Latvia Tax Review Latvia Tax Review many examples from OECD and other countries on the design of such an approach, with a very successful and prominent Addi onal assessment per audit example being the Cash Economy Task Force in Australia (see also the OECD Source Book on Taxpayer Educa on: Building Tax 209.9 135.2 131.4 144.4 187.0 (in thousands of Euros) Culture, Compliance and Ci zenship”--OECD 2014). Further analysis would be required to determine the appropriate approach Source: SRS annual reports. and tools for such an ini a ve in Latvia. Rewarding compliant taxpayers and s gma zing major evaders may be good incen ves for increasing voluntary compliance. The SRS is already opera ng a program of honoring the most compliant and biggest taxpayers in the country. The Box 16. The use of random audits for improving risk analysis in Denmark program is limited to larger businesses with annual tax payments higher than EUR 100,000. Demand for par cipa on in this white list program has also been expressed by medium and smaller businesses. There may be scope for broadening the program, SKAT in Denmark operates a rather extensive random audit program. SKAT jus fies the costs of this program by its extensive although it is acknowledged that this would impose a burden on SRS to ensure that the taxpayers selected really are fully tax- use not only as an input into tax gap analysis, but also to support tax administra on and compliance decision making. Random compliant. Korea has introduced an exemplary taxpayer award. In addi on to a three-year exemp on from tax audits (as in audit data are used in par cular to test risk profiles, as the random audit program provides very detailed risk profiles for Latvia), awarded taxpayers receive VIP status at financial ins tu ons and at airports, and taxpayers who declare a remarkably taxpayer compliance behavior. SKAT has used the program to test the efficiency of about 200 risk profiles. Risk profiles are higher tax liability than other taxpayers in a similar situa on and environment are specially awarded. Such an approach might be used to stra fy random audit samples. The risk profiles are categorized into high and medium risks, and those taxpayers considered as an addi onal instrument to promote the declara on of correct wages instead of envelop wages. not mee ng any of the risk profiles are classified as low risk. This has allowed SKAT to over-sample high and medium risk But the threat of penal es in case of non-compliance must also exist. Voluntary compliance can be increased both by popula ons and under-sample low risk popula ons. This design has the benefit of (a) increasing the efficiency of the sample; commending the best taxpayers in the country and by dissemina ng informa on on the penal es imposed on major tax (b) reducing opportunity costs of the survey; and (c) improving the mo va on of auditors to undertake the random audits. evaders. This is par cularly helpful where penal es were imposed on well-known personali es. For example, public awareness of the risks of tax evasion was raised substan ally in Germany when the father of tennis idol Steffi Graf was sent to jail for three Source: IMF country report 16/59: Denmark: The Value-Added Tax Gap (2015). years and nine months because of evading 6.5 million euros tax, or when the former CEO of the ‘Deutsche Post’ was sentenced Therefore, the audit yield does not by itself provide an accurate evalua on of the reliability of the risk analysis system. for tax evasion to a monetary penalty of one million euros plus a two-year jail sentence on proba on. Such court sentences The audit yield does not indicate whether the risk analysis system captures the full range of compliance risks or iden fies the spread the message that even rich and well-connected people face a risk of being imprisoned if they do not pay their taxes cases with the highest risk for revenue collec on. Such an analysis would require the comparison of risk-based audit results with properly. This demonstrates the fairness of tax collec on and provides incen ves for risk-averse taxpayers to comply. But it non-risk-based audit findings. This can be done by: (i) comparing findings and results from risk-based audits with random audit requires coopera on of the judiciary and the willingness of judges to consider tax evasion as a serious crime. In Latvia, however, findings, and (ii) selec ng a small number of audits based on the risk evalua on by experienced tax auditors and comparing it appears that tax evasion is considered a rather harmless offence that does not really deserve severe punishment, and in the results from both audit approaches. Box 17 gives the example of the use of random audits to test risk profiles in Denmark. par cular is not a reason for imprisonment of the offender. Such an a tude of the judiciary makes compliance management more difficult for the SRS. Other countries with a similar problem have organized mee ngs and awareness building events for Tax audit and control capacity and approach judges to explain why tax evasion in certain cases should be considered a serious crime. This has helped in some cases, while The SRS has a below average audit capacity, measured as the share of tax auditors in tax administra on staff. A general in others the interest of the judiciary in such awareness building events was rather limited. It is uncertain whether such efforts rule of thumb is that more than 30 percent of tax administra on should work on tax audits; the OECD average according to the would be produc ve in Latvia. It would be worthwhile, however, to brainstorm further how an effec ve criminal prosecu on of latest OECD tax administra on compara ve informa on series (2015) is 36.2 percent (see Table 32). In the SRS the audit staff major tax evasion cases can be ensured. is 25.9 percent of total staff, although the fact that SRS is a combined tax and customs administra on may reduce the value of Risk analysis this comparison. The SRS is steadily improving its risk analysis for audit selec on. The system is IT-based, and all taxpayers selected for an audit have been iden fied through the risk system. This has enabled SRS to reduce its field audit ac vi es, without reducing the Table 32. Verifica on and audit staff as a percentage of total tax administra on staff in selected countries level of addi onal taxes assessed through the audit process. However, regular desk audits complement the field audit process. Country Percentage With the use of the ESKORT system the SRS has selected a reliable and well-known so ware system to support the risk analysis process. OECD average 36.2 The most important ini a ve for assessing the reliability and the appropriate targe ng of the risk analysis is the cross- Latvia 25.9 checking of results from system-selected audits with results from check audits. The risk analysis system is currently evaluated Estonia 67.0 only by monitoring trends in the audit yield from field audit ac vi es. Addi onal audit assessments are impressive and show an upward trend in recent years. In addi on, an indirect impact of the audit selec on process, not even reflected in the audit Finland 38.9 yield sta s cs, is the possibility for taxpayers to voluntarily correct their tax declara on before the commencement of the audit, Sweden 32.5 which was used by 61 taxpayers in 2015. However, as the difference between the audit results in 2011 and the results from the Norway 41.6 subsequent years clearly demonstrate (see Table 31), the size of addi onal assessments can vary substan ally across years if in Denmark 40.7 a specific year a few major audit adjustments from big companies increase the total. Russia 47.1 Table 31. Latvia: Tax audit results UK 42.7 Source: OECD, Tax Administra on 2015. Year 2011 2012 2013 2014 2015 Total number of audits Nevertheless, the limited availability of audit staff results in audit coverage of only 3.5 percent of the incorporated 1,396 1,355 1,445 1,318 1,243 conducted taxpayer popula on. Given the various challenges and addi onal tasks for improving compliance management, which require Total amount of addi onal tax (in audit and verifica on resources in order to be implemented properly, the plan to reduce the staffing in this sec on by 90 293.07 183.25 189.93 190.36 232.43 posi ons seems ques onable and not helpful for strengthening compliance management. While the overall SRS staff reduc on millions of Euros) plan is not ques oned here, the current approach to have an equal percentage reduc on across all SRS func ons and units may result in weakening func ons that are urgently needed. 130 131 Latvia Tax Review Latvia Tax Review A further specializa on of auditors should be established to increase the quality and impact of the audit process. In B2B transac ons. par cular, the specializa on of auditors by taxpayer segment (separa on between small and medium businesses versus large  Effec ve early engagement with newly established businesses can have a long-term impact on compliance behavior. In businesses) and by industry for the largest businesses would enable auditors to improve their detec on of unusual behavior and addi on to the exis ng prac ce of sending welcome le ers and providing informa on for start-ups on the SRS website, evasion techniques. OECD country tax administra ons have separated the audit teams in their large taxpayer units according to SRS could further develop the ‘right from the start’ approach through a combined service and supervision approach for major business segments. Frequently such sectors are (i) the financial sector; (ii) natural resource companies, (iii) the telecom new businesses. This will also serve as an addi onal tool to combat VAT fraud. sector; and (iv)manufacturing. Private sector consultants, such as former managers of an insurance company or a manufacturing  Recent efforts to strengthen the cash register system are a step in the right direc on, but should be complemented business, are hired to train tax administra on staff in understanding the par culars of the business sector. Although the SRS by developing and implemen ng a cash register use control system. The opera on of a tax lo ery may be a weak and does not have a dedicated large taxpayer office, a similar specializa on effort of the audit teams dealing with such industry unreliable tool to achieve a be er level of invoice issuance. sectors should be launched.  The voluntary compliance promo on program could by strengthened by moving from a predominantly retroac ve to a A separate program to ensure compliance from high-net-wealth individuals (HNWI) could be developed. Experience shows more proac ve, outbound compliance management approach, with an increased use of social media. Communica on that rich individuals with poten ally high tax liability are using special tax avoidance and evasion techniques to reduce their campaigns should increase their emphasis on how tax revenues are spent and on the various public services and social tax liabili es. This o en includes sophis cated and non-transparent tax reduc on schemes. While some countries have set benefits that derive from taxa on. up dedicated HNWI units with highly-skilled officers undertaking special risk analysis, audit and debt collec on (e.g. Australia,  The current plan to reduce the staffing of the tax audit func on in SRS could greatly impair the ability of SRS to improve Canada, France, Ireland, Japan, South Africa, the U.K. and the United States), at a minimum a program for HNWI compliance the effec veness of compliance management. The management of audit resources could be improved by introducing management could be developed in Latvia. This would have to go beyond just audits and risk reviews and could also include a be er industry and taxpayer segment specializa on of auditors. some measures encouraging voluntary compliance.  Inves ng in cri cal staff exper se is crucial, for example for analy cal func ons and in areas such as large taxpayer audits. Human resource capacity challenges Providing a sufficiently a rac ve compensa on package and a rac ve working condi ons could improve SRS efficiency. The problems men oned earlier in this sec on with regard to building analy cal and compliance analysis capacity are just a core example of the broader challenges SRS faces in hiring and retaining qualified expert staff, par cularly in fields of specializa on that are also in high demand in the private sector, such as experienced lawyers or tax accountants. While few tax administra ons worldwide can offer salaries comparable to the private sector salary levels (but the Singapore Inland Revenue Service is an example showing that it is not impossible), working condi ons such as flexibility in working hours or possibility for part- me work, job security, and in-kind benefits like kindergarten facili es may improve compe veness with private sector agencies. Ini a ves to build an esprit de corps, making staff proud of working for the Revenue Service, also can compensate for differences in salary levels and should be developed further. Salary costs equaled 68.6 percent of total tax administra on expenditure in 2013, compared to an OECD country average of 71.2 percent.74 The SRS has developed plans to increase the compensa on package without increasing overall salary costs, through savings achieved from staff cuts. While staff reduc ons are expected to be evenly distributed across all SRS func ons, this plan may need to be reviewed to ensure that it does not impair the efficiency of core analy cal and opera onal func ons. SRS could consider introducing special compensa on levels or bonus systems for selected expert posi ons. A typical area for such special schemes is the group of specialized large taxpayer auditors, which has built capacity to deal with the most complicated audit cases. Conclusions:  A variety of op ons exist to reduce the gaps in tax compliance and develop a higher level of voluntary compliance. These op ons are not only on the administra ve side, but encompass important support measures that can be introduced on the tax policy side. Key elements on the tax policy side are the introduc on of withholding taxes for payments to subcontractors in certain high risk areas, expanded access to financial data, in par cular certain debit and credit card use informa on, and the introduc on of addi onal requirements for VAT registra on of a company.  While the SRS efforts to measure the size of the tax gap have made substan al progress, an addi onal level of analysis is required to decompose the overall tax gap by taxpayer segment and by compliance a tude and behavior. Only such a second level of analysis would provide valuable input into strategic management of SRS. But this requires a strengthening of the division responsible for gap analysis in SRS and the implementa on of addi onal instruments and tools, such as the analysis of risk based as well as random audit data for gap analysis purposes and the iden fica on of compliance a tudes through targeted surveys.  While the overall approach to risk analysis in SRS seems sound, an ongoing monitoring of the RASA (RASA Natural Persons Risk Analysis System) efficiency and reliability is important. In addi on to analyzing trends in audit yields and the review of the automated selec on results by experienced auditors, a small number (not more than 5% of total audits) of random audits could be undertaken and the results compared with results from audit cases selected by the RASA. Such an approach could also help to iden fy new risks which have not yet been incorporated into the RASA system.  Moving to a real- me control system of the VAT chain and introducing an early warning system in case of irregulari es could improve VAT compliance. This could be achieved by a (maybe gradual) introduc on of an e-invoicing system for 74 OECD Tax administra on compara ve informa on series, 2015. 132 133 Equitable Growth, Finance, and Institutions Europe and Central Asia Region CONCLUSIONS Latvia Tax Review Latvia Tax Review 10. CONCLUSIONS less than EUR 20,000 per year), lifestyle companies to provide opportuni es for low-skilled workers who find it difficult to secure employment in firms par cipa ng in the general tax regime due to the high taxes on labor. Tax Taxa on changes inevitably involve trade-offs between equity and growth objec ves, both in the short and the long term. subsidies that are limited in me and closely supervised also could be used to promote innova ve start-ups. Efforts Moreover, any increase in tax rates needs to be assessed in rela on to the likely growth and equity impact of the spending to strengthen tax administra on are cri cal to reduce the risk of many microenterprises entering the informal that higher taxes are intended to finance. Table 33 provides an overview of the growth and equity effects, taken from a recent sector. review of the evidence, of different expenditure and revenue policies. Judging the trade-offs also requires taking into account Latvia’s economic challenges, such as above-average inequality and good prospects for short-term growth, but high historical  Broadening the tax base, par cularly in the CIT and VAT, could generate significantly more revenues. Reduced- growth vola lity. Given the objec ve to reduce inequality, efforts to raise revenue could involve higher rates on PIT (or through and zero-rate VAT provisions should be reviewed for poten al sources of increased revenues. While less costly than taxes on capital) and CIT. Bringing in more revenues through social security contribu ons seems less suitable from either the in many EU countries, the tax expenditures related to VAT are s ll substan al. In addi on, there is room to reduce equity or the growth perspec ve, and could reduce employment. However, the microenterprise regime has reduced the social the threshold for firms par cipa ng in the VAT. contribu ons from a large share of the workforce, and ensuring that adequate provision is being made for further pension and  Tax structure could be changed. Tax revenues could be increased and equity improved by raising more revenues other social protec on needs is important. To limit growth vola lity, Latvia should ensure fiscal and financial sector stability from capital income taxa on through a uniform treatment of different types of capital income (par cularly to reduce and facilitate rebalancing of economic growth towards more stable structure, including through enhanced produc vity and the bias for inves ng in real estate and issuing debt rather than equity), introducing a progressive personal income export diversifica on. Proposed tax reform could be helpful in this regard—higher tax revenues would help in building-up fiscal tax, and taxing inheritances. Over me, the role of property/wealth taxes and excises, including environment- buffers over me (allowing for counter-cyclical response in bad mes) while the redesign MET, PIT and shi towards taxa on of related taxes, should grow. Latvia has an appropriate value-based property tax system but needs gradually to bring consump on would support higher produc vity and encourage workforce par cipa on. the assessment ra o for tax purposes closer the market value of the property. A balance of tax instruments that are designed in light of the sources of growth and the underlying income distribu on is useful in ensuring the resilience of revenues across the economic cycle.  Latvia’s high level of inequality (in the EU context) could be reduced by spending more on means-tested benefits, se ng withdrawal rates for minimum-income guarantees and housing at less than 100 percent, and removing the Table 33. Trade-offs between instruments for raising revenue ceiling on social contribu ons. In-work benefits, such as earned income tax credits, offer advantages in targe ng Growth Equity assistance to low-income workers, increasing incen ves for labor supply and suppor ng families. Generally, policy should seek to shi taxes away from labor, par cularly to reduce the high par cipa on tax for low-income workers. Short-term Long -term Short-term Long-term Expenditure increases  The corporate sector faces low statutory and effec ve tax rates in Latvia compared to most EU economies. Given the low revenue base, the costs and benefits of tax allowances/exemp ons should be assessed. There Educa on ++ ++ + ++ is some room to rebalance tax treatment across enterprises, which depending on their produc on mix face Health ++ + + + different possibili es for tax allowances/exemp ons. Further analysis of possible profit shi ing via related party/ Public investment ++ ++ mul na onal enterprises through use of cost a ribu on would be useful.  Reduc on in tax evasion/avoidance is a priority. While the high share of low-income workers that under-declare Revenue increases incomes is a cause of concern, richer taxpayers account for the largest share of losses. From the point of view of lost revenues, the challenge is to increase tax compliance across the income distribu on. Nevertheless, the Personal income taxes - -- gains from improved compliance, while poten ally substan al, are uncertain. Thus, planned increases in revenues Social security contribu ons - -- should rely on tax design measures aimed at broadening the tax base or raising tax rates. Corporate income taxes - -- + + Table 34. Es mates of revenue impact of tax measures Environmental-related taxes - + - Revenue impact Consump on taxes (other than environment-related - - - Measures ( % of GDP) taxes) 1. Personal income tax (wages) 0.09-0.3 Recurrent taxes on immovable property - 1.1. Non-linear tax schedule, lower tax for low-income workers* Other property taxes (mainly inheritance, gi , and - ++ + 3-rates PIT (19%/23%/33%) 0.31 wealth taxes) Sales of goods and services (mainly user charges) - + - + 3-rates PIT (19%/23%/29%) 0.10 Note: The + sign reflects posi ve welfare effects and the - side nega ve welfare effects. The longer term impact on output, when 3-rates PIT (19%/23%/29%) + EITC 0.00 narrowly defined as GDP, may be ambiguous. 1.2. 19% PIT rate for self-employed -0.01 Source: Cournède et al. 2013, Table 2. 2. Personal income tax (capital) 0.11 There is scope for Latvia to raise more tax revenues. If Latvia increases its tax revenues by about 4 percentage points of 2.1. Uniform tax rate (15%) on capital income 0.11 GDP, it could reach the average of its peers. A larger increase could bring Latvia to the maximum tax revenue level that countries with similar characteris cs have achieved. Table 34 provides a list of tax measures that would increase revenue to GDP by three 3. Corporate income tax 0.06-0.68 percentage points of GDP, assuming no behavioral responses. 3.1. Changes to tax deprecia on The following are the main recommenda ons for Latvia’s tax system: Remove accelerated deprecia on of fixed assets 0.22  The microenterprise tax regime should be phased out. The MET may have resulted in increased tax avoidance and Remove enhanced deprecia on for new technological equipment 0.29 evasion and has reduced social security contribu ons. A new scheme could be established for small (e.g. turnover 3.2. Limit on the offset of losses carried forward 136 137 Latvia Tax Review Limit loss relies to 80% of profit before taxa on 0.06 Limit loss relies up to 5 years 0.17 4. Microenterprise tax regime 0.21 Equitable Growth, Finance, and Institutions 5. 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Strokova, Victoria and Tomas Damerau. (2013a). Financial Incen ves of the Tax and Benefit System in Latvia. Background paper 144 145 Latvia Tax Review Latvia Tax Review for World Bank Tax-Benefit Review Study. Not excluding purchases abroad from VAT es mates results therefore in a slight overes mate of the VAT share in expenditures Strokova, Victoria and Tomas Damerau. (2013b). Expenditure and Performance of Welfare Benefits and Employment Programs for the higher quin les. But the opposite effect due to under-representa on of the richest households in the HBS is likely to be in Latvia. Strokova, Background paper for World Bank Tax-Benefit Review Study. stronger. On the other hand, “unofficial” purchases happen across the whole income distribu on. Plausibly, their share in total consump on expenditures is higher among low-income households. If this is the case, the VAT share in expenditures of low- Sutherland, H. and F. Figari (2013). EUROMOD: the European Union tax-benefit microsimula on model. Interna onal Journal of income households will be somewhat overes mated. Microsimula on 6(1), 4–26 (ii) For the purpose of matching EU-SILC households with HBS households featuring similar consump on pa erns, OECD- Torgler B., F. Schneider F. (2007). Shadow Economy, Tax Morale, Governance and Ins tu onal Quality: A Panel Analysis. IZA scaled size (Eq_size) is calculated for each household as the sum of member’s “weights” assigned as follows: the oldest person Discussion Papers 2563, Ins tute for the Study of Labor (IZA). is assigned 1, other adults 0.5, and children 0.3. Equivalized household disposable income (Eq_dinc) is derived as the household Torres, J. L. (2013). “Revenue and Expenditure Gaps and Fiscal Consolida on: A Cross-Country Analysis.” IMF Working Paper disposable income (available in both surveys) divided by Eq_size. Three main variables used in the 5 rounds of matching are: Interna onal Monetary Fund, Washington, DC. Eq_dinc/100 (rounded to the closest integer); Eq_size (6 categories); and educa on level of the main earner Edu_main (3 Torres, J. L., (2014). Revenue and Expenditure Gaps: A Cross-Country Analysis, IMF Working Paper, WP/14/xx categories). In the first round, 77.4 percent of 6113 EU-SILC households have been matched with HBS households. A er each Vanags, Alf and Anna Zasova. (2015). Latvia Stumbling Towards Progressive Income Taxa on. December 16, 2015, Bal c round, EU-SILC households with missing VAT values (ini ally this is the case for all households) are assigned the average of VAT Interna onal Centre For Economic Policy (BICEPS). 2014. h p://freepolicybriefs.org/2015/11/16/latvia-stumbling-towards- spending over matched HBS households. In the second round, only Eq_dinc/100 and Eq_size are used for matching. Only 13.9 progressive-income-taxa on/ percent of the EU-SILC households remain unmatched. In the third round, Edu_main is restored but Eq_size is replaced with Varsano, Ricardo, Kevin Kim and Michael Keen. (2006). “The “Flat Tax(es)”: Principles and Evidence,” IMF Working Papers 06/218, the number of children N_child (0, 1, 2 or 3+); only 7.7 percent of households remain unmatched. In the fourth round, only Interna onal Monetary Fund. Eq_dinc/100 and Edu_main are used (5.1 percent of households, all from the top quin le, s ll unmatched). Finally, in the fi h Vroman, W. and V. Brusentsev (2005). Payroll Taxes, Labor Taxes and Employment in Turkey: Revised Report. Paper prepared for round, matching is performed on Eq_dinc/500 , N_child and Edu_main, leaving just 3.1 percent of households unmatched. These the World Bank. remaining households are assigned the average VAT of the top quin le. Wallace, S. (2002). Imputed and Presump ve Taxes: Interna onal Experiences and Lessons for Russia. Working Paper 02-03, Georgia University. World Bank (2009). Report No 44056-TR. Es ma ng the Impact of Labor Taxes on Employment and the Balances of the Social ANNEX B: MEASURING UNDECLARED EARNINGS WITH EU-SILC DATA Insurance Funds in Turkey. Synthesis Report. April. In order to quan fy the incidence of complete and par al informality, data from surveys and administra ve sources World Bank (2012a). Older Worker Labor Force Par cipa on and Employment: Croa a. A World Bank Study. Washington, DC: are combined. Here we focus on informal employees, leaving aside informal self-employment. Our main data source is the World Bank. na onal version of the European Union Sta s cs on Income and Living Condi ons (EU-SILC) for 2008–2015. This provides World Bank (2012b). Older Worker Labor Force Par cipa on and Employment: Poland. A World Bank Study. Washington, DC: es mates of actual annual gross and net earnings in 2007–2014, thus covering pre-crisis, crisis and post-crisis periods. Table World Bank. 35 outlines the process of obtaining these es mates, without taking into account unimportant details and differences between World Bank (2012c). World Development Report 2013: Jobs. Washington: DC. Latvia and Estonia (e.g. whether the survey ques on concern annual or monthly earnings) or rela vely rare devia ons from the Zee, H. (2013). “Further Thoughts on Reforming the VAT: Treatment of Financial Intermedia on Services”, VAT Exemp ons, “mainstream” procedures. Note that we focus on cash (or near-cash) employee income, ignoring in-kind income and employee Consequences and Design Alterna ves, Rita de la Feria, Wolters Kluwer 2013, NewYork. benefits (health insurance, company car, etc.). Zentrum für Europäische Wirtscha sforschung (ZEW). (2014). Effec ve Tax Levels Using the Devereux/Griffith Methodology. In Latvia, earnings recorded in EU-SILC come from two sources: survey and administra ve (SRS and SSIA) data. If respondent’s Mannheim, 2014. earnings (from all jobs) according to SRS records (E2) are higher than those reported in the survey (E1), SRS-based earnings are Zoutman, Floris T., and Bas Jacobs (2015). “Op mal Redistribu on and Monitoring of Labor Effort”, Journal of Public Economics, recorded in EU-SILC; this is the case also when E2 is between 0.95*E1 and E1 (allowing for respondent’s error within 5 percent), forthcoming. as well as in the case of non-response; otherwise survey-based earnings E1 are kept. Sta s cal imputa on is used when both E1 Zoutman, Floris T., Bas Jacobs en Egbert L.W. Jongen (2015), “Op mal Redistribu ve Taxes and Redistribu ve Preferences in the and E2 are missing for respondents who reported that they had some earnings (note that SRS data would be missing if during Netherlands”, mimeo: Erasmus Universiteit Ro erdam/CPB. the income reference period the respondent was an informal employee, or worked only abroad or for employers who were not taxpayers in Latvia). Table 35. Es ma on of employee earnings (in all jobs) during the last calendar year in the Latvian and Estonian na onal EU- ANNEX A: VAT CONTRIBUTION TO INEQUALITY SILC data, 2008-2013 To quan fy the contribu on of VAT to inequality, we use the Latvian Household Budget Survey (HBS), which is the only source for Latvia on consump on data by category and group of households. The most recent survey available is HBS 2014. Data collec on method or EU-SILC variable Data content and/or calcula on formula However, the CSB does not recommend using the HBS as a survey representa ve in terms of income, because the sample size is substan ally reduced in comparison with that of the previous year and there was a rather high rate of non-responses.75 Survey item E1: Net earnings Furthermore, HBS does not provide as detailed informa on on taxes and benefits as EU-SILC. Therefore we use EU-SILC 2015 microdata as the main source, and assign annual VAT spending to each EU-SILC household using informa on imputed from HBS Administra ve (SRS) data E2: Net earnings 2014 as described below.76 Sta s cal imputa on E3, only when E1 is missing (non-response) and E2 is missing as (i) For each of the 3713 households in the HBS sample, informa on on consump on expenditures in cash by category Xi is well (no earnings are recorded in SRS database) matched with the respec ve VAT rates ti (21, 12 or zero percent, see ANNEX O [Annex indicates only one reduced rate of 12% SILC, net earnings PY010n E1 if E2 is missing; in 2014) and total VAT paid is es mated as . Due to data limita ons, it is not possible to iden fy at the household level two E1 if E2 ≤ 0.95*E1; categories of expenditures which should have been excluded: purchases abroad, as well as purchases in non-regulated markets E2 if E2 > 0.95*E1; and from sellers which are not VAT payers. According to CSB es mates, on average purchases abroad account for 1.3% of total E2 if E1 is missing (non-response); expenditures in the HBS 2014 sample, but this share is likely larger for wealthy households and smaller for low-income ones. E3 if both E1 and E2 are missing 75 Average equalized household disposable income of HBS 2014 respondents is by 18.4% lower than that of EU-SILC 2015 respondents (both surveys refer to income of 2014). Administra ve (SRS) data (2) MSSC1: Employee MSSC; PIT: personal income tax paid from 76 Conceptually similar but opera onally different methodology to impute informa on on spending for durable and non-durable commodi es into EU-SILC earnings data and simulate indirect taxes is being developed by the EUROMOD team at the University of Essex, see h ps://www.iser.essex.ac.uk/research/projects/ euromod-extension-to-indirect-taxa on. 146 147 Latvia Tax Review Latvia Tax Review SILC, gross earnings PY010g PY010n + MSSC1 + PIT Declared gross earnings = (Employer MSSC)/(Employer MSSC rate) (1a) Survey-based gross earnings G1 E1+ MSSC1 + PIT Employer MSSC are directly available from EU-SILC as (PY030g - PY031g) (see Table 1 [which table is this?]). In the “general” case, the employer MSSC rate in Latvia was 24.09 percent throughout the 2007-2013 period. Individuals that reached re rement SILC, PY031g (2007-2012: survey; since Employer op onal SSC age benefited from reduced employer social contribu ons rates that vary by year from 19.9 percent to 20.8 percent.79 As 2013: administra ve (SRS)) men oned above, data on employer MSSC in EU-SILC are less reliable for microenterprise workers. However, in these cases Administra ve (SSIA) data MSSC (employer + employee) total declared gross earnings can be found using SRS-based addi onal variables ME, ME_sh provided by Sta s cs Latvia for this SILC, Employer social security contribu ons Mandatory + op onal: project as follows: PY030g MSSC - MSSC1 + PY031g Declared gross earnings of microenterprise employees = ME/ ME_sh = Abbrevia ons: SRS: State Revenue Service; SSIA: State Social Insurance Agency; SSC: social security contribu ons; MSSC - (Earnings in microenterprises)/(Share of these earnings in total declared earnings) (1b) Mandatory SSC. Finally, for employees which are neither informal nor microenterprise workers but feature zero employer MSSC due to data imperfec ons, declared gross earnings are derived from the difference between gross and net earnings (see Table 37 for details). Completely informal employees (referred to simply as informal employees herea er) now can be iden fied in the EU-SILC In es ma ng undeclared (envelope) earnings we again dis nguish several cases (which are numbered from [1] to [6] in data as employees with posi ve earnings for whom no mandatory social security contribu ons (MSSC herea er) have been paid Table 37). In case [1], EU-SILC variable PY010g es mates total gross earnings, and declared gross earnings G are also available by employers during the income reference period (i.e. the previous calendar year). Table 36 specifies this defini on in terms (as described above). The difference between the two, when posi ve (which is almost always the case), is our es mate of of EU-SILC variables and addi onal data collected by Sta s cs Latvia. A few issues which complicate iden fica on have been undeclared earnings B, otherwise es mated to be zero. The share of undeclared earnings β is calculated as B/G. Cases [2] and [4] addressed using details of the data collec on process, and addi onal survey and administra ve data added to EU-SILC datasets refer to informal employees, when B = PY010g, and β = 1. Cases [1], [2] and [4] together cover about 40 percent of observa ons. on our request.77 First, some observa ons feature zero employer social contribu ons, but a posi ve difference between gross Case [5], when self-reported earnings are below the declared ones (by about 18 percent on average) also covers about 40 and net earnings (hence, some payroll taxes paid); those are obviously not informal employees.78 Second, star ng from year 2012 percent of observa ons. In this case B (and therefore also β) is assumed to be zero (hence our es mates of undeclared earnings (income reference period 2011) some employees receive earnings from microenterprises, which are subject to special taxa on should be seen as lower bounds). In case [6] (less than 5 percent of observa ons), self-reported earnings G1 slightly (within 5 regime: the only tax they pay is the microenterprise tax. Although part of this tax is a erwards transferred to social security, percent) exceed the declared ones G. Sta s cs Latvia ignores this difference and reports in such cases the SRS data, but for our Latvian EU-SILC data before 2015 in most such cases recorded zero employer social security contribu on. These employees purposes it makes sense to assume that the difference is due to undeclared earnings, so we es mate B = G1- G and β = B/G1. are, however, not informal because earnings from microenterprises are registered in SRS. Third, about 2 percent of EU-SILC The remaining case [3] corresponds to survey non-response (between 15 percent and 20 percent of respondents depending respondents with non-negligible earnings in the income reference period report in the survey that some of these earnings on the year), when only declared gross earnings G = PY010g are available. There is no reason to assume that respondents who were gained abroad. Earnings gained abroad in most cases are not recorded in SRS data, hence respondents who worked only have not answered the survey ques on on earnings do not receive envelope wages. On the other hand, excluding this (rather abroad would appear as informal based on zero mandatory social security contribu ons. We exclude these respondents from sizable) group could result in selec on bias. We use imputa on procedure to es mate the share of undeclared earnings, given the analysis of informality and envelope wages. our es mates for cases [1], [2], [4], [5] and [6]. A proxy equal to the average share of undeclared earnings in the same year across employees with respondent’s educa on level, gender and sector of economic ac vity (21 sectors) has been imputed in most Table 36. Iden fica on of informal employees in the Latvian na onal EU-SILC data, 2008–2015 cases; when the economic sector is unknown, ethnicity and ci zenship (3 categories) have been taken into account as well. We EU-SILC variables used PY010g, PY010n, PY030g, PY031g have also used the rota ng annual panel structure of the data: when the shares of undeclared earnings in the previous and in the next year for the same respondent are available, their average has been imputed instead of the above-men oned proxy. Addi onal survey items used IQ38: Did the respondent during the income reference When only one of these respondent-specific values is available, the average of it and the above-men oned proxy has been period gain some earnings abroad? imputed. Addi onal SRS data received on request Employee earnings from microenterprises (M_E) and share of these earnings in total declared earnings (M_E_ Table 37. Es ma on of declared and undeclared gross earnings in the Latvian na onal EU-SILC data, 2008-2015 sh). Defini on of informal employee PY010g > 0 & PY010n=PY010g and (PY030g - PY031g = Source of net earnings data Percentage of Declared gross Undeclared (“envelope”) earnings 0) & ME=0. (iden fiable from data using flags) observa ons earnings, G (by period) Respondents with earnings abroad (IQ38=1) are 2008- 2012- Amount, B Share in total earnings, β excluded from analysis. 