Lower income tax rates in Croatia make sense

Even as fiscal deficits balloon, lowering tax rates makes sense

Image by Steve Buissinne from Pixabay

With the New Year, for the first time in five years, marginal rates for income tax will fall. This is a welcome move after 2020 which was a challenge to us all, to put it mildly. Yet, for all of the progress over the past decade in the taxation domain, Croatia remains a high tax jurisdiction. This is especially the case when taxing labour. In the context of the recently released Draft National Development Programme to 2030, that is an important factor to consider.

AmCham has good ideas on tax reform

AmCham Croatia’s recently released Recommendations for Tax Reform in 2020 are thus even more topical. Apart from a comparison of regional regimes, their recommendation to extend the deadlines for profit tax submission makes particular sense. Namely, now, companies have to file their tax returns before deadlines for closing their books, preparing annual reports and having them audited. This necessarily means companies resubmit data to the authorities who have to process them. Evidently, this involves plenty of time and hassle. Moving the tax submission deadline to a time following when companies finalise their books and hence know exactly what their tax obligations are, would clearly reduce time lost to administrative procedures for both the authorities and companies.

Any concerns about the shift in when tax payments are made into the budget should be minimal. In 2015/16 when companies with revenues below HRK3mn were made liable to pay VAT only when they collected invoices rather than upon issuing them, the revenue shift was much larger. With profit tax revenues orders of magnitude lower than VAT revenues, and treasury bill borrowing costs close to zero currently, the government has ample room to accommodate this one-off shift in revenues.

Even as income tax rates are set to fall in 2021…

What really caught my eye in AmCham’s recommendations was a table comparing tax regimes with Croatia’s peers and neighbours. Because of how the media approached the issue of lowering income tax rates, part of the recently passed 2021 budget. Understandably, they focussed on the increase in net pay. More corrosively however they made the ritual observation that the highest paid workers gain by far the most benefit. Since the highest paid also pay the lion’s share of income tax, this should not come as a surprise. Rather than ideology, this is mathematical reality.

More importantly, this ritual reflects a blind spot in the local psyche. An almost involuntary tendency to ignore the fact there are 26 other EU member states and others in our neighbourhood outside the EU all with income tax regimes whose characteristics materially impact the cost of labour for business and thus those countries’ attractiveness as investment destinations.

…taxes will still eat up almost half of gross earnings

Over the past two decades income tax rates have come down. Whereas the top marginal rate was 45% between 2003 and 2010, before coming down to 40% and remaining there until 2016 when it was reduced to the current level of 36%. Next month’s reduction of marginal rates to 30% and 20% respectively are welcome and necessary. Yet, on a regional comparison, this remains a high tax jurisdiction in the domain of income tax. This is important considering multinationals decide where to locate regional headquarters and other activities with tax issues firmly in mind.

By our estimate, at the lower income tax rates from 2021, for a net salary of EUR 2,000 which is well above average monthly earnings, but nothing special if we are talking about attracting top quality talent, employers will save approximately EUR 2,200 in gross salary cost a year for a new hire when all social contributions, taxes and surcharges are included for a single person working in Zagreb. Under the current regime, a EUR 10,000 gross salary results in less than half that paid out net. This, of course includes all social contributions and surcharges. We estimate, next year that same cost will result in a net salary of approximately 53% of the total cost. That is much better, but workers see a significant part of their gross salary end up in the Treasury.

Change of mentality would support tax revenue growth

In the context of emigration post-EU accession and general adverse demographic trends, it makes sense to have a competitive tax regime to attract global talent. More productive, higher paid workers pass on more knowledge, are better linked to the latest global technological and other trends, and spend more money, boosting the local economy. This would increase the likelihood of regional investment by the private sector locating in Croatia.

This will require repeated efforts to mitigate, if not change, the blind sport mentality evident in the part of the debate. Namely, high earners may pay less income tax, but they still pay more than in most of the Croatia’s peers and neighbours. Greater awareness of that and how it impacts investment decisions is necessary to remove this blind spot.

Other political challenges remain. Since 2018 sub-national governments receive all income tax revenues. Clearly, as the national government changes tax rates, this directly impacts their revenue streams, which is a political complication. Having said that, a small number multiplied by a large number remains a large number. What I mean is, if employment can rise, supported by lower income tax rates, overall revenues can also rise. This is especially the case if local government areas can improve the quality of their services to businesses.

Low borrowing costs mitigate concerns about finding room for lower tax rates

Fiscal deficits and public debt levels are up markedly after a wretched 2020. Some people may wonder whether it makes sense to lower tax rates and consider doing more in coming years. With borrowing costs very low and set to fall further on account of euro adoption by as soon as 2023 in the best case, I believe the balance of risks falls on the side of further lowering income tax rates.

Existing employees will see net salaries increase. Employers in Croatia will be able to compete more effectively for the labour they need. And the attractiveness of Croatia as a business destination will improve. Over time, any increase in employment will dominate the lower tax rates to generate greater total income for the budget. Most importantly however, awareness in the general public of the need to keep one eye on the conditions under which our peers and neighbours operate will broaden horizons and inform more nuanced policy debates in the future. All of which forms a basis for more sustainable growth in the future.

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