In the spring of 2011, Finland held a general election, and tax reform was one of the major issues. The election was won by the Conservative Party with the Social Democrats a close second. Since then, putting aside a slight reduction of the corporate tax rate, most changes have been in the direction of higher taxes: capital gains tax was raised and made progressive for the first time; estate taxes had a similar treatment while all VAT rates were increased by one percentage point. Still, public debt and deficit are ballooning and the high cost of labor is penalizing companies. From either a tax or fiscal perspective, the outlook is rather grim at the moment.
General election in 2011
Throughout most of 2010, and all the way in the run-up to the 2011 election, there was much speculation about a forthcoming major reform of the Finnish tax system. The last time taxation in Finland went through a large-scale overhaul was in 2005, when the country abolished its dividend imputation scheme in favor of a partially tax exempt, partially double tax system on capital gains and corporate profits.
This time around, a working group headed by Matti Hetemäki was again proposing significant reform of tax on dividends, most of which would have led to a sharp increase in the effective tax rate. According to one proposal, the effective tax on dividends from publicly traded companies would be increased by more than half, from an effective rate of 19.6% to 30%, and this was only one of many proposed increases. The new models for calculating the taxable dividend income from non-listed companies were also extremely and unnecessarily complicated.
In the spring of 2011, Finland held a general election, and tax reform was one of the major issues. The election was won by the Conservative Party with the Social Democrats a close second. As a result, Jyrki Katainen of the Conservative Party became Prime Minister, but only after having made rather astounding concessions to the Social Democrats, who became the second major governing party. The party leader Jutta Urpilainen became Minister of Finance, and Lauri Ihalainen, a former trade union boss, became Minister of Labor.
The so-called “tax-exempt” dividend
One of the key issues behind the drive for tax reform was the fact that non-listed companies can distribute up to €90,000 in tax-exempt dividends to each individual owner. This possibility had long been derided by politicians and media alike, who were horrified that such large sums could be distributed free of tax. In their minds, it was extremely unfair that entrepreneurs, who were basically just employees of their own companies, could “transform” progressively taxed employment income to tax-free capital gains. And indeed, in Hetemäki’s report, this “distortion” was cited as a major reason for the need for reform.
However, one of the many flaws in this line of thinking is that the dividend is by no means tax exempt, because it is paid out of taxed corporate profits. Corporations don’t pay taxes, but their shareholders do, something that becomes extraordinarily evident in companies with only one owner and no employees. In order to be able to pay out a dividend of €90,000, a company had to have a net worth of one million euros per owner (according to the tax code, an amount equal to 9% of the company’s net worth could be distributed as tax-exempt capital gains dividends, capped to €90,000). To arrive at €1,000,000 in retained earnings, the shareholder would have had to pay €351,351.35 in taxes at the corporate level. Then, in order to keep the net worth €1,000,000 to be able to pay out €90,000 euro, the company profit must be at least €121,621.62, on which the company paid €31,621.62 in taxes from 2005 to 2011.
So the tax-exempt dividend was far from tax exempt. Another thing is, of course, that only a handful of the tens of thousands of entrepreneurs in Finland ever came close to be able to distribute €90,000 in dividends, tax exempt or otherwise. The average annual income of entrepreneurs is and has long been well below €40,000. Many don’t even distribute dividends because the money simply isn’t there. Instead, they pay themselves wages, which are taxed as such. This fact rarely featured in the debate.
Tax policy and reform
With the new government sworn in, the main points of the government’s taxation policy were published. The only change with the effect of lowering the tax burden was the proposed reduction in the corporate tax rate from 26% to 25%, which was subsequently lowered to 24.5%, and came into force on 1 January 2012. This had been part of Hetemäki’s proposals. The rest of the changes, though, were in the other direction. Capital gains tax was raised from the previous 28% to 30%, and for capital gains exceeding €50,000, to 32%. This was an historic change. Never before had capital gains tax been progressive; it had always been proportional. This was a major achievement for the Social Democrats, who had long been calling for higher taxes on capital gains, as such income was seen to be a privilege of the rich.
The tax-exempt capital gain dividend was left in place, as was the 9 per cent formula, but the maximum tax-free amount was lowered from €90,000 to €60,000. While this won’t affect many entrepreneurs today, it is a clear sign where things are headed, and there is already talk about a new, larger reform in a few years, which may well abolish the tax-exempt dividend altogether, moving Finland into a complete double tax regime.