2011 2015 The next step toward measuring envelope wages is to es mate, for every respondent, annual gross earnings G reported for [1] Survey (≥ SRS earnings) 35.1 31.5 See Table 38 PY010g - G if B/ PY010g tax purposes (referred to as declared earnings herea er), as well as undeclared earnings. Technical details are found in Tables posi ve; 37 and 38. For informal employees (iden fied as described above), G = 0. For other employees G is available (and received by 0 otherwise Sta s cs Latvia) from administra ve data. In cases of survey non-response G is available directly from the data (as variable [2] Survey (no SRS earnings) a 7.4 4.7 G=0 PY010g 1 PY010g, see Table 37). [3] SRS (survey non-response) b 15.5 18.6 G = PY010g βG/(1 - β) imputed When both survey-based and declared (administra ve) gross earnings (say, G1 and G) are available, income flags variables available in EU-SILC data make it possible to iden fy G1 and G separately (due to the fact that Sta s cs Latvia treats earnings [4] Sta s cal imputa on (no SRS 0.7 0.5 G=0 PY010g 1 from administra ve data as imputed rather than collected), except for when earnings recorded in EU-SILC equal survey-based earnings; survey non-response) a earnings. A er excluding informal employees, such cases (which account for about one-third of all observa ons, see [provide [5] SRS (> survey earnings) c 38.3 39.9 G = PY010g 0 0 source]) are dealt with as follows: (assumed) (assumed) 77 We thank Viktors Veretjanovs from Sta s cs Latvia for his advice. 79There are several other groups with employer MSSC rate different from the general case, but these groups are rela vely small and cannot be iden fied in 78 The apparent contradic on is due to a conflict between the two sources of administra ve data. the standard EU-SILC data. 148 149 Latvia Tax Review Latvia Tax Review [6] SRS (between 95% and 100% of 3.0 4.8 G = PY010g G1- G B/ G1 survey earnings) ANNEX C: METHODOLOGY OF ESTIMATING REVENUE GENERATION Notes: a Cases [2] and [4] refer to informal employees (see Table 38). POTENTIAL FOR LATVIA To assess the tax revenue poten al of the Latvian economy, we apply two approaches, which gives complementary b In case [3], a proxy equal to the average share of undeclared earnings in the same year across employees with respondent’s perspec ves on the scope to raise more taxes. The first approach, so-called peer analysis, is the most tradi onal. It models educa on level, gender and sector of economic ac vity (21 sectors) has been imputed in most cases; when the economic tax revenue as a func on of observable economic and ins tu onal characteris cs of a country (such as income per capita, with sector was unknown, ethnicity and ci zenship (3 categories) have been taken into account as well. In cases when the shares of a very wide range of other variables explored in the literature, see Table 40 for a review of the literature). The “poten al” for undeclared earnings in the previous and in the next year for the same respondent were available, their average was imputed addi onal tax revenue is then the fi ed residual, which, by construc on, averages to zero over the sample. The second approach instead, and when only one of these respondent-specific values was available, the average of it and the above-men oned proxy relies on “stochas c fron er analysis” that compares a country’s tax ra o not with the average, but with the maximum that was imputed. others with similar characteris cs have achieved. Stochas c fron er analysis models revenue poten al explicitly, taking revenue c to be a func on of maximum revenue, dependent on economic and ins tu onal characteris cs of a country, and “effort,” which In case [5], survey-based gross earnings are, on average, by 17.6 percent higher than administra ve data. is to at least some degree a choice variable, depending among other factors on wider social preferences. To simplify, peer d Respondents with some earnings abroad during the income reference year are excluded from analysis. analysis aims to determine the best fit to the observa ons, whereas stochas c fron er analysis aims to put a fron er around them. Table 38. Es ma on of declared earnings in the Latvian na onal EU-SILC data when survey-based earnings are recorded, It should be emphasized that the results of the proposed empirical strategies need to be treated cau ously. The main 2008-2015 difficulty in empirical work is to capture “tax effort” or willingness to tax more. Even for countries with a high taxing poten al Declared gross earnings G there might be good reasons (poli cal or social) to tax below poten al that could be reflected in low tax effort. For instance, government may believe that high taxes are harmful for GDP growth, or the society as a whole may have a stronger preference General case G = (Employer MSSC)/(Employer MSSC rate). for efficiency than for equity. Employer MSSC = PY030g - PY031g The selec on of variables for our empirical work follows the empirical literature. Explanatory variables try to capture level Informal workers G=0 of development, structure and important characteris cs of the labor force, inequali es, structure of economy as well some Microenterprise workers G = M_E/ M_E_sh = ins tu onal variables represen ng the efficiency of administra on and business friendliness. We use several data sources. First (Gross earnings in microenterprises)/(Share of these earnings in total declared of all, the data on tax revenue to GDP ra os were taken from IMF’s Government Finance Sta s cs and Eurostat. Secondly, we use earnings) the World Bank WDI database for some general indicators such as labor force par cipa on, age and old-age dependency ra os, popula on density or percentage of popula on living in urban areas, import and export to GDP ra os (indica ng openness Other workers with zero employer G = A = ((PY010g) - (PY010n) + tNM)/(s+t(1-s)) if A(1-s) > NM, where t is income tax of the economy), GDP growth, and GDP per capita level (in PPP), Gini coefficient, natural resource rents (as a percentage of MSSC in EU-SILC data rate applied to earnings, N is monthly non-taxable minimum, M is number of months GDP), external debt to GDP, structure of the economy and other variables (such as life expectancy, infant mortality, spending worked as employee, s is employee MSSC rate; on educa on or enrolment in ter ary educa on). Thirdly, the Doing Business database by the World Bank was used to extract G =((PY010g) - (PY010n))/s if A(1-s) ≤ NM indicators on the ease of doing business. We tested a few sub-indicators, as some dimensions may be more important for tax Notes: PY010g, PY010n, PY030g, PY031g are EU-SILC variables (see Tables 2, 3). MSSC stands for “mandatory social security collec ons that others. Fourthly, the World Governance Indicators database was used to assess the quality of governance. contribu ons”. Although we tested some transforma ons of independent variables, such as logs or summing export and import to GDP ra os to derive an indicator of openness, the simple indicators in most cases proved to be most efficient. Moreover, we added two Table 39 summarizes various indicators of under-repor ng earnings that are used in the analysis. dummy variables: one for Scandinavian countries and the second for Bal c States. In total, in our sample consists of 148 countries Table 39. Indicators of under-reported earnings between 2000 and 2015. Descrip on Level of measurement Defini on Table 40. Selected studies aimed at assessing tax effort Share of undeclared earnings Individual b = (Es mated undeclared earnings)/(Es mated total gross earnings) Publica on Method Macroeconomic variables tested Ins tu onal variables tested Share of undeclared earnings Economy, sector of Average value of b across all (or a group of) employees Torres (2013) Cross-country GNI per capita, Growth gap, Old-age Poli cal par cipa on averaged across employees economic ac vity, or regression dependency ra o, Annual popula on growth, (democracy index), Expected Envelope share in aggregate a certain category of Ra o of total undeclared earnings to total gross earnings (for Net oil and gas exports, Imports, Pop. density, years of schooling, DB ranking, earnings employees the economy, sector, etc.) gross debt, grants, gross min. annual wage. Dummy for countries. Incidence of envelope share Propor on of employees with b ≥ 10% (respectively, b ≥ 25%, Fenochie o, Panel stochas c GDP pc, squared GDP pc, trade (imports Public expenditure on educa on above certain level (10%, 25%, b ≥ 50%) among all (or a category of) employees Pessino (2013) fron er analysis + exports as % of GDP), value added of (% of GDP), Gini coefficient, 50%) agriculture as a % of GDP, % change of CPI Corrup on percep on index Incidence of complete Propor on of informal employees among all (or a category Khwaja, Iyer (2014) Panel GDP pc, share of services in GDP, share of control of corrup on, CIT, CIT informality of) employees regressions services in GDP, share of trade in GDP, age square, VAT, VAT square dependency ra o, , post 2008 dummy Notes: In our analysis we have used only employees with posi ve earnings as the base. Alterna vely, the analysis could be restricted only to employees with earnings above some threshold, e.g. one minimum monthly wage per year. Respondents with some earnings abroad during the income reference year are excluded from analysis. 150 151 Latvia Tax Review Latvia Tax Review Baunsgaard and Panel GDP pc, openness (sum of the shares of - 0.55*** 1.02*** Keen (2010), regressions imports and exports in GDP); infla on; aid in Old-age dependency ra o (0.12) (0.03) percent of gross na onal income, share of agriculture in GDP (AGR) -0.27** -0.32*** Life expectancy at birth Davodi, Grigorian Cross-country GDP pc; rate of consumer price infla on; measure of ins tu onal quality; (0.12) (0.04) (2007) regression share of agriculture in GDP; ra o of exports 5.06 15.38*** Constant plus imports to GDP; dummy variable for fuel (12.43) (2.92) exporters; share of the urban popula on in a R-sq 51% country’s total popula on; indicator of shadow economic ac vity Number of obs 1660 1660 Castro, Camarillo Cross-country GDP pc, openness (sum of exports and imports poli cal rights, civil liber es (2014) regressions, of goods and services as a % of GDP, FDI as indicator (Freedom House) Tax level poten al depends on GDP growth, government effec veness, demography, and also geography (which may reflect panel a % of GFCF, industry value added as a % of cultural, historical values). The results of the regressions are presented in Table 401. Surprisingly, government effec veness regressions GDP, gross ter ary school enrolment, life (measured by WB government effec veness indicator) is not sta s cally significant in the peer model, but it is in the stochas c expectancy, child mortality rate. fron er. This implies that countries that achieve the maximum collec on of tax revenues given their economic structures are characterized by a more efficient process of tax collec on. If the level of income (GDP) and ins tu onal variables are included Gupta (2007) Panel regression GDP pc, share of agriculture in GDP, share Highest marginal tax rates (CIT, together, income loses its significance because the ins tu onal quality variables already capture the impact of income. A higher of manufacturing in GDP, share of imports PIT), poli cal stability, economic old-age dependency ra o requires more transfers and redistribu on which translate into higher taxes. The Scandinavian dummy in GDP, ra o of debt and aid to GDP, Trade stability, corrup on, law and is also sta s cally significant, which may reflect cultural, historical or societal similari es, although it comprises only 3 out of Restric veness Index order and government stability. 148 countries. These variables alone explain 51 percent of the variability of tax-to-GDP ra os in our sample, so they are quite strong determinants of the tax level. Two methods adopted for the es ma ons require different analy cal strategies. For the peer analysis, we ran standard The tax revenue gap for Latvia is calculated based on both models. In the case of the first model it reflects what would be random-effect GLS regression with robust standard errors to choose independent variables and see how robust they are in expected on the basis of the characteris cs being controlled for, minus actual revenues (comparing Latvia’s tax receipts with the explaining revenues tax revenues. This regression served as a star ng point for the stochas c fron er analysis (SFA). The SFA is average of its peers). The second model compares Latvia’s tax ra o with the maximum that others with similar characteris cs based on the no on that several inputs are used to “produce” one output. Contrary to the firm-level approach, where the error have achieved. term clearly captures “inefficiency”, in this case the apparent “inefficiency” may be a deliberate policy choice. Mathema cally, the stochas c fron er panel model may be wri en as follows: ANNEX D: OPTIMAL TAX THEORY AND MARGINAL INCOME TAX RATES Where: Both the flat rate structure in the PIT and the uniform allowances in the PIT are sub-op mal from an op mal-tax —represents tax revenues for given tax in country i at me t, perspec ve. Op mal EMTRs should follow a U-shape with income as long as the social valua on of a euro declines with income: - is the matrix of independent variables, affec ng tax revenues; a euro is worth more to a poor than a rich person. This has been derived in the Nobel-prize-winning analysis on the op mal —is the “inefficiency” term, capturing the gap between the actual tax collec on and maximum revenue poten al. It is a income tax of Mirrlees (1971), which was clarified and extended later by Diamond (1998) and Saez (2001).80 For the same reason non-nega ve random variable associated with country-specific factors that affect the collec on of given taxes at the me t. allowances should generally be income-dependent. An example of op mal EMTRs is drawn in Figure 71 panel (a). The other —is error term, reflec ng measurement error that can be either posi ve or nega ve. graphs in Figure 71 explain why an op mal EMTR is U-shaped. It is important for policy makers to understand the economics As the and terms are independent, and the first one can be posi ve, it is possible that the country that has a very small behind the U-shape of EMTR’s. inefficiency term may lay above stochas c fron er. In our models, we adopt the es ma on method proposed in (Ba ese & Increasing the marginal tax rate above a certain income level y may make the system more progressive and increase Coelli, 1995), the maximum likelihood random-effects me-varying inefficiency effects model. revenues, but also generates costs in terms of reduced welfare. First, increasing the tax burden reduces welfare for affected tax payers. These welfare losses need to be subtracted from the revenue gains to obtain the total distribu onal effect of a higher tax Table 41. Regression results for the general model (dep. variable: total tax to GDP ra o) rate. Second, increasing taxes can distort the economic behavior of the affected workers. Workers with income y have weaker incen ves to work longer, invest in human capital or exert entrepreneurial efforts when the marginal tax increases. Moreover, incen ves for tax avoidance and tax evasion are also stronger.81 The behavioral response can be summarized by the elas city Stochas c of taxable income (ETI). The ETI measures the reduc on in taxable income y when the tax rate increases. For the moment we Variable Standard fron er assume that the ETI is a sufficient sta s c to summarize the welfare losses of the tax rate.82 How should the government then 3.54** 1.7*** op mize effec ve marginal tax rates? This ul mately depends on the behavior of both the distribu onal and the subs tu on log(GDP) effects with income. (1.80) (0.34) -1.5 1.59*** The distribu onal effect of a marginal tax rate is con nuously declining with income. This is shown in Figure 71, panel (b). Government effec veness (WGI) (1.42) (0.36) Intui vely, if the marginal tax rate is raised at a low income level, the redistribu onal effects are large, since many people will pay more tax. However, when the marginal tax rate is raised at a higher income level, the distribu onal benefit is mechanically -0.27*** Share of agriculture in GDP - 80 The U-shape is preserved when the analysis is extended with extensive labor-supply responses in Jacquet et al. (2013) and Zoutman et al. (2015). -0.08 81 This discussion ignores income and par cipa on effects, since these are generally not very important for the design of op mal tax systems (Zoutman et al., 13.3*** 8.17*** 2015). Scandinavian dummy 82 Che y (2009) shows that when marginal tax rates cause tax shi ing to other people, other tax bases and other periods of taxa on, then the ETI is no longer (2.80) (1.29) a sufficient sta s c to measure the welfare losses of taxa on. Intui vely, the revenue reduc on on the taxed base is par ally offset by larger revenues from taxing other people, other bases or other periods. 152 153 Latvia Tax Review Latvia Tax Review lower, since fewer people pay more tax. Consequently, the distribu onal benefit of se ng a higher marginal tax rate is always pa ern for op mal EMTRs. Intui vely, star ng from the lowest income, up to the mode, distribu onal benefits of marginal taxes declining with the income level at which the tax rate is increased. The valua on of the welfare losses imposed on tax payers also always decrease and welfare losses of marginal tax rates increase. This follows from Figure 71, panels (b) and (c). Hence, op mal determines the total distribu onal benefits of the marginal tax, and this valua on is intrinsically poli cal. For example, when marginal tax rates should decrease before the mode of the income distribu on. A er the mode, however, the distribu onal the government cares more for middle-class tax payers, the distribu onal benefits of raising marginal taxes at middle-class benefits of marginal taxes s ll decrease, but welfare losses of marginal tax rates typically decrease faster for most empirical incomes are reduced; imposing taxes on them is then seen as socially costly. Similarly, when the government cares less for the income distribu ons, see again Figure 71 panels (b) and (c). Hence, op mal marginal tax rates increase somewhat a er the top-income tax payers, the distribu onal gains increase. Imposing higher taxes on top-income earners then generates smaller mode. As a result, the op mal marginal tax schedule is U-shaped in income. distribu onal losses. The U-shape is not determined by poli cal judgments regarding the value of income redistribu on. The U-shape in Figure 71. Op mal U-shape of EMTRs and the reasons for it EMTRs is obtained both for very redistribu ve ‘le -wing’ and much less redistribu ve ‘right-wing’ social preferences for income distribu on. The U-shape of op mal taxes is primarily determined by the shape of the earnings distribu on. In the middle- (a) Op mal marginal tax rates (b) Distribu onal benefits income groups there are simply larger distor ons of marginal taxes than at the lower or higher income levels. Consequently, marginal tax rates should be lowest in the middle. This remains true irrespec ve of the government’s preferences for income redistribu on. The U-shape can be less pronounced if tax avoidance and evasion take place especially at the top and bo om of the income distribu on. Tax avoidance and evasion increase the ETI. When the ETI is higher at the top, the op mal top rate should decline—see also below. The survey in Saez et al. (2011) suggests that ETI’s are typically higher for the rich. Similarly, when the ETI is higher at the bo om due to avoidance and evasion, the op mal tax rates should decrease at the bo om. There may be more poten al to avoid or evade taxes at the bo om of the earnings distribu on due to the informal sector or the black economy. No robust evidence is available to verify whether this conjecture is correct. In any case, a higher ETI at the top or the bo om makes the U-shape of op mal EMTRs less pronounced. An op mal tax-transfer system does not have flat rates. The reason is that neither the distribu onal benefits nor the efficiency costs can be expected to be constant in income, as shown in Figure 71. A tax system with a flat tax rate and a uniform minimum-income tax exemp on requires much higher marginal tax rates to reach the same level of net income for the working poor, because all tax payers—also the middle-income and high-income tax payers—benefit from the minimum-income tax exemp on. The tax base erodes so much when the general tax exemp on is provided to everyone that much higher marginal tax c) Efficiency costs d) Income distribu on rates need to be used to balance the government budget. In an op mized non-linear system, the average marginal tax burden can be reduced—compared to an op mal flat tax—by targe ng the minimum-income exemp on to the poor and phasing it out with income. By phasing out the minimum-income exemp on with income, EMTR’s become non-linear. The government then broadens the tax base so that—on average—much lower marginal tax rates can be used, while at the same me protec ng the net incomes of the poor. Although on average marginal tax rates are lower, they typically increase at the bo om of the income scale, and then decrease quickly towards the middle-income groups. Consequently, a non-linear tax schedule can generate the same net income for the poor with much lower welfare losses. Equivalently, by se ng a non-linear tax schedule, the government can make the tax system much more redistribu ve, while incurring the same welfare costs. An op mal tax-transfer system does not have uniform exemp ons. For the same reason as above, the an op mal tax- transfer system targets income support to those that are most in need of public income support, i.e. the non-working and working poor. Uniform allowances, that are independent from income, are a subop mal tax policy. By targe ng income support, much lower marginal tax rates can be used, and hence welfare losses of taxa on can be reduced, while s ll protec ng the poor. Or, equivalently, tax progression of the tax-transfer system can be strengthened, while welfare losses of the tax system can remain the same. It is never op mal to have EMTRs at or above 100 percent. The func on of the marginal tax rate at income y is to redistribute income from people with income above y to people with income below y, or to the government. When the EMTR is raised to 100 The welfare loss of a marginal tax rate first increase and then decrease with income. Figure 71, panel (c) shows the percent (or higher) at income y, no one will earn income y. Individuals can then enjoy a higher net income by working less, both behavior of the welfare loss with income. The welfare losses from marginal taxes are primarily driven by the shape of the income of which raise their welfare. Consequently, EMTRs above 100 percent should be avoided as much as possible, as they will only distribu on (see also Figure 71, panel (d)). When incomes are low, raising the marginal tax rate generates few distor ons, since reduce revenue, erode tax progression and result in severe economic losses.83 only few people are affected and incomes are rela vely low. However, raising the marginal tax rates in the densely populated middle-income groups generates a lot of distor ons; not only are there more people in the middle-income groups, also their It can be op mal to subsidize labor par cipa on of low-income workers. People do not only respond on the intensive (e.g. incomes are higher. What happens a er the mode of income is an empirical ques on. Typically, the welfare costs of taxes decline hours or effort) margin in their labor supply. They also decide whether or not to work at all. Similarly, people decide whether to again. On the one hand, there are fewer people with a higher income. But on the other hand their incomes are higher. For most work in the formal sector rather than in the informal sector (household produc on, care ac vi es) or in the black labor market. The empirical income distribu ons the density of people declines faster than their income, hence the distor ons of marginal tax par cipa on decision, or extensive-margin labor-supply decision, is determined by the par cipa on tax rate. The par cipa on tax rates fall a er the mode. 83 Zoutman and Jacobs (2016) show that strict monitoring and condi onality of income transfers on work effort could result in op mal marginal tax rates that are above 100 percent, because monitoring acts as an implicit subsidy on work. Labor wedges, however, s ll remain below 100 percent in the An op mal tax-transfer system balances the distor ons of EMTRs and distribu onal benefits, which results in a U-shaped presence of monitoring and condi onality of transfers. 154 155 Latvia Tax Review Latvia Tax Review equals total taxes paid T(y) when working (in the formal sector) and earning income y plus the non-employment benefits b that a Figure 72. Income threshold and change in reported income, 2015-2016 worker foregoes when working. These non-employment benefits include for example social assistance (GMI) and housing assistance. The par cipa on tax rate is the total par cipa on tax as a frac on of gross earnings: (T(y) + b)/y. The higher is the par cipa on tax, the fewer people will stop working (in the formal sector). Diamond (1980) and Saez (2002) have shown that it can be op mal to subsidize par cipa on at the lowest end of the labor market when the government sufficiently values redistribu on towards the working poor. When par cipa on is subsidized the par cipa on tax is nega ve: -T(y) > b. That is: workers receive larger tax rebates than non-workers get in benefits. Such a program can be interpreted as an earned-income tax credit (EITC). Policy makers o en also have non-welfarist mo ves to promote labor par cipa on, which is seen as something that is intrinsically good so as to raise inclusion and social cohesion in socie es. Such concerns typically strengthen the case for EITC-like programs (Kanbur et al. 2006). The extensive labor-supply margin (par cipa on decision) lowers marginal tax rates, especially at the bo om. Recall that the func on of a higher marginal tax rate at income y is to redistribute income from individuals above y to individuals below y or to the government. As a result, the average tax burden for everyone above y increases. When individuals also make labor-supply decisions on the extensive margin, i.e., they decide whether to work or not (in the formal sector), a higher marginal tax burden induces some individuals to drop out of the labor market in response to higher levels of income taxa on. Since par cipa on is generally taxed on a net basis, lower par cipa on rates reduce the distribu onal benefits of a higher marginal tax rate (Jacquet et al., 2013). In Figure 74 panel (b), an endogenous par cipa on choice would shi the line of distribu onal benefits of a higher marginal tax rate downwards. The par cipa on elas city is typically higher for the working poor and secondary earners (with and without children). Consequently, the distribu onal benefits of a higher marginal tax rate are reduced more at the bo om Methodology of the earnings distribu on. Hence, marginal tax rates should be lowered especially at low-income levels. The op mal marginal tax rate does not shi down so much at the higher income levels, since high-income earners typically respond less elas cally on Δlog=Δlog(1−)+′+0+ the par cipa on margin (Zoutman et al., 2015). The following rela onship between income growth and tax rates can be derived from op mizing the theore cal framework based on Gruber-Saez (2002): where y is taxable income, METR is the marginal effec ve tax rate (effec ve tax rate because ANNEX E ELASTICITY OF TAXABLE INCOME OF HIGH-EARNERS IN LATVIA. social security contribu ons on the employee’s side are also taken into account). The variable (1−METR) is the marginal net-of- What happened a er imposi on of the solidarity tax? tax rate. It measures what share of addi onal taxable income the taxpayer can keep. This is the central variable that the taxable income literature concentrates on. The coefficient of this variable measures the extent to which taxpayers respond to marginal The elas city of high-income taxpayers to tax rates is es mated based on the introduc on of the solidarity tax in 2016. Based incen ves; it shows to what extent on average they generate less taxable income when facing a higher marginal tax rate. on this reform, the es mated elas city is around 0.13 and 0.2 depending on the sample selec on. These es mates are around the average of the range of elas city es mates in European countries. In prac ce this is a difference-in-difference (DID) model, where the reac on of the average individual affected by the solidarity tax reform (the treatment group) is es mated compared to an individual not affected (the control group). The control Reform episode for iden fica on of the elas city of taxable income of high-earners in Latvia group includes individuals with income below the threshold before the reform in 2015 (this income is exogenous to the reform), and the treatment group includes individuals with income above the threshold before the reform in 2015. Both control and A solidarity tax was introduced for income above 48,600 EUR yearly income from January 1, 2016. This reform significantly treatment groups include individuals in a range around the threshold as individuals very far away from the threshold might have increased the marginal tax rate (MTR) for income above the threshold. The MTR below the 48,600 EUR threshold remained a different reac on to the tax rate change (elas city of tax revenue to tax rate changes). 