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Republic of Poland: Selected Issues

Author(s):
International Monetary Fund
Published Date:
May 2000
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II. Income Tax Reform-Content And Context1

A. Developments in the Polish Tax System During the 1990s

Background

1. The Polish tax system was completely transformed from 1989 to 1993. The traditional revenue instruments of a planned economy were replaced with a structure more suited to a market economy with a significant and growing private sector. While this new structure marked significant progress—indeed, the revenue decline in Poland after transition was low compared to many transition countries—by 1998 several factors combined to make further reform desirable. First, given the cumulative effect of changes made over the intervening years, the taxes as of 1998 were rather different from those under the original structure. Particularly problematic in this regard were extensive tax preferences, exemptions, reliefs and privileges, in both the corporate and personal income taxes (the “CIT” and “PIT”, respectively), which distorted economic decisions, required the use of higher rates to raise needed revenues, complicated the task of tax administration, and contributed to both the perception and reality of unfairness in the tax system. Second, during the decade, increased capital mobility has increasingly undermined the ability of the world’s tax systems to effectively tax the return on capital and financial income, posing challenges for all countries. Finally, the need to harmonize the tax system in various ways with the tax systems of the European Union called for other changes, albeit largely in the indirect taxes (VAT and excises).

The government’s 1998 “White Paper”

2. The government in 1998 set out extensive recommendations for reform, in a White Paper. The main thrust of the paper was to eliminate many preferential deductions, exemptions and credits in the CIT, PIT and VAT. In addition, the proposals called for significant reductions in marginal rates, ultimately bringing both the corporate and personal marginal income tax rates to 22 percent, with flat taxation of individual income in excess of an exemption amount. Certain of the paper’s proposals—notably several in the PIT, including the elimination of housing construction benefits, restrictions on the use of joint filing by married couples, changes in family allowances, and the rate reductions—became the center of controversy. Ultimately, this controversy proved fatal to the enactment of reform in late 1998.

B. The 1999 Proposed and Enacted Reforms

Substance of the changes

3. In mid-1999, the government reintroduced sweeping reform proposals, embodied in complete redrafts of the CIT and PIT. By and large, these proposals represented significant improvements in the direct tax system, and were in line with recommendations of a November, 1998 FAD tax policy technical assistance mission. Late in the year, a series of amendments embodying the most important aspects of the CIT and PIT reforms were substituted for the full redrafts of the tax laws in order to facilitate the enactment of the major provisions in time to be implemented in 2000 (see Box 1 for details of these amendments). In late November, the amendments were passed by the parliament. The President signed the law amending the CIT, but vetoed the PIT amendments (which had once again engendered much greater controversy) on the grounds that their enactment was procedurally flawed. In addition, amendments to the VAT were enacted and signed. Most importantly, these will extend taxation (at the reduced 7 percent preferential rate) to various public services, in line with EU requirements, and eliminate preferential treatment of organizations employing the disabled. Extension of the VAT to the agricultural sector was not included in the final amendments. Broadening of the VAT base and increases in excise tax rates have been ongoing for several years, largely in response to requirements of EU accession.

Box 1.Major Proposed Amendments to Income Taxes, November 1999

The CIT—bill signed by the President on November 26, 1999:

  • Regularizes the periodic revaluation of fixed assets

  • Somewhat simplifies the grouping of assets for depreciation purposes and accelerates the rate of depreciation

  • Eliminates tax incentives for corporations employing the disabled

  • Eliminates, subject to generous grandfathering provisions, the extensive and complex system of investment allowances embodied in the existing CIT

  • Introduces a gradual reduction in the marginal rate, from the existing 34 percent to 30 percent in 2000, 28 percent in 2001–02, 24 percent in 2003, and 22 percent in 2004

The PIT—amendments enacted by Parliament and vetoed by the President would have:

  • Made parallel changes in the depreciation system for fixed assets of unincorporated businesses

  • Eliminated housing reliefs over two years

  • Maintained but reduced incentives for employing the disabled

  • Maintained but tightened optional joint filing for married couples

  • Phased in “pro family” allowances for 2 or more children

  • Lowered the marginal rates from the present 19,30,40 brackets to 19,29,36 in 2000, 19,28,35 in 2001, and 18,28 in 2002

