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Assessment of Impact of Corporate Income Tax Suspension on Financial Performance of Businesses

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Though there are a number of data and studies about the impact of tax incentives on investment, research and development, no detailed and systematic analysis has been elaborated on the effectiveness of taxation of profit to the financial performance of businesses in general. Businesses avoid corporate income tax to get more net profit. Evasion leads to economic stagnation. It is time to call for changes of the corporate income tax system and introduce tax suspension - tax only shared profit. The aim of the research is to assess the impact of corporate income tax suspension on retained corporate income. The research extends applicable theoretical foundation and comprehension of elements and factors affecting firms’ behaviour. The results show that the corporate income tax reform would change capital structure of businesses and improve company’s sustainability. The findings also give grounds for the development of an applicable model that would help government authorities choose the most effective way of taxation of corporate income.
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Economics and Business
ISSN 2256-0394 (online)
ISSN 2256-0386 (print)
2018, 32, 172–181
doi: 10.2478/eb-2018-0014
https://www.degruyter.com/view/j/eb
172
©2018 Valentīna Bizņa, Māris Jurušs, Tālis Laizāns, Roberts Šnikvalds.
This is an open access article licensed under the Creative Commons
Attribution License (http://creativecommons.org/ licenses/by/4.0), in the
manner agreed with Sciendo.
ASSESSMENT OF IMPACT OF CORPORATE INCOME TAX
SUSPENSION ON FINANCIAL PERFORMANCE OF
BUSINESSES
Valentīna BIZŅA1, Māris JURUŠS2, Tālis LAIZĀNS3, Roberts
ŠNIKVALDS4
1, 2, 3, 4Riga Technical University, Riga, Latvia
Corresponding author’s e-mail: Maris.Juruss@rtu.lv
Abstract. Though there are a number of data and studies about the impact of tax
incentives on investment, research and development, no detailed and systematic
analysis has been elaborated on the effectiveness of taxation of profit to the
financial performance of businesses in general. Businesses avoid corporate
income tax to get more net profit. Evasion leads to economic stagnation. It is
time to call for changes of the corporate income tax system and introduce tax
suspension tax only shared profit. The aim of the research is to assess the
impact of corporate income tax suspension on retained corporate income. The
research extends applicable theoretical foundation and comprehension of
elements and factors affecting firmsbehaviour. The results show that the
corporate income tax reform would change capital structure of businesses and
improve company’s sustainability. The findings also give grounds for the
development of an applicable model that would help government authorities
choose the most effective way of taxation of corporate income.
Keywords: profit, corporate income tax, equity, financial performance,
economic development.
JEL Classification: H25, C52, M21
INTRODUCTION
The degree of stability and reliability of tax legislation has the strongest influence
on the sustainable functioning of countrys businesses. Corporate income tax (CIT)
is a crucial factor for entrepreneurial activity. Advance payments, tax on calculated
profit or other regular tax charges reduce net profit, therefore, cash flow for future
investment and development of businesses. Several studies have attempted to
investigate the country-wide effect of changed rules for corporate income tax and
potential results on financial performance of businesses if income tax is suspended
(see, for example, the analysis by Guziejewska, Grabowski, & Bryndziak, 2014),
changes in company’s capital structure and dividend distribution (for example,
Hazak, 2009), and effects on performance (Masso, Meriküll, & Vahter, 2013).
Businesses try to hide profit, increase business expenses or make other fictive
activities to avoid deduction by the tax.
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Tax fraud impacts fair competition. Evasion leads to economic stagnation as
banks do not loan businesses due to official bad financial performance results.
The aim of the research is to assess the impact of corporate income tax
suspension on the retained corporate income. The tasks are to analyse the effects of
the corporate tax reform in Estonia, to conclude and forecast the possible effects if
the distributed profit taxation reform were introduced in Latvia.
There has been a huge gap between total investments in Estonia and Latvia.
One of the reasons is the Estonian corporate tax system that gives them the
competitive advantage over the neighbouring countries and diverts the investment
flow to Estonia. Estonia uses the distributed taxation system that only taxes profit
that is distributed compared to gross profit taxation system used in Latvia that taxes
all profit (Eurostat, 2016).
According to the data on the accumulated foreign direct investments in the
Baltic States (see Fig. 1), all Baltic States have an increase in investment since 2004.