31.1 percent, while above it increased from 23.0 to 31.1 percent.84 Based on comparing income changes below and above the threshold, we es mate the elas city response of high income individuals. There are two problems when es ma ng the rela onship between taxable income and tax rates. First, the income distribu on might change for reasons independent of the tax changes. For example, as a result of skill-biased technological change the wage Figure 70 plots the percentage changes in income from 2015 to 2016 for individuals with income below and above the dispersion might increase, or due to the phenomenon of “regression to the mean” some individuals with very high income solidarity tax threshold in 2015. The graph clearly suggests that individuals above the threshold on average decreased their might be experiencing a lucky year, most likely to be followed by a decrease in income. To deal with these problems usually (log) income more compared to those below. The red line represents the average income change in the two regions. ini al income (i.e., taxable income in the period before the tax change) is included as a control variable. In the regression we include ini al income (y0) and also demographic variables (X’) such as age, gender, region, se lement to control for individual heterogeneity of taxable income growth. The second econometric challenge is inverse causality between the dependent variable and the marginal tax rate. If taxable income of an individual grows above average for reasons independent of taxa on, then in a progressive tax system this will increase his tax rate. This way a simple OLS regression might indicate that a tax increase caused the taxable income to grow faster. In the literature, this problem is solved by using instrumental variable es ma on. However, in this reform episode endogeneity is not a problem, as in prac ce a flat tax was introduced by subs tu ng the capped SSC with the solidarity tax. 84 MTR is calculated as SSCemployee +(1- SSCemployee)*PIT+solidarity tax. A er the introduc on of the solidarity tax employers also have to pay solidarity tax on income above the threshold, which could reduce labor demand. We do not include either employer social security contribu on, nor the employer solidarity tax in the MTR as usual in the literature. 156 157 Latvia Tax Review Latvia Tax Review Table 42. Changes in marginal tax rates (including PIT, SSC and solidarity tax) Table 43. Comparison of control and treatment groups During the implementa on of the 2016 solidarity tax reform, income might have increased or decreased independently from the reform, but this did not addi onally change the taxpayer’s MTR because of the flat tax rate a er the reform. As can be seen in Table 41 above, the change in the MTR based on income in 2015 is exactly the same for all taxpayers in the control group and also for all taxpayers in the treatment group. Taxpayer A and B are in the control group (with income below the threshold at which the solidarity tax is imposed). If A remains below the threshold then the change in his log(1-MTR) is 0. If B goes above the threshold (his income increases a lot due to exogenous reasons) then the change in his log(1-MTR) will be 0 similarly (instead of the social security contribu on, now he pays the solidarity tax). So the change in the log(1-MTR) is 0 for both A and B because of the flat tax rate a er the reform. The exogenous increase in the income of B did not addi onally change his marginal tax rate. The situa on is similar for C and D who have income above the threshold before the reform, so they are in the treatment group. C remains above the threshold, so he is affected by the solidarity tax and his log(1-MTR) will be decreased by 0.11. D moves below the threshold because of a decrease in his income independent of the reform, so his log(1-MTR) also decreases by 0.11. So independently of whether there is an exogenous decrease in the income of people in the control group or not, their log(1-MTR) will change exactly the same because of the flat tax a er the reform (log(1-MTR) is not endogenous to changes in income). Without the endogeneity problem the regression can be thought as a simple difference-in-difference regression or a regression discon nuity design (RDD) es ma on. Data The database contains yearly administra ve panel data for 2010-2014, and monthly panel data for 2015 and for the first 6 months of 2016 from the State Revenue Service. As only the January - June income data is available for 2016, to have comparable yearly income we analyze changes in reported income between the first six months of 2016 and the first six months of 2015. Regression results If individuals respond to the reform by changes in their second half-year income or in their year-end bonuses, then it is not The coefficient of interest is the coefficient of the dlog(1-MTR) variable, which measures the response of taxpayers to captured in the available data and hence the elas city es mate may be underes mated. marginal incen ves. Table 43 contains regressions including individuals around the EUR 48,600 threshold, with yearly income The assump on underlying the DID is that the treatment and control groups were “reasonably alike”, hence in the absence between EUR 30,000 and 80,000 in 2015. Individuals older than 62 years in 2015 were excluded, as they the face a smaller social of the reform they would have changed their income similarly. That is why we include individuals in a range around the EUR security contribu on rate. The second three columns contain regressions including individuals who worked during all 12 months 48,600 threshold. We limit the sample for individuals with income between EUR 30,000 to 80,000. We also exclude individuals in 2015. As only the first half-year income is available for 2016, this way we try to exclude individuals presumably not working with the largest and smallest income changes—in the top and bo om 1 percent—to ensure that outliers do not drive the during the total 2016 year also. elas city es ma ons. Table 42 shows the comparison of control and treatment groups for both the 30-80 and 30-100 thousand Models (1) - (3): The elas city is significant at 0.2, and it decreases to 0.13 when demographic controls are also included in euro income groups. The income change was on average smaller in the treatment group, sugges ng individuals reacted to the the regression. The nega ve coefficient on the age variable suggests that the income of older people increased less, but the solidarity tax by reducing their income. The fourth row reports that changes in income before the reform were similar in both magnitude is small. The nega ve coefficient of Region2 suggests that the income of people with reported address in Vidzeme the control and treatment groups before the reform. The bo om panel suggests that the two groups are reasonably alike, so increased less, but again the magnitude is small. Models (4) - (6): The elas city es mate is larger and varies between 0.15 and the comparison is useful. 0.21. 158 159 Latvia Tax Review Latvia Tax Review Table 44. Es ma on results The actual tax rate changes for individuals are presented in Table 44. The control group includes individuals with income below the threshold, and the treatment individuals with income above in 2015. In contrast to Table 1 (where social security was included in the MTR), here the change in log(1-MTR) for person A and B or for person C and D are different. So if income increased or decreased independently from the reform, this addi onally changed the taxpayer’s MTR crea ng endogeneity problems. Table 45. Changes in marginal tax rates (including PIT, and solidarity tax) Regression results with the IV es ma on are presented in Table 5. Models (1) - (3): The elas city is significant at 0.27 and it decreases to 0.16 when demographic controls are also included in the regression. The nega ve coefficient of Region2 suggests that the income of people with reported address in Vidzeme increased less, but similarly to Table 3) the magnitude is small. Models (4) - (6): The elas city es mate is larger and varies between 0.28 and 0.2. The elas city es mates are similar, in a range between 0.15 and 0.28 (see Table 43 and Table 45), whether social security is considered as a tax and is included in the MTR or it is excluded. All results are OLS es ma ons with robust standard errors. Robust p values in parentheses. Asterisks mark es mated parameters that are significantly different from zero at the 1 % (***), 5 % (**), or 10 % (*) level. Two digit industry are also included among the control variables. The baseline regression contains individuals residing in the Riga and Pieriga region. The sample consists taxpayers with income between 30,000 and 80,000 euros in 2015. The last three columns include individuals working in all 12 months in 2015. One might also assume that taxpayers do not consider social security contribu on as a tax, but instead more like a present contribu on to future pension benefits. In this second specifica on we exclude the social security contribu on rate from changes in the MTR and re-es mate the regressions.85 When excluding the social security contribu on, the tax rate scheme is not flat but progressive in 2016. This might create inverse causality between the dependent variable and the marginal tax rate. That is, if taxable income of an individual grows above average for reasons independent of taxa on, then in a progressive tax system this will increase his tax rate. The literature uses instrumental variable es ma on to deal with the endogeneity problem of marginal tax rates. The instruments for the actual (endogenous) tax rates are the “synthe c tax rates.” These are calculated by applying the 2016 tax rules to the 2015 (indexed) taxable income of each individual. The index is the average income growth in the sample for individuals with income between 30,000 and 80,000 EUR (1.8%). The synthe c tax rate is based on before-reform individual informa on only; hence it is exogenous to the a er-reform income. (See Gruber-Saez 2002 for a detailed descrip on of the es ma on). To check whether the instrument is relevant we report the p-value of the Kleibergen–Paap underiden fica on test. The null hypothesis is that the equa on is underiden fied. The test sta s cs are favorable; both the exogeneity and underiden fica on tests are rejected as reported at the bo om of Table 5. The F-sta s cs for the first stage regressions shows that the instrument is not weak. 85 MTR is calculated as (1- SSCemployee)*PIT+solidarity tax. 160 161 Latvia Tax Review Latvia Tax Review Table 46. Es ma on results ANNEX F SELECTED PIT REFORM SIMULATION RESULTS Methodology. Reform simula ons have been conducted using the European Union tax-benefit micro-simula on mode EUROMOD86 and the latest available EUROMOD-adapted EU-SILC dataset for Latvia (Latvian EU-SILC 2012) updated to the tax- benefit system as of June 30, 2015. We present the number of persons affected, the fiscal effect (posi ve or nega ve), the change in equalized disposable income by decile, the change in equalized taxes and mandatory social contribu ons by decile, the change in selected inequality indicators (Gini , S80/S20 ra o, and decile dispersion ra o) and selected poverty measures. Addi onal (more specific) indicators will be added at a later stage of the project. It is important to note that simula on results do not take into account possible side effects of the reforms (such as increase in tax evasion by some of the affected groups). Reforms simulated. Four types of reforms have been simulated: (A) Raising the top PIT rate for top X percent of earners (X= 5, 10, 15, 20 have been considered). Labor income threshold Y* is determined such as, say, 15% of earners earn > Y*. Earnings not exceeding Y* for everybody are taxed, as before, at 23 percent, while earnings above Y* are taxed at 33 percent. For the given threshold, the fiscal effect of raising the top rate by 1 percentage point equals one tenth of the es mated effect of raising it from 23 percent to 33 percent (however, a lower top rate is likely to generate a smaller side effect in terms of tax evasion). (B) Introducing earned income tax credit (EITC). EITC is effec vely a tax subsidy (tax return) for (eligible) low-earners.87 The parameters of EITC are defined and results reported on an annual basis, but the implementa on also could be quarterly. In principle, the typical design of EITC (see e.g. Nichols & Rothstein 2015) looks as follows (rates are hypothe cal; they are significantly higher in most countries which apply EITC or similar in-work tax credits): For earnings Y < Y1 EITC rate is c (we have used 7 percent in simula ons). Between Y1 and Y2, EITC amount stays constant at C =cY1 (this amount is known as the maximum subsidy), so that the marginal EITC rate is zero, while the average effec ve EITC rate falls from c to b = C/Y2 < c at Y2. Between Y2 and the EITC eligibility threshold, Y3, the EITC amount falls linearly according to formula EITC= C - h(Y-Y2), where h is benefit withdrawal rate (h= C/(Y3 - Y2); in this (phasing-out) range, the marginal EITC rate is -h, while the average effec ve EITC rate falls from b to zero. Both EITC rates and earnings thresholds (including the eligibility threshold) might depend on the number of dependent children. This is the case in the United States, the UK, France, Ireland, and Slovakia (see Table 3 in Nichols and Rothstein, 2015). Below we present results of simula ons using the 2015 monthly minimum wage of EUR 360 in the following thresholds: Y1=9*MinWage =€ 3240, Y2=12*MinWage = =€ 4320 ; Y3=21*MinWage = € 7560 = 77% of 12 *(Average gross monthly wage) A scenario with EITC granted only to one of the parents of dependent children aged below 15 (or below 19 if the child studies in a general or professional secondary educa on ins tu on, does not receive a scholarship and is not married) has been also simulated. (C) Mixed reform: Raising the top PIT rate to 29 percent for top 10-15 percent of earners, lowering PIT rate to 19 percent for income below the minimum wage, and introducing EITC targeted only to one of the parents of dependent children. The 15 percent threshold earnings threshold (according to 2015 data), would be between EUR 1000 and 1200 per month for full- year workers, while the 10 percent threshold would be below EUR 1400 and EUR 1500 per month. We have chosen EUR 1300 per month for the simula ons. The results show that simulated revenues from raising the top rate are more than sufficient to finance both lowering the PIT rate for low-earners and introducing an EITC, so that the total fiscal effect is posi ve (above EUR 3 million per annum). All results are IV es ma ons with robust standard errors. Robust p values in parentheses. Asterisks mark es mated (D) Lowering the withdrawal rates of GMI from 100 percent to 50 percent or 75 percent. This reform changes the formula for parameters that are significantly different from zero at the 1 % (***), 5 % (**), or 10 % (*) level. Industrial sectors defined at calcula ng GMI from MAX_GMI - FAMILY_INCOME to MAX_GMI - 0.5*FAMILY_INCOME or MAX_GMI - 0.75*FAMILY_INCOME, the two digit level are also included among the control variables. The baseline regression contains individuals residing in the thus widening the eligible popula on. Riga and Pieriga region. The sample consists of taxpayers with income between 30,000 and 80,000 euros in 2015. The last three Results. As shown in Figure 73, raising the top PIT rate for the top 5 percent to 20 percent of earners reduces disposable columns include individuals working in all 12 months in 2015. income of the top decile by 7 percent to 4 percent and that of the 9th decile by 3.4 percent to 0.7 percent, while for the 7th and lower deciles the effect is almost negligible. The es mated fiscal effect ranges between EUR 88 and 222 million per annum (Table All in all, we can conclude that taxpayers did react to the introduc on of the solidarity tax. However, the policy implica ons 44). Income inequality goes down: the quin le ra o S80/S20 falls from 6.27 to 5.91-6.10 and the decile dispersion ra o D10/D1 of the main elas city es mate results should be considered with cau on, as we have only analyzed the behavior of a very high- from 10.27 to 9.54-9.86, while the Gini falls by 0.7 to 1.3 percentage points (Table 44). income and small target group. Results of a similar analysis could differ for the introduc on of a broader based PIT affec ng a 86 EUROMOD has been developed by the Ins tute for Social & Economic Research (ISER, University of Essex) in co-opera on with na onal teams and is sup- larger share of Latvian households. ported by PROGRESS funding from EC DG-EMPL. EUROMOD aims to simulate as much as possible of the tax and benefit components of household disposable income. The following instruments are simulated: income tax, social contribu ons (paid by the employees, self-employed and employers), unemployment benefit, family benefits, housing benefit, and guaran- teed minimum income benefit (EUROMOD, 2016). 87 The empirical evidence indicates that in the United States and other countries, EITC and similar in-work tax credits help to promote work, reduce poverty, and support children’s development (Marr et al. 2015; Hoynes 2014; Nichols and Rothstein 2015). 162 163 Latvia Tax Review Latvia Tax Review Figure 73. Simulated effect of raising the top PIT rate, by household income deciles more generous EITC for families with children is a feasible policy op on. As is evident from Table 45, this version of the EITC is Top panel: taxes and contribu ons. Bo om panel: Household equalized disposable income also be er targeted to those with lower household incomes, as the impact for deciles 3 to 6 is much smaller than for decile 1 compared to the “general” EITC simula on. The EITC has poten al to shrink the gap between the rich and the poor: the decile dispersion ra o falls from 10.27 to 10.05 for the “general” EITC and to 10.17 for the child-oriented EITC version (Table 45). Figure 74. Simulated effect of introducing EITC, by household income deciles Note: The figure shows the change in equalized disposable income. Source: EU-SILC microdata and staff calcula ons. Table 48. Introducing universal EITC and EITC targeted to families with children, simula on results Baseline 2015 Universal EITC EITC for parent of dependent child Fiscal impact, million EUR - -73.294 -19.583 S80/S20 6.274 6.158 6.219 Decile dispersion ra o 10.266 10.051 10.169 Gini 0.361 0.357 0.360 Source: EU-SILC microdata and staff calcula ons. Notes:Universal EITC simula on is an EITC of 7 percent of annual gross earnings below EUR 3240; EUR 226.80 for annual earnings between Table 47. Raising top PIT rate to 33%, simula on results EUR 3240 and EUR 4320; EUR 226.80 less 0.07 mul plied by (income minus 4320) for annual earnings between EUR 4320 and EUR 7560; and 0 for annual earnings above EUR 7560. The alternate EITC simulated is given only to one eligible parent (the parent who earns more Baseline and is eligible) of at least one dependent child. A nega ve number under the fiscal impact means that the program has a fiscal cost. % earners Top 20% Top 15% Top 10% Top 5% 2015 Source: EU-SILC microdata and staff calcula ons. Tax revenue from PIT, change (%) 15.9 13.3 10.1 6.3 Introducing a progressive PIT with three rates 19 percent/23 percent/29 percent) generates a posi ve fiscal effect of almost Revenue from PIT in 2014, million EUR 1397 EUR 23 million, raises household income in all but the top 2 deciles (Figure 78) and substan ally reduces the gap between the Fiscal impact, million EUR 222.5 185.7 141.3 88.2 rich and the poor: the quin le ra o goes down from 6.27 to 6.13, while the decile dispersion ra o falls from 10.27 to 9.95 (Table Quin le ra o S80/S20 6.274 5.909 5.953 6.015 6.101 45). When the PIT reform is combined with the EITC targeted to households with dependent children, the fiscal effect is s ll posi ve at EUR 3 million per annum, disposable income in middle- and, especially, low-income households increases further Decile dispersion ra o D10/D1 10.266 9.538 9.606 9.707 9.863 (Figure 75), and the quin le ra o and the decile dispersion ra o decline further to 6.08 and 9.86, respec vely (Table 46). Gini 0.361 0.348 0.349 0.351 0.354 Source: Eurostat (baseline revenue), EU-SILC microdata and staff calcula ons. The simula on of a modest EITC regime (with a maximum tax credit subsidy of EUR 226.80 per annum) reveals small, but not negligible, income effects for the 1st decile. The impact extends to (although of a smaller magnitude) deciles 2 to 6 (Figure 77). The fiscal cost of this “general” EITC scenario is about EUR 73 million per annum, but it falls to just EUR 19 million if the EITC is only targeted to families with dependent children (where just one parent is eligible). This suggests that providing a significantly 164 165 Latvia Tax Review Latvia Tax Review Figure 75. Impact of introducing a progressive income tax and a targeted EITC: Simulated effect, change in percent of income, (iii) Progressive “B”: Tax system 2015 + progressive PIT (19 percent up to income EUR 360, 23 percent for income by household income deciles above 360 and up to EUR1300, 29 percent for income above EUR1300 per month), applied to the sum of income from dependent employment. All self-employment income is taxed at the rate of 19 percent. (iv) Progressive “B”, joint: Same as Progressive “B” for all taxpayers but married couples. For married couples: (i) Tax allowance for non-working spouse (EUR 165 per month added to nontaxable income) does not apply (except for disabled spouses); (ii) Nontaxable income for the couple is EUR 150 per month; (iii) PIT rates 19 percent, 23 percent, and 29 percent apply, respec vely, for joint employee income up to EUR 720, above EUR 720 up to EUR 2600, and above EUR 2600; and (iv) All self-employment income is taxed at the rate of 19 percent. Simula ons have been performed based on EU-SILC microdata for 2015 (adapted for EUROMOD by the team). The nontaxable minimum is not differen ated as it has been conceptually agreed that if progressive PIT is introduced, there will be no need for a differen ated minimum. Although assumed threshold for the top rate is EUR 1300 for a single earner and EUR 2600 for a couple, due to lowering the PIT rate to 19 percent for incomes up to EUR 360/720, the net effect of introduc on of the progressive PIT (in comparison with the flat rate of 23 percent) on employee net earnings will be nega ve only for singles earning above EUR 1660 and couples earning above EUR 3320 (in the la er case we leave aside removing the allowance for non-working spouse, which has already happened). Introduc on of progressivity coupled with joint taxa on increases the income of households across the income Note: The figure shows the percentage change in equalized disposable income due to each simula on. distribu on. Figure 76 show that introduc on of joint taxa on slightly (by less than 0.5 percent) improves household income across the income distribu on (results for the Progressive “B” version are qualita vely very similar and not shown), the fiscal The “Reform 1” scenario shows the impact of introducing three PIT bands: a low rate of 19 percent (for annual earnings cost of the measure is EUR 27 to 29 million, and the effect on inequality is negligible. below 12 minimum monthly wages, i.e. EUR 4320 (12*360); a 23 percent rate for annual earnings between EUR 4320 and EUR 15600; and a top rate of 29 percent annual earnings above EUR 15600 (12*1300). The “reform 2” scenario shows the impact of Figure 76. Scenario Progressive A: Effect of introduc on of progressive PIT and joint taxa on of married couples on the introducing an EITC targeted to one eligible parent (the parent who earns more and is eligible) of at least one dependent child. equalized disposable income, change vs baseline Source: EU-SILC microdata and staff calcula ons. Table 49. Introducing progressive PIT and progressive PIT combined with EITC targeted to families with children, simula on results Scenario Baseline Three PIT tax Three PIT tax bands + 2015 bands EITC for parent of dependent child Fiscal impact, million EUR 22.820 3.234 S80/S20 6.274 6.131 6.082 Decile dispersion ra o 10.266 9.951 9.860 Gini 0.361 0.355 0.354 Note: The first scenario shows the impact of the introduc on of three PIT bands: a low rate of 19 percent (for annual earnings below 12 minimum monthly wages, i.e. EUR 4320 (12*360); a 23 percent rate for annual earnings between EUR 4320 and Notes: a Baseline, as well as Progressive PIT “A” include tax allowance for non-working spouse (EUR 165 per month), while the EUR 15600; and a top rate of 29 percent annual earnings above EUR 15600 (12*1300). The second shows the impact of the joint versions of Progressive PIT “A” does not. introduc on of three PIT tax bands together with an EITC targeted to one eligible parent (the parent who earns more and is Source: EU-SILC microdata and staff calcula ons using EUROMOD eligible) of at least one dependent child. Source: EU-SILC microdata and staff calcula on. Simula ons of progressive PIT without and with joint taxa on of married couples These simula ons compare the effect of four progressive PIT systems versus the baseline as of 2015 (the most recent fully available for EUROMOD simula ons): (i) Progressive “A”: Tax system 2015 + progressive PIT (19 percent up to income EUR 360, 23 percent for income above 360 and up to EUR1300, 29 percent for income above EUR1300 per month), applied to the sum of income from employment and self-employment. (ii) Progressive “A”, joint: Same as Progressive “A” for all taxpayers but married couples. For married couples: (i) Tax allowance for non-working spouse (EUR 165 per month added to nontaxable income) 88 does not apply (except for disabled spouses). (ii) Nontaxable income for the couple is EUR 150 per month. (iii) PIT rates 19 percent, 23 percent, and 29 percent apply, respec vely, for joint labor income up to EUR 720, above EUR 720 up to EUR 2600, and above EUR 2600. 88 This was a part of the tax system in 2015, but not in 2016. 166 167 Latvia Tax Review Latvia Tax Review Figure 77. Scenario Progressive B: Effect of introduc on of progressive PIT and joint taxa on of married couples on the equalized disposable income, change vs baseline ANNEX G: IMPACT OF LABOR TAXES ON EMPLOYMENT AND WAGES There is a sizable body of empirical research into the employment and wage effects of payroll taxes.89 Overall, a number of 2,0% studies have found that high labor taxes have a nega ve impact on employment, and tend to increase unemployment rates90, although other studies are less conclusive.91 Empirical studies have shown the existence of a posi ve rela onship between the 1,5% tax wedge on labor income and unemployment.92 However, as noted by Bell et al. (2002), “One problem the studies face is that 1,0% it is very difficult to isolate the causal effect of tax changes on wages and employment because other factors are changing at the same me. Nonetheless, the findings suggest that, in the long run, wages absorb the changes in payroll taxes.” 0,5% Impact on employment and unemployment. Although labor tax cuts and employment subsidies have been implemented in Progressive PIT "B" 0,0% many countries at different mes, the quan ta ve evidence of their impacts on employment is limited. The exis ng literature 12345678 91 0 offers some guidance on the plausible range of labor demand elas city es mates, although most of the studies are based on -0,5% data from industrialized countries. The interna onal evidence suggests that the likely range is between -0.30 and -0.50 (i.e., a -1,0% 10 percent decrease in the cost of labor would cause employment to rise from between 3 and 5 percent). Recently, there have been a growing number of studies from developing and transi on countries, with most of the (long run) elas ci es es mates -1,5% ProgressivePIT "B" + joint in the -0.20 to -0.60 range.93 -2,0% On the basis of cross-country regressions for Eastern European and Central Asian countries (ECA), Rutkowski (2007) es - mates that a one percentage point change in the tax wedge results in a 0.3-0.6 percent change in the employment rate. In ECA, -2,5% the tax wedge is expected to have a stronger nega ve impact on employment in more rigid labor markets, where wages are slow Notes: aBaseline, as well as Progressive PIT “A” include tax allowance for non-working spouse (EUR 165 per month), while the to adjust to downward shi s in labor demand because of, for example, strict employment protec on or a high minimum wage. joint versions of Progressive PIT “A” does not. A study by Bassanini and Duval (2006) using pooled cross-sec on/ me series data for OECD countries over the period Source: EU-SILC microdata and staff calcula ons using EUROMOD 1982–2003 found that a 10 percentage point reduc on in the tax wedge would be associated with a drop in the unemployment rate of 2.8 percentage points. The unemployment effects of high tax wedges are found to be largest in those countries where Table 50. Progressive PIT with and without joint taxa on of married couples: Impact on tax revenues and inequality binding minimum wage floors prevent tax shi ing to workers. For a summary of studies focusing on employment impacts of changes in payroll taxes, see Table 47. Progressive A Progressive B Baseline Table 51. Employment and wage effects of changes in payroll taxes 2015 a Not joint Joint Not joint Joint Author(s); year Countries Impact Tax revenue from PIT, change (%) 1.0% -1.0% -0.2% -2.1% Bassanini and OECD countries On average, it is es mated that a 10 percentage point reduc on in the tax Revenue from PIT in 2014, million EUR 1444.6 Duval, 2006 wedge, a 10 percentage point reduc on of unemployment benefits and/or a decline in product market regula on by two standard devia ons would Fiscal impact, million EUR 14.3 -15.1 -3.3 -30.4 be associated with a drop in the unemployment rate by about 2.8, 1.2 and Quin le ra o S80/S20 6.162 6.026 6.036 6.053 6.057 0.7 percentage points, respec vely. Decile dispersion ra o D10/D1 10.312 10.004 10.032 10.058 10.086 Bell et al., 2002 UK, the 1999 reform The reform shi ed the tax burden from low-wage to high-wage earners. in Na onal Insurance A 1 percentage point rise in the NICs share is predicted to reduce nominal Gini 0.348 0.343 0.343 0.344 0.344 Contribu ons (NIC) pay growth by around 1.4 percentage points a er a year, while producer a Notes: Baseline, as well as not joint versions of progressive taxa on include tax allowance for non-working spouse (EUR 165 prices in the manufacturing sector rise by around 1.3 percentage points. per month), while Joint versions do not. Also, it leads to a rise in employment growth of 0.5 percentage points, but Source: Eurostat (baseline revenue), EU-SILC microdata and staff calcula ons using EUROMOD. the employment effect is sta s cally insignificant. Daveri and EU countries The observed rise of 14 percentage points in labor tax rates between Tabellini, 2000 1965 and 1995 in the EU could account for a rise in EU unemployment of roughly 4 percentage points, a reduc on of the investment share of output of about 3 percentage points, and a growth slowdown of about 0.4 percentage points a year. No effects are found for a subsample of Anglo- Saxon and Nordic countries. Góra et al., 2006 A sample of 27 OECD The tax wedge has a sta s cally significant and strong nega ve effect on countries for two years the employment rate of unskilled prime-age male workers, but no effect (1997 and 2003) on skilled workers. 89 For a summary of the literature see, for example, Nickell and Layard (1999), Vroman and Brusentsev (2005), World Bank (2009), Melguizo and González- Páramo (2012), Antón, 2014. 90 Belot and van Ours, 2004; Nickell, 1997 91 Scarpe a, 1996; Nunziata, 2002; Macculloch and DiTella, 2002 92 Nickell and Layard (1999), Daveri and Tabellini (2000), Nickell et al. (2005), Ohanian et al., 2006. 93 Vroman and Brusentsev, 2005; Rutkowski, 2007 168 169 Latvia Tax Review Latvia Tax Review Author(s); year Countries Impact countries between 1956 and 2004 were studied by Ohanian et al (2008). The key finding of their paper is that differences in taxes across countries are a very important piece of the explana on for the vastly different levels of hours of market work. Katz, 1998 USA A 15 percent reduc on in labor costs because of the Targeted Jobs Impact on informality. Labor taxes heavily contribute to informal employment. In the words of Giles and Tedds (2002), “Per- Tax Credit yielded a net employment effect of 7.7 percent; under the haps the single most commonly cited ‘driving force’ of the underground economy is the actual, or perceived, tax burden.” 