A Fairer Tax System

Criticisms of the Proposed Tax Reform in Cyprus

The proposed tax reform in Cyprus has drawn significant criticism from various quarters, with three main concerns being raised. First, it is argued that the reform does not adequately address the long-term revenue and expenditure needs of the government. Instead, it appears to be focused on short-term benefits for large businesses and households, aligning with the preferences of President Christodoulides. Second, the structure of the proposed tax rates is seen as unfair, potentially leading to a more regressive system that could exacerbate income, wealth, and intergenerational inequalities. Third, the reform is criticized for favoring established large companies over fostering innovation, entrepreneurship, and equity investments in new firms, which are crucial for a modern economy.

Raising Sufficient Revenue

Tax reforms are typically infrequent, with the last comprehensive reform in Cyprus occurring over two decades ago. Given this context, a tax reform should aim to generate enough revenue to meet both current and future government expenditure needs. The Minister of Finance, Makis Keravnos, has stated that the reform should be "fiscally neutral." This implies that increases in revenue from certain changes, such as raising the corporate tax rate to 15%, would be offset by decreases from other changes, such as increasing tax deductions for green investments. However, this approach may perpetuate fiscal austerity, resulting in unnecessary surpluses while limiting spending on development and social needs, including the care economy.

To address future challenges such as defense, cybersecurity, climate change, and an aging population, it is essential to ensure sufficient revenue. The shrinking working-age population will need to cover most of the tax revenues, while the growing elderly population will place a greater burden on government resources through pensions and health benefits. Expanding the tax base through increased taxation of property wealth and combating tax evasion and avoidance are critical steps in this regard.

Fairness in the Tax System

A fair tax system should aim to distribute the tax burden more equitably among individuals and corporations. Over the past 20 years, the tax system in Cyprus has become increasingly regressive. Inflation has pushed lower- and middle-income earners into higher tax brackets, while the progressive Central Government tax on property was abolished in 2017. The reliance on flat-rate indirect taxes like VAT and excises has further contributed to this trend.

The proposed tax reform does little to reverse this decline in progressivity. For example, the personal income tax free threshold has been increased by only 5.1% to €20,500, despite significant inflation and wage growth. This means that many wage earners will still not pay income taxes. Additionally, the top marginal tax rate of 35% is below the EU average, and the reform proposes to reduce the threshold at which this rate applies, benefiting the wealthy.

To address these issues, it is recommended that Cyprus index tax brackets to inflation rates, similar to practices in countries like Austria, Denmark, and the Netherlands. Adjusting the tax-free threshold and increasing the top marginal tax rate would help restore progressivity and protect disposable incomes from inflation.

Wealth Inequality and Property Taxes

Cyprus faces high levels of wealth inequality, with the top 10% owning approximately two-thirds of the country's net personal wealth. The current tax system, which includes low taxes on wealth and the abolition of the progressive tax on immovable property in 2017, has contributed to this disparity. There is no inheritance tax, and capital gains are taxed at very low rates.

Despite the negative impact of these policies on wealth, income, and intergenerational inequalities, the proposed tax reform shows little consideration for addressing these issues. Reintroducing a progressive tax on immovable property, even if it delays the implementation of the reform, is essential to reducing wealth inequality.

Promoting a Modern Business Sector

The proposed tax reform emphasizes supporting existing businesses through tax breaks. While the corporate tax rate has been increased to 15%, the deemed dividend distribution system is set to be abolished, and the tax on actual dividends is reduced to 5%. Generous incentives for green and digital technologies are also included, with 100% tax deductions for losses from such investments for up to 10 years.

However, the reform lacks incentives for promoting innovation and entrepreneurship beyond the green and digital sectors. It also misses opportunities to develop the dormant capital market, including listing new companies on the Cyprus Stock Exchange. Critics argue that focusing on tax breaks for existing corporations may allow inefficient businesses to remain viable without improving productivity or competitiveness, potentially crowding out resources for more efficient firms and a thriving capital market.