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Historical, Philosophical and Practical origins of the Estonian Tax System, part I


William H. Cronenberg
Attorney at Law

To understand the origins of the Estonian tax system, one has to understand the nature of the transition Estonia has undergone since the collapse of the USSR in August 1991. My first personal experience with Estonia dates back to June of 1988 on a university study tour. The Soviet Union was in terminal decline then, but few people realized it. Like most observers at the time, I regarded the USSR as a firm geopolitical reality not likely to change in my lifetime, or at least not without a conflict of apocalyptic proportions. I was as surprised as anyone when the Soviet Union collapsed almost bloodlessly only a few years later. 15 diverse, totally unprepared, newly independent republics embarked on a very difficult period of adjustment. The legacies of Communism remain very much in evidence across the region today. But despite the challenges and difficulties, this transition also represented a rare historical moment of opportunity, and no former Soviet republic was better positioned to seize this opportunity than Estonia.

The Baltic States were always the most Western oriented of the Soviet Republics, and there were good historical reasons for this. Estonia in particular retained its Western character throughout the Soviet period most of all due its close proximity to Finland. This special relationship is much more than geographical. The Finns are close ethnic cousins of the Estonians, and their unusual languages are comparable to rough dialects of each other. Most Estonians in the Northern part of the country watched Finnish television during Soviet times and could understand it. Since TV programming in Finland was comparable to the rest of Western Europe, with plenty of international content, this provided a window on the outside world that few other inhabitants of the USSR enjoyed. Also important, due to the unusual special relationship between Finland and the Soviet Union, Finns crossed the Gulf of Finland to visit Tallinn relatively freely throughout most of the Cold War period. This routine direct contact with their cousins across the water influenced the Estonians profoundly as well.

I note that the day I started writing this installment, 27th of March 2013, marked the date that the Second Estonian Republic (starting August 20th, 1991) exceeded the age of the First Estonian Republic, 1918-1940. It has been declared a new holiday on the Estonian calendar, Enduring Liberty Day. When the Second Republic began, Estonia had not had a functioning market economy in over 50 years. Among many urgent challenges the new political leadership faced was creating an entirely new economic system. A new currency, banking system, commercial laws, and of course a system of taxation would all have to be integral parts of this momentous reorganization. 

There was broad consensus that Estonia needed to create a modern free market system, but the best path for achieving that was hardly clear. There were few historical parallels to the situation Estonia encountered when it suddenly and unexpectedly recovered its independence. While the Western economies provided very useful models and examples, it was simply not possible to "cut and paste" foreign laws and institutional models into Estonia and expect them to work. For one, while there was no lack of eagerness to learn, there was a near total lack of persons with the right education and expertise to manage such a system. Also, the relatively small size of Estonia needed to be taken into account. The new order needed to be simple, easy to administer, and functional. There was plenty of advice from abroad about what to do and how to do it. Some of this was helpful, some not, and much of it contradictory. In the end the Estonian leadership disregarded foreign advice more often than not, relying more on an intuitive understanding of their situation.

The creation of the present Estonian tax system also needs to be considered against the backdrop of the 50 years preceding the restoration of independence, when stealing from the State was informally regarded as a national sport. People routinely "appropriated" whatever they could get from their workplaces and bartered that in the informal economy to get things they needed which were otherwise unavailable. The arrangement was neatly summed up in a common expression from those times, "The State pretends to pay us, and we pretend to work." Thus, the Estonian leadership faced a challenge much more profound than reforming rules or institutions, though that was very much needed as well. They needed to do no less than reform the mindset of the citizenry, while simultaneously carrying out policy and administrative reforms, and enabling the State to fund itself to survive the process. No small undertaking, and certainly nothing one could hope to accomplish overnight.

Those who follow my blog have already read my comparison of the Estonian Company form to the Kalashnikov rifle. You could make a very similar comparison regarding the tax system. Estonia had no hope of successfully implementing a complex, graduated income tax system in those early and chaotic years after the Soviet Union fell. In addition to the lack of requisite skills and a suitable culture of compliance, the leadership had to reckon with the small size of the country. The size of Estonia dictates that enforcement resources are very limited. The implementation, management and enforcement of an income tax code comparable to those in most Western countries would have been not only impractical, but almost certainly also counter-productive in terms of raising needed revenues.

The Estonian solution was to implement a very simple single rate income tax system, and rely more heavily on VAT (value added tax) as a source of tax revenue. Some readers may be unfamiliar with VAT. Even a basic explanation of it would go far beyond my purposes here, but it is a consumption tax comparable to a point of sales tax in other contexts. VAT has the virtues of being relatively simple to administer, much harder to avoid, and relatively far less obnoxious and costly to comply with for both businesses and individual taxpayers than most alternatives.

The results achieved with this "Estonian approach" in the 1990´s were remarkable, some would even say astounding. While the revenue collected from income tax was modest as a share of GDP compared to most Western countries, the contribution to the public coffers remained significant. The business friendly environment that was fostered led to economic growth that exceeded all reasonable expectations. Largely as a result of this growth, and competent work on the part of the State authorities, VAT collections (which constituted the lion´s share of State revenues) shattered expectations. I cannot quote any precise statistics, but if Estonia was not the leading country of the former Communist bloc in terms of income growth and human development in the 1990´s, then it was certainly near the top. The success of its tax reform was hardly the only factor in this stellar performance, but it certainly played a key role.

The start of the 21st century saw Estonia moving rapidly towards both European Union and NATO membership, the two key objectives of Estonian foreign policy by end of the 20th century. In my next post I will examine the role tax policy played in the next major round of reforms that were required for achieving these important goals.