96 Gov- assump on of an infinitely elas c labor supply, this implies an elas city of ernments are some mes mo vated to decrease taxes, par cularly payroll taxes, to promote labor formality and thus provide labor demand of -0.5. social insurance services for a larger share of the popula on. However, many factors besides tax rates, including cultural factors, Nickell and Layard, Advanced countries A one percentage increase in real labor costs in response to a one corrup on, and enforcement capacity, affect the level of informality. Economic development has historically involved a gradual 1999 percentage point rise in the tax wedge increases unemployment [correct?] shi from informal to formal employment, as well as an increase in the size of government coupled with increasing tax rates. by between 0 percent in Austria and New Zealand to 1.6 percent in Thus, many high-income OECD countries combine high tax rates with a rela vely low incidence of undeclared work.97 In a sample Belgium, and 1.4 percent in Ireland and Switzerland. No important of 69 developing and developed countries, Friedman et al. (2000) finds that higher tax rates are associated with lower—not differen al tax effects on unemployment were found, but there is evidence higher—unofficial ac vity as a percentage of GDP, and argues that this is possible (at least in the richer countries) where a higher that overall labor tax rates do influence labor costs in the long run and tax burden is matched by be er provision of public goods. Thus, the cost of a higher tax burden is outweighed by the advantages hence raise unemployment. of be er public services, thereby reducing any incen ve for the tax payers to move into informality.98 Rutkowski, 2007 ECA countries A one percentage point change in the tax wedge results in a 0.3-0.6 Finally, there is evidence that higher labor taxes are associated with larger shadow economies for countries at similar levels percent change in the employment rate. of per capita income. Regressions on a rich country sample (14 countries) in the mid-1990s indicated that a unit standard devia- on tax difference of 12.8 percentage points is associated with, among other things, a rise in the shadow economy of 3.8 percent World Bank, 2005 EU8 countries For a given GDP growth rate, each percentage point difference in the tax of GDP, which corresponds to a 24 percent increase in the size of the shadow economy evaluated at the mean.99 wedge is associated with a decrease in employment growth by 0.5 - 0.8 Informality entails a loss in budget revenues due to lower taxes and social security contribu ons paid, and therefore a lower percentage points. availability of funds to provide public goods and services. A large informal sector also invariably leads to a high tax burden on A study by Katz (1998) for the United States finds that “wage subsidies to employers to hire disadvantaged workers appear registered labor and firms because of the narrow tax base. A high level of informality also can undermine the rule of law and to modestly raise the demand for labor for those workers. Stand-alone wage subsidies (or employment tax credits) that are governance. This situa on means that a significant share of the popula on does not have access to formal instruments to pro- highly targeted on very specific groups (such as welfare recipients) appear to have low u liza on rates and may (in some cases) tect themselves against economic risk. s gma ze the targeted group. But new evidence based on an examina on of changes in eligibility rules for the Targeted Jobs Overall, empirical evidence from different countries and regions confirms that the impact of labor taxes on employment, Tax Credit (TJTC), the major U.S. wage subsidy program for the economically disadvantaged from 1979 to 1994, suggests mod- wages, work hours and on informality can be rather substan al. In par cular, most studies from developing and transi on coun- est posi ve employment effects of the TJTC on economically disadvantaged young adults. Policies combining wage subsidies tries es mate the (long run) elas ci es in the -0.20 to -0.60 range, i.e., a 10 percent decrease in the cost of labor would cause with job development, training, and job search assistance efforts appear to have been somewhat successful in improving the employment to rise from between 2 and 6 percent. employment and earnings of specific targeted disadvantaged groups.” Es mates by Katz (1998) indicate that the TJTC program increased employment for disadvantaged 23- to 24-year-olds by 3.4 percentage points. Past studies have shown that the employment of less skilled workers appears to be more sensi ve to changes in the tax ANNEX H. OPTIONS FOR DIFFERENTIATED SOCIAL CONTRIBUTION RATES wedge than that of more skilled workers. Góra et al. (2006), using panel regressions for a sample of 27 OECD countries (including Income taxes and social security contribu ons may be subject to a floor, a ceiling, tax brackets, tax exemp ons, personal EU-8 countries) for two years (1997 and 2003), finds that the tax wedge has a sta s cally significant and strong nega ve effect basic exemp ons, and tax credits. Examples from some of the countries in Europe are listed below and are summarized as on the employment rate of unskilled prime-age male workers, but no effect on that of skilled workers. follows: Impact on wage levels. Another important gap in the literature is the effect of tax cuts and subsidies on wages, e.g., the  In many countries the tax legisla on sets up a social contribu on floor, o en by categories of workers, which is dif- extent to which labor taxes are shi ed on to employees (the “pass through” effect). Studies in middle-income countries provide ferent from the minimum wages. For example, in Bulgaria, the minimum amount of contribu ons varies according a wide range of es mates which indicate that, in some cases, the pass through can be quite large.94 For example, research in to occupa on and industrial branch, and is nego ated annually between the social partners. Lower floors are o en La n America suggests that anywhere from 20 to 70 percent of the employer’s social security contribu ons are passed on to established for self-employed, farmers, or voluntarily insured. In some countries (e.g., Switzerland, the Czech Republic, the worker, and in some cases close to 100 percent.95 This means that a large part of changes in payroll taxes is transferred to Bulgaria), persons who are not engaged in paid employment or are not insured on any other ground, are s ll obliged to workers by adjus ng wages, so that the effect on employment is marginal. Melguizo and González-Páramo (2012) base their pay minimum contribu ons at their own expense. meta-analysis work on 52 empirical studies, and conclude that “in the long run, workers bear between two thirds of the tax burden (on labor) in Con nental and Anglo-Saxon economies, and nearly 90 percent in the Nordic economies.” Higher values also are found by Gruber (1997), who in the case of Chile finds an almost total shi , and by Cruces et. al. (2010), who calculate  In many countries, a ceiling on contribu ons on insurable earnings has been established as a fixed amount (e.g., Aus- a “pass-through” effect between 40 and 90 percent in Argen na. However, Prasad (2008) finds no effect of personal income tax tria, Spain, Croa a, Cyprus, Bulgaria), or as a mul ple of average wages (e.g., Slovakia, Slovenia, Romania, the Czech rates on wage rates. This could be because his study focuses on manufacturing wages, and this sector is highly capital intensive, Republic), the minimum gross wages (e.g., Romania for sickness and maternity benefit contribu ons), or some other and as suggested by other authors (Davis et al., 2004), unresponsive to tax rates. benchmark. In Latvia, the maximum taxable amount had been established at EUR 48,600 a year, but star ng from Janu- Impact on work hours. The effect of personal income taxes on work ac vity has also been studied in the literature, although ary 1, 2016 mandatory contribu ons of the statutory social insurance have to be made also from income exceeding this the evidence is scarce. In par cular, cross-country comparisons in the mid-1990s conducted by Davis and Henrekson (2004) in- threshold (the solidarity tax). dicate that a tax hike of 12.8 percentage points (one standard devia on) leads to 122 fewer hours of market work per adult per year and a 4.9 percentage point drop in the employment-to-popula on ra o. It also increases the size of the shadow economy by 3.8 percent of official GDP. The evidence suggests that tax rate differences among rich countries are a major reason for large 96 h p://www.imf.org/external/pubs/ /survey/so/2007/car0726a.htm interna onal differences in market work me and in the industry mix of market ac vity. Changes in hours of work in 21 OECD 97 OECD, 2006 94 World Bank, 2009 98 Rei and Bha acharya, 2008 95 Azemar and Desbordes, 2010; World Bank, 2009; Heckman and Pagés 2004; Oghe et al., 2003 99 Davis and Henrekson, 2004 170 171 Latvia Tax Review Latvia Tax Review  Discounts in contribu ons have been established for certain categories of workers, or employees’ contribu ons are Minimum wages that are set higher for categories of workers with higher produc vity (and expected wages) can be omi ed or reduced in case of low incomes. In Austria, there is no employee unemployment insurance contribu on to a poten ally effec ve way to reduce undeclared earnings, by shi ing some por on of wages from cash to taxable be paid on incomes up to EUR 1,311. In Slovakia, contribu ons as a percentage of the assessment base for the disabled income. Another op on is to differen ate the minimum wage according to sector and occupa on. Yet another alter- is half of that for regular workers, and former long-term unemployed with low wages are exempted from insurance na ve is to set different minimum wage levels by region, given the substan al differences in regional wages in some contribu ons. In Germany, the employer pays a reduced contribu on for low-earners (on mini-jobs). In France, contri- countries. Whatever model is implemented, it is cri cal to maintain a low minimum wage for unskilled workers so that bu on for family allowances is paid by the employer at the rate of 5.25 percent, or 3.45 percent on wages lower than they are not priced out of the formal labor market. 1.6 mes the minimum wage. In Switzerland, lower premiums have been established for youths. In some countries, contribu on rates vary depending on the level of taxable earnings (e.g., U.K. and Austria).  Tax credits can be a useful tool to mi gate the tax burden on vulnerable groups. This program provides tax credits to the labor income of families whose annual earnings remain below a certain threshold, o en gradually phased out  In some countries, there are discounts for small enterprises. For example, in France, for general health insurance as income rises. These in-work tax credits reduce the net tax liability―or turn it nega ve in some cases for low-wage schemes for employees, and for accidents at work and occupa onal diseases, a flat-rate deduc on of employers’ con- earners―and increase the net income gain from accep ng a job rela ve to the alterna ve of being out of work. For tribu ons of EUR 1.50 per hour has been established for companies with less than 20 employees. However, there is no example, policies such as the EITC (Earned Income Tax Credit) in the United States or the WFTC (Working Families Tax evidence that targeted tax relief for small firms is more effec ve in increasing aggregate employment than general tax Credit) in the U.K. have been shown to improve transi ons from unemployment to employment by reducing the tax relief for businesses. In fact, special relief may hurt economic growth by crea ng a small-business trap, encouraging burden of some disadvantaged groups (e.g. employed single parents) (Lehmann et al, 2014). Currently, at least 14 small firms to avoid growing larger and thus lose their special tax treatment. Jobs created by small firms are also gener- advanced economies apply in-work tax credits, and experience has shown that low-skilled employment is rela vely ally of lower quality than jobs created by large firms, with the former paying lower wages, offering more modest health responsive to such financial incen ves (IMF, 2011). insurance and pension plans, and providing poorer working condi ons (Brown et al, 1990; IMF, 2012).  The presump ve approach. In order to expand the tax base, some countries impose taxes on bases that are adminis-  Many countries have established differen ated contribu on rates depending on working condi ons to cover the risks tra vely determined rather than self-assessed by taxpayers. Presump ve systems may, for example, calculate taxable associated with accidents at work and occupa onal diseases. income based on key factors that are presumably associated with income genera on such as sales, turnover, number of employees, size of firm, assets of the taxpayer, and so forth (Rutkowski, 2007). The es mated tax base typically is calculated based on coefficients for different factors applied to specific taxpayers or specific types of taxpayers (such as  Alterna vely, contribu ons for certain benefits or categories of individuals can be paid from the state budget. For ex- certain sized enterprises in par cular industries). The idea is to use data available to officials to capture at least some ample, financing of sickness and maternity benefits in kind is tax-based in Cyprus, Denmark, Italy, Portugal, and Spain. minimum level of tax from those taxpayers who are considered to be unreliable sources of informa on on their own In Bulgaria, contribu on for sickness and maternity leave benefits is covered from general tax revenues on behalf of ac vi es. civil servants, soldiers, and other military personnel; the judiciary, including judges, prosecutors, inves gators, and bailiffs; uninsured persons under 18 years of age and for students up to the age of 26; socially vulnerable persons with a right to social assistance or accommodated in social care centers; persons under arrest or imprisoned; war veterans Such presump ve taxa on can be found, for example, in Greece, where individuals may be taxed according to imputed and war invalids; and some other categories of individuals. A por on of the employer’s contribu ons is paid from the income, when imputed income is higher than actual income declared and the taxpayer cannot substan ate the dif- state budget for people with disabili es. Also, Bulgaria began to finance ac ve labor market policies from the general ference. Imputed income is calculated based on criteria such as rent of second home, opera ng expenses of vehicles, budget rather than the contribu on-financed Employment Fund (EC, 2014). costs of domes c servants, assets (e.g., cars, boats, ships), enterprise share-holdings, purchase or construc on of immovable property, and loans to personal enterprises, partnerships, and limited liability companies (Wallace, 2002).  Minimum floor. As the minimum wage sets a floor to the gross wage, especially in high income countries, the combina- on of the minimum wage and high employer contribu ons to social security leads to high wage costs for low-skilled  Reduced taxes on low income earners, older workers and women/secondary earners. Sec on 3.1 of the main text workers and reduces their job opportuni es in the formal sector. With binding wage floors in place, taxes paid by the illustrates how households in the lowest income quar le face a much higher marginal effec ve tax rate than those in employer cannot be passed on to minimum wage workers by lowering their pay. Employers may nevertheless be able higher income groups. An increase in labor taxes will have the strongest effect on the employment of workers for whom to shi taxes paid for minimum wage workers to higher-paid workers by lowering their wages. Social contribu on pay- labor demand is most elas c. These include low-skilled workers, youths, older workers, and women. The nega ve em- ments tend to accrue around the level of minimum contribu on, sugges ng that many firms report only wages that are ployment effect will be amplified if the elas city of labor supply of those groups is high. The current social protec on close to the nego ated minimum contribu on threshold. This under-repor ng, combined with the sizeable informal financing structures in many countries discriminate against low wage earners. Most countries charge similar rates of sector, means that the tax base is not as wide as it could be, and that tax rates on those who pay them are higher than payroll taxes and employer social contribu ons for minimum-wage labor as for higher-earning employees. Moreover, they otherwise might be. Hungary has tried to address this problem through the introduc on of a double minimum a minimum contribu on floor at such a low wage increases the tax burden considerably for those in low-paying, part- wage contribu on base with opt-out possibili es. Presuming widespread tax evasion through undeclared earnings, me jobs. Hungary has established the employer’s social contribu on base at twice the minimum wage, unless the employer declares that workers are indeed earning the minimum wage (which, in turn, raises the risks of a tax audit). A minimum contribu on floor increases the tax burden considerably for those in low-paying, part- me jobs. As a result, the total A high labor tax wedge on low income earners may reduce their probability of being formally employed. Reduc ons tax burden on employment income is very high for low income earners. in employer social security contribu ons then can be effec ve in raising employment if targeted to low-wage earners (e.g., decreasing the labor tax wedge at lower wage levels) and where the link with benefits is weak (e.g., for health expenditures). In par cular, targeted cuts in employer social security contribu ons can have a sizable impact on the  Differen ated minimum wages. Another approach is to introduce mul ple minimum wages to differen ate among employment prospects of low-skilled workers, par cularly given their rela vely high elas city of labor demand (Gill et workers with different produc vity levels. Some countries have put in place differen ated minimum wages (or contri- al, 2013). The low-skilled are more likely to be unemployed, informal or inac ve. They are also expected to work more bu on bases) to reflect presumed varia ons in the produc vity level of workers with different characteris cs. However, in temporary or part- me contracts rather than regular contracts. Austria, Belgium, France, the Netherlands, Spain, these can increase administra ve complexity, create enforcement challenges, and lead to wage discrimina on (Kuddo and the United Kingdom have cut social security contribu ons by low-paid workers by about 1.5 percentage points et al, 2015). since 1997 (IMF, 2011). 172 173 Latvia Tax Review Latvia Tax Review For example, France introduced payroll tax subsidies in 1993, and the system is s ll in place in a modified form. The pro- Finland gram provides payroll tax exemp ons for low-wage workers according to a sliding scale up to a threshold of 1.33 mes Insured person 5.55 2.16 0 0.7 0 8.41 the minimum wage, when the subsidy is stopped. The maximum exemp on is 18.2 percentage points in employer’s Employer 17.75 2.14 0.1 2.2 0 22.19 payroll tax for minimum wage workers. Crépon and Desplatz (2002) es mate that each reduc on in labor cost of 1 per- Total 23.30 4.30 0.1 2.9 0 30.60 centage point led to a rise in employment of 1.6 percent in manufacturing and 1.8 percent in nonmanufacturing, and the unskilled labor content increased substan ally. These changes in employment were due to two effects: subs tu on France between factors of produc on—as less skilled labor was subs tuted for more skilled labor and capital—and expanded Insured person 10.05 0.75 0 2.4 0 13.2 profitability and output (because reduced labor costs enabled firms to lower prices and thus boost demand). Employer 14.70 13.10 b) 4.3 5.4 37.5 Total 24.75 13.85 0 6.7 5.4 50.7 Germany The es mated employment effect, however, has varied. In Belgium, for example, the tax cut seems to have had a sig- Insured person 9.45 9.225 0 1.5 0 20.175 nificant impact on registered employment, but not in the Netherlands (World Bank, 2009). However, increasing the Employer 9.45 8.325 1.3 1.5 0 20.575 progressivity of taxa on may also have efficiency costs, notably in terms of tax avoidance and reduced incen ves to Total 18.90 17.550 1.3 3.0 0 40.750 improve skills and produc vity for low-income earners. Latvia Insured person 10.50 a) 0 a) 0 10.50 Older workers are found to be more sensi ve to financial incen ves than younger workers. Lower labor tax rates for Employer 23.59 a) a) a) 0 23.59 older workers can increase incen ves for them to remain in the labor force―although this also raises equity issues, Total 34.09 a) 0 a) 0 34.09 as high-income workers generally work longer. Australia, Denmark, the Netherlands, and Sweden, for example, have Lithuania introduced specific earnings tax credits for older workers, aimed at s mula ng labor-market par cipa on (IMF, 2011). Insured person 3.0 6.0 0 0 0 9.00 Employer 23.3 6.4 0.37 1.1 0 31.17 Total 26.3 12.4 0.37 1.1 0 40.17 Female labor supply is more responsive to taxes than male labor supply. Hence, tax relief for women would likely elicit a posi ve net supply response, even when financed by higher taxes on men. Where legal constraints prevent a gender Poland dis nc on in the tax burden, special tax relief can be targeted to single parents (single mothers generally have the high- Insured person 11.26 11.45 0 0 0 22.71 est elas ci es) or to secondary earners in couples. Another way to reduce the tax burden for secondary earners is by Employer 16.26 0 0.67 2.45 0 19.38 replacing family taxa on with individual taxa on. Family taxa on, or family-related tax elements, such as mandatory Total 27.52 11.45 0.67 2.45 0 42.09 joint filing, dependent spouse allowances, or credits condi onal on family income, is s ll widespread. However, many Sweden OECD countries have moved toward individual taxa on over the past decades. Family tax systems result in high tax Insured person 7.00 0 0 0 0 7.00 wedges for secondary earners in couples, especially when rates rise rapidly with family income (IMF, 2012). Employer 15.73 12.48 0.3 2.91 0 31.42 Total 22.73 12.48 0.3 2.91 0 38.42 Also, the nega ve employment effect of payroll taxes will be stronger if labor market regula ons (such as minimum United Kingdom wage or unemployment benefits) or strong trade unions limit the downward wage adjustment so that the tax cannot Insured person 9.05 2.05 a) a) 0 11.1 be absorbed by a commensurate fall in wages. Employer 11.90 1.90 a) a) 0 13.8 Total 20.95 3.95 a) a) 0 24.9 These reforms would need to be implemented in a budget neutral manner. While lowering the tax wedge might partly a) All or certain benefits are financed under another program. finance itself through increased revenues due to higher employment and output, these are likely to be insufficient to Source: SSA and ISSA, 2014. fully compensate for the lower contribu on or tax rates. It also seems that some transi on countries (e.g., Armenia, Bulgaria, Estonia, Kazakhstan, Slovakia, and Russia) have experienced increases in tax revenues when taxes have been Table 53. Social security contribu on arrangements in some of the EU28 and EFTA countries in 2016 cut. The larger is the share of informal business ac vity before reform, the higher is the revenue growth a er. Country, type of insurance Contribu on levels Table 52. Insured and employer contribu on rates, by country and program type in selected EU28 countries, Minimum Minimum amount of the contributory income per month varies in percent, 2014 contribu on floor Bulgaria, sickness and according to occupa on and industrial branch - between BGN 420 (EUR (including other maternity: cash benefits 215) and BGN 550 (EUR 281) per month; self-employed: 8% of the Old-age, Sickness and Work Unemploy- Family Total, all programs than minimum and benefits in kind contributory income. disability, and maternity injury ment benefits wage) survivors Employers and self-employed are both obliged to pay social tax not less Estonia, overall Estonia than the amount calculated from the rate established by the State - EUR contribu ons Insured person 2 0 0 2 0 4 390 per month. Employer 20 13 a) 1 0 34 Minimum annual amount for self-employed and voluntarily insured Total 22 13 0 3 0 38 Latvia, overall persons is twelve mes the amount of minimum monthly wage—EUR contribu ons 4,440 a year (12 x EUR 370) 174 175 Latvia Tax Review Latvia Tax Review Country, type of insurance Contribu on levels Country, type of insurance Contribu on levels Employees: minimum assessment base - minimum monthly wage Croa a, sickness and (CZK 9,900 (EUR 366)). Self-employed: 13.5% of the assessment base maternity cash benefit, old- Czech R., sickness and Ceiling: HRK 48,222.00 (EUR 6,314). (which is 50% of the annual income from business and from other age and unemployment maternity: benefits in kind independent gainful ac vity minus costs incurred to achieve, secure and benefit contribu ons maintain such an income). Ceiling: 30 mes the projected na onal average wage as laid down in Poland, invalidity and old Slovakia, sickness and the budget law, this ceiling applies to the combined contribu on of Minimum amount (for self-employed): 50% of the na onal average age benefit contribu ons maternity: cash benefits employer and insured person. wage. and benefits in kind Slovenia, old age Maximum: 3.5 mes the average wage. Slovenia, old age benefit Minimum: for self-employed and farmers - minimum wage; for contribu ons contribu ons execu ves and business partners - minimum Pension Ra ng Basis Reduc on of France, contribu on for Employers pay 5.25%, or 3.45% on wages lower than 1.6 mes the Croa a, unemployment Assessment base: minimum HRK 2,812.95 (EUR 368) contribu ons family allowances minimum wage benefit contribu ons For low-earners (up to EUR 450 per month) the employer pays a Germany, sickness and Minimum base for contribu ons: indexed every three months and contribu on of 13%, and for low-earners employed in the private Serbia, overall benefit maternity: benefits in represents 35% of the na onal average gross wage over the previous household sector a contribu on of 5%. These blanket contribu ons are contribu ons kind, and old-age benefit quarter. Minimum base is 21,718 RSD (2015). only payable if the employee is already insured in the statutory sickness contribu ons Ceiling on insurance. Cyprus, overall Ceiling on insurable earnings: EUR 1,046 per week or EUR 4,533 per contribu ons on Persons not covered by the health insurance system on any other contribu ons month. Mandatory insurable earnings Bulgaria, sickness and grounds are obliged to pay contribu ons amoun ng to at least 8% of minimum Maximum EUR 4,290 per month (5 mes the average monthly wage in maternity: benefits in kind the minimum contributory income for the self-employed (BGN 420 (EUR Slovakia, sickness, contribu on base 2014). 215) per month) at their own expense. maternity and old-age Czech R., sickness and Minimum assessment base: minimum monthly wage (CZK 9,900 (EUR benefit contribu ons maternity: benefits in kind 366)), applies also to those without taxable income. Poland, invalidity and Ceiling: 30 mes the projected na onal average wage as set out in the Sickness and maternity cash benefits: people not engaged in paid old-age insurance budget law; this ceiling applies to the combined contribu on of the employment pay a contribu on between CHF21 (EUR 19) and CHF1,050 contribu ons employer and insured person. (EUR 971) per year, according to their social condi ons. Ceiling: benefits in kind: 5 mes the average gross earnings; total gross Switzerland, sickness, Invalidity: people not engaged in paid employment pay a contribu on Romania, sickness and maternity, invalidity and between CHF65 (EUR 60) and CHF3,250 (EUR 3,005) per year, according earnings; ceiling: five mes the Average Gross, i.e. RON13,405 (EUR maternity, and old age old age benefits to their social condi ons. 2,959); cash benefits: 12 mes minimum gross wage for each employee. benefit contribu ons Old age: people not engaged in paid employment pay a contribu on [this is unclear] between CHF392 (EUR 362) and CHF19,600 (EUR 18,125) per year, Austria, sickness and according to their social condi ons. maternity, old-age and Ceiling: principally EUR 4,860 monthly, for 13th and 14th month salary unemployment benefit EUR 9,720 per year. Slovakia, sickness and Contribu ons contribu ons maternity benefit: benefits Low wages up to EUR 570 per month are exempted from tax. omi ed in kind Latvia, overall The maximum taxable amount is EUR 48,600 a year. No employers’ or employees’ contribu ons for women and men who contribu ons have reached the age of 58 before June 2011. Employees’ contribu ons Bulgaria, sickness and Austria, unemployment are omi ed or reduced in case of low incomes. There is no employee maternity, old-age, and Ceiling: BGN 2,600 (EUR 1,329) per month. benefit contribu ons contribu on to be paid up to EUR 1,311. For an income between EUR unemployment benefit 1,311 and EUR 1,430 the contribu on payable by the employee is 1%, contribu ons and for an income between EUR 1,430 and EUR 1,609 it is 2%. Spain, overall contribu ons Ceiling: EUR 3,642 per month. No employee and employer contribu ons if the employee receives old- Czech R., sickness Slovakia, unemployment age pension, early pension, or full invalidity pension or is a former long- and maternity cash benefit contribu on Ceiling: 48 mul plied by monthly average wage (CZK 1,296,288 (EUR term unemployed person on low wages. benefits, old-age and 47,959) per annum). Employees pay 12% (10.6% if member of approved occupa onal unemployment benefits Contribu ons vary pension scheme) on weekly earnings between GBP 155 (EUR 210) and contribu ons with the level of GBP 815 (EUR 1,104) and 2% of earnings over GBP 815 (EUR 1,104). No Lithuania, sickness and Ceiling: 48 average insured incomes per year. UK, overall contribu ons earnings contribu on paid a er State Pension age. Employer pays 13.8% on all maternity: cash benefits weekly earnings above GBP 156 (EUR 211). Employers get 3.4% rebate for employees in approved salary-related schemes. 176 177 Latvia Tax Review Latvia Tax Review Country, type of insurance Contribu on levels Country Financing arrangement for social protec on benefits Switzerland, sickness, Bulgaria Self-employed persons according to the Bulgarian legisla on are defined as: Discounts for youth, Lower premiums for insured persons under the age of 18 (children). The maternity, invalidity small firms, and low insurer may set a lower premium for insured persons under the age of (i) Persons registered as free-lance professionals and/ or cra smen; (ii) sole entrepreneurs, pro- and old age benefit paid workers 25 (young adults). prietors and co-proprietors of companies; or (iii) registered farmers and tobacco planters. The contribu ons minimum monthly amount of the insurable income for self-employed persons is differen ated For low-earners (up to EUR 450 per month) the employer pays a according to the amount of their annual taxable income for 2013: contribu on of 15%, and for low-earners employed in the private Germany, sickness and (i) up to BGN 5,400 (EUR 2,761): BGN 420 (EUR 215); household sector a contribu on of 5%. If the employee cannot maternity, and old age be exempted from mandatory pension contribu ons, he pays the (ii) from BGN 5,401 (EUR 2,762) to BGN 6,500 (EUR 3,323): BGN 450 (EUR 230); benefit contribu ons difference between the general contribu on percentage (18.7%) and the employer’s contribu on level (15% or 5%). (iii) from BGN 6,501 (EUR 3,324) to BGN 7,500 (EUR 3,835): BGN 500 (EUR 256); France, sickness and (iv) above BGN 7,500 (EUR 3,835): BGN 550 (EUR 281). maternity: benefits in kind, On over me: flat-rate deduc on of employers’ contribu ons of EUR The minimum insurable income for self-employed persons who did not carry out an economic family allowances, and old- 1.50 per hour for companies with less than 20 employees. ac vity in 2014 and for self-employed persons who started an economic ac vity in 2015 and in age benefit contribu ons 2016 is BGN 420 (EUR 215). The minimum insurance income for farmers and tobacco producers Belgium, Bulgaria, Czech R. (insurance contribu on varies according to is BGN 300 (EUR 153). The maximum amount of the insurable income for all categories of in- Contribu on rate Accidents at work and risk (between 0.2% and 1.2% of gross earnings) paid by the employer); sured persons, including self-employed, is BGN 2,600 (EUR 1,329). No difference to the standard varies with the occupa onal diseases Denmark, Finland, France, Germany, Italy, Lithuania (rate varies between schemes exists in rela on to benefits, including the non-contributory provisions. working condi ons 0.18% and 1.8%); Poland (rate varies between 0.67% - 3.86% of gross Croa a Croa a does not operate a separate system for the self-employed. They are covered by the gen- wage), Portugal, Romania, Spain, Switzerland. eral compulsory social security system. Source: MISSOC, 2016. h p://www.missoc.org/MISSOC/INFORMATIONBASE/COMPARATIVETABLES/MISSOCDATABASE/com- para veTablesSearchResultTree.jsp Cyprus There is a General Social Insurance Scheme which covers every person gainfully occupied either as an employed or a self-employed person. The rate of contribu on of self-employed persons is 19.2% of the insurable income, from which 14.6% is paid by the self-employed and 4.6% by the Table 54. Financing arrangements of social protec on benefits in the EU28 countries in 2016 state. For the determina on of the insurable income, each self-employed person is classified in the respec ve occupa onal category according to his/her occupa on and for each category Country Financing arrangement for social protec on benefits a compulsory minimum insurable income is prescribed. However, the individual self-employed person has the right to opt for a higher income up to the maximum insurable earnings of EUR Austria Austria used to have a comprehensive special scheme both for farmers and for cra smen and 1,046 per week. If a self-employed person proves that his actual income is lower than the mini- retailers un l 31 December 2004. As of 1st January 2005 all pension systems were harmonized mum insurable income of his occupa onal category, he is allowed to pay contribu ons based on for those persons who had not yet completed the age of 50 by 1st January 2005. In agriculture, his actual income. the protec on schemes for invalidity, old age and survivors are nearly one third financed from contribu ons; the rest are predominantly financed from government funds. The rate of contribu- Czech R. The Czech social security system is in principle uniform for employees and the self-employed. on is 15.5% of the insurable value of landed property that does not exceed the upper limit of The Basic Pension Insurance for old-age, survivor’s and invalidity pensions is compulsory. The assessment (€5,670 per month). In cra s and commerce, health care is financed predominantly self-employed are also protected in case of unemployment. The contribu on rates of the self- by contribu ons. The contribu on rate amounts to 9.1% of revenues liable to income tax up to employed amount to: 13.5% for health care; 2.3% for sickness cash benefits (op onal insur- the upper limit of assessment of €5,670.00 per month. ance); 28% for pensions (invalidity, old-age and survivors) and 1.2% for unemployment (State Employment Policy), of the applicable assessment base. For the health care insurance premium, Cash benefits in case of sickness (voluntary supplementary insurance): the amount is 4.25% of the assessment base is 50% of their income from business and from other independent gainful revenues liable to income tax up to the upper limit of assessment of €5,670.00 per month. ac vity minus costs incurred in order to achieve, secure and maintain such income. The mini- 66.9% of the protec on offered by the invalidity, old age and survivors schemes is financed from mum premium base is 12 mul plied by 50% of the monthly average salary (since 1 January 2016 contribu ons, 32.1% from government funds, and 1% is derived from other sources. Contribu- the minimum premium base is CZK 13,503 (EUR 500) monthly, so the minimum premium is CZK ons are 17.5% of revenues liable to income tax up to the upper limit of assessment of EUR 1,823 (EUR 67) per month). If such established minimum assessment base for “full me” self- 5,670.00 per month. Self-employed persons who employ no or less than 25 employees receive, employed is less than 50% of half of average wage, the minimum assessment base in 2016 is from the 43rd day of work incapacity due to sickness, a daily support benefit of EUR 29.23 for CZK 6,752 (EUR 250) monthly. The minimum assessment base for “part me” self-employed is up to 20 weeks. In case of sickness, self-employed persons covered for more than six months by 10% of the average wage (in 2016 CZK 2,701 (EUR 100) monthly). The maximum premium base voluntary supplementary insurance receive a cash benefit from the fourth day of sickness for a is 48 mul -plied by the monthly average wage (CZK 1,296,288 (EUR 47,959)) per annum. Family maximum of 26 weeks. Unemployment insurance is voluntary. benefits are tax financed. Belgium A special system covers all self-employed persons against all tradi onal risks, with the excep on Denmark The social protec on system is based on the principle of na onal insurance. Persons covered of accidents at work, occupa onal diseases and unemployment, and also provides for na onal are not defined according to their social situa on and the general system does not dis nguish insurance in case of bankruptcy. This system is financed at 65.2% by contribu ons, at 34.7% by between the employed and the self-employed. Consequently, self-employed persons receive the taxes and at 0.1% by other sources. social protec on of the general system. Financing is carried out according to the regula ons of the general system. 