Tax reforms In Slovakia: A story of never-ending experiments?

Slovakia has earned the reputation of a reform-minded country that is willing to go quite far in order to achieve economic growth and institutional change. Although some say the age of radical reform is over, recent political developments in Slovakia indicate that radicalism, especially in tax policy, is anything but dead.

Foto: Creative Commons/ The University of Iowa Libraries

In 2005, the World Bank named Slovakia the world’s leading economic reformer. Its record is impressive even by the standards of Central and Eastern Europe (CEE). In 2000-2010, the Slovak economy grew by an average of 4.95%, beating other EU newcomers like Bulgaria, Romania and the Baltic states, despite starting from a higher base. Slovakia’s politicians, especially those on the centre-right, like to link the high economic growth to the tax reform of 2004, which saw the introduction of a 19% flat tax. While the extent to which the tax reform contributed to high growth is debatable, one thing is certain: Slovak politicians have never shunned radical policies, even if those policies had more to do with ideology than economics.

First attempts at reform

In 1998 a wind of change came to Slovakia. A broad coalition of centre-right and social democratic parties ousted Slovakia’s populist Prime Minister Vladimír Mečiar from power. Mečiar’s heavy-handed, nationalist government was widely seen as an obstacle to Slovakia’s aspirations to join the EU and NATO.

The new government was led by Mikuláš Dzurinda, originally a Christian Democrat who was heading an amalgamation of centre-right parties. After the elections, the coalition teamed up with the social-democratic Party of the Democratic Left (SDĽ). The government’s goal was to quickly catch up with other CEE countries in terms of Euro-Atlantic integration efforts and to improve Slovakia’s economy. Besides macroeconomic stabilisation and privatisation, tax reform was seen as one of the key ways to improve conditions for business and investment.

Slovakia’s tax system at that time consisted of a value-added tax, a single-rate corporate income tax, and a progressive personal income tax (a single-rate withholding tax applied to dividends, capital gains and interest). Excise duties and wealth taxes played a supporting role.

An important part of the tax system overhaul was the adoption of a comprehensive system of mandatory public health and social insurance contributions (payroll taxes). These applied exclusively to labour income and were financed jointly by employers and employees. The origin of Slovakia’s payroll taxes can be traced back to the first Czechoslovak Republic (established in 1918), which itself was heavily influenced by the systems in the Austro-Hungarian and German Empires.

The Dzurinda government did not consider the system itself problematic. Rather, tax rates were considered too high for a country that desperately needed foreign investment. The rate for corporate income was set at 40%;  rates for personal income tax ranged from 15% to 42%. Payroll taxes amounted to almost half of gross wages but were paid mostly by employers. In 2001, the government agreed to reduce the corporate tax to 25%. Personal income tax rates were also reduced to a range of 10-38%.

After the initial phase of painful macroeconomic stabilisation that included a bailout (and consequent privatisation) of state-owned commercial banks, amounting to 12% of GDP, the economy began to recover, posting growth rates of 3.5% and 4.6% in the years 2001-2002. This was seen as the proof that the government’s policy of stabilisation, privatisation and reducing direct taxes was working.

The road to a flat tax – paved by the self-destruction of the Left

The election of 2002 was a key event in the introduction of Slovakia’s flat tax.

Before the elections, right-wing parties began flirting with the idea of introducing a flat tax, which was already in place in high-growth economies like Estonia.

The social-democratic party in the ruling coalition, SDĽ, on the other hand, was losing voter support after its most popular and ambitious member (and a future prime minister) Robert Fico left to found his own party called Smer.

Given the populist and somewhat anti-European rhetoric of Smer, the right-wing parties were now able to present themselves as the only guarantors of Slovakia’s entry into the EU.

The result of these events was the virtual destruction of SDĽ and a general fragmentation of Slovakia’s left. In the 2002 election, SDĽ did not make it into parliament and Smer only got  13.46% of the popular vote.  In addition, there was a rift in the opposition Slovak National Party (SNS), which split into two parties, neither of which managed to get elected to parliament.

This enabled Dzurinda to serve a comfortable second term heading a government  which was formed exclusively of centre-right parties. The way was cleared for the flat tax. It is conceivable that the flat tax would never have been introduced without the crisis of SDĽ and SNS, and the consequent general shift to the economically liberal right in Slovak politics.

The shift to the right coincided with a similar shift in world politics, of which the most notable was perhaps the election of the neoconservative George W. Bush as president of the United States and who introduced radical tax cuts for the rich. Overall, there was a general dominance of the radical right in global economic policies in the first decade of the new millennium.

Here comes the 19%

The reform was introduced in 2004. The two leading figures behind it were Finance Minister Ivan Mikloš and his adviser, the liberal Richard Sulík, who had become the leading proponent of the concept. The tax reform was based on the assumption that Slovakia’s tax system was too complicated and too burdensome, and that all the different rates should be abolished and replaced by a single flat rate.

