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What has been referred to as the „Estonian tax” is in reality an adaptation of the “pass-through company tax”, also known as the “flow-through company tax”, which is widely used in the United States. This solution basically means a “tax that passes from the company to the owners”. The definition tells us that companies using this taxation model are not subject to the Corporate Income Tax (CIT). Instead the taxation applies to the owners of the pass-through companies, who control their incomes.
These incomes are subject to the Personal Income Tax (PIT), but only when they are paid to shareholders in the form of a dividend for a specific period. Therefore, the PIT is paid instead of the CIT. It turns out that such a system is more transparent and easier to navigate for both the fiscal authorities and the taxpayer.
An idea dating back to the times of Ronald Reagan
The implementation of the pass-through tax treatment began with the tax revolution of 1986, which was an expression of the approach referred to as “Reaganomics”. Back then, tax legislation under the telling name of “The Tax Reform Act of 1986” was passed at the initiative of the US President Ronald Reagan. For the first time in the US modern history, the tax rates were turned upside down, because the highest PIT rates become lower than the CIT rates. The benefits of the pass-through tax treatment became evident.
From the point of view of the taxpayer it is immediately clear that the pass-through model prevents double taxation, occurring first at the company level (CIT), and then at the level of the individual taxpayer reporting income from their business activity (PIT). This solution seems to be unfavorable from the point of view of the immediate fiscal interests of the state. However, its introduction was based on practical experience, which indicated that it is easier to hide profits for a company issuing and receiving hundreds or even thousands of invoices each month than for individuals.
The tax authorities gain more from the disclosure of higher profits and the reduction of the costs of tax audits, which become easier, than they lose by eliminating double taxation. One great advantage of the pass-through tax treatment is that taxes can be planned and shifted in time through the selection of the dividend payment dates. And finally, the CFOs and the accountants do not have to jump through hoops with regard to the settlement of investment-related taxes.
We also have to mention the economic reasoning of the fiscal authorities. The pass-through taxation mechanism is pretty effective in filling the government’s coffers. At the same time, it changes the structure of tax revenues in a way that increases the share of PIT, which are much easier to calculate and to enforce.
Collecting taxes from businesses is difficult but collecting taxes from individuals is a piece of cake. This is also due to the fact that even though debtors’ prisons are now a thing of the past, in the United States and other countries, including Poland, people still can go to prison for tax evasion, although in Poland that is a relatively rare occurrence.
The gradual marginalization of the CIT
According to the documentation of the United States’ Congressional Budget Office, in 1965 PIT accounted for 42 per cent and CIT accounted for 22 per cent of all tax revenues. In absolute terms, the revenues from the PIT reached USD48.8bn while those from the CIT amounted to USD25.5bn, with the overall federal tax revenues reaching USD116.8bn.
In 1988, two years after the implementation of Reagan’s tax reform and the popularization of the pass-through tax treatment principle, these ratios changed slightly — the PIT accounted for 44 per cent, and the CIT accounted for barely 10.4 per cent of all revenues. In 2018, the difference is even greater, as the PIT accounted for 50.5 per cent of federal tax revenues (USD1.684 trillion), while the CIT accounted only for 6.3 per cent (USD205bn), with overall federal tax revenues reaching USD3.33 trillion. This means, that more than half a century ago the US government’s PIT revenues were two times larger than CIT revenues, while today the PIT provides revenues that are over 8 times larger than those derived from the CIT.
A similar process is taking place in Poland, except that the proportions between the two countries are distorted by the Value Added Tax (VAT), which does not exist in the US at the federal level, and taxes of this kind are usually levied at the state level.
In 2018, Poland’s CIT revenues amounted to USD12.3bn (10.7 per cent of the overall tax revenues), while the PIT revenues reached USD30.7bn (27 per cent of the overall revenues). Fifteen years earlier, in 2003, the CIT brought revenues of 4.16bn (10.2 per cent of all tax proceeds), and the PIT revenues amounted to USD9.8bn (24 per cent).