178 179 Latvia Tax Review Latvia Tax Review Country Financing arrangement for social protec on benefits Country Financing arrangement for social protec on benefits Estonia Self-employed persons are covered by the general schemes of health insurance (benefits in kind France Social protec on for the self-employed is subject to separate regula ons. Farmers come under and in cash in case of sickness and maternity) and pension insurance (invalidity, old-age, and sur- the agricultural system (MSA). Cra smen, retailers and manufacturers fall within the scope of the vivors) on compulsory base, but they are not covered by the unemployment insurance scheme Social Protec on Scheme for the Self-employed (RSI) while members of the liberal professions (neither on compulsory basis nor may they join the scheme voluntarily). In respect of unemploy- are covered by separate schemes (CNAVPL). ment, the self-employed are however covered by the non-contributory State unemployment Farmers: allowance scheme. The amount of social tax to be paid by the self-employed per working-able insured person cannot be smaller than the amount of tax calculated from the rate established by Financing: the State in the annual State budget, and shall not be higher than the amount of tax calculated The farmer’s contribu ons are calculated according to professional income. Rates applied: on the basis of 15 mes this rate. In 2015, the monthly rate established in the State budget was EUR 390. Accordingly, the minimum amount of social tax to be paid by the self-employed is EUR AMEXA (sickness, invalidity, maternity): 10.84%; 128.7 (0.33 x 390) per month, while the ceiling is EUR 1,930.5 (0.33 x 15 x 390) per month. In the flat-rate contribu on for sickness (cash benefits): EUR 200; case of being simultaneously employed and self-employed, the minimum amount is applied on the total of wage income and income from the self-employment. capped old-age insurance for farmers (AVA): 11.47% Finland The self-employed are covered by the same social security schemes based on residence as em- old-age insurance for farmers (AVA) without a ceiling: 2.04%, ployed persons and any other person residing permanently in Finland. The self-employed are insured by the basic unemployment insurance. The self-employed can join the earnings-related individual old-age insurance (AVI): 3.30% of the professional income within the limit of the ceil- unemployment insurance scheme voluntarily and qualify for the earnings-related unemploy- ing, ment allowance as members of special unemployment funds compulsory supplementary re rement (RCO): between 2.15% and 5.25% depending on profes- Germany There are, on the one hand, special provisions for certain groups of self-employed (notably sional income; cra smen), who are compulsorily insured with the statutory pension insurance and, on the oth- family benefits: 5.25% on professional income (digressive reduc on according to the income. er, independent social security systems for farmers (including assis ng family members), self- employed ar sts and publicists and the special schemes for the members of the professions, Amount of the social security ceiling as of 1 January 2015: EUR 3,218 per month, EUR 38,616 which have the right to form associa ons. per year. Agriculture: The benefits granted to the pensioners or re red farmers are funded from tax rev- Cra s, Commerce and Manufacturing, Liberal Professions enues, if they are not covered by their contribu ons and solidarity supplement included in the Financing contribu on of the working farmers. Health insurance of working farmers is almost totally fi- nanced from contribu ons, with contribu ons assessed on the basis of surface values and laid Sickness and maternity insurance: down in 20 contribu on categories. Cra s and commerce: Insurance against invalidity, old age Benefits in kind: 6.5% of the total professional income. and survivors is financed from contribu ons and from tax revenues (federal level). The protec- on scheme accidents at work and occupa onal diseases is financed by means of contribu ons, Sickness benefits in cash (daily allowances) for cra smen, retailers and manufacturers: 0.7% and the amount of contribu ons is determined in rela on to the risk. Family benefits and basic within the limit of EUR 193,080. security benefits for job-seekers are covered by tax revenues. Old-age insurance: Basic system for cra s, commerce and manufacturing: 17.65% of the professional income within the annual limit of the social security ceiling (EUR 38,616) and 0.50% for income exceeding this ceiling. Compulsory supplementary scheme: 7% of professional income within the limit of EUR 37,546 and 8% between EUR 37,546 and EUR 154.464 for cra smen, retailers and manufactur- ers. Old-age pensions: except for the liberal professions which are under a specific scheme, the rules applied in the systems of cra smen, retailers and manufacturers are iden cal to those of the general system. No unemployment insurance system exists for cra smen. 180 181 Latvia Tax Review Latvia Tax Review Country Financing arrangement for social protec on benefits Country Financing arrangement for social protec on benefits Greece There exists a contributory basic system for farmers, called Agricultural Insurance Organiza on. Italy Agriculture, Cra s and Commerce Self-employed persons (cra smen, retailers, professional motorists, hotel owners and others) Basic principles are insured with the Social Security Organiza on for the Self-Employed. Members of the liberal professions (medical personnel, doctors, pharmacists, engineers, lawyers, notaries etc.) are in- The self-employed receive health and maternity care, as well as benefits for accidents at work sured with the Insurance Fund for Independent Professionals. Financing of the system is based and occupa onal diseases, according to the specific qualifying condi ons provided for within on the insured persons’ contribu ons and, for those affiliated to the system a er 1 January 1993, their special scheme. The general system is also in force, but with special regula ons, in rela on on par cipa on of the State as well. Condi ons for old-age pensions for farmers: 67 years of to cash benefits for maternity. age and insurance record of 15 years, or 62 years of age and insurance record of 40 years. Sick- For the disability, old-age, survivors and family benefits branch, a special system exists compa- ness benefits are not part of the system for farmers. However, a flat maternity allowance of EUR rable to the general system. Financing 436.98 is provided. Unemployment risk is not covered in the farmers’ system. Hungary In principle all self-employed persons are covered for all the branches of social security in the Farmers pay a percentage - based on four values - which varies according to the type of land general system, consis ng of health and sickness schemes (covering health care, sickness, mater- cul vated, age, number of workdays and a reference income. The daily conven onal income of nity and the specific treatment of work incapacity related to an accident at work or a professional EUR 55.05 is updated by Ministerial Decree in May every year. Cra smen pay 23.10% on com- disease), the social insurance pension scheme (covering old-age and survivorship), benefits prior pany income up to EUR 46,123 or 24.10% on company income between EUR 46,123 and EUR to re rement age (social benefits), benefits for persons with changed working capacity and a 76,872. Tradespeople pay 23.19% on company income up to EUR 46,123 or 24.19% on company mandatory unemployment insurance. income between EUR 46,123 and EUR 76,872. The minimum pensionable income for cra smen and trades people is EUR 15,548. The maximum pensionable income is EUR 76,872 for cra smen The family support scheme is of a universal type, which covers every Hungarian ci zen, regard- and tradespeople registered before January 1996 and EUR 100,324 for those whose work insur- less of their employment status. Consequently, every self-employed is covered by the family ance commenced a er 1 January 1996. support scheme. The same principle is applied for the universal means tested social assistance Latvia All socially insured self-employed persons are subject to the social security system. Self-employed schemes. persons are only considered as socially insured if their contribu ons have actually been made. Financing Self-employed persons are subject to compulsory social insurance as provided by the law “On Unlike employees, self-employed persons pay the contribu on him/herself on the basis of the State Social Insurance” (Likums “Par valsts sociālo apdrošināšanu”). The Cabinet of Ministers self-employed income which she/he declares, but at least on the basis of the na onal minimum sets the minimum amount of the contribu on basis. The minimum amount of earnings subject wage (pension contribu on on the basis of 100% of the minimum wage; health insurance and to contribu ons was EUR 4,440 per year in 2016. The social insurance contribu on rates differ labor market contribu ons on the basis of 150% of the minimum wage; and the social contribu- amongst the categories of self-employed persons. They were the following in 2016: on tax on the basis of 112.5% of the minimum wage). Self-employed persons pay contribu ons (i) self-employed persons (also those with disabili es of group I or II) insured for the risks of old- on a monthly basis. age, death, sickness, parental leave, maternity and disability: 30.58%; For health, pension and unemployment insurance, the self-employed pay both employer and (ii) self-employed persons over re rement age and persons who receive old-age pension (includ- employee contribu ons as follows: ing pre-re rement pension) insured for the risks of old-age, death, parental leave, maternity and (i) as an employee: 4% for benefits in kind and 3% for cash benefits, 1.5% as labor market contri- sickness: 28.21%; bu on and 10% for pension insurance; (iii) individuals managing real estate and registered as tax payers for income gained from eco- (ii) as an employer: 27% for social contribu on tax. nomic ac vity who are insured for the risks of old-age and disability: 26.19%. Self-employed persons who perform ac vi es in a complementary way: a flat-rate contribu on Self-employed persons do not make social insurance contribu on payments for insurance against of HUF7,050 (EUR 23) per month for the en tlement to insurance against accidents at work, the occupa onal accidents or unemployment as they employ themselves and bear the responsibility occupa onal disease scheme and for in-kind health. for their working condi ons and safety. Ireland The protec on of the self-employed is achieved within the general system through social insur- Lithuania Self-employed persons, if they declare their income as wages, are covered by pension insurance. ance or social assistance payments. The general contribu on rate for these persons is 26.3%: Financing • Owners of personal enterprises contribute based on income declared as wages; when they do not have state social insurance guarantees, they contribute based on the minimum monthly The self-employed Social Insurance Contribu on provides cover for survivors, maternity/adop- wage; ve and guardians and old age. There are no specific contribu ons for unemployment and sick- ness. For old age, maternity and survivors, the self-employed pay contribu ons at the rate of 4% • Farmers and their partners pay contribu ons based on 12 minimum monthly wages per year, of all income, subject to a minimum payment of EUR 500 per annum. There is no annual income except if their income is equal to or higher than 4 Economic Size Units and they do not pay in- ceiling. come tax. Family benefits are tax financed and available to all. 182 183 Latvia Tax Review Latvia Tax Review Country Financing arrangement for social protec on benefits Country Financing arrangement for social protec on benefits Luxembourg Social protec on of the self-employed is regulated under the general system, but with certain Slovakia The protec on of the self-employed in the areas of benefits-in-kind for sickness and maternity, par cular features which take account of the specific situa on of the self-employed. Social pro- as well as benefits-in-cash for sickness, maternity, invalidity, old-age, survivors, unemployment tec on covers all risks; this includes unemployment for the self-employed who had to cease and family benefits, is achieved within the general system. their occupa on and who are looking for a salaried job. For farmers, the premium method is set Financing inclusively based on vegetable and animal produc on of the farm during the year preceding the year of contribu ons. There are specific rates of contribu ons in the general system for self-employed persons. The Netherlands The general protec on system applies as a rule to all residents; therefore, there are only a few Assessment Base of self-employed persons for health insurance and for other types of insurance special regula ons for self-employed persons. is 1/1.486 (ca. 67.3%) of average monthly taxable income in 2014 (for voluntary insured the sum assigned by him/her). Malta The social protec on system in Malta is a general scheme that covers both employed and self-em- ployed persons. Self-employed contribu ons are paid by persons who are not gainfully occupied There are upper and lower ceilings for the Assessment Base. The maximum monthly Assessment but have a net annual income that exceeds EUR 1,005. Persons who are gainfully occupied and Base ranges from half to 5 mes the na onal average wage. whose annual net earnings exceed EUR 910 pay self-occupied contribu ons. The self-occupied Rates of contribu ons of self-employed persons as a percentage of the Assessment Base for: contribu on for a person born in 1961 or before is EUR 28.73 per week if the annual net earnings of the preceding year are less than EUR 9,060. For a person born in 1961 or before, if the annual • Old-Age and Survivors is 18% (if appropriate, 14% for the 1st and 4% for the 2nd pillar), net earnings exceed EUR 17,933, the contribu on due is EUR 51.73 per week. For a person born • Invalidity and Survivors is 6% (but no contribu on if the person is en tled to old-age benefit or in 1962 or a er if the annual net earnings exceed EUR 22,139, the contribu on due is EUR 63.86 pre-re rement bene-fit), per week. The self-employed contribu on for a person born in 1961 or before is EUR 24.52 per week if the annual net income exceeds EUR 1,005 but does not exceed EUR 8,500. If the annual • Sickness and Maternity (Health care) is 14% (but only 7% if disabled), net income exceeds EUR 8,500, the rates are the same as in the self-occupied category. • Sickness and Maternity (Cash benefits) is 4.4%, Poland From 1 January 1999 onwards, self-employed persons who perform non-agricultural ac vi es and their co-opera ng persons are part of the general social insurance system. They are insured • Unemployment is 2% (only voluntary insurance), in the pension scheme on a mandatory basis (covering old-age, survivorship and invalidity) and • The Reserve Solidarity Fund is 4.75%. in the employment injuries and occupa onal diseases scheme. Par cipa on in health insurance by such persons is voluntary. The scheme on employment and preven on of unemployment is Self-employed persons with a yearly income less than EUR 5,148 (50% of the na onal average also applicable to self-employed persons (not to farmers). In the social security schemes there wage in 2014) are exempted from compulsory sickness and maternity insurance (cash benefits) are in principle no specific rules for self-employed persons. Self-employed persons have the right as well as from compulsory invalidity, old-age and survivors as well as from unemployment insur- to the same benefits as employees. ance. Portugal All self-employed persons (including, among others, helping spouses and farmers) are compulso- Slovenia Self-employed persons are covered by the compulsory insurance based system. The contribu on rily covered by the social protec on system (general system of social security for self-employed rate for all health insurance rights (benefits in kind, cash benefits) for self-employed is 12.92% persons). However, membership is voluntary for persons whose annual reference income for (plus 0,53% for accidents at work and occupa onal diseases) of the basis for pension and invalid- self-employed work is equal to or less than six mes the indexing reference of social support. The ity insurance, but not less than 60% of the last known average of the annual salary of employ- amount of the contribu on is calculated by applying the relevant rate to a flat-rate remunera on ees. The contribu on rate for old-age, survivors and invalidity pensions for the self-employed based on the actual total income (gross earnings) resul ng from the self-employed ac vity and is 24.35% of insurance basis (15.50% as employees and 8.85% as employers). Self-employed fixed according to one of the 11 levels indexed to the indexing reference of social support (IAS), persons are also covered by compulsory unemployment insurance. The contribu on rate for the first corresponding to one mes this reference and the last to 12 mes this reference. If the unemployment for the self-employed is 0.20% of the gross wage (0.14% as employees and 0.06% annual reference income of the self-employed work is equal to or less than 12 mes the IAS, the as employers). contribu on base can be decreased for a maximum period of 36 months from the start of the ac vity, the limit being 50% of the said indexing reference. Benefits are granted according to the regula ons of the general system for the employed. However, some excep ons exist. Romania Self-employed are the incorporated in the exis ng universal or general social protec on schemes. Unemployment insurance is voluntary. 184 185 Latvia Tax Review Latvia Tax Review Country Financing arrangement for social protec on benefits Table 55. Part- me employment as percentage of the total employment, involuntary part- me employment as percentage of the total part- me employment, and temporary employees as percentage of the total number of employees in 2015 in the Spain Spain has a special scheme (R.E.T.A.) for the self-employed in cra s and commerce. The special EU28 countries, in percent scheme for mari me workers comprises also self-employed workers. Agriculture (Special System) Involuntary part- me Part- me employment Temporary employees Financing employment Aged Aged Aged Aged Aged Aged Aged Aged 15- Benefits in the event of sickness and maternity, invalidity, old-age and survivorship are funded Aged 55-64 15-64 15-24 55-64 15-64 15-24 55-64 15-64 24 from contribu ons, with an overall rate of 18.75% of a certain contribu on basis. Coverage for permanent incapacity and survivors’ pensions as a result of occupa onal con ngencies is com- EU28 19.6 32.2 22.1 29.1 28.0 22.3 14.1 43.3 6.5 pulsory. The contribu on basis varies between a minimum of EUR 893.10 and a maximum of EUR Belgium 24.3 27.4 33.6 10.0 23.5 4.4 9.0 36.6 3.3 3,642.00 (per month), with certain excep ons. Bulgaria 2.2 5.7 2.8 60.6 50.8** 55.3 4.4 11.7 3.5 For accidents at work and occupa onal diseases, rates are fixed by government decree according Czech R. 5.3 10.8 7.6 16.4 12.5 10.2 10.0 31.0 7.1 to the different risk levels of ac vi es, industries and jobs. Denmark 24.7 67.0 20.0 15.7 8.2 16.4 8.7 22.7 3.2 Cra s, Commerce and Others Germany 26.8 23.6 30.2 13.8 10.1 15.4 13.2 53.6 3.6 Financing Estonia 9.5 22.8 9.7 13.3 : 16.1 3.4 11.4 1.6 An overall rate of 29.80% of a certain contribu on basis is paid for benefits in the event of sick- Ireland 22.2 44.5 25.9 37.8 30.4 34.1 8.7 32.7 5.2 ness and maternity, for invalidity insurance, old-age provision and provision for survivors. The Greece 9.4 23.1 8.0 72.6 63.9 54.6 11.9 33.3 9.3 contribu on basis varies between a minimum of EUR 893.10 and a maximum of EUR 3,642.00 Spain 15.6 37.9 12.4 63.2 54.3 53.4 25.2 70.4 10.3 (per month), chosen by the beneficiary within certain limits. France 18.4 24.8 22.4 43.7 55.8 37.0 16.0 58.0 8.4 Farmers: Old-age Croa a 5.9 12.2 8.8 26.7 23.6 8.0 20.3 60.9 8.3 The compulsory old-age insurance of the Special System corresponds essen ally to that of the Italy 18.3 29.5 13.7 65.6 83.7 57.3 14.1 57.1 5.7 General Scheme. Cyprus 13.0 25.8 16.9 68.9 69.4 62.8 18.4 29.1 8.3 Unemployment Latvia 7.2 12.3 9.3 32.7 19.8* 35.1 3.8 10.9 4.2 Unemployed workers are en tled to the out-of-work benefit if they opted for the coverage of Lithuania 7.6 11.4 11.1 31.9 : 36.6 2.1 6.5 : occupa onal con ngencies. Luxembourg 18.5 29.1 25.7 14.8 13.2 11.9 10.2 47.1 4.7 Sweden The social protec on system is based on the principle of na onal insurance. The people pro- Hungary 5.7 6.9 10.3 36.9 45.4 18.0 11.4 24.1 10.8 tected are thus not defined according to social status, and no dis nc on is made between em- ployees and the self-employed. Self-employed persons thus enjoy the social protec on of the Malta 14.5 23.0 14.5 15.4 18.6 16.6 7.4 16.8 6.2 general system. The regula ons of the general system apply for financing. Netherlands 50.0 80.0 49.2 9.9 9.6 8.6 20.0 53.3 6.1 United Kingdom The general protec on system basically includes the self-employed. For individual regula ons, Austria 27.3 22.7 29.0 12.4 15.5 11.2 9.1 35.8 3.0 special requirements apply for the self-employed but there are no further dis nc ons made Poland 6.8 14.1 10.4 30.5 25.6 16.0 28.0 72.7 16.6 within the group of self-employed persons. Portugal 9.8 22.6 16.5 50.1 49.3 31.7 22.0 67.5 10.9 Financing Romania 8.8 19.2 15.1 59.0 74.1 26.8 1.4 5.4 : Na onal Insurance contribu ons are graduated for the self-employed (in contrast with those for Slovenia 10.1 41.3 13.4 13.0 7.4 5.8* 17.8 75.5 9.0 employees) according to three income classes: Self-employed persons with annual profits less Slovakia 5.8 11.9 7.3 29.9 28.6 20.3 10.5 29.1 7.5 than GBP 5,965 (EUR 8,419) can apply to be expected from paying compulsory contribu ons. Those with annual profits GBP 5,965 (EUR 8,419) or more pay a flat-rate contribu on of GBP 2.80 Finland 14.1 41.7 15.3 31.4 24.9 23.5 15.1 41.8 7.1 (EUR 3.95) per week. In addi on, those self-employed people with annual profits between GBP Sweden 24.3 49.1 24.6 29.4 41.8 19.1 16.6 55.7 7.1 8,060 (EUR 11,376) and GBP 42,385 (EUR 59,823) pay an earnings-related contribu on of 9%, U.K. 25.2 37.9 31.0 17.9 23.9 12.5 6.1 15.0 4.8 and 2% above GBP 42,385 (EUR 59,823). *-2014. **-2013. 186 187 Latvia Tax Review Latvia Tax Review ANNEX I. SOCIAL PROTECTION OF THE SELF-EMPLOYED AND SOCIAL iii. of the average wage, the minimum assessment base in 2016 is CZK 6,752 (EUR 250) monthly. In Austria, the rate of contribu on is 15.5 percent of the insurable value of landed property that does not exceed the CONTRIBUTIONS upper limit of assessment of monthly EUR 5,670. Self-employment may be seen as either a survival strategy for those who cannot find any other means of earning an in- iv. In Estonia, the Social Tax Act s pulates a minimum amount of social tax and a ceiling on the social tax, which is to be come, or as evidence of entrepreneurship and a desire to be one’s own boss.100 The Europe 2020 strategy recognizes entrepre- paid by the self-employed (the same minimum also applies to social tax paid by employers on behalf of their employ- neurship and self-employment as key for achieving smart, sustainable and inclusive growth; however, at the same me, it urges ees, but there is no ceiling on social tax paid by employers). The amount of social tax to be paid by self-employed per countries not to promote involuntary or precarious self-employment. Self-employment makes a considerable contribu on to working-able, insured person cannot be smaller than the amount of tax calculated from the rate established by the the EU economy in terms of entrepreneurship and job crea on. It accounted for 14.1 percent of total employment in the Union State in the annual State budget, and shall not be higher than the amount of tax calculated on the basis of 15 mes in 2015 (or 30.5 million self-employed). Moreover, European level data indicate that the self-employment sector has shown a this rate. In 2015, the monthly rate established in the State budget was EUR 390. Accordingly, the minimum amount degree of resilience to the economic crisis, as the employment decline has been more moderate in comparison with that of of social tax to be paid by the self-employed was EUR 128.7 (0.33 x 390) per month, while the ceiling was EUR 1,930.5 employees. In Latvia, the number of self-employed increased from 87,400 in 2008 to 100,500 in 2015 (11.6 percent of the total (0.33 x 15 x 390) per month. In the case of being simultaneously employed and self-employed, the minimum amount employment), of which 36,500 were self-employed persons with employees (employers), and 64,000 were self-employed per- is applied on the total of wage income and income from self-employment sons without employees (own-account workers). v. In Hungary, minimum contribu ons are linked to the na onal minimum wage: for pension contribu ons on the basis In some countries, the self-employed seem to be more ‘at risk’, i.e. they do not have the same social protec on as em- of 100 percent of the minimum wage; for health insurance and labor market contribu on on the basis of 150 percent ployees if they are short of work, ill, or disabled. The self-employed also fare worse in terms of pensions and en tlements to of the minimum wage; and for social contribu on tax on the basis of 112.5 percent of the minimum wage. For health, paid holidays, and are more vulnerable in the event of unemployment. In some countries, the self-employed opt to make lower pension, and unemployment insurance, the self-employed pay both employer and employee contribu ons as follows: contribu ons to social insurance programs and, therefore, have lower levels of protec on, than do employees. (i) as an employee, 4 percent for benefits in kind and 3 percent for cash benefits, 1.5 percent as labor market contribu- Coverage. Most countries in the EU28 do not operate a separate social protec on system for the self-employed. In Cyprus, on, and 10 percent for pension insurance; (ii) as an employer: 27 percent for social contribu on tax. Croa a, Denmark, Estonia, Finland, Hungary, Ireland, Malta, the Netherlands, Poland, Romania, Slovakia, Slovenia, Sweden, and vi. In Ireland, self-employed Social Insurance Contribu on provides coverage for survivors, maternity/adop ve and guard- the United Kingdom, the self-employed are covered by the general compulsory social security system. On some occasions, for ians, and old age. There are no specific contribu ons for unemployment and sickness. For old age, maternity, and individual regula ons, special requirements apply for the self-employed (Annex H, Table 50). survivors, the self-employed pay contribu ons at the rate of 4 percent of all income, subject to a minimum payment of In some other countries, a special system covers self-employed persons against all tradi onal risks, with few excep ons (for EUR 500 per annum. There is no annual income ceiling. example, Belgium, France, Germany, Greece, Italy). For example, in France, social protec on for the self-employed is subject vii. In Lithuania, the general contribu on rate for self-employed persons is 26.3 percent. Owners of personal enterprises to separate regula ons. Farmers come under the agricultural system (MSA). Cra smen, retailers, and manufacturers fall within contribute based on income declared as wages. In some cases, when they do not have state social insurance guaran- the scope of the Social Protec on Scheme for the Self-employed (RSI), while members of the liberal professions are covered by tees, they contribute based on the minimum monthly wage. Farmers pay contribu ons from 12 minimum monthly separate schemes (CNAVPL). In Greece, there exists a contributory basic system for farmers, called the Agricultural Insurance wages per year, but only in cases where their income is equal to or higher than 4 Economic Size Units. Organiza on. Self-employed persons (cra smen, retailers, professional motorists, hotel owners and others) are insured with viii. In Slovakia, there are upper and lower ceilings for the Assessment Base. The minimum monthly Assessment Base is 50 the Social Security Organiza on for the Self-Employed. Members of liberal professions (medical personnel, doctors, pharma- percent of the na onal average wage. Self-employed persons with a yearly income less than EUR 5,148 (50 percent of cists, engineers, lawyers, notaries etc.) are insured with the Insurance Fund for Independent Professionals. In Germany there the na onal average wage in 2014) are exempted from compulsory sickness and maternity insurance (cash benefits); are, on the one hand, special provisions for certain groups of self-employed (notably cra smen), who are compulsorily insured compulsory invalidity, old-age, and survivors; as well as unemployment insurance. The maximum monthly Assessment with statutory pension insurance and, on the other, independent social security systems for farmers (including assis ng family Base is 5 mes the na onal average wage. members), self-employed ar sts and publicists, and special schemes for members of the professions, who have the right to form ix. Several other countries have established floors and ceilings for contribu ons. In par cular, in Spain, the contribu on associa ons. basis varies between a minimum of EUR 893.10 and a maximum of EUR 3,642.00 (per month), chosen by the benefi- Financing of social protec on for the self-employed. In Latvia, the Cabinet of Ministers sets the minimum contribu on ciary within certain limits. In the Czech Republic, the maximum premium base is 48 mul plied by the monthly average basis. The minimum amount of earnings subject to contribu ons was EUR 4,440 per year in 2016. Self-employed persons are wage (CZK 1,296,288 (EUR 47,959)) per annum. In Bulgaria, the maximum amount of insurable income for all categories insured if their income exceeds the minimum amount of the base for compulsory contribu ons defined by the Cabinet of of insured persons, including self-employed, is BGN 2,600 (EUR 1,329). Ministers. Social insurance contribu on rates differ among categories of self-employed, and were the following in 2016: (i) self- x. In the United Kingdom, Na onal Insurance contribu ons are graduated for the self-employed (in contrast with those employed persons (also those with disabili es of group I or II) insured for risks of old-age, death, sickness, parental leave, mater- for employees) according to three income classes. Self-employed persons with annual profits less than GBP 5,965 (EUR nity, and disability: 30.58 percent; (ii) self-employed persons over re rement age and persons who receive an old-age pension 8,419) can apply to be exempt from paying compulsory contribu ons. Those with annual profits GBP 5,965 (EUR 8,419) (including pre-re rement pension) insured for risks of old-age, death, parental leave, maternity, and sickness: 28.21 percent; or more pay a flat-rate contribu on of GBP 2.80 (EUR 3.95) per week. Finally, those self-employed with annual profits (iii) individuals managing real estate and registered as tax payers for income gained from economic ac vity who are insured for between GBP 8,060 (EUR 11,376) and GBP 42,385 (EUR 59,823) also pay an earnings related contribu on of 9 percent, risks of old-age and disability: 26.19 percent. In Latvia, self-employed persons do not make social insurance contribu on pay- and 2 percent for income above GBP 42,385 (EUR 59,823). ments concerning insurance against occupa onal accidents and insurance against unemployment, as they employ themselves Eligibility for benefits. Access to benefits for the self-employed differs compared to the wage-based employed popula on and bear responsibility for their working condi ons and safety. across EU countries. As far as cash benefits for sickness and maternity are concerned, in Austria, Italy, and Germany, for farmers, EU countries use different benchmarks, floors, and ceilings to tax the self-employed. A few examples follow. no relevant statutory protec on system has been set up. In Belgium, the right to benefits is applied a er a qualifying period of i. In Bulgaria, the minimum insurable income for self-employed persons who have started an economic ac vity in 2015 six months. In addi on, for sickness benefits, a 1-month wai ng period exists. In Poland, sickness insurance is to be taken on a and in 2016 is a fixed amount of BGN 420 (EUR 215) established in the annual budget. The minimum insurance income voluntary basis for self-employed persons. The same is true for maternity benefits. In Italy, insured persons receive maternity for farmers and tobacco producers is BGN 300 (EUR 153). benefits of 80 percent of conven onal earnings, for two months before the expected date of birth and un l three months a er ii. In the Czech Republic, the minimum premium base is 12 mul plied by 50 percent of the monthly average salary (since delivery. 1 January 2016 the minimum premium base is CZK 13,503 (EUR 500) monthly), so the minimum premium is CZK 1,823 In the EU, membership of statutory pension insurance is compulsory for the self-employed, and as a rule, old-age benefits (€ 67) per month). If such established minimum assessment base for “full me” self-employed is less than one-quarter are granted according to the provisions of the general rules. O en the qualifying period has been established. For example, 100Self-employment is defined as the employment of employers, workers who work for themselves, members of producers’ co-opera ves, and unpaid family in Germany it is five years for cra smen and retailers having a home-based business. Membership in old-age insurance is also workers. The la er are unpaid in the sense that they lack a formal contract to receive a fixed amount of income at regular intervals, but they share income compulsory for farmers. Before the beneficiary is able to receive benefits, he/she should have reached the legal re rement generated by the enterprise. Some countries also make the dis nc on between self-employed status and ‘dependent self-employed’ (e.g. Spain, Italy), where age and the agricultural undertaking must be given up. The qualifying period for farmers is 15 years. In Greece, full pension for the self-employed person works for only one client. Others dis nguish self-employment which is carried out in addi on to paid employment (e.g. Belgium). 