Fig. 1. Accumulated foreign direct investment in the Baltic States, million EUR
(Ministry of Economics, 2016).
Figure 1 shows the accumulated foreign direct investment data in the Baltic
States in period of 2004–2015. The amount of foreign investment in all three
countries increased, and the fastest growth was in 2007 in all countries. In the period
of 2008–2010, there was a decrease in foreign investment due to the economic
crisis. Since 2010, the Baltic States have recovered upward indicators an average
of 7 %–9 % a year.
The highest foreign investment of the Baltic States is demonstrated by Estonia,
where in 2004 foreign investment accounted to only 7 374 million EUR and
compared to 2015 it increased by 2.36 times, reaching 17 462 million EUR.
Latvia has the lowest foreign investment in the Baltic States despite the fact
that in 2015 the Latvian and Lithuanian data were at the same level, but it was
observed that investment increased during the last 5 years, i.e., from 2010 to 2015
it increased by 5 362 million EUR. Lithuania has similar investments as in Latvia,
but from 2004 to 2015 investment increased by only 8 807 million EUR. In 2015,
the Latvian and Lithuanian data were similar 13 545 million EUR in Latvia and
13 497 million EUR in Lithuania. Compared to Estonia, the amount of foreign
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investment in Latvia and Lithuania is less than in Estonia by approximately 22 %–
23 %.
The leader of foreign investment in Latvian business development is Sweden
(18.2 % of all foreign investments in 2016) and the main sector is finances and other
services (Ministry of Economics, 2016).
Foreign direct investment is the main source for the development of businesses,
their assets and labour productivity. Productivity data in the Baltic States have also
grown from 2004 to 2015 (Ministry of Economics, 2016).
The Baltic States have similar productivity indicators – in the period of 2008–
2009 it was the fastest negative growth of indicators, where a higher decline
indicator compared to the previous year seemed to be in Lithuania. Since 2012, the
Baltic States have experienced a moderate productivity growth the lowest
productivity growth is observed in Estonia, i.e., an average of 0.85 percentage
points, while in the other Baltic States the data are similar an average of 2
percentage points in Latvia and 1.5 percentage points in Lithuania. According to
the data in 2016, the lowest productivity indicator was in Estonia 106.0 and the
highest indicator in Latvia – 115.4, Lithuania was similar to Latvia – 112.5.
Operation of businesses to attract investment affects all production and service
processes, for which it is necessary to follow opportunities of improving the
existing technical equipment, qualification of employees, and using the opportunity
to acquire and introduce modern technologies that influence company’s
productivity.
1. METHODS
The present paper uses difference in differences (DiD) analysis method in order
to assess the potential effects and results of the tax reform of 2018 in Latvia. The
DiD analysis has been used as a control tool and measuring method to provide
experts with sound results. A similar DiD approach was used to study the effect of
corporate income tax reform in Estonia by Masso, Meriküll, and Vahter (2011,
2013).
The introduction of the tax reform should have minimal expectation result due
to the fact that a new legislative package was approved by the Parliament of Latvia
in December 2017 and enforced on 1 January 2018. Therefore, the law will affect
all Latvian firms equally and concurrently. The pre-2018 tax system was a standard
gross profit taxation system with a corporate tax rate of 15 %, while the post-2018
tax system reform will introduce identical redistributed profit taxation with a
straight rate of 20 % on profit which is not used to invest in the business
development but paid-out as dividends.
2. TAX SUSPENSION
A possible solution might be corporate income tax suspensions which could
motive business do not hide profit or fraud with expenses. Business will be
motivated to increase profit as the state will no charge tax on it until shareholders
do not share profit. The undistributed profit increase equity and therefore financial
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performance. It could be a call for banks to give loans to business activities;
therefore, the process will stimulate economic development.
The hypothesis is that corporate income tax transformation from the existing
system to the principle that tax is suspended until the distribution of profits has a
positive effect, particularly on the financial performance of businesses (see Fig. 2).
Fig. 2. Impact of tax suspensions on the financial performance of businesses
(made by the authors).
Implementation of corporate income tax to distributed profit (see Fig. 2) has
the five main effects on business financial performance. The main effect of tax
suspension is business motivation in development.