The CIT is still a noticeable source of revenues for the Polish state, but it does not play a crucial role. This means that a possible shift towards the pass-through tax treatment would not be associated with a high risk of losing a substantial part of the tax revenues, especially if it is limited to SMEs.
Growing number of pass-through businesses in the US
The pass-through tax treatment is primarily used by sole proprietorship. The number of such businesses increased from approx. 9 million in 1980 to over 24 million in 2013. Two other forms of business organization that in the US settle their taxes according to the pass-through treatment, that is, partnerships (including law firms and consulting companies) and so-called S Corporations (that is, companies with 100 or fewer shareholders) which also became more numerous over the years (an increase from 2 million to approx. 8 million entities).
Large and very large businesses tend to be organized in the form of publicly traded companies, and even if these are so-called family businesses, the ownership structure is usually very confusing. If we imagine millions of shareholders, dozens of subsidiaries, and hundreds of second-tier subsidiaries, along with the resulting enormous problems with the proper assignment of the distributed profits, it immediately becomes clear why the principle of pass-through tax treatment does not apply to corporations, and why Poland’s Prime Minister Mateusz Morawiecki only promised to introduce the “Estonian tax” for SMEs.
In 2016, nearly a half (45 per cent) of the revenues of American companies using the pass-through tax treatment was attributable to taxpayers with annual incomes above USD500,000, and a third was attributable to persons with an income of USD1m and more. The higher the income, the higher the applied tax rate, which ultimately reaches up to 37 per cent.
However, since the majority of shareholders of pass-through companies functioning in the US are not excessively wealthy (in 2016 over 22 per cent of them had an annual income below USD100,000), a conditional 20 per cent pass-through tax deduction has been introduced recently.
This will provide significant benefits to the taxpayer, because in this case the marginal tax rate decreases from 37 per cent to 29.6 per cent. However, in order to qualify for the deduction, the taxpayers have to remain within certain income limits. If they exceed the adopted threshold, they will not be able to take advantage of the deduction. These thresholds are relatively low considering the market conditions in the US. The basic threshold is USD157,500 a year for “single filers”, and USD315,000 for married couples who file joint tax returns. This negates the potential argument that the US fiscal authorities are once again favoring the wealthy, as in reality this deduction was addressed to the local middle class.
Small enterprises have the lowest tax rates
Estimates of the effective rates of taxation of business incomes in the US are presented in a paper released in 2016 as a part of the “Tax Policy and the Economy” series. The work entitled “Business in the United States: Who Owns It, and How Much Tax Do They Pay” was prepared by a group of authors including the officials from the US Treasury Department and scientists from University of California, Berkeley and the University of Chicago Booth School of Business.
The authors claim that their calculations constitute “the most comprehensive estimate available of the average tax rate on US business income”. If we were to believe them, the average rate of taxation of economic activity in the US is 24.3 per cent. The effective tax rate for large companies (C Corporations) is 31.6 per cent, while for large companies with no more than 100 owners (S Corporations) it is 24.9 per cent. The average income tax rate for partnerships is 15.9 per cent, while in the case of non-agricultural sole proprietorships it stands at 13.6 per cent.
These tax rates were estimated on the data from 2011, so the exact values may have changed, but there is no reason to believe that the proportions have not been changed.
Therefore, fiscal practices in the US aren’t that different from those observed in Europe — large companies are supposed to pay high taxes, while small companies have lower taxation. The authors openly criticize the tax privileges granted to partnerships.
This form of business organization is typically used by big law firms, companies providing financial services, as well as providers of health care services. These are business activities generating enormous profits, and the people performing these services have no qualms about setting exorbitant prices.
On the basis of the conducted simulations, the authors determined that had it not been for the tax regulations introducing pass-through tax treatment, the government’s CIT tax revenues would have been USD100bn higher in 2011 than they were in reality. The difference in absolute terms would be substantial, as the actual revenues in that year amounted to USD181bn, which means that without the pass-through tax treatment they would have been about 55 per cent higher.
When it comes to the proportions between the revenues obtained from the individual tax groups, the effect would be noticeable but not striking, as the share of CIT in overall tax revenues in 2011 amounted to 7.9 per cent, and following an increase in revenues of USD100bn this share would have grown to 12.2 per cent.