188 189 Latvia Tax Review Latvia Tax Review self-employed becomes available at 67 years of age and an insurance record of 15 years; or 62 years of age and an insurance Total 241,772 257,334 279,924 304,861 330,395 345,255 350,924 record of 40 years. In Poland, self-employed persons generally do not have the right to an early re rement pension. In Finland, a self-employed person is obliged to take out pension insurance when the ac vity concerned has lasted for at least four months and the es mated earned income is above a certain amount. Earnings-related pension insurance for self-employed persons in Annual average number of microenterprise employees (including self-employed b) agriculture, i.e., farmers, fishermen, and reindeer herders, is compulsory when the farm contains more than 5 ha of arable land and income is above a certain amount. Total - 25,530 45,288 60,784 74,239 83,063 Insurance against invalidity is compulsory for the self-employed in Belgium, Spain, and Slovenia. For example, in Spain, c Employed only in microenterprises - 16,328 28,833 38,750 48,016 54,841 a er a minimum contribu on period, which depends on the age of the beneficiary when invalidity occurred, the beneficiary is en tled to an invalidity pension under the same condi ons as in the General Scheme. Insurance against accidents at work and Employed by a microenterprise and a occupa onal diseases is compulsory in Slovenia, but there is no special protec on system against risk of accidents at work and general tax regime employer c - 9,202 16,455 22,034 26,223 28,222 occupa onal diseases in the Netherlands, Germany (for cra smen and retailers in the statutory system), the Czech Republic, (Microenterprise employees)/(all employees) 3.3% 5.6% 7.4% 8.8% 9.8% and Bulgaria. In Finland and Romania, self-employed persons may take out voluntary insurance against accidents at work and With posi ve microenterprise earnings 548 22,164 37,647 50,892 62,246 70,372 occupa onal diseases. For self-employed farmers, the insurance is compulsory. In the EU28, family benefits are tax financed (universal non-contributory scheme) in most countries, except Austria, Bel- …in only 1 microenterprise - 322 15,187 25,427 33,654 40,928 46,403 gium, France and Italy, and the self-employed are en tled to the same benefits. ...in more than 1 microenterprise Prac ces differ with regard to protec on against unemployment. In Slovenia, self-employed persons are also covered by (but not in a general tax regime compulsory unemployment insurance. They are therefore en tled to unemployment benefits, payment of social security con- enterprise) - 4 256 706 1,268 1,941 2,567 tribu ons, and payment of contribu ons for pension and invalidity insurance one year prior to fulfilment of the minimum con- di ons for old-age pension. Unemployment insurance for the self-employed is available also in Finland and Poland. In Estonia, … in a microenterprise and a general the self-employed are not covered by the unemployment insurance scheme (neither on compulsory base nor voluntarily); the tax regime enterprise c - 222 6,721 11,514 15,970 19,377 21,402 self-employed are, however, covered by the non-contributory State unemployment allowance scheme. On the other hand, (Microenterprise employees)/(all employees) 0.08% 3.1% 5.0% 6.6% 7.9% 8.9% there is no compulsory unemployment insurance for self-employed farmers in Germany. If there is no sufficient income and no (Microenterprise employees)/(private sector employees) 4.7% 7.5% 9.7% 11.5% 13.0% disposable assets, self-employed farmers are in principle en tled to the standard allowance granted to jobseekers, Arbeitslosen- Total number of persons with posi ve microenterprise earnings in the given year geld II, which is a universal allowance granted to the gainfully employed to secure their subsistence. There is no compulsory unemployment insurance for self-employed cra smen and retailers. Also, in Greece, unemployment risk is not covered in the 94,437 103,787 farmers’ system. For all self-employed in the Netherlands, the corresponding law applies only to employees. In Romania, the …in no more than 1 microenterprise in any month d 54,017 59,739 self-employed can apply for voluntary insurance against unemployment. … in more than 1 microenterprise (but no general regime earnings) in at least 1 month 3,329 4,267 In summary, the financing of social protec on benefits for self-employed varies by country. Many countries have estab- lished the minimum level of income for which social contribu ons apply (minimum floor of taxa on). However, if the “refer- … with posi ve microenterprise earnings and general regime earnings c in at least 1 month 37,091 39,781 ence” wage (determining a minimum social contribu on) is not adjusted for hours worked, social contribu ons become dis- Microenterprise regime (millions of Euros) propor onately high for part- me workers and self-employed with low incomes, making working part- me too costly. Some countries have also established a ceiling for taxable incomes, thus crea ng incen ves for high produc ve employment. As far as Turnover - 6.26 218.58 355.25 489.34 603.28 663.36 benefits are concerned, depending on the country, a combina on of mandatory insurance (especially for pensions), voluntary insurance, and lack of insurance for certain benefits applies. Total microenterprise tax revenue - 0.04 13.01 26.16 40.53 51.07 58.85 Total social security contribu ons for ANNEX J. MICROENTERPRISE TAXATION: FURTHER EVIDNECE ON ITS microenterprise regime - 0.02 8.46 18.31 26.34 33.2 40.84 IMPACT a b Note: Number of taxpayers is for the first day of the calendar year. “Self-employed” here refer to microenterprise owners. cc Table 56. Number of tax payers, employees and revenue by tax type, 2009-2015 Irrespec ve of number of employers. d in both 2014 and 2015, about 11 thousand of these workers had also general regime earnings, but not in the same months as microenterprise earnings. 2009 2010 2011 2012 2013 2014 2015 Source: Latvia’s State Revenue Service and State Social Insurance Agency data and staff calcula on. Number of microenterprise taxpayers, by type of business ac vity Table 57. Top 20 sectors with the largest shares of microenterprise workers in private employment, 2015 Individual entrepreneur - 517 1,015 1,284 1,491 1,623 1,726 Individual enterprise, farming or Number of MET share in private fishing enterprise - 186 247 254 254 273 265 NACE code Economic ac vity microenterprise sector employment, % (MET) workers Limited liability company - 4,424 11,902 17,080 21,693 25,201 27,521 90 Arts and entertainment 766 144.4 Performer of commercial ac vity registered at the SRS - 2,067 4,656 6,546 8,540 12,910 17,657 85 Educa on 1,465 77.9 Total - 7,194 17,820 25,164 31,978 40,007 47,169 74 Other professional, scien fic & technical ac vi es 2,622 56.3 Number of taxpayers under general regime, by type of business ac vity a 69 Legal and accoun ng ac vi es 6,541 54.8 Natural en es 86,342 95,439 102,261 112,926 124,587 129,124 129,197 70 Head offices and management consultancy 2,445 52.5 Limited liability company 155,430 161,895 177,663 191,935 205,808 216,131 221,727 96 Other personal service ac vi es 6,196 46.5 190 191 Latvia Tax Review Latvia Tax Review 81 Services to buildings and landscape 3,010 39.9 1.082 0.974 0.991 95 Repair of computers and household goods 661 39.5 Share of zero-earnings 59 Cinema & video programs & music publishing 327 38.5 employees, 2010 0.103 0.046 1.613 *** 1.648 *** 1.879 *** 73 Adver sing and market research 1,824 31.9 0.288 0.293 0.268 71 Architecture and engineering 2,051 31.9 Sectoral dummies 93 Sports, amusement and recrea on 1,252 30.4 Educa on and social work 62 Computer programming, consultancy and related 3,471 30.3 (NACE 85 & 88) 0.026 0.159 X 0.514 *** 0.497 *** 82 Office administra ve and support 1,172 29.4 0.033 0.048 02 Forestry and logging 2,100 26.9 Arts & entertainment 0.013 0.113 X 1.240 *** 1.236 *** 43 Specialized construc on ac vi es 5,300 24.7 (NACE 90) 0.042 0.032 33 Repair & installa on of machinery & equipment 856 22.1 Constant -0.166 *** -0.157 *** -0.170 *** 63 Informa on service 1,106 20.1 0.029 0.030 0.027 86 Human health 1,567 17.4 R-squared 0.699 0.805 0.872 c 68 Real estate ac vi es 2,473 17.3 Root MSE 0.083 0.068 0.084 All of the above 47,205 33.6 N obs. 75 75 75 75 Notes: The Table reports annual average number of workers with posi ve microenterprise earnings. In Arts and entertainment, main Notes: Linear regressions with robust standard errors (sample as described in Notes to Table 55). Explanatory variables refer to jobs of most of employees are in public sector, hence number of MET workers exceeds private employment. Four sectors with high employers working under the general tax regime in 2010, thus characterizing the situa on immediately before introduc on of MET share in private employment but small (<200) number of MET workers in each are excluded. Source: Calcula ons based on State the MET (MET was launched in September 2010, but the general tax regime accounted for 99.9% of annual average number of Revenue Service and CSB data. wage earners in 2010). a Models [1]-[2] weight sectors by the number of private sector wage earners. b Taxes are measured as a share of turnover in 2010. c Root MSE measures precision of the es mates. ** (***) - es mates significant at 5% (1%) level. Source: Calcula ons based on State Revenue Service data. Table 58. Propor on of microenterprise workers in sector’s private employment (2015), by labor taxes - turnover ra o in 2010, Percent Table 60. Determinants of change in the burden of main taxes in sectors of Latvian economy between 2010 and 2014 p25 p50 p75 mean # sectors (Labor taxes)/Turnover in 2010 Descrip ves Es mated coefficients (robust s.e. below in italic) < 0.05 1.7 4.7 13.6 9.5 19 mean [1] mean [2] [1] [2] MET sharec ≥ [3] MET sharec < 0.01 0.05 to < 0.075 2.4 5.6 17.3 13.1 23 s.d. [1] s.d. [2] all sectors 0.01 0.075 to < 0.10 1.1 8.3 17.8 13.4 16 Dependent variable: 0.007 0.005 0.10 to < 0.15 6.2 11.3 31.9 18.5 7 Change in tax burden a (2010-2014), as a share of 0.031 0.029 0.15 to 0.25 14.2 20.3 67.4 40.3 10 2010 turnover Total 2.4 8.7 22.1 16.4 75 Explanatory variables Notes: Non-weighted means and percen les. The sample includes all two-digit NACE Rev. 2 divisions with at least 100 private sector wage earners in 2015, excl. “Gambling and be ng”. Share of MET-only -0.220 0.058 0.071 *** -0.255 *** X workers, 2014 b Source: Calcula ons based on State Revenue Service data. 0.072 0.075 0.072 0.073 Table 59. Determinants of microenterprise share in sector’s private employment, 2015 0.474 0.028 0.035 *** 0.468 *** X Share of mixed workers, Descrip ves Es mated effects (robust s.e. in italic) 2014 c 0.040 0.042 0.130 0.135 (non-weighted) Weighted a Non-weighted Share of all MET workers, 0.086 0.106 X X -4.549 *** mean s.d. [1] [2] [3] 2014 d 0.110 0.114 1.428 Taxes on labor, 2010 b 0.084 0.049 0.764 ** 0.543 ** 0.597 *** VAT returned, 2010 0.024 0.021 0.760 *** 0.622 ** 0.773 *** 0.291 0.263 0.214 (as a share of turnover) 0.021 0.017 0.178 0.245 0.196 Taxes on profit, 2010 b 0.012 0.010 6.641 *** 6.537 *** 5.154 *** Average firm size (# 0.021 0.015 X -0.388 *** X workers/1000), 2010 0.029 0.019 0.076 192 193 Latvia Tax Review Latvia Tax Review Sectoral dummies Root MSE b 0.0831 0.1698 0.2042 0.2324 Manufacturing - electronic 0.013 0.016 -0.009 *** -0.012 *** X N obs. 57 57 57 57 & op cal 0.113 0.126 0.003 0.004 Notes: Non-weighted linear regressions with robust standard errors. The sample includes all two-digit NACE Rev. 2 divisions for Arts & entertainment -0.046 0.013 0.016 *** -0.048 *** X which Entrepreneurship indicators of enterprises are available. a Value added measured in constant prices of 2010. b Root MSE measures precision of the model-based predic ons. **, *** - es mates significant at 5%, 1% level, respec vely. 0.113 0.126 0.003 0.004 Source: Calcula ons based on State Revenue Service data and CSB data. Constant -0.011 * 0.001 0.017 Table 62. Ou lows from microenterprise regime, 2014-2015 0.006 0.007 0.011 R-squared 0.3550 0.3107 0.7219 Tax regime, 2015 Root MSE e 0.0255 0.0254 0.0207 No legal Only self-employment Only or mainly general regime as Tax regime, 2014 earnings (general regime) employee N obs. 79 63 79 63 16 Mixed (N = 32389) 790 (2.4%) 6 (0.02%) 9035 (28.2%) Notes: Non-weighted linear regressions with robust standard errors. The sample includes all two-digit NACE Rev. 2 divisions with annual average number of wage earners in 2014 was at least 50 (but excludes “Gambling and Mainly microenterprise (N = 14046) 1264 (9.0%) 19 (0.14%) 4162 (31.7%) be ng” which is subject to special regula on). a Tax burden is measured as a share of turnover in respec ve year. b, c, d Only microenterprise (N = 46067) 6193 (13.4%) 98 (0.24%) 3443 (8.3%) Propor ons of MET-only workers, workers with earnings in both MET and general regime, and all microenterprise workers among all workers with posi ve earnings in 2014, based on annual average of monthly data. e Root MSE MET regime total (N = 92691) 8247(8.9%) 123 (0.14%) 16640 (19.2%) measures precision of the model-based predic ons. *,**, *** - es mates significant at 10%, 5%, 1% level, respec vely. Source: Calcula ons based on State Revenue Service data. Source: Calcula ons based on State Revenue Service data. Table 61. Microenterprise workers’ impact on growth of labor cost and labor produc vity in sectors of Latvian economy, 2010-2014 Table 63. Change in annual average registered employment, 2010-2015 by sector, firm size and tax regime Dependent variables: Growth between 2010 and 2014 ∆E 2010-2014, by ∆E 2010-2015, by tax regime Labor cost per Labor produc vity measured as Type of sector firm size (64 (77 sectors) sectors) Full- me 1 euro of Value added a Value added a per equivalent (FTE) output per FTE employed <10 10+ Total MET-only workers General Total MET: mean (incl. mixed) Net effect 0.148 0.162 0.008 0.070 1 pa ern up up up up up up up s.d. 0.138 0.210 0.522 0.530 thous. 32.0 39.3 71.3 39.0 47.8 90.1 42.3 Es mated coefficients (robust s.e. in italic below) Descrip on. 30 sectors where both MET and the general regime employment increased, and MET impact on employment Explanatory variables growth was big: MET-only workers account for ≥ 30% of total ∆E (23 sectors) or for ≥ 134% of employment change in Share of all MET workers, 1.092 enterprises with less than 10 workers (4 sectors) or number of all MET workers in the sector exceeds 1000 (remaining 4 2014 b 0.098 -0.251 *** *** -0.804 *** -0.579 ** sectors, as well as 15 other sectors). List of sectors: Forestry and logging; Manufacturing of wood products; Manufacturing 0.116 0.081 0.244 0.247 0.233 of furniture; Prin ng and reproduc on; Repair & installa on of machinery & equipment; Construc on of buildings; Specialized construc on ac vi es; Wholesale and retail trade (incl. that of motor vehicles); Land transport; Warehousing Labor cost per full- me 2.207 -0.229 *** X -0.149 ** X and transport support; Food service ac vi es; Computer programming; Informa on service; Head offices and management worker, 2010 (1000 euros), consultancy; Finance and insurance suppor ng ac vi es; Legal and accoun ng ac vi es; Architecture and engineering; log 0.386 0.037 0.063 Adver sing and market research; Veterinary ac vi es; Ren ng and leasing; Travel agencies; Security and inves ga on; Sectoral dummy Services to buildings and landscape; Office administra ve and support; Human health; Arts and entertainment; Sports, Manufacturing of basic 0.018 -0.439 *** X -3.743 *** -3.801 *** amusement and recrea on; Other personal service ac vi es. metals 0.132 0.017 0.041 0.041 2 pa ern up down up up down up up Constant 0.055 thous. 5.3 -3.5 1.8 6.0 -4.0 2.0 5.9 0.686 *** ** 0.402 *** 0.113 ** 0.079 0.026 0.133 0.043 R-squared 0.6581 0.3606 0.8650 0.8283 194 195 Latvia Tax Review Latvia Tax Review Descrip on: 9 sectors where MET employment increased at the expense of general regime employment; moreover, MET- Root MSE c 0.1128 0.1077 0.0944 only workers account for more than a half (in some cases even more than 100%) of total ∆E, and (in 7 out of nine cases) N obs. 75 75 75 75 for most of employment growth in enterprises with less than 10 workers. List of sectors: Manufacturing of food products; Manufacturing of wearing apparel; Manufacturing n.e.c.; Cinema & video programs & music publishing; Notes: Linear regressions with robust standard errors (sample as described in Notes to Table 58). Explanatory variables refer to Telecommunica ons; Real estate ac vi es; Other professional, scien fic and technical ac vi es; Educa on; Repair of employers working under the general tax regime in 2010, thus characterizing the situa on immediately before introduc on of computers and personal and household goods. the MET. a Model [3] weights sectors by the number of general regime employers in 2015. b Taxes are measured as a share of turnover in 2010. c Root MSE measures precision of the model-based predic ons. *,**, *** - es mates significant at 10%, 5%, 3 pa ern up up up up up up up 1% level, respec vely. thous. 2.2 7.3 9.5 1.9 22.2 23.3 1.2 Source: Calcula ons based on State Revenue Service data. Descrip on: 8 sectors (not belonging to type 1) where both MET and the general regime employment increased and number of MET-only workers exceeds 100, but accounts for less than 21% of total change in employment. List of sectors: Table 65. Distribu on of monthly earnings in the main microenterprise job and in the main general regime job for individuals Agriculture; Manufacture of tex les; Manufacture of glass products; Manufacture of metal products; Civil engineering; with posi ve microenterprise earnings in 2014 or 2015 Accommoda on; Employment services; Social work. Microenterprise earnings General regime earnings 4 pa ern - - MET-only Mixed Mixed thous. 1.1 -0.4 0.7 1.0 29.3 27.4 -1.9 workers workers workers General-only workers Descrip on: 41 sectors with number of MET-only workers in 2015 in each ≤50 (in 5 cases zero, in 9 cases <10, but in 2 cases 2014 2015 2014 2015 2014 2015 2014 2015 ≤ 150) and is small compared to either employment or its over 2010-2015 in this sector. Less than Min. wage 28.2 30.6 23.3 25.7 36.2 36.0 36.7 31.9 Source: Calcula ons based on State Revenue Service data and CSB data. Min. wage 4.1 4.7 2.0 2.1 10.1 9.7 7.3 6.5 Min. wage + €0.01 to Table 64. Determinants of the share of MET payers among employers by sector, 2015 (Min. wage+ €10) 1.1 1.0 0.6 0.5 2.5 2.4 2.6 2.5 Min. wage + €10.01 to Descrip ves Es mated effects (robust s.e. in italic) €699.99 28.8 24.5 23.9 20.0 29.1 27.1 33.0 31.3 (non-weighted) Non-weighted Weighted a €700 to €719.99 13.7 11.2 18.0 14.9 1.3 1.5 1.5 1.9 mean s.d. [1] [2] [3] €720 23.6 27.5 31.7 36.3 0.2 0.2 0.1 0.2 Taxes on labor, 2010 b 0.084 0.049 1.574 *** 1.347 *** 1.264 ** €720.01 to €999.99 0.3 0.3 0.3 0.3 7.9 9.0 8.7 11.6 0.347 0.348 0.520 ≥€1000 0.2 0.2 0.2 0.2 12.7 14.2 10.0 14.1 Taxes on profit, 2010 b 0.012 0.010 6.550 *** 7.041 *** 6.444 *** Total 100 100 100 100 100 100 100 100 1.404 1.425 1.652 Notes: Min. wage refers to minimum monthly wage (€320 in 2014 and €360 in 2015). Share of zero-earnings Source: Calcula ons based on State Revenue Service data (monthly records). employees, 2010 0.103 0.046 1.676 *** 2.049 *** 2.064 *** 0.271 0.322 0.431 Table 66. Individuals with posi ve microenterprise earnings in 2014 or 2015, by tax regime group and economic ac vity of 0.018 0.021 X 2.062 *** 2.407 the microenterprise Average firm size (# workers/1000), 2010 0.939 1.579 Percent Sectoral dummies With microenterprise earnings in 2015 No microenterprise earnings in 2015 a High-tech 0.026 0.159 -0.167 *** -0.226 *** -0.166 ** (NACE 21 & 26) 0.038 0.077 0.063 MET- Mainly Mainly Economic ac vi es Mixed Unstable Total Unstable Total only General General Arts & entertainment 0.013 0.113 0.106 ** 0.149 *** 0.163 ** Agriculture & Fishing 0.9 0.5 0.6 0.6 0.7 0.7 0.7 0.7 (NACE 90) 0.051 0.052 0.076 Forestry & Logging 4.5 1.3 1.9 3.5 3.3 1.5 3.3 2.2 Membership organiza ons 0.013 0.113 -0.537 *** -0.492 *** -0.476 *** Manufacturing & Other Industry 6.8 5.2 6.4 6.7 6.3 6.6 6.6 6.6 (NACE 94) 0.058 0.060 0.088 Construc on 12.6 11.6 15.1 20.6 13.6 14.2 17.5 15.6 Constant -0.097 *** -0.159 *** -0.153 ** Trade & Repair of Motor Vehicles 3.2 1.8 2.8 3.8 2.9 2.3 2.7 2.5 0.037 0.046 0.066 Trade excl. motor vehicles 7.3 5.3 7.4 8.1 6.9 8.3 8.3 8.3 R-squared 0.6394 0.6765 0.7485 Transporta on & Storage 4.2 4.1 5.3 4.7 4.3 4.8 4.2 4.5 196 197 Latvia Tax Review Latvia Tax Review Accommoda on & Food service 2.2 2.1 3.7 3.8 2.5 3.6 3.7 3.6 Figure 79. Microenterprise workers in 2014-2015, by source of earnings in Latvia, 2008-2015 Other Personal Service & 11.2 7.1 8.3 10.0 9.7 5.7 6.7 6.1 Household ac vi es Mainly manual labor ac vi es 53.0 38.9 51.4 61.8 50.2 47.6 53.7 50.2 Informa on & Communica on 7.3 8.1 5.7 4.5 7.0 5.4 4.6 5.0 Finance, Insurance & Real Estate 3.7 4.3 3.5 2.4 3.7 2.8 2.7 2.8 Professional, Scien fic & Technical 18.2 27.4 16.9 12.2 19.8 16.1 13.4 15.0 Administra ve & Support Service 7.9 8.6 10.4 8.8 8.4 8.2 6.9 7.7 Educa on, Health & Social Work 4.1 5.0 4.7 3.0 4.2 3.2 2.9 3.1 Arts, Entertainment &Recrea on 2.8 3.3 3.7 2.9 3.1 2.3 2.4 2.3 Mainly professional ac vi es 44.1 56.7 44.8 33.6 46.1 37.9 32.9 35.8 NA 2.9 4.4 3.8 4.6 3.6 14.4 13.5 14.0 Total 100 100 100 100 100 100 100 100 A er excluding NA: Notes: The Figure is based on individual records (rather than annual average data) and covers 129.4 thousand individuals with Mainly manual labor ac vi es 54.6 40.7 53.4 64.8 52.1 55.7 62.0 58.4 posi ve microenterprise earnings in 2014 or 2015 (or both). For each of the years, the Figure presents percent distribu on of Mainly professional ac vi es 45.4 59.3 46.6 35.2 47.9 44.3 38.0 41.6 all these persons by source of earnings. The Figure does not cover persons who had posi ve earnings under the MET regime in N obs., 1000 53.2 28.1 8.6 13.8 104 11.2 8.3 19.5 2010-2013 but did not have such earnings in 2014-2015. Labels show absolute numbers (in thousands). a Notes: Economic ac vi es as of 2014. Source: Calcula ons based on State Revenue Service data. Source: Calcula ons based on State Revenue Service data. Figure 80. Average number of months with posi ve employee income, 2008-2015. Individuals with posi ve microenterprise Figure 78. Individuals who worked in microenterprises in 2015: Distribu on of work and labor income across tax regimes, by earnings in 2014 or 2015, by tax regime group occupa on (individuals with zero earnings in respec ve years are excluded) Notes: The Figure covers only individuals with posi ve microenterprise earnings in 2015. Non-microenterprise share has been calculated in the aggregated labor income of each group (rather than average across workers). Source: Calcula ons based on Source: Calcula ons based on State Revenue Service data State Revenue Service data. 198 199 Latvia Tax Review Latvia Tax Review Figure 81. Average declared annual earnings of “MET-only” and “Mixed” workers as propor on of economy-wide average Figure 83. Individuals with posi ve microenterprise earnings in 2015 annual earnings of general regime employees, 2008-2015 by tax regime group, gender and age group (individuals with zero earnings in respec ve years are excluded) Source: Calcula ons based on State Revenue Service data. Source: Calcula ons based on State Revenue Service data. Figure 82. Average declared annual earnings of “Unstable” and “Mainly General” workers as propor on of economy-wide Figure 84. Regional distribu on of individuals with posi ve microenterprise earnings in 2015, in comparison with general average annual earnings of general regime employees, 2008-2015 regime employees (individuals with zero earnings in respec ve years are excluded) Notes: SRS data for 2014 cover all general regime employees with posi ve earnings. LFS data for 2015 (which have been merged with SRS data to iden fy microenterprise workers) cover employees with posi ve earnings under general regime and no microenterprise earnings. Source: Calcula ons based on State Revenue Service data Source: Calcula ons based on State Revenue Service data and LFS data. 200 201 Latvia Tax Review Latvia Tax Review Figure 85. Absence of declared earnings in 2008-2015 among individuals with posi ve microenterprise earnings in 2014 or In the Latvian case we es mate that τcit = 15 percent > τme = 9 percent. Moreover, we have τssc = 23.6 percent > τcit (1 + τssc) 2015, by tax regime group = 18.54 percent. Intui vely, in Latvia the MET regime is a rac ve because the MET rate is lower than the CIT rate. Hence, by filing as a MET firm one can avoid paying the CIT. Moreover, the MET regime is a rac ve because MET firms don’t pay SSCs. This advantage more than compensates for the lack of deduc bility of wage costs from the CIT if the SSC rate is roughly higher than the CIT rate. As a result, the MET regime can be used to avoid paying SSCs. The advantage of not paying SSC increases when the SSC rate is higher than the CIT rate. Finally, the disadvantage of the MET regime is that neither the costs of intermediate goods nor the costs of debt are deduc ble, whereas they are under the standard regime. Hence, firms with substan al use of intermediate goods or high amounts of debt will not find it desirable opt for the MET regime. However, when the firm spends li le on intermediate goods, and all investments are financed with equity, there is no advantage of the tax-deduc bility of intermediate goods and debt under the standard CIT, and the MET regime is then preferred over the standard regime. What are the welfare consequences of the microenterprise tax regime? The CIT distorts the leverage of firms, as too much debt finance is chosen because debt is deduc ble. In addi on, investment is distorted downwards. Consequently, capital use is below the socially desirable level if not all investments can be financed with debt. SSCs reduce labor demand below socially op mal levels. Since all costs of intermediate goods are deduc ble, firms make efficient investments in terms of intermediate goods use. The standard CIT thus distorts investment of firms, gives excessive leverage and distorts labor demand. The MET regime also distorts investments downwards, since none of the financing costs are deduc ble. However, the distor on on investment is typically smaller since the CIT rate is higher than the MET rate: τcit = 15 percent > τme = 9 percent. This lower distor on is associated with the first term in (4). Moreover, since the tax treatment of debt and equity is the same, the MET regime does not provide an excessive incen ve for debt finance. This lower distor on is associated with the last term in (4). The MET distorts labor demand, just as the CIT. However, distor ons in labor demand are typically less under the MET, since the effec ve tax rate on labor demand is lower: τssc = 23.6 percent > τme = 9 percent. This lower distor on is associated with the second term in (4). The MET regime introduces distor ons in intermediate goods use, since their costs are not deduc ble under the MET, whereas they are under the CIT, see the third term in (4). The MET regime thus reduces economic distor ons in ANNEX K: AN ECONOMIC ANALYSIS OF THE MICROENTERPRISE TAX investment, financing and labor demand, while it increases distor ons in intermediate-goods use. The net effect is not clear, but This appendix asks two ques ons. First, what is the nature of the tax advantages of the MET regime compared to the one may expect that the MET regime reduces overall distor ons from corporate taxes by lowering effec ve tax rates on business standard CIT regime? It is shown that - provided that firm debt is not too high - the current MET regime allows firms to avoid ac vi es, especially if intermediate-goods use is small. both CIT and SSC. Consequently, the MET regime is likely to generate tax avoidance, especially for firms that use li le debt finance or intermediate goods, and that rely mainly on equity finance. When the MET regime is adjusted, by raising the SSC and lowering the rate, the advantages of the MET to avoid SSCs are eliminated, but the advantages of the MET regime to avoid ANNEX L. ESTIMATES OF WORKERS MOST VULNARABLE TO PHASING OUT CIT are strengthened. And, second, what are the welfare effects of the MET-regime? It is shown that firms get incen ves to invest more, increase labor demand, use less debt financing and use less intermediate goods. Higher investment and labor OF THE MET demand are socially desirable, since these are distorted downwards by the CIT and SSCs. Less debt financing is also desirable if Here we develop es mates of the workers likely to be most vulnerable to a phasing out of the MET regime. We begin by the CIT promotes too much debt financing via the deduc bility of interest. However, the MET distorts intermediate-goods use placing the 129.4 thousand individuals with posi ve microenterprise earnings in 2014 or 2015 into four broad groups depending in produc on, which is not socially desirable. on the share of their earnings from microenterprises versus firms working under the general tax regime: MET-only, mainly To formalize these ideas, we develop a theore cal model of firm behavior. Let firm profits be Π. Firms have sales (turnover) general, mixed, or unstable (see Table 63 for defini ons and Table 69 for profiles of these four groups). Note that the terms MET- equal to Y. Total firm assets equal K = D + E, where D is debt and E is equity. The cost debt is equal to rd and the cost of equity only workers and mixed workers, which in the main text were year-specific, refer to earnings history over the two-year period is equal to re. Labor demand is denoted by L and the wage rate is w. Demand for intermediate goods equals X and the price 2014–2015. of intermediate goods is denoted by p. We assume throughout that dividends and interest are taxed in the same way in the PIT under the standard CIT-regime and the MET-regime. We might under-es mate the advantages of the MET-regime because Table 67. Profiling of individuals with posi ve microenterprise earnings in 2014 or 2015 capital gains are not taxed in the MET-regime, while they are in the CIT-regime. by tax regime, 2014-2015 Under the standard CIT-regime firms face the CIT-rate τcit and they have to pay employer SSCs at rate τssc. Cost of debt is Group by tax regime Descrip on deduc ble from the CIT, whereas the cost of equity is not. Profits in the normal CIT-regime are thus equal to: (1) Group MET = MET1 + MET2 consists of 53.2 thousand individuals, each of whom as employee had When the firm is a MET, then the firm pays a tax rate τme on sales Y (turnover). It neither pays CIT (τcit = 0), nor SSC (τssc = 0). Group MET (MET-only) only microenterprise earnings either in 2014 (33.8 thousand) or in 2015 (49.7 thousand ) or in Hence, profits in for the MET-firm are equal to: both years (30.3 thousand). Exact defini on: (2) Group MET1 (N=49,687): Had only microenterprise earnings in 2015, while in 2014 either had Now, we gain insights into the drivers of tax evasion by subtrac ng profits in the MET regime from the profits in the standard some microenterprise earnings or as employee under the general regime worked less than 6 CIT regime (and dividing by sales Y): months (or did not work at all). (3) Group MET2 (N=3,560): Had only microenterprise earnings in 2014, while in 2015 had mainly From the difference in profit levels, we can already derive the following conclusions: microenterprise earnings, as well as for 1 to 5 months had earnings as employee under the general  The MET regime is more a rac ve the higher is τcit relative to τme (first term in (3)) regime.  The MET regime is more a rac ve the higher is τssc relative to τcit (second term in (3)).  The MET regime is less a rac ve the higher is the use of intermediate goods X (third term in (3)).  The MET-regime is less a rac ve the higher is debt D (fourth term in (3)). 202 203 Latvia Tax Review Latvia Tax Review Group by tax regime Descrip on Out of the remaining 53 thousand MET-only workers, nearly 50 thousand have no general regime earnings in 2015, and the same is true for 3 thousand Unstable workers (out of 13.5 thousand), see Table 65 What will happen to these 53 thousand Group GEN = GEN1 + GEN2 includes 19.8 thousand individuals. individuals if the MET regime is abolished? For some of them (see es mates in Table 68 below) the new version of the small-scale Group GEN Group GEN1 (N = 8,634): Had posi ve general regime earnings for at least 6 months in both 2014 business regime, the patent fee regime, or self-employment are feasible op ons. But others will have to find a general regime (Mainly General) and 2015, and no microenterprise earnings in 2014. job to replace their microenterprise earnings. This might be difficult for workers in these two groups, given their (average) low Group GEN2 (N = 11,153): Had posi ve general regime earnings for at least 1 month in 2014 and produc vity, as the new law on minimum social contribu on and the gradual increase in the minimum wage level will depress the for at least 6 months in 2015, and no microenterprise earnings in 2015. demand for workers with low produc vity. Group MIX (Mixed) Group MIX consists of 28.1 thousand individuals who sa sfy the following condi ons: (i) do not belong to Group MET; (ii) do not belong to Group GEN; Table 69. MET-only and Unstable workers (ex. those with low risk of income loss) (iii) either in 2014 or in 2015 had posi ve microenterprise earnings for at least 1 month and by gross general regime earnings and MET share in net labor income, 2015 posi ve general regime earnings for at least 6 months MET share in gross annual employee earnings, general regime (iv) in 2015 had posi ve microenterprise earnings for at least 1 month or posi ve general regime net labor income, earnings for at least 6 months No percent >0 but < 12*minwage >=12*minwage Total income Group UNS Group UNS = UNS1 + UNS2 + UNS3 + UNS4 + UNS5 + UNS6 + UNS7 consists of 28.2 thousand MET-only (Unstable) individuals which do not belong to any of groups MET, GEN, and MIX. UNS1 (N=10,207): in 2015, had only or mainly microenterprise employee earnings, but in 2014 had Up to 15 0 35 0 35 only or mainly general regime earnings or no earnings at all. 15+ to 33 13 126 7 146 UNS2 (N= 5,992): In 2015, had only or mainly general regime employee earnings, but in 2014 33+ to 50 19 199 17 241 were either in the mixed regime, or had mainly or only microenterprise earnings, or did not have 50+ to 75 81 695 58 838 any earnings. UNS3 (N=1,776): Both in 2014 and in 2015, had 4 to 12 months of posi ve microenterprise 75+ to 99 222 2144 4 51929 earnings and 1 to 5 months of posi ve general regime earnings. 99+ to 100 49338 221 0 49559 UNS4 (N=282): Both in 2014 and in 2015, had 1 to 3 months of posi ve microenterprise earnings Total 49673 3420 86 53189 and 1 to 3 months of posi ve general regime earnings. UNS5 (N=279): In 2014, had 1 to 3 months of posi ve microenterprise earnings and 4 to 5 months Unstable of posi ve general regime earnings, and in 2015 had only 1 to 5 months of posi ve general regime Up to 15 0 258 0 258 earnings. 15+ to 33 0 956 41 1000 UNS6 (N=1,054): in 2014 had only (or almost only) general regime earnings, and in 2015 had 1 to 3 months of posi ve microenterprise earnings and 4 to 5 months of posi ve general regime 33+ to 50 2 1100 52 1157 earnings. 50+ to 75 5 2685 64 2755 UNS7 (N=8,649): In 2014, had posi ve microenterprise earnings, and in 2015 had either no 75+ to 99 13 5287 3 8306 declared labor income (N=8,524) or had only self-employment income (N=125). 