Corporate income tax was reduced to 19%. The progressive personal income tax was replaced by a system where only a 19% tax rate applied; however, a universal personal allowance (the non-taxable part of the tax base) kept the system mildly progressive. VAT rates were unified at 19%. Dividend taxes were abolished with the argument that they constituted an unjustified double taxation. Gift and inheritance taxes were also abolished. In general, this constituted a further shift from direct to indirect taxes as the main source of government income.

There was also a slight reduction of payroll taxes by about 2%, but the system of payroll taxes on the whole remained largely unreformed and complicated, with different types of social and health insurance having different bases and ceilings, and different dates to be paid. Tax administration costs were lower than before but remained relatively burdensome due to the inefficiency of Slovakia’s tax authority, its antiquated IT system and old fashioned paper tax returns.

The tax cuts were financed by a combination of raises in indirect taxes, elimination of tax loopholes, and cuts in public spending. This led to an overall reduction in the share of the economy redistributed by the government. Public spending fell from 46.1% of GDP to 36.5% of GDP in the period of 2002-2006. Public revenue declined less dramatically from 36.8% of GDP to 33.3% of GDP in the same period.

The tax code became considerably leaner and easier to understand. Slovakia succeeded in attracting foreign direct investment, especially in the automotive, electronics and energy sectors. High-income employees and receivers of capital income were the main beneficiaries of the tax reform, in terms of the effect on individual tax wedges. Middle-income groups were expected to lose purchasing power due to a rise in indirect taxes. This was, however, generally offset by an acceleration in nominal wage growth that was faster than tax-induced inflation, so that real wage growth remained positive in 2004.

A myth is born

While the effect of the flat tax on economic growth in Slovakia has never been academically examined, Slovakia did experience a significant boost in economic growth in the years following its introduction in 2004, which was the same year as Slovakia’s entry into the EU.

There is still disagreement as to whether the primary factor behind Slovakia’s small economic miracle was the entry in the EU, low labour costs, or the reforms of Dzurinda’s cabinet. Most probably, it was the combination of all three.

The reform certainly did well politically. Although heavily criticised by the opposition at the time of its introduction, it managed to survive for nine years almost untouched. The leftist-nationalist government of Prime Minister Robert Fico, which replaced Dzurinda’s government in 2006, left the reforms largely intact, despite having promised to reverse them. There were only a few minor changes made to the system.

The first was the introduction of the so-called “millionaire tax”, which is a misnomer as it merely constitutes a gradual reduction in the personal allowance of personal income tax (PIT) to taxpayers with a yearly income higher than circa €18,000. This is approximately twice the Slovak average annual gross wage. The tax increase applies to the top 5% of PIT taxpayers. Another feature was the introduction of negative income tax for low-income taxpayers. There was also a reintroduction of reduced VAT rates, one at 10% that applied to books and pharmaceuticals, the other at 6% that applied to a rather obscure group of homemade agricultural products.

So the flat tax remained largely untouched. Hence, some thought that the age of radical reforms was over. This view, however, may be superficial. Because of the perceived success of the flat tax, it came to be accepted (at least on the part of the centre-right parties), that in order for a reform to be useful, it has to be radical.

As a political force that has viewed itself as the agent of change and modernisation, the Slovak right has thus adopted an anti-status quo stance. It is expected that centre-right governments have the duty to perform radical reforms in a similar fashion as the second Dzurinda cabinet. The 19% flat tax has become a mythical symbol of successful economic reforms.

Radicalism is not dead

The election of 2010 brought the centre-right back to power. Yet the government of liberal Prime Minister Iveta Radičová was to be a short-lived one. It collapsed in October 2011 after SaS (Freedom and Solidarity), the party of Richard Sulík, refused to vote in favor of Slovakia increasing guarantees to the European Financial Stability Facility (EFSF). SaS is a relatively young and eurosceptic radical liberal political party that is partially influenced by American libertarianism and supports the idea of rolling back the public sector, even further than the second Dzurinda cabinet did.

Besides raising the main VAT rate to 20% as a means of fiscal consolidation, the government’s changes in tax policy were centered around payroll tax reform. Changes in income tax were minimal. For example, in personal income tax, the government introduced a differentiation between active income (employment and business income) and passive income (interest, dividends, capital gains), to which the personal allowance no longer applies.

The attempt at a comprehensive payroll tax reform was largely unsuccessful. The reform proposal was loosely based on the so-called “Payroll Tax Bonus” of Richard Sulík and was intended to introduce a “super-gross wage“ as a common base for computing income tax, health and social contributions. In the original concept of the „Payroll Tax Bonus“ the state would replace different types of social transfers by a single „basic state benefit“, for which all citizens would be eligible (the low-income ones as cash, the higher income earners as a tax credit).

This reform proposal failed to gain support of a majority in parliament. A group of coalition MPs refused to back the reform, calling it an irresponsible experiment. The reform concept was also heavily criticized by Robert Fico, the leader of the opposition.