It is necessary to add, however, that some part of the hypothetical revenue loss on the part of the CIT would have certainly been compensated on the part of the PIT. What is also important for this assessment is the practical implementation of these tax settlements. The cited estimates were probably prepared on the basis of the so-called accrual method of accounting, in which liabilities (in this case, tax liabilities) are recorded on the date on which they arise, regardless of the actual date of payment.
It may take years before these liabilities materialize in the form of cash in the bank account. Moreover, at times this may not happen at all, as a result of various appeals and court decisions. The situation with the PIT is easier, because there are fewer areas that generate doubts and disputes, as a result of which the estimates based on the accrual method of accounting are more consistent with those prepared on the basis of the cash method of accounting.
The soothing effects of pass-through tax treatment
American legislators have been introducing constant changes to the US tax code for many decades. Wolters Kluwer claims that the US’ tax code has a total of 75,000 pages and is 187 times longer than it was 100 years ago. In 1913, all the federal tax regulations had a total of 400 pages and grew by only 100 pages in the first 26 years after the introduction of the income tax. The biggest increase in the volume of tax regulations occurred in the past three decades.
The US is not the only country applying pass-through tax treatment. This solution is used to a varying extent in several English-speaking countries, such as Australia, or New Zealand. However, Estonia went the furthest. This small country certainly made things easier in this regard.
In 2018, Estonia’s GDP reached almost USD31bn and was 19 times lower than Polish GDP, although per capita it was one and a half times higher. Such a small state is more agile and therefore has lower operating costs.
The main difference between the “Estonian tax” and the original solution, which has been used in the US, is its universal application. In Estonia, there is no distinction between corporations and other forms of business organization.
The income tax is only paid upon the distribution of profits, for example, in the form of dividend payment to shareholders. In 2018, the tax rate was 20 per cent of the gross profit, although the tax is officially formulated as 20/80 of the net payments. If a company paid out, for example, EUR100,000 in the form of dividends, then income tax is charged in the amount of EUR25,000, as EUR10,0000 × 20/80 = EUR25,000. The owners receive EUR100,000 and the company’s expenditures amount to EUR125,000, as EUR100,000 + EUR25,000 = EUR 125,000.
Mr. Morawiecki announced that he would consider the introduction of the pass-through tax treatment in Poland. Like other people, he referred to this idea as the “Estonian tax”, thus undeservedly attributing its invention to the Estonians. Maybe it’s for the best, however, as the name “Estonian tax” is more accessible than the original name used in the US.
Imitation is desirable, but with some reservations. The Estonians applied the pass-through tax treatment to all companies, but that is a small country. The biggest Estonian company Tallink Grupp AS mainly operates in maritime transport. In 2017, it had revenues of EUR967m, less than EUR50m in profits, and only ranked 7th on the list of the 50 largest companies in the Baltic states prepared by Coface. Incidentally, the first place on the list has for many years been occupied by Orlen Lietuva, the Lithuanian subsidiary company of Orlen.
The demands for a thorough review of the tax code law seem to fall on deaf ears. They are ignored in the same way in the US, in Poland, and elsewhere. This is not about the simplification of the law, because the more complex and developed the economy, the harder that would be. What is necessary, however, is to provide clearer rules and definitions to remove inconsistencies and contradictions, and to introduce transparent language and shorter sentences. This would make tax legislation easier to understand for ordinary executives and accountants, and would allow us to eliminate arcane and convoluted legal language.
Such calls need to be repeated in the same way that Marcus Porcius Cato, known as Cato the Censor, used to repeat his famous phrase “Ceterum censeo Carthaginem esse delenadam”, meaning “Furthermore, I believe, that Carthage must be destroyed”. But as long as this fiscal Carthage is left intact, there’s nothing wrong with providing some relief to SMEs. The “Estonian tax” has its place in Poland, because small and medium-sized companies need to grow, and it’s easier for them to do that if they have fewer obstacles to overcome.