99+ to 100 2651 352 0 3003 Source: Elabora on on State Revenue Service data. Total 2671 10638 160 13476 What is the income loss risk for microenterprise workers assuming the MET regime is abolished? We start by defining Notes: Labor income includes microenterprise and general regime employee earnings, as well as self-employment income. MET workers with low risk of income loss as those who sa sfy one of the following condi ons: (i) the microenterprise share in Source: Calcula ons based on State Revenue Service data. net earnings in 2015 did not exceed 15 percent; (ii) annual gross labor income (AGLI) was above 12 minimum monthly wages and, in addi on, microenterprise earnings accounted for no more than 30 percent of the difference between AGLI and 12 On the other hand, over 3 thousand MET-only workers and over 10 thousand Unstable workers would need to supplement minimum monthly wages. Note that some individuals sa sfying (i) might have average gross monthly general regime earnings their general regime earnings (by increasing work hours or taking on a secondary job) to put their annual labor income above the (over months worked) below the minimum wage; they face the risk to be fired because of the minimum social contribu on 12 minimum wages threshold (Table 68). Mixed and Mainly General workers will most likely s ck to their general regime jobs when requirement. These persons are excluded from the low-risk category unless they had posi ve self-employment income in 2015. the MET regime is abolished. However, 12 thousand of them can lose up to half of their labor income, and about 18 thousand—more Table 645 presents the incidence of low income risk by group of MET workers. Overall, there are 7391 such workers, mostly in than a half (see Table 66 for details) if their ac vi es carried out under the MET regime are not con nued in a different legal form. the Mixed and Mainly General groups. They are excluded from further profiling, leaving us with 96 thousand workers. Table 70. Mixed and Mainly General workers (ex. those with low risk of income loss) Table 68. Incidence of low risk of income loss among individuals with posi ve microenterprise earnings in by gross general regime earnings and MET share in net labor income, 2015 2015, by tax regime group MET share in net gross annual employee earnings, general regime labor income, percent 18+ MET-only Mixed Mainly Unstable Total >0 but < 12 12+ to 18 > 30 to 30 min. Total General min. wages min. wages min. wages wages Number of workers 93 5127 2964 581 8765 Mixed Percent 0.2 18.2 34.3 4.2 8.4 Up to 15 650 0 0 0 650 Notes: Experience as of the end of 2015. Source: Calcula ons based on State Revenue Service data. 204 205 Latvia Tax Review Latvia Tax Review 15+ to 33 1364 715 490 150 2719 Total 20231 3399 23630 33+ to 50 1464 835 952 1589 4840 Mainly General 50+ to 75 3559 3050 2005 477 9091 Up to 4 000 57 45 102 75+ to 100 5853 364 95 18 6330 >4 000 but <=20 000 319 325 644 Total 12890 4964 3542 2234 23630 >20 000 but <=70 000 1270 310 1580 Mainly General > 70 000 3135 235 3370 Up to 15 431 0 0 0 431 NA 329 76 405 15+ to 33 853 482 294 51 1680 Total 5110 991 6101 33+ to 50 868 388 323 173 1752 Unstable 50+ to 75 1126 449 174 18 1767 Up to 4 000 99 219 318 75+ to 100 463 6 2 0 471 >4 000 but <=20 000 648 914 1,562 Total 3741 1325 793 242 6101 >20 000 but <=70 000 2,829 808 3,637 Notes: Labor income includes microenterprise and general regime employee earnings, as well as self-employment income. > 70 000 5,927 658 6,585 Source: Calcula ons based on State Revenue Service data. NA 1,047 327 1,374 How should the number of MET workers from each group that plausibly can switch to self-employment, the patent Total 10550 2926 13476 regime or the new scheme for small (subsistence) businesses be es mated? One approach is to assume that these op ons Source: Calcula ons based on State Revenue Service data. are realis c for microenterprises which either have turnover up to EUR 20 thousand or are not incorporated. Table 67 presents Table 72. Profiling of MET workers by characteris cs the distribu on of MET workers (ex. those with low risk of income loss) in each of the four groups by turnover and legal form of the microenterprise. Shaded cells in Table 67 refer to incorporated (e.g. opera ng as legal rather than natural persons) Groups Descrip on MET share Number of Av. number Likely to Likely microenterprises with turnover above EUR 20 thousand, i.e. workers for whom self-employment or the patent regime do not of labor MET of months become self- to need appear as straigh orward op ons and who will likely find it difficult to obtain a general regime job to replace their microenterprise income, workers, worked in employed a full me earnings. As follows from Table 68, this is the case for 38 thousand MET-only workers, almost 19 thousand Mixed workers, about 2015 2015 2015 or enter job as a 5 thousand Mainly General workers and nearly 10 thousand Unstable workers, which adds up to 71 thousand. It appears that (percent) some “small general the most realis c way out from this situa on is to make sure that most of incorporated microenterprises switch to the general business” regime regime. Even so, the resul ng rise in labor costs will mean lower earnings, or at least temporary unemployment, for many scheme (e.g. employee employees. patent fee) Table 71. Microenterprise workers (ex. those with low risk of income loss) Below average wages and by group, turnover and legal form of the main microenterprise, 2015 produc vity. Gained pay under MET regime. Propor on of Annual turnover of the main Legal form of the main microenterprise highly-educated slightly lower microenterprise, EUR Legal person Natural person Total than among general regime Up to 35 At least 18 MET-only employees. More than a half 98.1 53247 9.1 MET-only thousand thousand work in sectors employing mainly Up to 4000 600 853 1453 manual labor. Higher than in >4000 but <=20000 3268 3707 6975 other groups (but similar to general regime employees) share >20000 but <=70000 12186 3605 15791 of workers aged 55+ (22 percent). > 70000 23223 2549 25772 NA 2441 757 3198 Total 41718 11471 53189 MIxed Up to 4000 193 162 355 >4000 but <=20000 1329 913 2242 >20000 but <=70000 5719 1245 6964 > 70000 11763 835 12598 NA 1227 244 1471 206 207 Latvia Tax Review Latvia Tax Review Groups Descrip on MET share Number of Av. number Likely to Likely (2) Low risk of income loss 0.06 4.5 2.5 0.3 7.4 of labor MET of months become self- to need Self-employment or some “small business” scheme income, workers, worked in employed a full me 2015 2015 2015 or enter job as a (3) Microenterprises - natural 11.5 3.4 1.0 2.9 18.9 (percent) some “small general persons, ex. (2) business” regime (4) Microenterprises - legal scheme (e.g. employee persons with turnover ≤ 3.9 1.5 0.4 0.7 6.5 patent fee) 20000 EUR, ex. (2) Low produc vity and remain low paid/vulnerable under MET (5) Ac vi es suitable for self- regime. Share of secondary- employment or small family 19.5 11.4 2.2 3.8 36.9 educated is larger but share of business, ex. (2), (3), (4) ter ary-educated smaller than Unstable (6) Total: (3) + (4) + (5) 34.8 16.3 3.6 7.5 62.2 among general-regime-only Up to 7.5 At least 6 (switching 71.7 13799 6.8 To avoid or reduce income loss, need to increase work hours or to find a second job as a employees. Almost two-thirds thousand thousand between regimes) general regime employee (ex. (2) and (6)) work in sectors employing mainly manual labor. Half of (7) 0.01 1.3 0.5 0.02 1.8 the members of this group are Likely need to find a full me job as a general regime employee younger than 35, and more than 20 percent are younger than 25. (8) = (1) - (2) - (6) - (7) 18.3 6.0 2.0 6.0 32.4 Source: Calculated based on State Revenue Service data. Above average workload and earnings. Younger than other general regime employees The es mates in Table 73 are op mis c as they assume maximal plausible ou low to self-employment. A range of policy Mainly general tax (45 percent below age of 35). Up to 3.6 At least 2 measures would be necessary to make it happen (even on a smaller scale). Such measures might include decreasing the PIT 29.0 8634 11.1 regime Features more low-educated thousand thousand rate for self-employment income from 23 to 19 percent, or providing mentoring and consul ng services free of charge, as individuals and less of those with well as marke ng and accoun ng services at low cost, for the newly self-employed. Smaller-than-projected ou lows to self- Master degrees than general- employment or some “small business” scheme (especially from MET-only and Unstable groups) would mean a larger need for regime-only employees. general regime employee vacancies, as well as some increase in unemployment and informal employment. Works more than average worker, main winner of the MET regime in terms of earnings. Half of group ANNEX M: SUMMARY OF TAX PROVISIONS FOR SMALL -AND MEDIUM- Mixed members are ter ary-educated, 46.7 28107 11.3 Up to 16 At least 6 SIZED ENTERPRISES IN THE EU and three-fi hs work in sectors thousand thousand There are considerable differences in the tax regimes for SMEs across the EU, with some member states (e.g. Belgium, employing mainly professionals. France, Poland, Spain) providing a wide range of incen ves in the form of special tax rates, tax credits or tax deduc ons, while 70% are concentrated in Riga and other member states (e.g. Austria, Italy, Sweden) do not provide any special incen ves for SMEs. Some member states (e.g. Pieriga Luxembourg, Netherlands, Portugal, and the U.K.) have general tax measures (e.g. progressive tax rate structure, tax relief for investment and R&D) that tend to favor SMEs more than larger companies. Source: Calcula ons based on SRS data. Some member states (e.g. Finland, France, Ireland, Italy, and Sweden) provide incen ves to encourage risk capital investment in SMEs through the provision of income tax and capital gains tax relief for investors. Special incen ves for start-up businesses Another approach to looking at the prospects for MET workers is based on the economic ac vity of the microenterprise. are provided in a number of member states, including Belgium, France, Ireland, Italy, Netherlands and Poland. Several member Ac vi es classified as Mainly professional in Table 63, as well as Other Personal Service and Household ac vi es, are likely to be states (Austria, France, Italy, Poland, Portugal, Slovenia, and Spain) provide the op on of a presump ve basis for calcula ng tax suitable for self-employment or small family businesses101 (in other ac vi es self-employment might or might not be suitable payable for microenterprises and sole proprietorships with low turnover levels. depending on circumstances). Combining this criterion with the one based on turnover and legal form, one arrives at the es mates presented in Table 72. Most SME tax incen ves are targeted at small and microenterprises, while medium-sized enterprises benefit only from R&D incen ves. Under the EU defini on, SMEs are categorized as follows: Table 73. Projected op mal ou lows from MET by group, 1000 of workers - Medium: < 250 employees < EUR 50m turnover < EUR 43m balance sheet Mainly MET-only Mixed Unstable Total General - Small: < 50 employees < EUR 10m turnover < EUR 10m balance sheet (1) MET workers, 2015 53.2 28.1 8.6 13.8 103.8 - Micro: < 10 employees < EUR 2m turnover < EUR 2m balance sheet 101 This is clear when the ac vi es in ques on are carried out in a microenterprise. For Administra ve and Support Service ac vi es (Sec on N of NACE Rev.2) this is not so straigh orward due to a very diverse scope of ac vi es; in this case we assume suitability for self-employment or small family business for 50% An EU Commission study in 2015 of SME taxa on in the EU recommended that tax incen ves should not be explicitly of microenterprise workers. connected to the size of companies or inhibit their growth, but rather should be designed to encourage desirable outcomes 208 209 Latvia Tax Review Latvia Tax Review such as innova on, investment and employment crea on. In this regard, it noted that member states generally place more Country Incen ves and other measures to assist SMEs emphasis on the provision of tax relief for R&D than relief specifically for SMEs and that R&D incen ves tend to be rela vely more advantageous for SMEs. The report recommends that all tax incen ves for SMEs should fulfil the basic requirements of Bulgaria Bulgaria, which has a standard CIT rate of 10%, has no special tax incen ves for SMEs. Small companies are transparency, effec veness and neutrality. It considers that special tax rates for SMEs have unfavorable features compared to subject to administra ve concessions, whereby enterprises with net sales below BGR300,000 (about EUR other forms of relief and that tax credits based on a propor on of investment costs, subject to a maximum amount, is a more 150,000) in the previous year do not have to make advance payments, while those with net sales between appropriate instrument to support SMEs. BGR300,000 and BGR3m (about EUR 1.5m) only have to make quarterly advance payments. Croa a Croa a, which has a standard CIT rate of 20%, provides significant incen ves for new investments, which A similar 2015 OECD report on SME taxa on noted that: “While many of these special SME tax rules are designed to support reduce the CIT rate on income from investment and which vary according to the size of the investment and the growth and profitability of SMEs, their design and introduc on can have distor ve impacts by giving businesses an incen ve new employment: to remain small or to split up into different businesses to con nue benefi ng from the preferen al tax treatment.” The OECD 100% reduc on for investment of at least EUR 3m and 15 new employees, report concluded that there may be a special case for providing support measures for new and younger SMEs which face 75% reduc on for investment of EUR 1m-3m and 10 new employees, par cular difficul es in rela on to finance and cash flow and are likely to have more poten al for innova on and growth than 50% reduc on for investment of less than EUR 1m and 5 new employees. older SMEs. For micro companies, there is a reduc on of 50% (i.e. tax rate of 10%) for income from investments of at least EUR 50,000 which create at least 3 new jobs. Table 71 provides a brief outline of tax measures for SMEs in various EU member states. Croa a also provides allowances for eligible costs of educa on and training which are enhanced for SMEs Table 74. SME incen ves and assistance measures, EU countries (defined according to EU guidelines). Country Incen ves and other measures to assist SMEs Estonia does not have special tax incen ves for SMEs, having regard to its corporate tax system which only Estonia taxes profits on distribu on. Austria Austria has no special tax incen ves for SMEs. All companies, including SMEs, are subject to the standard 25% rate of CIT. There is, however, an adjusted minimum tax for newly established companies of EUR 1,092 that Finland Finland has a special incen ve for SMEs in less developed regions which provides 150% of deprecia on rates applies to low income companies. There is also capital gains tax relief on the disposal of SME assets on the in the first 3 years for investment produc on facili es or tourism enterprises. SMEs are defined according to closing down of a business, with gains reduced by EUR 7,300 or spread and taxed over 3 years. EU defini on. Small businesses with annual revenue less than EUR 220,000 can pay tax on a presump ve basis, with taxable Finland also provides a tax relief for business angels, which provides for a deduc on for income tax purposes income calculated as 88% of annual revenues and normal tax rates applying. of 50% of investment in SMEs with less than 50 employees and turnover less than EUR 10m. There are limits on the amount of investment—maximum of EUR 150,000 per person and overall limit of EUR 2.5m Belgium Belgium has numerous incen ves for SMEs. For Belgian tax purposes, SMEs must meet two of the following investments per company in any year. criteria: - not more than 50 employees, turnover not exceeding EUR 7.3m, balance sheet not exceeding EUR 3.65m. While the standard rate of CIT is 33.99% (inclusive of 3% austerity surcharge), SMEs can benefit from a progressive CIT rate structure as follows: 24.9% on income up to EUR 25,000 31.9% on income between EUR 25,000 and EUR 90,000 35.5% on income between EUR 90,000 and EUR 322,500, and 33.99% on income in excess of EUR 322,500 Certain condi ons apply for an SME to qualify for the reduced rates. The company must not be a financial ins tu on. Fi y percent or more of the shares must not be held by one or more other companies. The company must not distribute dividends for an amount exceeding 13% of the issued share capital of the income year. The company pays a salary of at least EUR 36,000 to at least one of its managers. And the company must not be part of a group which owns a coordina on center. SMEs employing not more than 20 employees can benefit from an investment deduc on of 11.5% of asset deprecia on, with unused amounts carried forward subject to a maximum carry-forward of EUR 933,350. There is also a temporary allowance of 4% for ordinary investments that do not benefit from the special investment deduc on. The accelerated deprecia on for SMEs, whereby companies could avail of twice the normal deprecia on rate in the first three years, has been curtailed since 2011 and the standard deprecia on rates now apply. The tax credit on R&D investments is adjusted for companies with taxable incomes below EUR 322,500 according to a progressive schedule. Start-up innova ve companies can benefit from a 65% exemp on for wage withholding tax on the remunera on of researchers and research managers. SMEs are en tled to an extra 0.5% deduc on on top of the no onal interest deduc on of 3% of qualifying equity available to all resident companies in Belgium. There is also provision for SMEs to include income of up to 50% of retained earnings, or at most EUR 37,500, in a tax-exempt reserve which must be re-invested within three years. 210 211 Latvia Tax Review Latvia Tax Review Country Incen ves and other measures to assist SMEs Country Incen ves and other measures to assist SMEs France France offers a wide range of incen ves for SMEs, including special tax rates, tax credits and exemp ons for certain Greece Greece does not provide any tax incen ves specifically for SMEs. However, a scheme allowing for establishing kinds of income. a tax-free reserve amoun ng to between 15-40% of investment in qualifying undertakings provides more For SMEs with a turnover below EUR 7.63m, income up to EUR 38,120 is taxed at 15% instead of the normal 33.33% favorable treatment for smaller enterprises which can qualify for a higher relief of 25-45% of the investment. rate. The surcharge of 3.33% does not apply for SMEs within this turnover threshold. Microenterprises can elect for Hungary A small business tax rate of 10% (instead of basic CIT rate of 19%) applies for income up to a threshold of EUR special tax rates of 13% on income up to EUR 81,500 from the sale of goods and 23% on income up to EUR 32,600 1.6m. SMEs can avail of accelerated deprecia on in the form of immediate expensing of payments for fixed from services. To qualify as a microenterprise, a company must meet two of the following condi ons: - turnover tangible and intangible assets put into use for the business. not more than EUR 534,000, balance sheet total not more than EUR 267,000, and not more than 10 employees. Hungary also provides two simplified tax regimes for small businesses: Various tax credits are available for SMEs: The first, KIVA, is a cash-flow based tax which replaces corporate income tax, social contribu on taxes and A tax credit of 20% is granted on expenditure up to EUR 400,000 on innova ve ac vi es. voca onal training contribu ons. This tax applies at a rate of 16% of the tax base, which is based on the taxpayer’s A formula based tax credit is also available for SMEs with at least 20 employees where the number of employees cash-flow profit and is increased by staff costs. The tax is available to en es with less than 25 employees and increased by at least 15% in each of the two previous years. The credit is calculated taking income tax payable in where the revenue and balance sheet for the previous tax year were less than HUF 500 million (about EUR the current year mul plied by a percentage rate up to 100% (the rate is linked to employment increase - with 100% 1.6m). rate applying where employment increased by at least 15%) less income tax payable in the previous period. A second simplified regime, KATA, is a lump-sum tax for the self-employed. Under this regime, full- me A tax credit of 50% of qualifying expenses in hiring an addi onal employee to develop export business is available entrepreneurs registered as small business taxpayers pay tax of HUF 50,000 per month. Taxpayers may elect to SMEs, subject to a maximum credit of EUR 40,000 over two years. to pay HUF 75,000 per month in return for higher social security service eligibility. Part- me entrepreneurs pay For SMEs based in Corsica, there is a special tax credit of 20% of qualifying investment for SMEs based in Corsica HUF 25,000. The lump sum tax is payable separately for each person registered as a small business taxpayer. with employment and turnover levels not exceeding 250 and EUR 40m respec vely. This applies up to a revenue limit of HUF 6 million (about EUR 19,350). Once revenues exceed this amount, tax is France also provides certain exemp ons to assist start-up SMEs (defined according to EU defini on). An exemp on payable at 40% on the part of the revenue exceeding HUF 6 million. Payment of KATA releases the taxpayer from of 100% of income is provided for innova ve SMEs in the first year of ac vity, with a 50% exemp on in the second corporate income tax, personal income tax, social contribu ons tax, and healthcare, pension, employment and year (up to 2011 the relief was available over the first 5 years of the business ac vity, but this has since been voca onal contribu ons. It does not, however, provide an exemp on from VAT obliga ons. reduced to two years). To qualify, R&D ac vi es must account for at least 15% of expenses incurred. Ireland Ireland provides specific incen ves aimed at promo ng investment in SMEs and new business start-ups. The There is also a special tax exemp on on profits of companies crea ng a new industrial or commercial business in a Employment and Investment Incen ve scheme allows an individual investor to obtain personal income tax regional aid (AFR) area, equal to 100% exemp on for the first 2 years. The exemp on is gradually reduced to 75%, relief on equity investments in unquoted trading companies of up to EUR 150,000 per annum in the period to 50%, 25% for the following 3 years. The tax-exempt amount may not exceed EUR 225,000 over 3 years. Exemp on 2020. The income tax relief available is up to 30% but a further 10% is available (11% for investments made from local taxes for the first two years of a new business is provided at the decision of the relevant local authority. before 2015) where it has been demonstrated that employment levels have increased within 3 years of the There is a capital gains tax exemp on on the sale by a company of a branch ac vity, with 100% exemp on applying investment or where the investment was used for expenditure on R&D. The company in which the equity where the value of the branch does not exceed EUR 300,000 and 50% exemp on where the value is between EUR investment is made must be an SME (defined according to EU defini on) and the sum invested must be used 300,000 and EUR 500,000. for the purposes of the trading ac vi es carried on by the company. There are limits (EUR 10m in total and In addi on to the above tax relief, SMEs benefit from the following provisions for investors in SMEs: EUR 2.5m in any year) on the aggregate amount that may be invested in a company by all investors under Small enterprises with turnover less than EUR 15m are not subject to any minimum tax. the scheme. Investments in SMEs are eligible for PIT relief and CGT relief, with 18% of amounts invested in a qualifying SME Ireland also provides a number of tax relief provisions to assist new business start-ups. A corporate tax relief deduc ble from taxable income up to a maximum of EUR 50,000 and capital gains of SME directors selling their is available for start-up companies for the first 3 years of trading following the commencement of a new shares on re rement exempt from tax. 50% of investments in qualifying SME are deduc ble for wealth tax purposes, subject to a maximum of EUR 45,000. trade. The qualifying trade must not have been previously carried on by another person and the ac vi es of Finally, microenterprises with annual revenue not exceeding EUR 82,200 for sales of goods and EUR 32,900 for the trade must not have been previously carried on as part of another person’s trade. The relief provides a tax provision of services can use a presump ve basis for calcula ng tax payable. For microenterprises selling goods, credit based on the amount of employers’ social security contribu ons subject to a maximum of EUR 5,000 taxable income is set at 29% of annual revenue with normal tax rates applying. For microenterprises providing per employee in any year and an overall limit of EUR 40,000 per annum. Unused credits, which cannot be availed of in the first 3 years because of losses or insufficient profits, may be carried forward and offset against services, taxable income is set at 50% of annual revenue with normal tax rates applying. tax in subsequent years, subject to the EUR 5,000 and EUR 40,000 limits for any year. There is also a Start Your Own Business scheme which provides income tax relief for individuals who set up their own business, having Germany While Germany does not have a special tax rate for SMEs, it provides accelerated deprecia on for SME business been unemployed for a period of at least 12 months prior to star ng the business. The relief is capped at EUR assets cos ng less than EUR 235,000. It also has two tax incen ves that specifically target small companies. To 40,000 per annum for a period of two years. Finally, an income tax refund scheme is available for individuals qualify as a small company, net assets must be less than EUR 235,000 if the company applies the net worth star ng their own company under which qualifying share investments in the company can be offset against method to determine taxable income and less than EUR 100,000 if the company applies the net income taxable income at the marginal income tax rate (40/41%) over the previous six years prior to the investment, method. (The thresholds were reduced from EUR 335,000 and EUR 200,000 respec vely in 2011). The relevant thereby genera ng a refund of tax. The company must be an SME (by the EU defini on) and be carrying on a assets must be used in a domes c permanent establishment of the company for at least a year. The incen ves new trade, and the individual must be employed in the company as a full- me employee/director for at least are (i) an addi onal deprecia on of 20% of acquisi on or manufacturing costs of new movable assets over a 1 year a er the investment is made. 5-year period and (ii) recogni on of an investment reserve up to 40% of future acquisi on or produc on costs of depreciable assets, subject to a maximum EUR 200,000, with income in the reserve not subject to tax un l respec ve assets start to be depreciated. 212 213 Latvia Tax Review Latvia Tax Review Country Incen ves and other measures to assist SMEs Country Incen ves and other measures to assist SMEs Italy Italy does not provide corporate tax incen ves specifically for SMEs. However, it does provide a tax incen ve Poland Poland provides several incen ves for SMEs. Firstly, SMEs benefit from a higher rate allowance for investment to encourage investment in new start-up companies that focus on research, development and innova on. in new technologies, with a deduc on of 70% for small enterprises and 60% for medium sized enterprises, Under this incen ve, personal taxpayers can obtain a tax allowance of 19% of the amount invested in the compared to the general rate of 50%. In addi on, SMEs can receive a credit of up to 70% of eligible costs, subject start-up company up to a maximum of EUR 500,000, while corporate tax payers can obtain a tax allowance to a maximum credit of PLN4m (about EUR 950,000), for investment in new and innova ve technologies. The of 20% of the amount invested up to a limit of EUR 1.8m. The investor must maintain their investment in defini on of SMEs corresponds to the EU defini on. For micro companies with a turnover of less than EUR the company for at least 2 years. The relief has been extended to innova ve SMEs (EU defini on) subject to 1.2m, immediate deprecia on of expenditure on certain fixed assets up to EUR 50,000 is provided. the following qualifying condi ons: 3% of sales or costs must be a ributable to R&D ac vi es, one third of Micro companies can also opt for quarterly advance tax payments, rather than monthly payments. Small and employees must have a degree and the company must own a patent. micro start-up companies are en tled to receive a credit of 100% of tax due in the first year of opera on, Italy also provides a presump ve method for calcula ng income tax payable by natural persons opera ng which must be repaid within 5 years. a business with annual revenue less than EUR 40,000 (the threshold varies by sector). Taxable income is Poland also allows a presump ve method for calcula ng tax payable for (i) natural persons or partnerships calculated by applying a ra o to annual revenue, and a flat tax rate of 15% applies. with business revenue in the previous year of less than EUR 150,000 - with a flat amount of tax payable as Latvia The main incen ve for small business in Latvia is the microenterprise tax (MET), which was introduced determined by the tax authority—and (ii) microenterprises employing less than five employees—with tax in 2010 to promote the development of new businesses, reduce the administra ve burden for small/ payable according to the ac vity, scope and number of employees. microenterprises and facilitate transi on from the informal to formal economy. An enterprise can qualify for Portugal Portugal provides a progressive tax structure for federal and local business taxes which favors SMEs - 18.5% the MET if its turnover does not exceed EUR 100,000 in a tax year, there are no more than 5 employees, the for income up to EUR 15,000, 24.5% up to EUR 1.5m, 27.5% up to EUR 7.5m, 29.5% up to EUR 35m and 31.5% monthly income of any employee/director does not exceed EUR 720 (excluding dividends) and, for limited therea er. SMEs can also qualify for a higher tax credit for R&D expenditure with a deduc on of 47.5%, liability companies, the owners/ members are natural persons and only employees can be board members. compared to 32.5% for companies generally. Portugal also allows for tax to be calculated on a presump ve The MET operates as a tax on turnover, with turnover up to EUR 100,000 taxable at a 9% rate for the first basis for enterprises with an annual revenue of less than EUR 200,000 or net assets less than EUR 500,000. three years and 12% from the fourth year. A 20% rate applies for turnover in excess of EUR 100,000. Under Taxable income is calculated by applying a coefficient for each type of income to annual revenue. the MET, a single tax payment replaces CIT, PIT and social security contribu ons. Proposed changes from 2017 Romania Romania provides a turnover tax regime for microenterprises, under which privately owned companies with will mean that employees of microenterprises will be subject to mandatory social insurance contribu ons, income below EUR 65,000 pay tax at 3% of turnover (instead of the CIT rate of 16%). The regime does not while the rate of turnover tax for turnover up to EUR 100,000 will decline to 5% for the first 3 years and 8% apply to banking, gambling, consultancy or management sectors. for subsequent years. Lithuania Lithuania has two main incen ves for microenterprises - (i) Companies with not more than 10 employees Slovenia Slovenia does not provide tax incen ves specifically for SMEs under the general tax regime. However, SMEs and taxable income not more than LTL1m (EUR 290,000) benefit from a reduced tax rate of 5% (instead of are granted favorable tax treatment in designated economic areas where the maximum aid in the form of tax basic CIT rate of 15%). To qualify, the company must not be more than 50% owned by a person or group of concessions is 50% for small enterprises and 40% for medium sized enterprises. There are reduced penal es persons who also own a sole proprietorship or have more than 50% ownership in other companies. (ii) A for micro, small and medium-sized enterprises in the case of late or insufficient payments. Slovenia also micro company mee ng these criteria is also en tled to free deprecia on of fixed assets other than buildings. allows a presump ve basis for calcula ng income tax payable for businesses with annual revenue of not more In addi on to these incen ves, companies with taxable income of not more than LTL100,000 (EUR 29,000) than EUR 50,000 in the previous year (or less than EUR 100,000 where the taxpayer employs one full- me are allowed to determine their income on the basis of cash-accoun ng. person for at least 5 months). Under this basis, taxable income is calculated at 80% of annual revenue. Luxembourg A reduced tax rate of 20% (instead of the CIT rate of 22.47%, inclusive of surtax) applies to all companies Spain Spain provides a wide range of incen ves for SMEs. For small companies with net revenue of less than EUR with an income below EUR 15,000, while the first EUR 17,500 of income is exempt from municipal business 5m and less than 25 employees, a reduced tax rate of 20% applies on the first EUR 300,000 of income, with tax. Enterprises mee ng two of the following criteria—their total balance sheet should not exceed than EUR a rate of 25% on income in excess of EUR 300,000. SMEs with turnover below EUR 10m that do not meet 4.4m, and turnover not more than EUR 8.8m, and there should not be more than 50 employees—are not these criteria are subject to a 25% rate on the first EUR 300,000, while the normal 30% rate applies to income subject to compulsory audit controls. A tax credit on investments in qualifying depreciable tangible assets is above this amount. 