By Ioannis Tirkides

The Cypriot tax system, which was designed almost a quarter of a century ago, in 2002, is facing problems of ageing. Although it was originally designed to be competitive at an international level, the existing system involves unproductive discrimination against domestic companies, favors increasing foreign ownership, and, after a long period of accumulated inflation, places an excessive burden on lower income groups.

By comparison, it is one of the least progressive tax systems in the EU, with the greatest dependence on indirect taxes such the value added tax, and on social security contributions. A tax reform should correct these shortfalls, even if the result is still not revenue-neutral, and do so in accordance with the clearly defined principles of taxation that we have recognized since the time of Adam Smith as the principles of good taxation.

These are the principles of equality, efficiency, simplification, and adequacy, which we discussed in a previous article, here. For Adam Smith, taxation was both a moral and economic responsibility—where contribution is a function of ability.

In the social dialogue surrounding the tax reform, no entity or political group has presented a comprehensive or integrated approach to the issue, apart from piecemeal amendments. Volt Cyprus is the exception, at least in its social dialogue. Volt submitted its proposals early on for all the main aspects of the tax reform.

The Volt Cyprus proposals: combating regressivity

Given the relative regressivity of the tax system, any increases in indirect taxes, such as green taxation, must be offset by measures that will reduce tax revenues from indirect taxes as a whole. Such measures would include expanding the range of products and services subject to the low rates of 5 per cent and 9 per cent, making the zero rate a permanent feature, and expanding the range of products covered by it.

To address the problem of low progressivity more generally, tax brackets need to be adjusted for cumulative inflation over the relevant period, namely since the previous tax reform in 2002. Without adjustments, inflation acts as an additional tax, reducing the real disposable income of citizens

For illustrative purposes. Cumulative inflation for the period 2002-2025 is around 50 per cent. This means that an income of €30.000 in 2025 in real terms has the same purchasing power as an income of €20.000 in 2002. The tax burden on an income of €30.000 in 2025 is much higher than that on €20.000 in 2002. The real disposable income of €30.000 in 2025 would be approximately €26.000 in nominal terms, or approximately €17.000 in real terms, at 2002 prices. Similarly, the nominal and real disposable income of €20.000 in 2002 would be at least €19.000. In other words, a worker with an income of €30.000 in 2025 will be in a much worse position in terms of real disposable income than a worker in 2002 with an income of €20.000. Taking into account higher indirect taxes such as VAT and the higher cost of living – more expensive electricity and rents – things will be even worse.

Volt’s proposal is perfectly in line with the above. Volt proposed an increase in the tax-free allowance to €24.000, or 23 per cent, in the absence of credits for lower incomes. And an increase in all other tax brackets by 33 per cent against a cumulative inflation of 50 per cent. This would mean up to €37.200 for a tax rate of 20 per cent, up to €48.000 for a tax rate of 25 per cent, and up to €80.000 for a tax rate of 30 per cent. For incomes above €80,000, the tax rate will be 35 per cent.

These tax bracket adjustments do not eliminate the phenomenon of fiscal drag, but they do make the taxation of middle incomes fairer and more efficient, because they strengthen the consumer power of the economic groups facing the greatest financial pressures.

The tax reform proposed by the government places a greater burden on middle and low incomes, which is precisely the income group it claims to want to support. In real terms, the actual disposable income of these economic groups, after taxation, is lower than their corresponding incomes in 2002, given the cumulative inflation in the intervening period.

Volt also proposed introducing a ceiling of €70.000 income, above which no further tax exemption from life insurances would be allowed within the framework of the 1/5 for exemptions for all social insurance, welfare funds, health plans, and insurances. This is fully compatible with fiscal adequacy but, more importantly, with increasing the progressivity of the tax system.

It is also proposed that tax brackets be automatically adjusted for inflation. In order to limit the phenomenon of fiscal drag and avoid the problems caused by accumulated inflation, it is necessary for tax scales to be adjusted at regular intervals, for example every three years, for the cumulative inflation of the period. This will also make the tax system fairer, ensuring that tax burdens do not increase simply because of inflation.

Opposing ineffective allowances

Income tax exemptions for children and for housing exacerbate inequalities according to Volt, as they favor higher incomes, and in most cases where incomes are below the non-taxable amount, there will be no benefit. Population and housing policies must be targeted according to specific income criteria. Housing policy and policies that support childbearing relate to the expenditure side, not the revenue side. This is the only way to achieve the objectives in a fair and equitable manner. Every child born should receive a subsidy of a specific amount, for example, €500, without any income criteria. Support for home ownership or rent subsidies should be provided in a targeted manner based on criteria. This could be part of an expanded role for the ‘central agency for the distribution of burdens’, which would include in addition to refugees, the lowest income groups also. Tax allowances and breaks are not the obvious solution, despite the impressions they generate.

Corporate reform and economic growth

In the corporate sector, the tax reform abolishes the withholding tax on profits, reduces the special defense contribution from 17 per cent to 5 per cent, strengthens incentives for research and development, and extends the period for carrying forward losses from five to seven or ten years. The statutory corporate income tax rate is increased from 12.5 per cent to 15 per cent for all companies. The appropriateness of this increase for small and medium-sized enterprises is questionable. At the same time, the reform maintains key incentives —such as the intellectual property rights framework and the notional interest deduction against capital issuance— which greatly benefit foreign companies by allowing them to reduce their effective tax rate. The increase in the corporate tax rate from 12,5 per cent to 15 per cent will not be effective unless it includes effective taxation clauses, which it does not. The increase to 15 per cent will be purely revenue-raising in nature.

Conclusion: the cost of inaction

A tax system that draws more revenue from its most regressive segments, particularly indirect taxes, while total tax revenues grow faster than economic growth, presents a complex picture with various implications. It raises concerns about equity. Regressive taxes take a larger share of income from lower-income households than from higher-income households. As the economy grows, the tax burden on lower-income households increases disproportionately.

Fiscal drag occurs when inflation and income growth push taxpayers into higher income tax brackets, leading to an increase in their tax bills, without any change in tax rates, leaving individuals and households with less disposable income in real terms. The fiscal burden also occurs through indirect taxes that are proportional to prices, which naturally rise with inflation. Thus, consumers end up paying more taxes on their purchases, even if their purchasing power has not improved, further reducing their disposable income.

By refusing to align tax scales more closely with actual cumulative inflation and opting instead for tax deductions, the reform in Cyprus is squeezing the lower end of the scale. High earners benefit from the shift in the €60,000-80,000 tax bracket. Middle earners benefit little from the deductions if they earn enough to have a tax liability that offsets them. Low-income earners do not benefit from the deductions, do not benefit from the changes to the thresholds, and face higher living costs. The reform does not prioritise equity, which is the main problem with the existing system. The surplus is maintained only through a 20-year-plus ‘inflation tax’ on citizens, while offering ‘social’ measures that are invisible to the most vulnerable.

Ioannis Tirkides is an economist and president of the Cyprus Economic Society. Views are personal.