In reforming the Cyprus tax system basic conditions of adequacy, fairness, and its effective and uncomplicated administration should be met
While the Cyprus government is repeatedly advertising the good performance of the economy by referring to the relatively rapid GDP growth, the falling unemployment rate, and the recording of sizable fiscal surpluses, the majority of households are facing cost of living and debt servicing problems.
Income and wealth inequalities are increasing and decent employment opportunities and affordable housing for the younger generation are diminishing. Most notably, the seasonally adjusted youth unemployment rate reached a staggering 19.9 per cent by December 2023.
These problems are caused partly by a regressive and unfair tax system that deliberately and grossly favours wealthy property owners and high-income earners. Furthermore, weak tax administration has facilitated and even induced massive tax evasion and avoidance that has further widened inequalities and cheated the government out of substantial amounts of much-needed revenue.
Finance Minister Makis Keravnos has said that tax reform can wait until a two-year study undertaken by the University of Cyprus is completed. But, as Cyprus persons and businesses are being overtaxed by the impact of inflation on incomes the urgent need for tax reform exists.
Tax reform proposals
In reforming the Cyprus tax system four basic conditions, namely, adequacy, fairness, and its effective and uncomplicated administration should be met. However, this note concentrates mainly on proposals to reform the key fairness and adequacy conditions that should enable the tax system to serve society better.
Adequacy
The government should be provided with sufficient revenue to meet the basic needs of society, with an adequate amount of taxes being necessary to meet the community’s demand for public goods and services including income support.
For Cyprus government revenues are not sufficient to finance the public investments and social protection expenditures required to meet the standards of many advanced European countries, as the ratio of taxes and social contributions to GDP was just 36.5 per cent in 2022, that is, well below the average of euro area countries of 41.9 per cent.
For boosting tax revenue three basic courses of action are recommended.
Firstly, the progressivity of the tax system should be raised so that high income earners and wealthy property owners pay a greater and fairer share of taxes. Indeed, revenue from taxes on income and wealth amounted to a mere 10.5 per cent of GDP in 2022 compared with 13.6 per cent for the euro area.
Secondly, the tax base should be broadened, especially through reintroducing a central government tax on immovable property.
And, thirdly, tax revenue should be boosted substantially through the effective combatting of tax evasion.
Fairness
The Cyprus tax system has become increasingly regressive with considerable reliance on flat rate taxes such as VAT and excises to raise government revenue. The tax system should be made more progressive so that high income persons and wealthy property owners pay a larger share of their incomes and wealth than those less able to pay.
Personal income tax
It is unbelievable that the last change in the personal income tax-free threshold was in 2008, when it was increased from a taxable annual income of €10,750 to €19,500, while the top marginal rate was last changed in 2011, being then increased from 30 to 35 per cent.
The personal income tax system has become substantially less progressive as there has been no account taken over the last 15 years for the impact of inflation on nominal incomes. In consequence, with no changes in tax thresholds, lower and middle-income persons have been driven into higher tax brackets. Notably, by 2023 the consumer price index and the estimated median of the gross annual earnings of employees had increased by around 20 per cent compared with their levels in 2008. That is, the process of dragging taxpayers into higher tax brackets to raise government revenue termed “fiscal drag” has led to considerable losses in personal disposable incomes and, indeed, real take-home pay for lower and middle-income households over these 15 years.
In order to prevent fiscal drag many countries adjust periodically income tax brackets for inflation, with even 11 European countries carrying out such automatic indexation every year.
Accordingly, to build progressiveness into the personal income tax system and to take account of inflation it is proposed that the tax brackets should be changed so that persons earning less than €65,000 annually are taxed at lower rates, while those persons earning incomes above €65,000 yearly are taxed at higher rates.