7% for amounts up to EUR 150,000 and 2% for amounts in excess of this. SMEs can avail of accelerated depreca on which provides for deprecia on at twice the ordinary rate for Netherlands While the Netherlands does not have incen ves specifically for SMEs, it has a progressive CIT rate structure all tangible assets and three mes the rate if the assets were acquired as a reinvestment of a capital gain. which favors SMEs, under which income up to EUR 200,000 is taxed at 20% and income in excess of this Immediate expensing of tangible assets was allowed in 2013 and 2014 in companies that at least maintained is taxed at 25%. A progressive structure benefi ng SMEs also applies to the general investment deduc on employment levels. SMEs can also qualify for a tax credit of 10% of expenditure on new tangible assets for for small scale investments in certain business assets, where a deduc on of 28% applies for investments renewable energy. between EUR 2,300 and EUR 55,248, a flat deduc on of EUR 15,470 applies for investments between EUR For SMEs employing less than 50 workers, tax credits are available for hiring employees under 30 years of age 55,248 and EUR 102,311, a deduc on of EUR 15,470 less 7.56% of amount in excess of EUR 102,311 applies (EUR 3,000 per employee) and for hiring persons who have been unemployed for at least three months (50% for investments between 102,311 and EUR 306,931, and there is no deduc on for amounts in excess of EUR of outstanding unemployment payments). 306,931. SMEs with turnover of less than EUR 10m can establish a special provision for bad debt amoun ng to 1% of The Netherlands also provides an accelerated deprecia on regime for start-up companies which are able debt balance at year end. A capital gains exemp on of 99% is provided for venture capital investments in to depreciate all their assets without limita on in the first three years of the business opera on. In addi on, SMEs opera ng in the area of technological innova on. start-ups undertaking R&D ac vi es can benefit from a wage tax credit that provides higher deduc on rates Spain also allows for income to be calculated on a presump ve basis for unincorporated enterprises engaged for the first EUR 200,000 of the business’ wages. in certain business ac vi es with annual revenue less than EUR 450,000. Taxable income is calculated on the basis of certain coefficients (based on employees, size of business premises etc.) applied to annual revenue, with normal tax rates applying. 214 215 Latvia Tax Review Latvia Tax Review Country Incen ves and other measures to assist SMEs Gas oil, € per 1,000 liters 330 up to 330 Sweden While Sweden does not provide incen ves specifically targeted at SMEs, a special deduc on is available commercial for investors in small companies (defined according to the EU defini on). A tax deduc on is provided to LPG € per 1,000 kilograms 125 up to 231 individual investors of up to 50% of the investment cost of shares in eligible companies, subject to a maximum deduc on of SEK650,000 (about EUR 100,000) and a maximum level of investment of SEK20m per company. UK UK had a special reduced 20% CIT rate for SMEs, but this no longer applies now that the general CIT rate has been reduced to 20% for all companies. ANNEX O: INTERNATIONAL EXPERIENCE WITH PROPERTY TAX RATES AND SMEs benefit from increased allowances for R&D investment—while large companies are allowed to deduct EXEMPTION POLICIES an addi onal 30% of their R&D expenditure, SMEs are allowed to deduct 125%, subject to maximum relief of £7.5m (EUR 8.78m). The relief is available to a wider range of SMEs—i.e. companies with up to 500 The analysis that follows draws primarily on prac ces in the three countries that generate significant revenues from property employees, £100m turnover and £86m balance sheet total. taxes compared to GDP: France (4.1 percent); Canada (3.7 percent) and the United States (2.8 percent). It is presumably in these An annual investment allowance allows businesses to deduct the full value of capital expenditure on fixed countries that the pressure for targeted tax relief is most acute. The analysis also covers current prac ces in nearby Poland. assets (excluding motor vehicles) in the year of purchase up to £200,000. Targeted property tax relief can take four basic forms: ANNEX N: EXCISE TAX RATES: CURRENT STATUS AND RECOMMENDATIONS  Reduc ons based on the value of the property. This includes so called progressive tax rates, which impose higher rates Alcoholic beverages (as a percent of assessed value) on higher value proper es. It also includes progressive assessment ra os, which impose higher ra os on proper es with higher market values, and outright exemp ons or lump-sum credits for proper es EU below a certain assessed value. Product Rate Basis Minimum 2018-19 Rates  Reduc ons based on other property characteris cs. This include higher (or lower) rates or assessment ra os for € per hectolitre per proper es on the basis of their use. Industrial and commercial proper es, for example, may be taxed at a higher rate Beer 1.87 up to 5 than residen al proper es. Within the residen al category, single family homes may be taxed at a lower rate than degree alcohol Wine € per hectolitre 0 up to 86 apartment buildings and owner-occupied proper es may be taxed at a lower rate than proper es that are rented out. Older buildings may be taxed at a lower rate than new buildings (or vice versa). Religious, educa onal or cultural € per hectolitre of proper es as well as proper es owned by central and local government are typically exempt altogether. Spirits 550 up to 1,400 pure alcohol Cigare es  Reduc ons based on characteris cs of the taxpayer. These typically take the form of exemp ons or reduc ons for households with incomes below a certain threshold, but reduc ons may also be based on the age of the taxpayer or 7.5 whether the taxpayer is disabled, a veteran, or eligible for welfare payments. percent Specific ll 76.5  Ceilings on year-to-year increases. These are typically limits on the percentage increase in tax liabili es from one year € per 1,000 cigare es 77.9 component percent of to the next. the total tax In the countries reviewed for this note, these reduc ons are o en imposed in combina on. For example, taxpayers percent over age 65 may be eligible for a reduc on only if the value of their property falls below a given threshold. of the percent of max. retail i. France has two main taxes on residen al property.102 The first, the impot fonciere (property tax) is paid by property Ad valorem maximum price pppriselling 15 owners. The second, the taxe d’habita on (residence tax) is imposed on the occupant of the property—i.e., in the case component retail price of rental property, the tenant. In both cases, assessments are intended to reflect the rent that the property would be selling price expected to receive in the open market, having regard to the condi on, size and loca on of the property. Assessments on older proper es have not been updated in decades, however, and are therefore out of date. Minimum € per 1,000 cigare es 90 up to 102.65 excise tax The impot fonciere is subject to a number of exemp ons and abatements—the most important of which are means- Percent of the tested. Persons residing in their own homes who are over 60 years of age or receiving welfare payments are en rely Minimum weighted average 60 61 exempt from the tax, provided their income falls below a threshold level. 103 Other property owners are en tled to a excise tax retail selling price tax reduc on, depending on their income.104 French law also mandates a reduc on in the taxe d’habita on for owner Fuel occupied residen al property (applicable only to the principal residence) based on the number of children residing there. For each child, the tax is reduced by 10-15 percent. In addi on, local governments have the authority to grant Leaded € per 1,000 litres 421 up to 455 addi onal rebates of up to 15 percent to households with incomes below a threshold amount, provided the assessed gasoline 102 In addi Unleaded € per 1,000 litres 359 up to 411 on, income derived from rental property of any kind is subject to the income tax. France also imposes a professional tax (taxe professionelle) payable on business premises based on a percent of the taxpayer’s income, and a tax on wealth. Gas oil € per 1,000 litres 330 up to 382 103 For a one-person household, the threshold for 2016 was EUR 10, 697. For a household of three, it was EUR 22,121. Persons subject to the wealth tax are not eligible for this exemp on regardless of their income. 104 To qualify, a one-person household must have an income of less than EUR 25,155. The threshold is higher for larger households. 216 217 Latvia Tax Review Latvia Tax Review value of the property is not more than 30 percent higher than the average for the area in which the property is located. Box 17. California: A Cau onary Tale ii. Canada. Property taxa on in Canada is governed by provincial legisla on, which varies from one province to The state of California grants an immense de facto tax reduc on to long- me property owners. Under California’s another. Specific regula ons, as well as tax rates, also vary among local governments within a given province. proposi on 13 (enacted 1978), values on residen al property were rolled back to 1976 levels. Increases in assessed value from that date are capped at two percent per year or the rate of infla on, whichever is less. The maximum tax In Toronto (as elsewhere in Canada) property is assessed on the basis of its market (sales) value. Proper es are rate is capped at one percent. Proposi on 13 does allow proper es to be reassessed when they are sold--the new re-assessed every four years. Between reassessments, increases are phased in. Thus one-quarter of the increase in assessment is based on the actual sales price. But therea er, such proper es are subject to the same restric ons on assessments that occurred between 2012 and 2016 will be reflected in the tax bills for 2017; another 25 percent in the annual increases and tax rates as all other residen al proper es. tax bills for 2018, and so on un l the 2016 assessment are fully phased in in 2020. Increases are also capped at five percent per year. In fiscal terms, the results have been catastrophic. In 1977, property taxes accounted for X percent of local government revenues. By 2015, that propor on had shrunk to Y percent.[need to insert values for X and Y] Proposi on The rate of the property tax (as a percent of assessed value) varies considerably depending on the use of the 13 has also introduced gross inequi es in the distribu on of the property tax burden, as similar proper es are taxed property. As of 2016, the rate on single family homes was 0.69 percent.105 The rate on mul -family residen al proper es, at very different levels, depending on when they were sold. in contrast, was 1.64106 percent. Commercial proper es were taxed at a rate of 2.64 percent and industrial proper es at 2.7 percent. iv. Poland. In Poland, as in the other three case studies, the property tax is assigned to local government. The administra on of the property tax is nevertheless governed by na onal legisla on: specifically, the 1991 law on local taxes and fees, In addi on, the city of Toronto offers a range of exemp ons, reduc ons and deferrals of property tax liabili es. as amended. This law sets out the defini on of the base and the methodology to be used in determining the value of In the case of owner occupied residen al proper es, persons over age 65 are en rely exempt from the property tax individual proper es, as well as the list of mandatory exemp ons and abatements. Individual local governments have provided their combined household income is less than C$38,571 and the assessed value of their residence is less than the authority to set the level of the tax, subject to ceilings set in na onal legisla on. C$ 715,001. (Persons receiving disability benefits and persons receiving old-age welfare benefits are also eligible for this exemp on.) Toronto also offers a tax-deferral program for persons over age 65, provided their combined household Under the law on local taxes and fees, the real estate tax is imposed on land and buildings, other than those used for income is less than C$50,001. The deferral applies regardless of the value of the property. The deferred amount, agricultural and forestry purposes (these are subject to a separate tax.) 109 Assessment prac ces vary by property type. however, must be repaid once the property is sold. A forty percent reduc on in tax liabili es is granted to proper es Land, regardless of use, is assessed on the basis of a fixed amount, expressed in zlotys, per square meter. The amounts that are used for charitable purposes. are fixed by local councils, subject to ceilings in na onal legisla on. These are adjusted annually and vary by land use. In Warsaw, for example, the 2017 rate on land used for business purposes is PLN 0.89 per square meter. 110 The rate on iii. United States. As in Canada, property taxa on in the United States is governed by individual state legisla on. Specific other land (including land used for residen al purposes) is only half that: PLN 0.46 per square meter. 111 regula ons, as well as tax rates, vary among local governments within a given state. In New York City, different rates and assessment ra os apply to different classes of property. The market value of ‘class 1’ proper es--single family Residen al buildings, similarly, are assessed on the basis of a fixed amount, expressed in zlotys, per square meter.112 In homes, condominiums, and mul -family residen al buildings with three or fewer units-- is calculated on the basis of Warsaw, the fixed amount for 2017 is PLN 0.74 per square meter. Buildings used for commercial/business purposes are assessed comparable sales. The assessment ra o on these proper es is six percent, and the tax rate is 19.5 percent. As a result, on the basis of book value, at a flat rate of two percent. Where book value is unknown (e.g., in the case of unincorporated the tax on a single family home with a market value of US$ 500,000 is US$ 5,850, or 1.2 percent of its market value. businesses) the taxing authori es are authorized to determine it at the owners’ expense. The value of larger mul -family proper es (as well as other forms of property) is calculated on the basis of actual rental income, net of allowable expenses. The assessment ra o is 45 percent. Tax rates range from 12.9 percent (for buildings As a result of these prac ces, the effec ve rates of the property tax in Poland are extremely low, par cularly in the case with 4-10 units) down to 10.65 percent (for buildings with more than ten units.) Thus the tax on a twelve unit building of residen al property. The tax on a fairly substan al single family home in Warsaw (a 100 square meter home on 200 square genera ng US$ 500,000 in net revenue per year would be about US$ 24,000, or five percent of net revenue. meters of land) would be only PLN 194 (€ 45) at the 2017 rates. The effec ve rate on commercial property is somewhat higher. Nevertheless, because assessments are based on book value, valua ons for tax purposes lag far behind actual market values. New York City offers a variety of exemp ons and reduc ons on the property tax. Property belonging to persons age Since 1994, the Polish authori es have been considering a shi to market values as the basis for property taxa on. To date, 65 or older is eligible for a tax reduc on, provided the property is the taxpayer’s primary residence and the taxpayer’s these efforts have been successfully resisted. income is less than US$ 37,399.107 Condominiums and units in coopera ves in buildings with over three units are eligible for a separate reduc ons of 17.5 percent to 28.1 percent (regardless of the taxpayer’s age) provided they are the Na onal law exempts property used for educa onal, charitable and certain other purposes: e.g., land owned by museums. occupant’s primary residence. (Unlike a reduc on for the elderly, the amount of the reduc on is based on the assessed With one excep on, it does not authorize exemp ons or abatements based on the characteris cs of the property owner.113 The value of the property, not the income of the taxpayer.)108 law also permits local governments to concede addi onal abatements. Because the effec ve rate on residen al property is so low, such abatements would seem to be superfluous. ANNEX P: HISTORY OF CHANGES IN LATVIAN TAX SYSTEM 1. Personal Income Tax and Social Security Contribu ons 109 h p://www.finanse.mf.gov.pl/pl/podatki-i-oplaty-lokalne/podatki-od-nieruchomosci 110 h p://www.um.warszawa.pl/zalatw-sprawe-w-urzedzie/artykuly-sprawy-urzedowe/podatek-od-nieruchomosci 105 This reflects the combined rates of the city tax (0.497 percent); the educa on tax (0.188 percent); and the transit tax (.003 percent). 111 Land in designated redevelopment areas is assessed at a much higher rate: PLN 2.98 per square meter. 106 Except in the case of ‘new’ mul -family residen al proper es, which were taxed at the same rate as single family homes. 112 Although the law permits municipal councils to differen ate the assessments on residen al buildings to take into account the loca on, type of construc- 107 The amount of the reduc on varies according to the taxpayer’s income. For incomes between US$ 36,500 and US$ 37,399, the reduc on is only five per- on, condi on and age of buildings, it is not clear that these provisions are used.. cent. For incomes less than US$ 29,000, the reduc on is 50 percent. 113 The exemp on applies to private plots owned by members of agricultural coopera ves who have reached re rement age, are disabled, or are 108 Proper es assess at US$ 50,000 or less are eligible for a 28 percent reduc on. For proper es valued at over US$ 60,000 the reduc on is 17.5 percent. otherwise unable to work on a farm or live independently. 218 219 Latvia Tax Review Latvia Tax Review 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Personal Income Tax Personal Income Tax Wage Tax rate Wage Tax rate low rate 25% 25% 25% 25% 25% 25% 25% 25% 25% low rate 25% 25% 25% 25% 25% 25% 23% 26% 25% top rate 10% 10% 10% - - - - - - top rate - - - - - - - - - income threshold for income threshold for 5 691 5 122 85 372 - - - - - - - - - - - - - - - the second rate the second rate Self Self 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 15% 15% 26% 25% employed employed Social Security Contribu ons Social Security Contribu ons Wage 38.0% 38.0% 38.0% 37.0% 37.09% 37.09% 36.09% 35.09% 35.09% Wage 33.09% 33.09% 33.09% 33.09% 33.09% 33.09% 33.09% 33.09% 35.09% Employer’s 37.0% 37.0% 37.0%33% 28.0% 28.09% 28.09% 27.09% 26.09% 26.09% Employer’s 24.09% 24.09% 24.09% 24.09% 24.09% 24.09% 24.09% 24.09% 24.09% Employee’s 1.0% 1.0% 1.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% Employee’s 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 11.0% Cap (maximum Cap (maximum - - - 17 074 17 074 19 920 21 343 22 766 24 616 26 181 28 315 28 315 29 453 33 864 42 117 - - - celling) celling) Self Self 33.90% 33.82% 32.59% 32.10% 32.27% 30.27% 30.27% 30.50% 30.20% 29.95% 30.44% 30.48% 28.17% 31.52% employed employed Minimum SSC income Minimum SSC income 717 768 768 683 683 768 1 878 1 878 1 878 2 561 2 561 3 073 3 073 3 415 (annual) (annual) Minimum SSC income Minimum SSC income 60 64 64 57 57 64 157 157 157 213 213 256 256 285 (monthly) (monthly) 2012 2013 2014 2015 2016 Personal Income Tax Wage Tax rate low rate 25% 24% 24% 23% 23% top rate - - - - income threshold for - - - - the second rate Self 25% 24% 24% 23% 23% employed Social Security Contribu ons Wage 35.09% 35.09% 34.09% 34.09% 34.09% Employer’s 24.09% 24.09% 23.59% 23.59% 23.59% Employee’s 11.0% 11.0% 10.50% 10.50% 10.50% Cap (maximum - - 46 400 48 600 48 600 celling) Self 32.46% 32.17% 31.06% 30.58% 30.58% employed Minimum SSC income 3 415 3 415 3 840 4 320 4 440 (annual) Minimum SSC income 285 285 320 360 370 (monthly) 220 221 Latvia Tax Review Latvia Tax Review 1. Non-taxable 1. Non-taxable minimums, euro per 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 minimums, euro per 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 month month 1.1. Non-taxable 36/ 32/ Min 32 30 30 30 30 30 30 30 30 minimum 32 36 1.1. Non-taxable 75, 37 46 71 114 128/50 50 64 64 64 75 75 1.2. Non-taxable minimum Max - - - 142 142 142 142 142 142 142 142 100 minimum for pensioners 2. PIT allowances, euro 1.2. Non-taxable 142 157/235 235 235 235 235 235 235 235 235 235 235 per month minimum for pensioners 2.1. Allowance for 2. PIT allowances, euro 28/21 21 16/18 15 15 15 15 15 15 15 15 per month dependents 2.2. Tax relief for persons 2.1. Allowance for 26 31 50 80 90 90 100 100 100/114 165 165 175 with disabili es: dependents 32/ 2.2. Tax relief for persons - Group I and II 28/21 21 36 36 36 36 36 36 36 36 with disabili es: 36 21/ - Group I and II 36 54 85 137 154 154 154 154 154 154 154 154 - Group III 19/14 14 28 28 28 28 28 28 28 28 24 - Group III 28 43 67 107 120 120 120 120 120 120 120 120 2.3. Tax relief for 2.3. Tax relief for poli cally repressed poli cally repressed persons and par cipants persons and par cipants of the na onal resistance of the na onal movement resistance movement - if granted a pension - - 32/ 36 36 36 36 36 36 36 36 - if granted a pension 36 54 85 137 - if a pension not granted - - 36 65 65 65 65 65 65 65 65 - if a pension not 154 154 154 154 154 154 154 154 65 100 157 250 3.1. Eligible expenses granted 3.1. For educa on, euro 3.1. Eligible expenses 128 128 128 128 128 128 128 per year 3.1. For educa on, euro 213 213 213 213 per year For medical services, euro 213 213 213 213 427 213 213 213 213 213 213 215 85 85 85 85 85 85 85 per year For medical services, 3.2. Dona ons and gi s, euro per year % of the annual taxable 100% 100% 20% 20% 20% 20% 20% 20% 20% 20% 20% 3.2. Dona ons and gi s, income** % of the annual taxable 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 3.3. Contribu ons made, income** % of the annual taxable 3.3. Contribu ons made, income % of the annual taxable - in private pension funds - - - 100% 100% 100% 10% 10% 10% 10% 10% income - insurance premium - in private pension 10% 10% 20% 20% 20% 10% 10% 10% 10% 10% 10% 10% payments in conformity funds with life insurance - - - - - - - - 10% 10% 10% - insurance premium agreement (with payments in conformity accumula on of funds) with life insurance 10% 10% 20% 20% 20% 10% 10% 10% 10% 10% 10% 10% agreement (with - costs for purchase of accumula on of funds) investment cer ficates of the investment funds, - costs for purchase of if these cer ficates have - - - - - - - - - - - investment cer ficates been in the ownership of of the investment funds, the taxpayer for at least if these cer ficates have - - 20% 20% 20% - - - - - - - 60 months been in the ownership of the taxpayer for at least 60 months 222 223 Latvia Tax Review Latvia Tax Review 2. Value Added Tax 2011 2012 2013 2014 2015 2016 2002 2003 2004 2005 2006 2007 2008 2009 2010 Value added tax 22% 22%/21% 21% 21% 21% 21% Value added tax 18% 18% 18% 18% 18% 18% 18% 21% 21% Non-registered 49 801 49 801 49 801 50 000 50 000 50 000 taxable persons Non-registered 14 231 14 231 14 231 14 231 14 231 14 231 14 231 14 231 14 231 VAT value (12 taxable persons months) VAT value (12 months) Reduced rate, 12% 12% 12% 12% 12% 12% including: Reduced rate, 9% 5% 5% 5% 5% 5% 10% 10% including: 1) Medical and 12% 12% 12% 12% 12% 12% pharmaceu cal 1) Medical and 5% 5% 5% 5% 5% 10% 10% products pharmaceu cal products 2) Specialty 12% 12% 12% 12% 12% 12% products for infants 2) Specialty 9% 5% 5% 5% 5% 5% 10% 10% products for infants 3) Educa onal and 12% 12% 12% 12% 12% 12% original literature 3) Educa onal and 10% 10% original literature 4) Periodical 12% 12% 12% 12% 12% 12% 4) Periodical 5% 5% 5% 5% 5% 10% 10% 5) Transport of 12% 12% 12% 12% 12% 12% passengers 5) Transport of 5% 5% 5% 5% 10% 10% passengers 6) Hea ng for 12% 12% 12% 12% 12% 12% popula on 6) Hea ng for 5% 5% 5% 10% 10% popula on 7) Woodfuels for 12% 12% 12% 12% 12% 12% popula on 7) Woodfuels for 5% 5% 10% 10% popula on 8) Hotel 12% 12% 12% 12% 12% 12% accommoda on 8) Hotel 9% 5% 5% 5% 5% 5% 10% accommoda on 9) Books 9) Books 5% 5% 5% 5% 5% 10) veterinary medicines 10) veterinary 9% 5% 5% 5% 5% 5% medicines 11) mass media 11) mass media 9% 5% 5% 5% 5% 5% 12) water, sewage and waste disposal 12) water, sewage 9% 5% 5% 5% 5% 5% and waste disposal 13) funeral services 13) funeral services 5% 5% 5% 5% 5% 14) film and sports event ckets 14) film and sports 5% 5% 5% 5% 5% event ckets 15) natural gas supply popula on 15) natural gas 5% 5% 5% 10% 10% supply popula on 16) electricity supply popula on 16) electricity 5% 5% 5% 10% 10% supply popula on 17) renova on services for ci zens 17) renova on 5% 5% services for ci zens 18) hairdressing 18) hairdressing 5% 5% 5% 224 225 Latvia Tax Review Latvia Tax Review 3. Electricity tax and subsidized 5. Lo ery and gambling tax 2007 2008 2009 2010 2011 2012 Lo ery and gambling Electricity tax, EUR for MWh 0.50 0.64 0.78 1.01 1.01 1.01 state duty Subsidized Electricity tax Roule e, per year for 13 660 13 660 13 660 13 660 15 026 17 279 17 279 17 279 17 279 18 000 each year Electricity in the produc on of which fossil energy - - - - - - Cards and dice games, resources were used 13 660 13 660 13 660 13 660 15 025 17 279 17 279 17 279 17 279 18 000 per year for each year Electricity in the produc on of which renewable energy - - - - - - Slot machines, per resources were used 2 390,42 / 3 390,42 / year for each games 2 390 2 390 2 732 3 142 3 142 3 142 3 142 3 204 Sta ons that provide a centralized heat system and the 3 244,15 3 244,15 machine site subsidized electricity tax rate has a direct impact on the - - - - - - final heat tariff users The success of the game on the phone, 10% 10% 15% 15% 15% 15% 15% 15% 15% 15% % of income from the 2013 2014 2015 2016 organiza on Electricity tax, EUR for MWh 1.01 1.01 1.01 1.01 Totalizator and be ng, 42686,15 42,686 Subsidized Electricity tax % of income from the 15% 15% 15% 15% 15% 15% 15% 15% +10% +10% Electricity in the produc on of which fossil energy organiza on - 15% 15% 15% resources were used Bingo, % of income 17 074,46— 17 074,46 - 10% 10% 10% 10% 10% 10% 10% 10% Electricity in the produc on of which renewable energy from the organiza on 51 233,39 51 223,39 - 10% 10% 10% 10% 10% 10% resources were used Gambling using 10% 10% 10% 10% 10% 10% 10% Sta ons that provide a centralized heat system and the telecommunica ons, subsidized electricity tax rate has a direct impact on the - 5% 5% 5% % of income from the final heat tariff users organiza on Tax on lo eries and 8% 8% 10% 10% 10% 10% 10% 10% 10% 10% 4. Real estate tax instant lo eries, % of cket sales 2007 2008 2009 2010 2011 2012 2013 Immovable Property Tax 1.5% 1.0% 1.0% 1.5% 1.5% 1.5% 0,2-3% 6. Company car tax and vehicle exploita on tax For land and buildings 1.5% 1.5% 1.5% 1.5% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Un dy property >1,5% Company Car Tax Residen al houses if cadastral value does un l 2000 cm3 - - - - - - - - - 27.03 - - - 0.1% 0.2% 0.2% 0.2% not exceed EUR 56,915 between 2001 Residen al houses with cadastral value cm3 and 2500 - - - - - - - - - 42.69 - - - 0.2% 0.4% 0.4% 0.4% between EUR 56,915 and EUR 106,715 cm3 Residen al houses with cadastral value above 2500 - - - 0.3% 0.6% 0.6% 0.6% - - - - - - - - - 56.91 above EUR 106,715 cm3 Electric Vehicle - - - - - - - - - 42.69 2014 2015 2016 Other Immovable Property Tax 0,2-3% 0,2-3% 0,2-3% - - - - - - - - - 42.69 company car For land and buildings 1.5% 1.5% 1.5% Vehicle exploita on tax (of gross weight per year for each year) Un dy property >1,5% >1,5% >1,5% For passenger car, if the car is not in Table1 Residen al houses if cadastral value does un l 1500 kg 17.07 17.07 17.07 17.07 17.07 17.07 17.07 17.07 34.15 35.57 0.2% 0.2% 0.2% not exceed EUR 56,915 1501-1800 kg 34.15 34.15 34.15 34.15 34.15 34.15 34.15 34.15 68.3 75.41 Residen al houses with cadastral value 0.4% 0.4% 0.4% 1801-2100 kg 64.03 64.03 64.03 64.03 64.03 64.03 64.03 64.03 106.72 128.06 between EUR 56,915 and EUR 106,715 2101-2600 kg 76.84 76.84 76.84 76.84 76.84 76.84 76.84 76.84 135.17 162.21 Residen al houses with cadastral value 0.6% 0.6% 0.6% 2601-3000 kg 102.45 102.45 102.45 102.45 102.45 102.45 102.45 102.45 163.63 196.36 above EUR 106,715 3001-3500 kg 102.45 102.45 102.45 102.45 102.45 102.45 102.45 102.45 163.63 226.24 above 3500 kg 110.98 110.98 110.98 110.98 110.98 110.98 110.98 110.98 213.43 256.12 226 227 Latvia Tax Review Latvia Tax Review 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 7. EXCISE DUTY For heavy goods vehicles 1. Energy products un l 1500 kg 17.07 17.07 17.07 17.07 17.07 17.07 17.07 17.07 17.07 17.07 1501-1800 kg 34.15 34.15 34.15 34.15 34.15 34.15 34.15 34.15 34.15 34.15 Petrol, EUR per 1000 litres Gas Oil, EUR per 1000 litres 1801-2100 kg 64.03 64.03 64.03 64.03 64.03 64.03 64.03 64.03 64.03 64.03 Unleaded Leaded petrol 2101-2600 kg 76.84 76.84 76.84 76.84 76.84 76.84 76.84 76.84 76..84 76.84 Year +bio at least +bio 5%-303 without bio without bio agriculture 100% bio5 +bio 85%2 +bio 5%1 Used for 2601-3500 kg 102.45 102.45 102.45 102.45 102.45 102.45 102.45 102.45 102.45 102.45 30%4 3501-12000 kg 110.98 110.98 110.98 110.98 110.98 110.98 110.98 110.98 110.98 145.13 2012 2004 Company Car Tax (From 247.58 234.77 - 362.83 210.59 200.62 147.98 0 - un l 2000 cm3 27.03 27.03 27.03 27.03 29.0 May-1) between 2001 2005 273.19 258.96 - 399.83 233.35 220.55 162.21 0 - cm3 and 2500 42.69 42.69 42.69 42.69 46.0 2006 273.19 258.96 - 399.83 233.35 220.55 162.21 0 - cm3 2007 44.82 above 2500 297.38 283.15 From 418.32 253.27 241.89 177.86 0 - 56.91 56.91 56.91 56.91 62.0 cm3 Jul-1 Electric Vehicle 42.69 42.69 42.69 42.69 10.0 2008 16,22- 324.41 308.76 422.59 274.61 261.81 193.51 0 - Other 97,32 42.69 42.69 42.69 42.69 46.0 company car 2009 Vehicle exploita on tax (of gross weight per year for each year) 19,14- (From 382.75 364.26 426.86 332.95 317.3 233.35 0 - 114,83 For passenger car, if the car is not in Table1 Feb-1) un l 1500 kg 35.57 35.57 35.57 35.57 35.57 2010 382.75 364.26 114.83 426.86 332.95 317.3 233.35 0 - 1501-1800 kg 75.41 75.41 75.41 75.41 75.41 2011 411.21 382.75 123.36 455.32 1801-2100 kg 128.06 128.06 128.06 128.06 128.06 From From From 411.21 2101-2600 kg 162.21 162.21 162.21 162.21 162.21 Jun-1 Jun-1 Jun-1 332.95 332.95 233.35 0 - 2601-3000 kg 196.36 196.36 196.36 196.36 196.36 From Jun-1 3001-3500 kg 226.24 226.24 226.24 226.24 226.24 2012 411.21 411.21 123.36 455.32 332.95 332.95 233.35 0 - above 3500 kg 256.12 256.12 256.12 256.12 256.12 2013 411.21 411.21 123.36 455.32 332.95 332.95 233.35 0 - For heavy goods vehicles 2014 411.21 411.21 123.36 455.32 332.95 332.95 233.35 0 - un l 1500 kg 17.07 17.07 17.07 17.07 36 2015 50 1501-1800 kg 34.15 34.15 34.15 34.15 72 411.21 411.21 123.36 455.32 332.95 332.95 332.95 0 From Jul-1 1801-2100 kg 64.03 64.03 64.03 64.03 138 2016 436 436 131 455.32 341 341 341 0 50 2101-2600 kg 76.84 76.84 76.84 76.84 165 2601-3500 kg 102.45 102.45 102.45 102.45 219 3501-12000 kg 145.13 145.13 145.13 145.13 156 228 229 Latvia Tax Review Latvia Tax Review Labelled fuel9, EUR per from Aug-1, 2015 70 70 64 70 110 1360 3.8 Liquefied petroleum gas Heavy fuel oil7, EUR per oil6, EUR per 1000 litres Kerosene and light fuel 1000 litres (LPG)8, EUR per 1000 From Mar-1, 2016 74 74 64 74 120 1400 4.2 1000 kilogram From Mar-1, 2017 78 78 64 78 130 1450 4.5 kilogram Year From Mar-1, 2018 82 82 64 82 135 1500 4.8 without bio +bio 510 3. Tabacco Cigare es Cigars Fine Cut Smoking Tobacco, EUR per 1000 grams 2004 and Cigarillos, (From 210.59 12.81 108.14 18.5 - Year Specific excise, EUR per Ad valorem excise, EUR per Finely sliced Other May-1) 1000 cigare es as % of TIRSP 1000 2005 233.35 14.23 118.1 19.92 - pieces 2006 233.35 14.23 118.1 19.92 - 23.6 16.2 2007 253.27 15.65 123.79 21.34 - 2004 9.0 10.0% 15.7 27 (From May-1) 18.5(From May-1) 2008 274.61 15.65 123.79 21.34 - 29.9(From Jul-1) 2009 2005 9.8 10.5% 15.7 29.9 18.5 (From 332.95 15.65 128.06 21.34 - 2006 10.8 14.8% 15.7 29.9 19.9 Feb-1) 12 19.2% 2010 56.91 21.34 (From Jan-1) (From Jan-1) 332.95 15.65 128.06 From 2007 15.7 32.7 19.9 From Jul-1 14.2 25.0% Jul-1 (From Jul-1) (From Jul-1) 2011 332.95 15.65 128.06 56.91 21.34 2008 25.3 32.2% 15.7 32.7 19.9 2012 332.95 15.65 128.06 56.91 21.34 32.7 19.9 2013 332.95 15.65 128.06 56.91 21.34 2009 32 34.5% 15.7 32,7 (From Feb-1) 2014 332.95 15.65 161 56.91 21.34 32 34.5% 2015 332.95 15.65 161 56.91 21.34 2010 15.7 32.7 but not less than 68.30 EUR per 1000 cigare es 2016 341 15.65 206 56.91 21.34 34.1 35.6 34% (From 41.3 (From Jan-1) 2. Alcoholic beverages 2011 Jan-1) Other s ll Other s ll Intermediate 37 (From Intermediate Other but not less than 73.99 EUR per 1000 cigare es 48.4 (From Jul-1) fermented fermented products, > Jul-1) 1 Wine products, ll alcoholic Beer beverages, beverages, 15 ll 22 % 2012 35.6 34% 37 48.4 15 % beverages Date >6% vol. ≤ 6% vol. vol. 2013 35.6 34% 37 48.4 39.8 33.5% per EUR per hl/degree EUR per 100 litres but not less than 79.68 EUR per 1000 cigare es hectolitre of alcohol (From Jan-1) From May-1, 2004 42.69 42.69 59.76 99.6 782.58 1.742 2014 51.8 25.0% 39.8 55.5 from Jan-1, 2006 42.69 43.69 59.76 99.6 896.41 1.852 but not less than 85,6 EUR per 1000 cigare es From Feb-1, 2009 56.91 56.91 59.76 99.6 1173.87 2.063 (From Jul-1) From Jul-1, 2009 56.91 56.91 59.76 99.6 1266.36 3.1 From Feb-1, 2010 64.03 64.03 64.03 99.6 1266.36 3.1 54.2 25.0% From, Jun-1, 2011 64.03 64.03 64.03 99.6 1337.5 3.1 2015 but not less than 89.80 EUR per 1000 cigare es 39.8 55.5 (including tobacco leaves) From Jan-1, 2014 64.03 64.03 64.03 99.6 1337.5 3.1 (From Jul-1) 230 231 Latvia Tax Review Latvia Tax Review Cigare es Cigars Fine Cut Smoking Tobacco, EUR per 1000 grams 5. Coffee and sweet drinks and Products From May- From Feb- From Jan-1, Cigarillos, 1, 2004 1, 2009 ll 2011 Year Specific excise, EUR per Ad valorem excise, EUR per Finely sliced Other ll Jan 31, Dec-31, 1000 cigare es as % of TIRSP 1000 2009 2010 pieces Coffee, EUR per 71.14 142.29 142.29 56.2 25.0% 100 kg 2016 but not less than 93.7 EUR per 1000 cigare es 42.7 58 (including tobacco leaves) Sweet so drinks, 2.85 5.69 7.4 (From Jul-1) EUR per 100 litres 58.2 25.0% 2017 but not less than 97 EUR per 1000 cigare es 42.7 60 (including tobacco leaves) (Footnotes) (From Jul-1) 1 We ignore income effects for top income earners here, since these are generally considered small and have not o en 60 25.0% been es mated (Saez et al., 2012). 45 2018 but not less than 100 EUR per 1000 cigare es 62 (including tobacco leaves) (From Jul-1) 2 This es mate should be interpreted with cau on and can be revised when micro-data become available. 3 The Pareto distribu on is characterized by 1 – F(y) = ηαy-α. Taking logs from both sides yields ln(1 – F(y)) = αln(η) – αln(y). Consequently, the Pareto parameter α is (minus) the slope of a regression of ln(y) on ln(1 – F(y)). 4. Natural gas Usage From Jul-1, From Sep-1, From Jul-1, From Jan-1, 4 When we es mate the Pareto parameter using the P80-P99 percen le ra os, the Pareto parameter drops to 3.1. 2010 ll 2010 ll Jun- 2011 2014 August 31, 30, 2011 5 Indirect taxes should be added to the EMTR since also indirect taxes lower the price of leisure or non-work ac vi es in 2010 terms of consump on. The EMTR including indirect taxes is calculated as: EMTR = (direct tax + indirect tax)/(1 + indirect tax). As a fuel, EUR per 99.6 - 99.6 99.6 1000 m3 As a hea ng fuel, 22.2 - 17.07 17.07 EUR per 1000 m3 As a fuel for - - - 5.65 industrial produc on and processing of agricultural raw materials processes, EUR per 1000 m3 232 233