Balance of the taxes

4. The relative shares of central government revenues as a percentage of GDP derived from the CIT, PIT, VAT and excise taxes for the years 1994-2000 are shown in Box 2. The overall reforms have resulted in a shift in emphasis from the income taxes toward the domestic indirect taxes.2

Box 2.Shares of CIT, PIT, VAT and Excise Taxes

199519961997199819992000200120022003
proj.proj.proj.proj.proj.
(percent of GDP)
Central govt tax revenue 1/24.423.422.521.819.419.419.620.09.4
o/w:
CIT2.92.82.82.72.32.01.92.01.7
PIT 2/7.76.86.46.33.93.83.73.93.6
VAT6.77.37.97.88.18.58.78.88.9
Excise taxes4.04.03.83.84.14.44.64.74.7
(percent of central government tax revenues)
CIT11.811.912.512.312.010.39.710.08.8
PIT 2/31.529.028.328.90.219.518.99.518.6
VAT27.731.034.935.741.943.844.444.045.6
Excise taxes16.217.216.917.620.822.723.523.524.2
Sources: Authorities; staff projections.

Beginning in 1999, figures are staff projections and percentage shares of GDP are calculated using staff projections for nominal GDP.

Beginning in 1999, payroll contributions to new health insurance funds, which are recorded elsewhere in general government revenue, are credited against the PIT. This reduces PIT collections by that amount; the series is therefore not comparable before and after 1999.

Sources: Authorities; staff projections.

Beginning in 1999, figures are staff projections and percentage shares of GDP are calculated using staff projections for nominal GDP.

Beginning in 1999, payroll contributions to new health insurance funds, which are recorded elsewhere in general government revenue, are credited against the PIT. This reduces PIT collections by that amount; the series is therefore not comparable before and after 1999.

Next steps

5. It is the government’s intention to reintroduce in Parliament the changes to the PIT in early 2000. It is expected that Parliament will again enact these proposals, but without the procedural flaws that dogged the process in 1999.2 The changes would then be effective as of January 1, 2001, including the schedule of rate reductions enacted in November, but delaying their implementation by a year. As part of this process, it is envisioned that the original comprehensive 1999 legislation would be reintroduced for both the PIT and CIT, providing needed clarification and unification of the drafting of the laws.

6. In light of the fact that the amendments to the CIT were enacted, and those to the PIT vetoed at the end of 1999, there are now significant discrepancies between some of the structural aspects of the measurement of business taxable income arising in corporations and that in unincorporated businesses. Even if the PIT amendments are enacted this year, that discrepancy will persist throughout 2000. The authorities are attempting to minimize this problem through regulation and administrative orders affecting, for example, the structure and rate of depreciation deductions. Nevertheless, this is an issue which must be addressed as soon as possible through the comprehensive alignment of the structure of the tax on business income. The most satisfactory course in this regard is frequently, as suggested by the 1998 FAD mission, to adopt a single law covering the taxation of income of all taxpayers, incorporated businesses and individuals. This would permit the same business tax structure to apply to both, with much less chance of discrepancies creeping in.3

7. The comprehensive revisions would also include a variety of other important technical changes, including some designed to achieve conformity with principles of the EU, for example, with respect to reorganizations of companies and corporate groups domestically and across internal EU borders.4

Evaluation of the changes

8. The great majority of the structural changes enacted in the CIT and proposed for the PIT represent improvements in the law. The broadening of the tax base through the elimination of the numerous incentives, allowances and reliefs for investment is of particular significance, as is the elimination of relief for hiring the disabled, and elimination of the housing reliefs in the PIT. Remaining shortcomings include, however: overly complex depreciation allowances; optional joint filing for spouses; continuation of the requirement to file returns by persons whose income consists solely of wages from a single job; insufficient taxation of the agricultural sector; and failure to introduce immediately taxation of interest on bank accounts and government securities. In addition, a complex and expensive system of personal dependency allowances related to family size would be introduced with the PIT amendments.

