In the mid-2000s, the Czech Republic, Poland and Slovakia were in the throes of a flat-tax revolution. Lured by the prospects of greater efficiency and simpler revenue collection, the governments of these ex-communist countries enthusiastically embraced the new approach.
Almost 20 years on, the tax landscape in central and eastern Europe has changed significantly. In practice, administering the flat tax has proved more complex than expected. All three countries have added more progressive elements, although in certain cases they have further simplified the system. Meanwhile, the impact of the Covid-19 pandemic could prompt more changes.
‘The system’s limited progressivity, the poor levels of tax compliance and the high tax burden for low-income workers became apparent’
The three countries saw the flat tax as an opportunity to boost their economies and attract foreign investment. Slovakia was first to introduce it, in 2004, setting personal income tax, corporate income tax and VAT all at 19%.
Michal Havlát, director for tax revenue and fiscal analyses at the Slovak Ministry of Finance, says: ‘Before, the personal income tax system had five income brackets, and the corporate rate was at 25%. With this reform, Slovakia became the first OECD country to have a flat personal income tax.’
In fulfilling the key goals of boosting the economy and attracting foreign investment, observers broadly agree that the new arrangements worked well. In 2008 the Czech Republic set personal income tax at 15%. ‘It was was generally very good for the Czech Republic’s image abroad. It sent a signal that it was a good location for inward investment and helped the country earn top spots in tax competitiveness indices,’ explains Bryan McSweeny, senior tax manager at Mazars Czech Republic. ‘It has helped keep investment coming into the Czech Republic and benefited the economy.’
Havlát agrees, noting that after 2000, proportionate to GDP Slovakia lured more foreign direct investment (FDI) than numerous other OECD countries. He says that prior to EU accession, the country also attracted more foreign investment than its peers in the Visegrad bloc, which consists of Poland, Hungary, the Czech Republic and Slovakia.
‘Although the corporate income rate is only one of the factors that motivate multinational companies’ investment decisions, large FDI inflows coincided with the decline in the Slovak Republic’s statutory corporate tax rate from 40% in 1999 to 29% in 2000 and 19% in 2004,’ he adds.
However, Poland, the Czech Republic and Slovakia have all shifted to some extent away from the one-size-fits-all approach of a single tax rate. Slovakia instituted a second personal income tax bracket in 2013 and raised corporate income tax to 23%. Havlát cites low tax revenues as one reason for the move. ‘The system’s limited progressivity, the poor levels of tax compliance and the high tax burden for low-income workers became apparent,’ he says.
Havlát explains that the budgetary deficit had to be brought below 3% under the EU Stability and Growth Pact rules. Although the second income tax bracket was in line with the policies of the centre-left government that introduced it, the new tax band was brought in mainly as part of a consolidation package to reduce the deficit.
Similar questions confront tax legislators and business in Poland too. There, the self-employed can opt to pay a flat tax of 19% on their income, a feature introduced under the 2004 tax reforms.
‘The measure has been popular. Poles are earning more and are looking for possibilities to pay lower taxes,’ says Aleksandra Grabarczyk, tax consultant at Mazars Poland. But she notes that ‘the flat tax rate is profitable only when a taxpayer earns more than 100,000 zloty [£19,100] a year.’
The average Polish salary is currently about 62,000 zloty. ‘I would estimate that this system blocks the development of entrepreneurship among smaller companies in Poland because it rewards [only] the richest,’ Grabarczyk adds.
Similar criticisms have been levelled at the changes under the 2008 Czech personal income reforms. In practice, an individual’s tax base was calculated at 135% of their salary. This ‘super gross tax base’ was phased out under the January 2021 tax changes.
‘This system blocks the development of entrepreneurship among smaller companies in Poland because it rewards [only] the richest’
‘The new system from 2021 really does tax employment income at an initial rate of 15%, while income over 1,701,168 koruna [£57,600] will be taxed at a 23% rate. This change will help the majority of employed people in the Czech Republic to enjoy a higher level of net spendable income,’ McSweeny says.
He adds that despite the simplicity arguments, the 2008 reform was complex to administer. ‘The old flat tax had the unusual super gross tax base, a 7% solidarity tax and the 15% flat tax, so it was rather confusing and required several side calculations to determine how much tax would be ultimately payable.’
The Estonian way
In January 2021, Poland also launched major reforms in corporate tax, dubbed ‘Estonian CIT’ – a reference to the simplified corporate tax system in the Baltic state. Companies can pay tax when profits are paid. Like the flat tax of the 2000s, Estonian CIT is designed to streamline tax collection.
Analysts point out several caveats, however. Not all companies can take advantage of the new arrangement, and certain tax reliefs cannot be applied. Grabarczyk says that Estonian CIT cannot have the same effects in Poland as it has in Estonia because it has not been introduced in the same form as in Estonia. ‘In Estonia, this tax concerns the whole system and all economic entities,’ she points out.
Analysts are closely monitoring revenues generated through these reforms. And the pandemic may result in further changes. ‘I would say that the pandemic will cause a decrease in VAT revenues in Poland and an intensification of customs and tax inspections,’ says Grabarczyk.
Libor Frýzek, lead partner of EY’s tax advisory team in the Czech Republic, takes a similar view. He says: ‘Whether the future will also involve significant legislative changes to increase tax burden remains to be seen, as it will have to be balanced with efforts to boost the economy as well as with international tax developments.’