Government must combat tax evasion and avoidance to greatly boost government revenues and lessen the need to raise tax rates
The current Cyprus government is failing in addressing interrelated key economic, social and environmental issues as well as corruption by not implementing rational reforms and measures.
It is just resorting to random short-term measures to deal with cost of living and debt servicing problems of households in order to try to regain some semblance of popularity. And given this policy orientation there is the danger that the promised forthcoming tax reform will be geared toward attracting short-term popularity from the self-serving political and business “elite”, as well as advertising its benefits in supposedly reducing tax rates on the general public.
Following the passing of 22 years since Cyprus last instituted a tax reform, Finance Minister Makis Keravnos stated recently that an overhaul of the tax system is essential and would be undertaken during 2024.
“This reform aims to make the tax system fairer, more efficient, and more competitive, while strengthening the trust of citizens and businesses in the state,” he said.
However, what seems to be missing from these aims as well as those from the university of Cyprus’ Research Centre, that is leading the tax reform project, is the over-riding objective of making revenue from the tax reform sufficiently adequate to finance the expenditure requirements of the government.
Adequacy
It is essential that the government should be provided with enough 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.
Nobel Laureate Joseph Stiglitz once questioned the Swedish finance minister on why his country’s economy was doing so well. His answer: “because they had high taxes”. Of course, what he meant was that Swedes knew that a prosperous country required a high level of public expenditures, on infrastructure, education, technology and social protection, and that the government needed revenues to sustainably finance these expenditures. In this respect, despite recent inflation-boosting government revenues, the ratio of receipts of taxes and social security contributions to GDP for Cyprus at 38.8 per cent in 2023 was much lower than that of Sweden at 43.2 per cent and somewhat less than the average of EU members at 40.8 per cent.
Notwithstanding relatively low tax ratios, the Cyprus government has given priority to generously compensating its employees and advisors and to generating budget surpluses in recent years. To accomplish these self-serving objectives, expenditures on social protection and public investment projects have been depressed to very low levels. In fact, government social protection expenditures as a proportion of GDP amounted to just 11.8 per cent in 2022 compared with an average of 19.5 per cent for EU countries, while the implementation of development expenditures have continued to be less than 65 per cent of the amounts budgeted each year.
Furthermore, as elaborated by Marios Clerides in a recent article, the “good” fiscal outcomes of recent years have been the result of pitifully low public development expenditures owing to the failure of contractors to meet their obligations in implementing large scale investment projects such as the Vasiliko LNG import terminal. Undeniably, the costly shortfalls and corruption in executing key projects in dealing with the production and distribution of cleaner and renewable energies and waste management are severely hindering the promised green transition.
While designing a new tax system to substantially raise the ratio of tax receipts to GDP needs to take account of the fairness, competitiveness and the growth friendliness of adjustments in tax rates and coverage, serious consideration should be given to the efficiency of the administration in increasing tax revenue.
Indeed, there is an urgent need to institute policies and reforms in tax administration to substantially combat tax evasion and avoidance that in turn if successful would greatly boost government revenues and lessen the need to raise tax rates. However, the present government by its populist measures such as putting back the dates for tax returns and in continuing to turn a blind eye to prolific tax evasion, especially by the self-employed, is not only seriously diminishing the effectiveness of the tax system in raising revenue, but is distorting the business environment against honest competitive firms as well as widening income and wealth inequalities.
Fairness
As stated in Article 24 of the Constitution of the Cyprus Republic “every person is bound to contribute according to his means towards the public burden” meaning that residents should pay taxes according to their ability to pay. Unfortunately, the tax system and its administration have become more regressive in Cyprus with lower-and-middle income households increasingly shouldering a rising proportion of the tax burden mainly with the payment of higher VAT and excises as well as their being subject to higher income tax rates as a result of the recent surge in inflation.
VAT rates should be kept low on basic food, baby and sanitary products, even returning rates on such products to the zero levels in effect during periods of 2024. And VAT rates and excises on energy products dependent on fossil fuels should not be changed so as to promote the green transition; instead, lower income households and vulnerable persons as well as persons living in higher elevated areas should be subsidised more in their consumption of designated energy products.
To narrow disposable income inequalities the structure of tax rates on personal incomes should be made more progressive by reducing rates on lower incomes and raising rates on higher incomes. In particular, the tax-free threshold for personal incomes of up to €19,500 needs to be adjusted upwards to take account of the impact of inflation in raising incomes. In fact, Cyprus is one of very few countries in the euro area that does not index personal income tax rates to the rate of inflation.
In truth, “fiscal drag” that is the dragging of persons into higher tax brackets because of inflation has been another factor responsible for the “good” fiscal outcome. Furthermore, the top marginal rate of 35 per cent for annual incomes above €60,000 in Cyprus needs to be increased to at least 40 per cent to bring it more in line with that of Greece of 44 per cent and the EU average of 46 per cent.
Regarding corporation taxation in Cyprus, the rate on profits of multinational enterprises with annual revenue over €750 million was raised to a minimum of 15 per cent from 12.5 per cent and enacted into law on December 12, 2024 in line with an EU directive. And undoubtedly, there is a compelling need for such enterprises to comply with their new tax obligations and for the Cyprus authorities to close loopholes that allow the easy evasion and avoidance of taxes by companies, in order to diminish the reputation of Cyprus as a tax haven and to attract respectable foreign investors.
Cyprus is one of the very few countries that does not levy significant taxes on wealth. There is no inheritance tax and immovable properties are not subject to any substantial taxes as in most EU countries. Thus, to boost tax revenue and in view of the very large wealth inequalities prevailing in Cyprus and that property taxes are the least growth unfriendly of taxes, serious consideration should be given to re-introducing a central government progressive tax on immovable property.
Furthermore, excessive investments in the construction of new properties, especially of luxury apartments and commercial buildings, in the cities and tourist resorts of Cyprus are degrading the natural environment and risk ushering in another episode of financial instability. Such investments need to be discouraged and restrained through reducing the issue of building permits and monitoring more strictly compliance with environmental regulations and the payment of taxes and duties on the sale of properties and on property rental income.
Many of the measures recommended above to institute a decent tax reform such as raising tax rates on the wealthy and high incomes of persons and corporations and the serious clamping down on tax evasion will be unpopular and could impose short-run costs on the economy. However, these measures should contribute to placing the economy on a more solid and competitive footing to achieve balanced and equitable growth over the longer term, while enabling the government to provide adequate social protection as well as preventing the further profound degrading of the natural environment.
But, even if the contents of the pending tax reform are well designed and rational, its potential success in benefiting society and the economy could be undermined by the government’s continued tolerance of poor tax administration and corruption as well as pathetic legal action that encourage and allow persons and corporations not to comply with their tax obligations.
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
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