9. There are persuasive arguments that the top marginal rate of personal income tax should be aligned with the corporate tax rate—in the context of current reforms, such an alignment should occur at least by the time the phased schedules of rate reductions in the two taxes are complete. These arguments relate to the tax induced incentives to distort the choice between incorporating a business and operating as an individual proprietorship, as well as to opportunities for wealthy individuals to incorporate portfolio investments and thus to obtain a lower current rate of tax on accumulated earnings. Such an alignment of rates will not be achieved under present plans, in which the top marginal rate in the PIT will remain at 28 percent, while the CIT rate is reduced to 22 percent. Nonetheless, overall, the structural reforms, both those enacted to date and those to be reintroduced more comprehensively, on balance represent substantial progress on tax policy.

C. Rate Reductions

10. The substantial income tax rate reductions that accompany the structural reforms can be analyzed from several aspects, both in the context of those reforms, and separately from them.

Overall tax package

11. Taken in conjunction with the structural changes, the rate reductions represent a package designed to achieve more efficiently the original goal of the existing complex system of incentives and reliefs to stimulate investment. The basic strategy of the tax reform—lowering the marginal rate of tax on business income while broadening the tax base, eliminating the special tax incentives granted through the “special economic zones” and various decrees of the Council of Ministers—is consistent with the general trend in OECD countries in recent years. In combination with a relatively simple and fairly accelerated system of depreciation and appropriate periods for the carryforward of losses5, such a system provides better incentives to stimulate investment than the complex system of preferences in place under existing law. Such a transformation heralds greater certainty and stability for potential investors; these are highly valued, but rare, characteristics in the tax systems of emerging and developing economies.

12. In this context, one of the stated reasons for the elimination of the existing tax privileges and the introduction of more uniform conditions for all taxpayers, was in part a response to the OECD with respect to whether such privileges in Poland could be characterized as a form of “harmful tax competition,” as defined under the ongoing OECD project in this area. Both the EU6 and the OECD7 have recently promulgated guidelines for appropriate behavior of member countries, attempting both to slow the increase of tax competition and, perhaps even more difficult, to eliminate such measures already in place. Both of these sets of guidelines take the position that preferential regimes-generally designed to discriminate in favor of non-residents or mobile capital-are particularly damaging.8 And certainly Poland’s existing system does contain elements of discrimination of various types.

Revenue impact

13. The authorities estimate that the schedule of reductions in corporate tax rates already enacted, and the personal tax rate reductions which will be reintroduced this year under a delayed schedule will result in significant revenue losses, taken in isolation from other factors and given the macroeconomic assumptions underlying the revised 2000 budget submission. For the CIT, the reduction in revenue in 2000 from the rate reductions only is estimated at 2.0 billion zlotys; 2.9 billion zlotys in 2001, and 3.0 billion zlotys in 2002. In the PIT, the corresponding amounts (when the changes were anticipated to begin in 2000 rather than 2001) were 0.6 billion zlotys in the first year; 0.9 billion zlotys in the second year; and 4.0 billion zlotys in the third year of the reductions.9

14. There are, however, other effects on revenue arising from both the CIT and PIT amendments. On net, taken together with the rate changes, these changes are estimated to yield an overall impact from the direct tax amendments of, in the CIT, revenue losses of 1.9 billion zlotys in 2000, 2.2 billion zlotys in 2001, and 1.8 billion zlotys in 2002. In the PIT, the net revenue effects are estimated at a loss of 0.1 billion zlotys in the first year of reform, a gain of 1.1 billion in the second year, and a net loss of 1.5 billion in the third year, when the basic bracket is lowered.

15. More comprehensively still, when the direct tax changes discussed here are viewed together with the changes to the indirect tax system as parts of a single unified reform plan, the overall package is actually revenue enhancing over the medium term. The VAT base is broadened, and excise rates continue to be increased significantly in order to bring them up to applicable EU minimums in time for accession in 2003.

16. The authorities have targeted a fiscal consolidation, moving from the current general government deficit in excess of 3 percent of GDP, to balance in 2003. Such large income tax rate reductions as enacted and further proposed could appear to be at odds with this strategy. The authorities with some justification, however, see the current and proposed income tax rate reductions as part of an overall tax reform package, encompassing the base broadening provisions in the PIT and CIT as well as the revenue increasing measures in the VAT and excise taxes. In this context, the view could be taken that the desirable structural changes would not be possible, or even appropriate, without the rate reductions. The government will, however, have to be prepared to take corrective fiscal measures, should the momentum toward deficit reduction slip, and consolidation go off track.