In addition, VAT rates were increased by one percentage point across the board, to 9%, 13% and 23% respectively. A new VAT on newspaper and magazine subscriptions was introduced, now up from nothing to 9%. The government has proposed to increase the VAT-rate with another percentage point, but this increase has yet to come into force.
Estate tax was also increased somewhat after having been significantly reduced a few years earlier. A fourth bracket was introduced to the previous three with a tax rate of 16% for Class I heirs. The other tax rates at this level are 7%, 10% and 13%. For Class II heirs, the last three brackets were doubled to 20%, 26% and 32% respectively. What class an heir belongs to is determined by his or her relationship to the deceased. In general, direct lines of descent or ascent puts the heir in Class I, while other relatives belong to Class II. The spouse and children of the spouse also belong to Class I.
The progressive personal income tax rate has long been high in Finland compared to other countries, but the rates have remained steady or come down a little in recent years. The top rate in 2011 was 49.2%. There are a number of deductions available from both taxable income and the tax itself, but they are, for the most part, quite limited. The one deduction that for many people has meant a significant decrease in their income tax liability is the mortgage deduction, particularly when interest rates were still low (5-6%). The interest paid on the mortgage is deductible from the person’s capital gains income. However, many people have little or no capital gains income, which means they report a loss or deficit for that revenue source. The tax code allows a person to deduct an amount equal to 28% of that deficit from their personal income tax liability, capped at €1,440. In practice, this means that any person with a deficit of €5,000 in the capital gains revenue class could get a full deduction from personal income taxes.
The effective tax rate on earned income of €76,000 is 29.7%, whereas an income of €230,000 results in an effective tax rate of 40.9%. To this, social security is added, resulting in a total rate of 36.9% and 48.1% respectively. The government has proposed to introduce a special “solidarity tax”, and extra tax on people earning more than €100,000 per year, but how this solidarity tax will be implemented is yet unclear.
Ballooning debts and deficits
The financial crisis, which started in 2008, has hit government finances hard, which can be easily seen in the sharp increase in Finland’s national debt. In early 2009, the national debt was €53 billion, an amount roughly equal to the national budget. However, in less than three years, the national debt has surged to well over €80 billion. Even the Ministry of Finance expects the debt to exceed €100 billion as early as 2014. The new government managed to decrease the budget deficit to €7 billion and change, but it is very likely that the actual deficit will be greater than that. With a GDP of about €180 billion, the debt may not be as bad as that of many other European countries, but the trend is alarming, not least when considering that there are no apparent growth promoters in business in Finland at the moment. After the last severe economic crisis in the 1990s, Finland had Nokia to pull the economy up again. Today, Nokia is in decline, as it has been for many years, with no one to take its place.
From either a tax or fiscal perspective, the outlook is rather grim at the moment. During the past few years, the Finnish labor market has experienced several major and minor strikes, a clear signal that the workers are still not ready to accept that wage increases must be connected to increases in productivity and profitability. Even though the corporate tax rate is comparatively low, labor costs are still a big deterrent to investing in Finland, which can be seen in companies like Nokia axing thousands of jobs in an attempt to increase profitability. With a strong Social Democratic representation in the government and a former trade union boss as the Minister of Labor, liberalization of the labor market won’t be forthcoming any time soon.
Even more alarming is the clear and negative change in the attitude of the Tax Administration. It has become distinctly more aggressive the past two years, ever more prone to impose tax increases and penalties, and seeking to tax income that either isn’t Finnish source income, or is tax exempt. In particular, the Tax Administration has allocated large resources to a new Transfer Pricing Department, the chief objective of which is to allocate as much of the income of multinational groups to Finland as possible. In addition, the Tax Administration is very reluctant to grant refunds for wrongfully levied tax, no matter how thoroughly the claimant argues his or her case. Many times, the Tax Administration seeks to distort and delay the proceedings instead of objectively reviewing the legal question at hand, violating the principles of the rule of law.
The tax reform of 2011 is expected to show real effects by 2013 or 2014. One of the most discussed issues is the introduction of thin capitalization rules. Thus far, Finland doesn’t have any limitations on the debt-to-equity ratio in companies, making the country fit for heavy debt pushdown. This may change in the future, though no formal government proposals have been introduced yet. Another central topic is limits on the mortgage deduction for individuals. Overall, the government has been moving to shift the focus of taxation to consumption, as suggested by the increase in VAT, but also raising and/or introducing new excise taxes as well as energy and environmentally-related taxes.
This article was first published as part of the Institute for Research in Economic and Fiscal Issues (IREF) report Taxation in Europe 2012.