Tax reform will affect the profit of businesses – there will be no tax on taxable
income; therefore, businesses can use their undistributed profit for further business
activities and development.
Undistributed profit will have positive growth in businesses equity
(Capitalisation, Fig. 2). Equity consists of company’s share capital, reserves and
retained profit. Capital equity is one of the main data that investors are interested in
because it shows the structure of capital and businesses’ stability and independence
from external resources.
Equity gives an opportunity to provide stable solvency due to a larger share of
equity capital. Higher equity shows less dependence of borrowed capital that is
one of the attractiveness forces to investors. The growth of equity gives additional
ways to get external funds to business development and, therefore, growth in assets.
Improvement of financial performance would have a more favourable effect on
the development of business environment and increase of investments. The next
effectiveness impact of tax suspension is activation businesses will be motivated
to develop their activity by additional investment in capital (Activation, Fig. 2).
Finally, the last positive impact of a new corporate tax reform will be
acceleration, which means net sales increase (Acceleration, Fig. 2).
Capitalization
Motivation
Tax suspensions
Profit undistribution
Multiplication
Activisation
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3. FINDINGS
Applicable statistics and other relevant data have been analysed to find out
correspondence for changed corporate tax regime via analysing quantitative
(financial) results for different industries and comparing these theoretical
projections with actual data and results from the Baltic States.
The data have been retrieved from Amadeus database. The relevant data about
net profit, equity, assets and net turnover have been used.
According to statistical data about profit and loss in Latvia, there was not fast
profit increase from 2010 to 2015 as we can see in Fig. 3.
Fig. 3. Assessment of profit, equity, and assets of businesses in Latvia, million
EUR (made by the authors using data from Amadeus, 2016).
Average profit increase during 2010–2015 was only 21.7 %. In 2009,
businesses had negative profit that was caused by the economic crisis. Before there
was positive profit, but it decreased compared to the amount in 2005. Profit data
depend on business operational area or sector, operational specifics, and
investments in assets affect profit, but the level of profit in 2005 still was not
reached (see Fig. 3).
In 2015, Companies’ equity in Latvia increased by 2.5 times compared to 2005.
Even though in 2009 business data decreased to 16.9 percent compared to the
previous year, since 2010 capital equity has had annual growth of 10.2 %. This
means that increase in equity will provide opportunities to get additional
investments. Analysing business structure in positive and negative equity showed
that most of Latvian companies had positive capital equity, but a negative share of
equity was still high. In 2015, the positive and negative equity ratio was 58 to 42,
respectively, while in 2005 it was 71 to 29. According to assessment by the authors,
every year it will be the double growth of equity capital, potential 13 % or 3.5
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billion EUR in Latvia (Fig. 3). According to the data about net sales, there has not
been an increase in fast net sales since 2012 an average of 3.6 % each year. By
2015 there was an increase in assets that was similar to business equity. Positive
assets growth shows that businesses are interested in development. The data in Fig.
3 outline that the amount of assets in Latvian businesses within the period of 10
years (from 2005 to 2015) increased reaching 62,240 million EUR in 2015. The
decrease of assets observed in 2009 as in equity shows a connection with both
indicators.
After introducing tax suspension in Latvia, there could be a potential
investment increase by 10 billion EUR that could be used as a resource to invest in
their fixed and current assets. Assets are related to liquidity ratio that implies
business ability to cover short-term liabilities with existing funds and sources.
Business activity after tax reform would affect their net turnover – potential growth
of 12 % or 10 billion EUR (see Fig. 3).
Therefore, tax suspension will have a positive impact on financial position,
stability, productivity and export opportunities for businesses in Latvia.
4. DISCUSSION
Investors’ decision to invest in any of the countries may be dependent on
several factors. CIT rate is one of the following factors (Guziejewska, Grabowski
& Bryndziak, 2014). There can be several options for taxation of profit, including
integrated approach, according to which the individual income taxes can provide to
shareholders a credit for corporate taxes paid on distributed dividends (Graetz &
Warren, 2016). To avoid double taxation of company income and dividends
distributed to shareholder, only one type of tax might be applied (Nasyrov &
Shtyrlyaeva, 2015).
Changes in tax system may lead to competitive advantage growth among other
countries as the development of fixed assets, technologies, investments. That also
gives to companies export growth opportunities (Jurušs, Stinka & Kūma, 2017).