The „Payroll Tax Bonus“ considered all types of income equal as a basis for computing income tax and payroll taxes. There was supposedly a problem in the system in not treating capital and labour income equally.

The perceived problem arose from the fact that while labour income was taxed by both income tax and payroll taxes (i.e. social and health insurance), capital income was only taxed by corporate income tax at the company level (the dividend tax had been abolished in 2004), which was as unfair and motivated taxpayers to evade payroll taxes.

To address the problem, the government passed a law applying health insurance to income from dividends, rent, annual bonuses, winnings from lotteries, etc. The measure resulted in higher administrative costs for various groups of taxpayers (especially those with rent and dividend income), since the administration of health insurance payments is considerably more complicated than that of a simple withholding tax. In response to widespread criticism from the public, the measure was partially revoked and rent income is no longer subject to health insurance.

Another type of criticism revolved around the fact that health insurance was capped and therefore unfair to small entrepreneurs who had to pay a larger proportion of their individual income than large entrepreneurs (or shareholders).

Sulík‘s ideas were certainly at odds with some well-accepted principles of taxation as we know them from the Western world. Most of the developed world’s tax systems differentiate between labour income and capital income. Labour is typically taxed via a combination of a progressive income tax and payroll taxes which may or may not be capped. Capital business income is usually taxed via corporate income tax at company level and a witholding tax that is due when dividends are paid to shareholders. Sulík declared this to be nonsense, and in essence he wanted to apply the principle of labour income taxation to capital income taxation. By the way, strangely, to Sulík, dividend tax constituted double taxation, but health insurance paid from dividend income did not.

Radicalism lives on – in opposition

The early election of March 2012 brought a resounding victory for Robert Fico, who had criticized the Radičová government for being unstable, incompetent and insensitive to lower income classes. He promised to abolish the flat tax and put an emphasis on raising direct taxes instead of VAT.

The parliament has now passed most of the necessary legislation, and so starting January 2013 Slovakia’s flat tax will be history. The corporate income tax rate will be increased to 23%. A higher 25% personal tax rate will be introduced for yearly incomes surpassing roughly €39,000. Given the current income profile of the working population, the higher rate will apply to the top 1% of  taxpayers. Health insurance applied to dividend income will remain in place, but its administration will change, so that it be withheld like a classic withholding tax. Payroll tax ceilings have been raised and unified for all types of social and health insurance.

People working on part-time complementary labour contracts will also see their tax burden rise – social and health insurance will now also apply to them. The most significant measure to address Slovakia’s budget deficit, however, is not a tax increase, but a reduction in  contributions to Slovakia’s mandatory private pension pillar from 9% to 4% of gross wage. While these measures may seem moderate to outsiders, they are an ideological red flag to the Slovak centre-right, which sees this as an attempt to destroy one of its reform symbols.

Meanwhile, there is currently a process of ongoing fragmentation in Slovakia’s opposition. Due to a lack of clear leadership (the former centre-right leader SDKÚ has barely managed to get into into parliament after a scandal that involved the publication of an anonymous wiretapping transcript), there is a push for new parties and factions being formed by ambitious politicians. The new parties compete for attention and public support by proposing radical reforms in various fields of public policy, including taxation.

In September 2012, former Christian Democrat Daniel Lipšic formed a new party called New Majority that at first said it intended to abolish taxes and accounting procedures for most self-employed businesspersons! The party later specified it merely intended to introduce wide business licenses (with lump-sum taxation) for the self-employed. A former colleague of Mr. Lipšic, Christian Democrat Radoslav Procházka, has just recently formed a platform in the Christian Democratic Movement party called Alfa. In the platform’s manifesto, Mr. Procházka proposed to abolish Slovakia’s payroll tax system altogether – and pay for healthcare and social services out of general taxation. What types of taxes and at what rates, he didn’t specify. SaS keeps hoping that the “Payroll Tax Bonus” will one day be implemented despite the recent setbacks.

Many of these radical proposals come from politicians who consider themselves political conservatives and, at least in theory, should act as guardians of traditions rather than propose revolutionary ideas.

This can perhaps partially be explained by the fact that Slovakia’s centre-right has traditionally viewed itself as the agent of change and modernisation, while leftist parties have been outspoken opponents of market reforms and tried to protect the interests of the „losers“ of Slovakia’s transition.

In the last few years, Slovakia has experienced frequent policy shifts caused by a combination of a strong desire to change the status quo and a lack of a broad consensus on such fundamentals as progressive taxation of personal income, double taxation of capital income, and the aims and the desired shape of the payroll tax system. The question is: Will this trend continue or will there be a consensus-based shift to the centre?

Tomáš Meravý

Tomáš Meravý

served as junior adviser to former finance minister Ivan Mikloš in 2011-2012 and Head of the Economics, Finance and Business section of SDKÚ-DS, a Slovak centre-right opposition party (2012).