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Estonian Model Challenges – Impact of Small and Medium Business Sectors

The year of 2017 started with significant changes for business sector. Namely, Estonian Model of profits tax reformation came into force. The model introduction process generated various estimations from the side of businessmen, politicians, economists. Everybody agrees that the Estonian Model will genuinely bring positive effect onto business, especially, on small and medium business sectors.

However, it is interesting to analyze gaps in this model and what obstacles may arise after its enforcement, how prepared Georgian business sector has met the new regulations.

In autumn 2015, under grant of USAID project of Governing for Growth (G4G),  Association of Young Economists carried out assessment of impact of introduction of Estonian Model regulations in Georgia (RIA). Under the document, the authors have appraised potential economic effects after enforcement of Estonian Model. The analysis shows one-time effect that will arise in 1.5 year after the model introduction. Under the assessment, the reform will bring positive effect on investments. Stock capital will increase by 3.23%. This signifies economic agents will implement more investments, real GDP will increase by about 1.44%, total private consumption will increase by about 0.85%. Besides positive influence on macroeconomic indicators, the model is also expected to bring about 3% budget deficit expansion,   as well as legislative and other risks.

Estonia carried out profits tax reformation in 2000. The report proves that the reform has considerably improved macroeconomic parameters of the country and condition of companies. It is worth noting that reform impact scales vary in case of Georgia and Estonia.

Reforms impact was higher in Estonia. This difference may be explained by tax burden that existed in Estonia before 2000 and its alleviation has given huge opportunities to Estonian companies for profits reinvestments. Moreover, higher effects of reform were mainly preconditioned by considerable contraction in bureaucratic expenditures, while in Georgia taxation system is more liberal today compared to Estonia in  2000. This signifies that we have better starting positions for reformation process. Consequently, we will receive less effect compared to Estonia.

According to the model developed in the regulation impact assessment report, scales of compensation actions were calculated and this signifies that  the mentioned deficit may be replenished by raising the incomes tax by 1% or growing the consumption tax by 1.25% (taxes  on purchase of goods and services that is paid by a consumer. For example, such VAT, excise).

According to their recommendations, in the process of moving to a new balance position the Government should not increase administrative costs during several years.

Economist Irakli Kipiani told Eugeorgia.info that Estonian Model enforcement will definitely make positive impact on small and medium business sectors, because similar companies used to make reinvestments and put finances in the company development, before enforcement of this model.

“These companies will not change their conduct and they will put this sum in reinvestments. They will save 15% in addition. Therefore, I believe this model will bring positive effect for small and medium business companies. As to reforms, they were implemented very badly, I think”, Irakli Kipiani noted.

Kipiani refers to the regulation impact assessment document prepared by Association of Young Economists, under which the Government was to implement a number of reforms jointly with Estonian Model  so as to reap positive results of the model. Under the research, reforms have mighty effect on investments growth, while other aspects, such as institutional instability expressed in dissolution of stability of formal institutions because of various political changes, may shadow positive effect of reforms. As a warning, the document mentions that if the Government adds amendments to Tax Code, budget expenditures should not increase for several years.

“Under one of the recommendations, Government was to maximally cut bureaucratic costs, much more than expected after Estonian Model enactment. However, Government has raised excise tax, did not reduce bureaucracy expenditures considerably and therefore, Estonian Model is not giving expected results today. Under the research, private sector was to accumulate about 500-600 million GEL thanks to these reforms. Today in the 2017 budget approved by third hearing, the business sector can save only 300 million GEL. This signifies Estonian Model suffers from double “inflation” because of other incorrect reforms”, Irakli Kipiani said.  Estonian Model genuinely brings positive effects, especially for small and medium business sectors. However, financial managers of many companies have analyzed  the model details and some of them made the model expediency questionable, Shota Komladze, manager of taxation-customs direction of Georgian Business Association, said.

“Under the new model, loans and relations with offshore companies are taxed jointly. Companies’ loans and relations with offshore compnies become more expensive in advance and business sector does not like this, but this taxation eradicates money laundering risks”, Shota Komladze noted.

Another important issue is how prepared small and medium business sectors have met the model and whether Government had tight communication with business sector representatives prior to implementation of legislative amendments. Government genuinely have problems with communication with business sector, Irakli Kipiani noted:

“Before excise tax introduction, Government had not negotiated the issue with any vehicle importer company. Government just told them that starting January 1 they would not continue their business activities in previous regime. I suppose Government does not know how to communicate with the business. Any reform should meet business sector interests”, Irakli Kipiani noted.

Vakhtang Shengelia, a representative of BLH (Business &Legal Hub) consulting company talks about challenges related to the new model introduction. He explains problems related to model implementation:

“Small-budget companies have to take higher costs for hiring professional accountants. Therefore, I think small companies will face certain difficulties. However, in midterm and longterm perspectives I think the new model will make positive effect on small and medium business companies”, Vakhtang Shengelia said. The model has not received a valuable form yet and the Government continues working in this direction, Shota Komladze said.

“Naturally, we expect changes. We have introduced several ones. The one thing is that those, who paid profits tax in ordinary regime in 2016, if they share profits, including profits of 2016, to 2017, 2018 and the following years , they will have to pay tax on taxed profits  in the part of dividends. Government agrees on this issue and shows readiness to make amendments to the legislation, but no ideal model has been represented yet. This is not a simple job to improve this gap”, Shota Komladze said.

Georgian Business Association has already submitted a package of amendments to Government to prevent taxation in the process of purchase of securities in turnover of foreign exchanges, because in this case companies have to pay 15% higher taxes for trade on exchanges. Government has taxed purchase of securities in free turnover by 15% and in this way restricted companies to sell and buy shares in their own companies, as well as money laundering in this way. Shota Komladze asserts that these amendments should not concern purchase of securities in free turnover, because trade process on exchanges proceeds in transparent regime and money laundering risks have also disappeared.

When estimating influence of Estonian Model on foreign investments inflow, Shota Komladze noted that losing profits of 100% deduction of amortized fixed assets will bring restrictions to the investors who plan to become profitable companies in short-term period. However, for investors oriented on long-term objectives, this model will genuinely bring stimulating effect. As to difficulties related to the law enactment, adaptation period will run definitely. It is also difficult to say whether new model will be simpler for small and medium business sectors in terms of administrative aspects.

“We even applied to Ministry of Finance not to use strict measures in relation to business bodies in the first months, because many companies cannot even fully realize the law formulations. They should pass a transient period for several months and easier get adapted to new realities. I do not think administrative aspects will go better, because they used to fill out declarations every year and now they have to do the same every month. It should be also noted that small companies have simpler operations”, Shota Komladze said.

Finally, Estonian Model introduction is a step forward for economic stimulation. Everybody agrees that the model is especially attractive for small and medium business sectors. However, it should be also noted that effect of Estonian Model greatly depends on various factors in Georgia. According to economists and businessmen, the model will bring important positive effects in midterm and long-term periods, while before, Government should not considerably expand administrative expenditures and it should curb budget deficit in this way.

Any legislative amendments should meet business sector’s interests. Another important aspect is the existing gaps in Estonian model and readiness of business sector. Small and medium business bodies may easier fill out declarations, but moving to essentially new model will make them take additional costs and a certain adaptation period is required so as financial managers grasp the new system details.

Ketevan Melkadze – ISET MA in economics

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