The research of corporate income tax on distributed profit in Estonia showed
that liquidity of businesses increased by an average of 2 % after tax reform
implementation compared to Latvia and Lithuania, this indicator was larger by 2
times for small firms (Masso, Meriküll & Vahter, 2013).
The research already carried out shows that Latvian net turnover in 2014 was
lower by 10.7 % than in Estonia. Net sales growth after tax suspension per capita
in Estonia increased by 3.9 times that confirmed positive effect not only on
businesses performance but also on productivity (Prohorovs, Fainglozs & Jonina,
2016).
In Latvia and Lithuania there used to be a classical or traditional corporate tax
income system, which is different from the Estonian corporate income tax system.
In Estonia, the corporate tax system on distributed profit was implemented in 2000,
which provided tax payment only at the time when profit was distributed. The main
feature of such a system is the distribution of profit according to the businesses
decision, hence, the planning of tax payments. Classical corporate tax income
system differs from distributed profit taxation as the tax calculation applies to the
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taxation period of business profit (Hazak, 2009). Estonian corporate income tax rate
on distributed profit is 20 % while Latvia (by 2017) and Lithuania have 15 % tax
rate on taxable base. In the case of classical CIT systems, there is double taxation
corporate income tax and also personal income tax for dividends interact in
common (Gruevski & Gaber, 2015).
One of the reasons to tax suspension can be tax impact on investments, for
example, impact on the liquidity of businesses that lead to mutual caution between
investors and companies, which reduces opportunities to obtain additional funds.
The corporate tax system at the international level is also affected by tax
calculations, reliefs and exemptions specific of each country. It creates an incentive
for companies to look for a better place for investments and profit distribution
(Gorter & Mooij, 2001).
There are many types of research into the effectiveness of corporate income
taxation. The studies regarding the effects of corporate income tax reform in Estonia
concluded the positive impact on economic development (Hazak, 2007; 2009).
There was also observed a positive effect on investment and labour productivity
(Masso, Meriküll & Vahter, 2011).
It posed a more valuable effect on investment amount growth for small firms
an increase of only 0.37 %, and an increase in the investment rate by 0.203
percentage points. The share of investments in the capital of businesses increased
by 20 %. Analysing the impact of tax reforms on labour productivity, there was
such an assumption that fast-growing companies could increase the employment
rate to affect common indicators. The observation showed that productivity
indicators increased by 0.134 percentage points over four years since the
implementation of tax reforms in Estonia compared to Latvia and Lithuania (Masso,
Meriküll & Vahter, 2011).
The impact of tax reforms on businesses liabilities in total assets was also
researched there was a decrease in an average of 5.7 %. Business liquidity after
the corporate tax reform in Estonia had 2 % growth and undistributed profit share
in total assets grew by 8.1 % compared to Latvia and Lithuania these research
results showed that a bigger effect exerted on small businesses (Masso, Meriküll &
Vahter, 2013). This confirms that small businesses are more affected by tax changes
and reforms that require them to look for additional funds in order to adapt to these
changes.
The reform did not change the structure of their investments but rather helped
increase their size so that they could buy better and more expensive machinery, for
example (Masso, Meriküll & Vahter, 2011, 2013).
Tax reform implementation in Estonia gave an enormous difference between
businesses capital equity in Estonia and Latvia Estonian capital equity of
businesses increased by 3.5 times in the period from 2004 to 2014. After tax reform
implementation in Latvia, there was a positive impact – 2.44 % of gross domestic
product growth in next 10 years. The reform has increased the entrepreneurial
activity and has been one of the driving forces for the growth in the Estonian
economy (Prohorovs, Fainglozs & Jonina, 2016).
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Corporate tax reform in Estonia increased the total tax revenues collected, at
the same time reducing administrative burden and costs of tax administration.
(Jurušs, Stinka & Kūma, 2017).
Such a tax reform made easier administration in Estonia and also motivated
companies to not avoid tax payments. Compared to the Latvian corporate tax
calculation, the adjustments on taxable income contribute to errors and therefore
make the tax calculation and administration more complicated.
Tax suspension in Latvia can be the main force to business development as they
can use additional funds to increase their assets and investment attractiveness
opportunities. This can also solve the double taxation problem of corporate income
tax and personal income tax there will be one tax instead of two (Jurušs, Stinka
& Kūma, 2017).
