The hall fell silent when the numbers appeared on the vote tallying board: 51 in favour, 12 against, four abstentions. The first smattering of applause was then heard. Finally the MPs rose to their feet and delivered a standing ovation. In the past, Estonia’s Parliament had been known to greet historic decisions with clapping, but 8 December 1993, when new Income Tax Act was passed, was the first time that a piece of legislation had drawn an ovation.
On that day, Parliament in fact laid the capstone on the entire process of tax reform, which signified the start of a brand-new period for Estonian tax policy. The low flat rate established on individuals and companies alike was unusual anywhere in the world. Many acclaimed economists predicted that the Estonian financial system would quickly collapse, yet it weathered the storms and remained in place, just as other tax laws are still in force.
Estonia’s first post-occupation constitutional government, which took office in October 1992, included social democrats in addition to conservative parties. Yet the flat tax was introduced into the coalition government’s programme without a snag. Taxes were not all that important a topic for the people at that point. People’s minds were gripped by much more harrowing choices: East or West, democracy or dictatorship, red or white.
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Everyday life was a true test of survival, a battle to stay warm and fed. Aside from wartime, the winter of 1992 was one of the most challenging periods modern Estonian history has known. Fuel deliveries were cut off to Estonia after the country turned its economy away from Russia’s. People in entire city districts faced the threat of freezing to death. Public transport was not operating, only a few cars could be seen on the streets, and in January 1992 staple goods – bread and milk – disappeared from store shelves. Even in the larger supermarkets in the capital, shelves were bare for days on end.
Who was interested in tax brackets at a time like this? What difference was there between a progressive or proportional tax rate when the average wage was under USD 50 a month!
Before becoming prime minister in 1992, historian Mart Laar had read only one economics treatise, Milton and Rose Friedman’s Free to Choose. First published in Estonian in that same year, 1992, the volume has shaped the views of two Estonian parties that have figured in many coalitions - Pro Patria and Reform Party (the same two parties are in the coalition now as well).
What captivated Estonian politicians was the fact that Friedman saw the opposite of equality as liberty, which was the supreme goal for a people that had just shaken off Russian power. Freedom outweighed all other values in the eyes of Estonian voters.
Ministry of Finance officials and international experts expressed the greatest opposition to the government’s plan to establish a flat income tax. The director of the Tax Board was the most concerned; he found that although politicians could come up with all sorts of reforms, the state was too weak to even find the taxpayers, let alone collect taxes according to the laws.
At that time, Tallinn had hundreds of small companies that did a brisk business but were off the radar for the Tax Board. Fraudsters registered companies at non-existent addresses, as the city government could not manage to check the data. Turnover and profit were often as phantom-like as the firms themselves. Business was transacted in cash and wages were paid in envelopes so that often not a cent from these phantom firms flowed into the state treasury.
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To provide incentive for the Tax Board, the government established a rule that 5% of all additional money collected by the state went straight into the Tax Board budget. This made the Tax Board work harder, but also increased the temptation for abuse of power. Thus, the extreme measure was abandoned after a short time.
Foreign experts were against the low flat tax, fearing a major budget deficit. No other country had a flat tax. Estonia itself had a progressive tax for both companies and individuals, with the highest rate being 50% of income.
The new universal rate agreed upon was 26%, which was as low as balanced budget principles allowed. The same rate was imposed on companies. The goal was to end tax avoidance and evasion and make the job of the Tax Board easier. Thus, in spite of the sudden drop in the income tax rate, in fact more money started flowing into state coffers.
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The taxation acts passed 20 years ago have withstood the test of time. The personal income tax in Estonia continues to be a flat tax; only now the tax rate is lower – 21%. Corporate income tax has been completely abolished. As the taxation system is simple, it is also easy and convenient to file tax returns. Nearly all Estonian individuals and companies interact with the Tax Board exclusively by computer and online. Once a year, people file personal income tax returns and it generally does not take more than 15 minutes to complete the process.