Taxes and the Crisis

No one likes paying taxes, and yet the government needs tax revenues to finance itself, and the various infrastructure and social projects it develops. Businesses benefit from these projects (unless the money is wasted in corruption). The real question is how much tax to pay to make both the government and businesses happy.

The Doing Business background study of the effect of taxes on investment, growth and entrepreneurship deals with exactly this question. It investigates all taxes that businesses need to pay in 85 countries.

Take Bulgaria as an example. The average Bulgarian business pays the following taxes: corporate income tax (10% of profit), social security contributions (24% of gross salaries), municipal fee (1% of the value of land and buildings), vehicle tax (950 leva per vehicle), property tax (0.15% of the value of land and buildings), and value added tax (20% on the value the business created using the various inputs and labor). If the average business paid all its taxes, about 35% of its profits will go to the tax collector.

Is 35% the right level of business taxes for Bulgaria? Let's compare to some other countries. Austrian businesses pay 55% of profits in taxes. German businesses pay 48%. Latvian businesses pay 33%. Irish businesses – 29%. Former Yugoslav Republic of Macedonian businesses pay 18%.

There is a good rule in setting taxes: the poorer the country, the lower the tax burden. This is for two reasons. First, poorer countries waste more tax money through corruption. Second, lower tax burdens for businesses lead to more economic activity.

The first point is obvious: everyone has a long list of projects that were supposed to be built with tax money and somehow the money disappeared. This is particularly obvious with road projects, where it is easy to see that the money was stolen (no roads).

The second point requires some numbers. For every ten percent reduction in business taxes, the average country in the 85-country study would gain 2% in additional investment and about 1% in GDP growth. Both come from more business activity: countries with lower taxes also have more registered businesses. In particular, a ten percent reduction in business taxes increases the number of businesses by 15%. Poorer countries gain more-- as there are more investment opportunities. A country like Bulgaria would gain almost 4% in investment and 1.7% in GDP growth if it reduced business taxes by 10%.

With the current economic crisis, these numbers become even more interesting. If the Bulgarian government wanted to keep economic growth next year as high as in 2008, a 10% reduction in taxes would do it (the projected 2008 GDP growth is 6.3%, while the latest government budget anticipates 4.7% growth for 2009). This would bring Bulgaria to the tax level of Hong Kong (24% of profits), Chile (25) and Singapore (27).

The Doing Business numbers can be used by other governments, as well, to do this type of analysis.