Latvian companies have higher tax burden on labour. The corporate income tax
system in Latvia is the least competitive. Lithuania provides favourable conditions
for entrepreneurs by offering a lower effective CIT rate corresponding to the tax
actually paid (Domnīca Certus, 2016).
CONCLUSION
The distributed profit taxation system can be one of the main forces for the
country’s economy to grow. It increases the entrepreneurial activity and encourages
foreign and local investment in the country. The increase in the investment allows
companies to improve their quality of investment and productivity, which allows
them to rapidly increase their revenues and profit in the future.
In the conditions of the distributed profit taxation system, the number of
liabilities in total assets decreases and liquid assets like cash in total assets increase
making the company’s capital structure stronger and increasing their sustainability.
The reform also decreases the need of companies to hide or manipulate their
profit to decrease taxes payable. Due to this reason, the total amount of unaccounted
part of the economy will decrease increasing the total tax revenue and making
companies more transparent.
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AUTHORS’ SHORT BIOGRAPHIES
Valentīna Bizņa holds a Bachelor’s Degree.
Valentīna Bizņa is a student at the Faculty of Engineering Economics of Riga
Technical University. She has been involved in several types of research at
RTU about corporate income taxation in Latvia.
E-mail: valentina.bizna@inbox.lv
Māris Jurušs, Dr.oec., Assistant Professor.
Māris Jurušs obtained Dr. oec. degree from the Faculty of Engineering
Economics at Riga Technical University in 1999. He made research project
Theoretical Aspects of Improvement of Tax System”. He worked for the
Ministry of Finance from 1996 to 2007. He was involved in many European
Commission and Councils working groups during Latvian tax legislation
harmonisation with the EU principles. From 2007 to 2012, he worked for
PricewaterhouseCoopers as a Tax Manager. He was involved in many tax
projects regarding excise duty, customs matter and others. Since 2012, Māris
Jurušs is Assistant Professor at Riga Technical University. He has been
involved in many study programs and courses.
E-mail: Maris.Juruss@rtu.lv
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Tālis Laizāns holds a Master’s Degree in Economics.
Tālis Laizāns is an Associated Professor, Researcher at Riga Technical
University. He is a Lecturer at MBA Programme Innovation and
Entrepreneurship and Master Study Programme Finances of
Entrepreneurship. He delivers the study courses Corporate Finance,
Entrepreneurship and Planning, Financial Risks, Financial Innovation,
Financial Markets and Investments”.
List of publications is related to management, venture capital, corporate
finance.
E-mail: Talis.Laizans@rtu.lv
Roberts Šnikvalds holds a Bachelor’s Degree in Economics.
Roberts Šnikvalds is a student at Riga Technical University. Field of study:
logistics, materials and supply chain management.
E-mail: roberts.snikvalds@outlook.com
... On the other hand, it is emphasized that a major source of declining business performance is rather the financial and time effort required by the tax administration system. Bizna et al. (2018) analyze the results of the tax reform implemented in 2018 in Latvia. A central aspect of this reform was the over-taxation of uninvested profit and transferred to shareholders in the form of dividends. ...
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Corporate income tax Reforms and tax competition This paper analyses the development of taxes on corporate income in EU and G7 countries over the last two decades. We establish a number of stylized facts about their development. Tax-cutting and base-broadening reforms have had the effect that, on average across EU and G7 countries, effective tax rates on marginal investment have remained fairly stable, but those on more profitable investments have fallen. We discuss two possible explanations of these stylized facts arising from alternative forms of tax competition. First, governments may be responding to a fall in the cost of income shifting, which puts downward pressure on the statutory tax rate. Second, reforms are consistent with competition for more profitable projects, in particular those earned by multinational firms. Michael Devereux, Rachel Griffith and Alexander Klemm
The Impact of Private Equity Ownership on Corporate Tax Avoidance. Harvard Business School Working Papers 10-004
  • B Badertscher
  • S P Katz
  • S O Rego
Badertscher, B., Katz, S. P., & Rego, S. O. (2009). The Impact of Private Equity Ownership on Corporate Tax Avoidance. Harvard Business School Working Papers 10-004. Retrieved from: https://ideas.repec.org/p/hbs/wpaper/10-004.html