Thus, it is recommended that the tax-free threshold be adjusted upwards from the current €19,500 for taxable annual personal income to €23,500, that is, importantly above the estimated median annual gross income for employees of €22,750 in 2023. And the top marginal tax rate should be increased from 35 per cent to 40 per cent (still below the euro area average of 41.7 per cent) on annual personal incomes above €65,000. In addition, marginal tax rates in between the lowest and top tax thresholds should be adjusted so that middle incomes individuals would pay lower personal taxes than currently.
Immovable property taxes
To promote the burgeoning property sector the Cyprus authorities have continually reduced and removed taxes and fees making the purchase, transfer and ownership of property in Cyprus quite under-taxed at least compared with most other euro area countries. Staff of the IMF and the European Commission have argued strongly that a tax on immovable property is one of the least growth-unfriendly taxes and if progressively structured can help significantly to reduce income, wealth, and in particular, intergenerational, inequalities.
The immovable property tax, which was levied by the Cyprus central government and progressively structured, from 0.6 to 1.9 per cent on property based on January 1986 market values, was completely abolished starting from 2017.
Accordingly, in order to boost tax revenue and narrow inequalities there would seem to be a compelling case for reintroducing a central government recurring, progressive tax on immovable properties based on the latest updated market values. Initially, tax rates could range from 0.2 to 0.4 per cent depending on immovable property value of single housing units, while a flat rate of 0.3 per cent could be levied on the value of the immovable properties of commercial establishments.
Corporation taxes
Taxes on corporations, including allowances for deductions and exemptions, should be kept in line with EU directives. The Pillar 2 directive for corporation taxation required Multi National Enterprises with yearly revenues of at least 750 million euro to pay global tax at the effective rate of at least 15 per cent to be implemented into domestic law by the end of 2023. At present the corporate tax rate in Cyprus is 12.5 per cent, which is below the EU average of 21.7 per cent and that of Greece at 22.0 per cent.
Indirect taxes
Flat rate taxes such as VAT and excises are regressive. Although reductions in such taxes, especially on fossil fuel products, tend to be frowned upon by the EU, such taxes can be used to mitigate cost of living problems of lower-income and less wealthy households. Lowering VAT rates on electricity consumption in Cyprus is a good example. On the other hand, reduced VAT rates in certain areas such as for property purchases can promote excessive investments in an over-supplied market such as in “luxury” apartments in Cyprus cities. Furthermore, lost revenue from reductions in indirect taxes need to be countered by boosting revenue from other sources including the collection of greater revenue from the effective tackling of tax evasion and from taxes aimed at protecting the natural environment such as the green tax on fuels.
Tax administration
While the subject of strengthening tax administration, hopefully, will be addressed in a future publication, it is noted that tax administration in Cyprus suffers from many weaknesses, which most disturbingly have led to prolific and widespread tax evasion. According to the Treasury Department tax arrears amounted to over €2.3 billion at the end of 2022. However, this is only the tip of the iceberg on the extent of tax evasion as much income is undeclared, such as by persons undertaking work in the large Cyprus underground economy.
Concluding remarks
The implementation of reforms of the tax system of Cyprus would help in alleviating the cost of living and debt servicing problems of lower and middle-income households. Undeniably, lower tax rates and the redistribution of higher government revenues in providing income support would increase personal disposable incomes. But, over the medium to longer-term the economy’s productivity and competitiveness will need to be raised by more efficient resource allocation in order to improve sustainably the standard of living of most households through the creation of better jobs. Thus, the onus will be mainly on the government with its budgetary expenditure policies and on financial institutions (primarily banks) with their lending activities to allocate and use the economy’s real and financial resources more efficiently to add to the income of the economy and its households.
And in this connection, it is contended that tax evasion and corrupt practices as well as very generous debt relief provided by banks enable many companies to remain profitable and keep inefficiently using the economy’s resources. Accordingly, it would be expected that the effective combatting of tax evasion and the ironing out of corruption should lead to a more productive use of resources and the flourishing of genuinely competitive businesses.
Les Manison is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus
