1. Martin Bruncko Ministry of Finance of the Slovak Republic Paris January 11, 2006 MAKING ROOM FOR A RADICAL TAX REFORM The case of Slovakia

2. Making Room for a Radical Tax Reform Paris January 11, 2006 2 SLOVAK ECONOMY – KEY CHARACTERISTICS Lower middle income country –2004 GDP/head in PPP: 54% EU25, 50% EU15, 52% OECD –Room for real convergence and catching-up Small and open economy –2004 - Export: 77% GDP, Import: 80% GDP Economic policy agenda – structural reforms –2003-2004: pensions, labour market, welfare, education, tax reform –since 2005: focus on knowledge-based economy

3. Making Room for a Radical Tax Reform Paris January 11, 2006 3 FISCAL REFORM: GENERAL CONTEXT Medium term – Fiscal Consolidation –Reduction of the deficit to 3% of GDP in 2007 → meet Maastricht criterion → adopt euro in 2009 –Meet the ultimate SGP goal in 2010 (close to balance or in surpluse position) Long term – Ensure Fiscal Sustainability –Inter-temporal constrain of public debt under 60% of GDP –Ageing issue –Contingent liabilities

4. Making Room for a Radical Tax Reform Paris January 11, 2006 4 THE SLOVAK TAX REFORM: GOALS BASIC PHILOSOPHY: LIGHT, NONDISTORTIVE, SIMPLE AND TRANSPARENT TAX SYSTEM create business and investment friendly environment for both individuals and companies eliminate existing weaknesses and inefficiencies in the tax law eliminate distortive roles of tax policy as instruments for achieving non-fiscal goals improve tax fairness by taxing all types and all amounts of income equally

5. Making Room for a Radical Tax Reform Paris January 11, 2006 5 THE SLOVAK TAX REFORM: GOALS Flat income tax - simplicity, fairness, proporcionality –Cutting number of tax rates 18 → 1 –Broadening tax base (eliminating special treatments and exemptions) → Allows low standard tax rates → Minimizes distortions in the economy –Eliminating double taxation (e.g. dividends) –Progressivity of taxation reduced but not eliminated (high tax free treshold, tax credit on children)

6. Making Room for a Radical Tax Reform Paris January 11, 2006 6 PERSONAL INCOME TAX CHANGES –Abolishment of multiple tax rates including five-band rate structure on labour income –Only one but much higher tax-free treshold Basic tax allowance for tax payer (SKK 38,760 → SKK 80,832) Spousal allowance (SKK 12,000 → SKK 80,832) tax free treshold automaticly indexed to minimum substince (poverty-line income treshold) –Introducing annual tax credit of SKK 4,800 per child (part of new child support and working incentives policy) –Since 2005 introducing purpose-oriented allowance of SKK 12,000 (tax-free savings, ageing issue) –Tax exemption on income from the sale of securities held for 3 years or more cancelled

7. Making Room for a Radical Tax Reform Paris January 11, 2006 7 CORPORATE TAX CHANGES –Most income tax exemptions cancelled (tax holidays for newly established firms, tax base reductions for certain sectors) –Remaining investment incentives in compliance with the EU law on state aid –Dividend tax abolished –Reduction of effective tax burden on businesses Depreciation period on some groups of tangible assets shortened (property and buildings 30y → 20y) Loss carry-forward rules relaxed Limits on tax deductibility of advertising and of vehicle depreciation cancelled

8. Making Room for a Radical Tax Reform Paris January 11, 2006 8 1 flat rate: 19% 1 flat rate: 19% THE REFORM RADICALLY DECREASES ECONOMIC DISTORTIONS CREATED BY THE TAX SYSTEM 2003 OLD SYSTEM 2004 NEW SYSTEM PERSONAL INCOME TAX RATE CORPORATE INCOME TAX RATE VALUE ADDED TAXES 5 tax rates: 10%, 20%, 28%, 35% and 38% 5 tax rates: 10%, 20%, 28%, 35% and 38% 19% 25% one unified rate: 19% one unified rate: 19% standard rate : 20% lowered rate : 14% standard rate : 20% lowered rate : 14%

9. Making Room for a Radical Tax Reform Paris January 11, 2006 9 THE REFORM RADICALLY SIMPLIFIES THE TAX SYTEM AND INCREASES ITS TRANSPARENCY 2003 OLD SYSTEM 2004 NEW SYSTEM PERSONAL INCOME TAX BASE CORPORATE INCOME TAX BASE OTHER TAXES LOTS OF exceptions, exemptions and special regimes LOTS OF exceptions, exemptions and special regimes NO exceptions, exemptions and special regimes NO exceptions, exemptions and special regimes LOTS OF exceptions, exemptions and special regimes LOTS OF exceptions, exemptions and special regimes VIRTUALLY NO special taxes and rates VIRTUALLY NO special taxes and rates LOTS OF special taxes and rates LOTS OF special taxes and rates NO exceptions, exemptions and special regimes NO exceptions, exemptions and special regimes

10. Making Room for a Radical Tax Reform Paris January 11, 2006 10 THE REFORM ELIMINATES MOST FORMS OF DOUBLE TAXATION OF INCOME DIVIDEND TAX DIVIDEND TAX REAL ESTATE TRANSFER TAX (as of 2005) REAL ESTATE TRANSFER TAX (as of 2005) GIFT TAX GIFT TAX INHERITANCE TAX INHERITANCE TAX

11. Making Room for a Radical Tax Reform Paris January 11, 2006 11 IMPLEMENTATION STRATEGY Chronology of the changes in the tax laws 1. Changes in indirect taxes: amendment of VAT Act – introduction of one single rate of 19% (before: 20% and 14%) amendment of Acts on Excise Duties – increase of certain excise duty rates: mineral oils, beer and tobacco products 2. Changes in direct taxes: new Income Tax Act – introduction of flat tax new Real Estate Transfer Tax Act – abolishment of gift and inheritance tax and introduction of 3% flat rate for real estate transfer tax 3. Changes in indirect taxes in compliance with EU tax legislation - new VAT Act and new Excise Duties Acts - as of May 1, 2004

12. Making Room for a Radical Tax Reform Paris January 11, 2006 12 FLAT TAX STILL ENSURES PROGRESSIVE TAXATION OF INCOMES Poverty Line

13. Making Room for a Radical Tax Reform Paris January 11, 2006 13 IMPACT ON TAX PAYERS: AVERAGE EFFECTIVE TAX OF INDIVIDUAL IN % Marginal rate 19% Minimum wage since January 2004 – SKK 6,080 Average wage in 2004 – SKK 15, 825

14. Making Room for a Radical Tax Reform Paris January 11, 2006 14 IMPACT ON TAX PAYERS (2): AVERAGE EFFECTIVE TAX OF INDIVIDUAL WITH NON-WORKING SPOUSE AND 2 CHILDREN IN % Negative tax (tax credit on children) Average wage in 2004 – SKK 15,825

15. Making Room for a Radical Tax Reform Paris January 11, 2006 15 REFORM IMPACT ON SELECTED TAX PAYERS change in net income in % STATIC APPROACH DYNAMIC APPROACH PIT Overall tax burden Real disposable income INDIVIDUAL Minimum wage 3,51,4 3,1 Average wage (AW) -0,4-2,4 0,9 3 x Average wage 6,54,5 8,3 FAMILY Employee (AW) + 2 children 2,70,7 3,9 Employee (AW) + Non-working spouse + 2 children 7,85,7 8,9 Employee (AW) + Spouse (AW) +2 children 2,90,9 5,9

16. Making Room for a Radical Tax Reform Paris January 11, 2006 16 TAXING LABOUR INCOME IN SLOVAKIA: 2003 VS. 2004 in %IIII-2C-2 (67%)(100%)(167%)(67%)(100%,0%)(100%,33%) Tax wedge 200340.341.444.627.832.334.0 Tax wedge 2004 38.842.044.525.427.229.4 Marginal tax wedge 200343.149.4 43.1 Marginal tax wedge 2004 48.3 36.1 Source: OECD, I = individual; C = couple; number of children; % in average wage in industry

17. Making Room for a Radical Tax Reform Paris January 11, 2006 17 TAXING LABOUR INCOME: SLOVAKIA VIS-A-VIS OECD IN 2004 in %IIII-2C-2 (67%)(100%)(167%)(67%)(100%,0%)(100%,33%) Tax wedge Average OECD32.536.541.416.826.628.7 Slovakia38.842.044.525.427.229.4 Marginal tax wedge Average OECD42.344.850.144.745.743.1 Slovakia48.3 36.1 Source: OECD, I = individual; C = couple; number of children; % in average wage in industry

18. Making Room for a Radical Tax Reform Paris January 11, 2006 18 EFFECTIVE CORPORATE TAX RATE IN SLOVAKIA Effective corporate tax rate = statutory corporate tax rate x dividend tax rate

19. Making Room for a Radical Tax Reform Paris January 11, 2006 19 COMPANY EFFECTIVE TAX BURDEN IN 2004 Source: ZEW Economic Studies Vol.28, OECD Tax Database

20. Making Room for a Radical Tax Reform Paris January 11, 2006 20 OVERALL TAX BURDEN IN EU25 (% OF GDP, ESA 95), 2003 Note : Eurostat published 30,9% of GDP for Slovakia in 2003 but GDP was revised upward since then.

21. Making Room for a Radical Tax Reform Paris January 11, 2006 21 CHANGE IN OVERALL TAX BURDEN IN EU25 IN THE PERIOD 1995-2003 (% OF GDP, ESA 95)

22. Making Room for a Radical Tax Reform Paris January 11, 2006 22 REFORM IMPACT ON GOVERNMENT REVENUES (1) ESA 95, % HDP 2004 Budget 2004 Actual Difference PIT 2.12.60.5 CIT 1.82.50.7 Withholding IT 0.90.4-0.5 FLAT TAX 4.85.50.7 Total taxes 17.918.00.1

23. Making Room for a Radical Tax Reform Paris January 11, 2006 23 REFORM IMPACT ON GOVERNMENT REVENUES (2) ESA 95, % HDP 2004 NON- REFORM scenario 2004 Actual Difference PIT 3.52.6-0.9 CIT 3.12.5-0.6 Withholding IT 0.60.4-0.2 FLAT TAX 7.25.5-1.7 Total taxes 18.418.0-0.5

24. Making Room for a Radical Tax Reform Paris January 11, 2006 24 POSITIVE BUDGETARY IMPACT IN 2004 Sources –Macroeconomic development (+) –Conservative approach to budgeting revenues (+) Assessment limitations –Corporate tax: cyclical upturn or tax planning by coprorations –Reliability of wage distribution data

25. Making Room for a Radical Tax Reform Paris January 11, 2006 25 REFORM IMPACT ON MACROECONOMIC ENVIRONMENT Short-term period – minimum effect (broadly budgetary neutral) Medium-term period – expected scenario

26. Making Room for a Radical Tax Reform Paris January 11, 2006 26 CONCLUSION: POLITICAL WILL AND MANAGEMENT ARE KEY FOR SUCCESSFUL REFORMS must have a clear vision where you want to go timing is key in the implementation –implement less popular steps first resist lobbies and entrenched interests –if you give in to one demand, you will be less able to say no to others compensate the most vulnerable part of the population

27. BACK-UP SLIDES

28. Making Room for a Radical Tax Reform Paris January 11, 2006 28 KEY MACROECONOMIC INDICATORS growth in %200320042005F2006F2007F Average 2003 - 2007 GDP 4.54.55.55.54.94.95.35.36.16.15.25.2 Real wage -2. 02.52.54.14.13.93.93.73.72.42.4 Employment 0.80.80.30.30.70.70.90.90.80.80.70.7 Unemployment rate 15. 214. 313. 413. 012. 713. 7 Inflation 8.58.57.57.53.33.32.52.52.02.04.84.8 Average exchange rate SKK/EUR 41. 540. 038. 237. 636. 838. 8 Balance of current account (% of GDP) -2. 0-3. 5-4. 2-4. 7-1. 0-3. 1

29. Making Room for a Radical Tax Reform Paris January 11, 2006 29 KEY MACROECONOMIC INDICATORS % of GDP20022003200420052006B2007B Deficit 7.8 3.83.14.04.2 3.0 Gross debt 43.7 43.142.536.738.437.9 Deficit ( ex cluding PAYG pillar shortfall) 7.8 3.83.13.22.91.6 Source: Convergence Programme, State budget draft 2006-2008, MoF, 2004, 2005