D. Comparative Tax Rates and Burdens

17. The strategy originally set forth in the 1998 White Paper, and embodied in the amendments to the income taxes passed in 1999, eliminates most investment incentives, makes depreciation allowances somewhat more generous, and significantly reduces corporate tax rates. A primary goal of this approach is to make Poland more attractive to investment (both domestic and foreign) by eliminating distortions and complexity in the tax laws, while maintaining or reducing overall effective taxation of investment. In this context, it is useful to compare the preexisting level of marginal and effective tax rates in Poland with those of neighboring comparator countries, as well as the marginal statutory rates with those in Europe more generally.

18. Looking simply at the statutory tax rates on corporate income in comparator neighboring countries, even before the rate reductions just enacted Poland compared favorably with all but Hungary, which has an 18 percent rate and Slovenia. (See text Table 1. Comparisons for the OECD countries are shown in AppendixTable 1). Perhaps more telling, a recent comparison of effective rates of taxation on investment in Romania, the Czech Republic, Hungary, Slovakia, Slovenia, and Poland indicates that, for a representative manufacturing investment project, Poland’s effective tax burden under the basic tax systems would have ranked fourth highest among the six countries, leaving out of account the existing tax preferences available in the six countries. Including the effects of the existing preferences in all the countries, however, the effective marginal tax rate on investment in a representative manufacturing project in Poland became highest among the six countries.

Table 1.Comparative Statutory and Effective Corporate Tax Rates
PolandHungaryCzech Rep.SlovakiaSloveniaRomania
Statutory corporate tax rate341835402538
Effective tax rate on manufacturing investment project without considering tax incentives30.222.033.339.112.445.4
Effective tax rate on manufacturing investment project taking into account existing incentives22.113.110.916.912.44.3
Source: Unpublished World Bank,/IFC study.
Source: Unpublished World Bank,/IFC study.

19. There is no comparable marginal effective tax rate study for the just reformed corporate tax regime in Poland. The combination of greatly reduced statutory marginal rates and slightly more favorable depreciation would likely represent a relative reduction in the effective tax rate, however. The marginal statutory rate in Poland will in 2004 decline to the level of the marginal effective rate calculated for the example investment project with all existing incentives.10

E. Reforms in the Context of the “Nordic Model”

20. A significant development in the approach to income taxation in the last decade is the development and spread of the so-called “Nordic model,” or dual income tax. The premise of this approach is to abandon the principle of global progressive income taxation in favor of a regime in which capital income is taxed separately, and at a lower rate, from other sources of income (primarily labor and pension income). This is a more extreme variant of the trend in some European countries to introduce separate lower rates of tax on some types of capital income—frequently through such devices as final withholding on interest—in response to the increased mobility of capital. This latter trend can, of course, be viewed as one aspect of the tax competition referred to above. On the other hand, it can be viewed merely as a practical response to the administrative difficulty of capturing such income in the tax base at all.

21. In the “pure” version of the dual income tax model, the lowest marginal rate on earned income is set equal to a flat rate on capital income, which in turn is set equal to the corporate tax rate. There are several economic justifications offered for the dual income tax approach: it provides an implicit inflation adjustment for the return to capital; and it compensates for the discrepant treatment between investment in human capital (which is essentially taxed under a consumption model, with investment made in one period and increased income earned and taxed in a later period) and in financial capital (where reinvested returns on investment made in the first period are taxed “twice”). There are also clear problems with the dual income approach—for example, in distinguishing the returns to capital and labor in the case of unincorporated businesses.

22. The Polish reforms do not go as far as the dual income tax model. Rather, they take the more common approach of taxing corporate income at a lower rate than individual income, with partial relief of double taxation through a low final withholding rate on dividends distributed to individuals. By applying low rate final withholding to certain interest income the Polish reform is in line with the recent European trend. In some sense the proposed PIT reform comes from the opposite direction of the Nordic model’s shift away from global taxation, however, since heretofore that income has been exempt from tax in Poland.

F. Taxes on Labor

23. The overall direct tax system in Poland, even with its previous high rates of corporate income tax, has imposed a very heavy relative burden on labor income.11 With both a high (by contemporary standards) top marginal rate on personal income of 40 percent, a quite high basic rate, at 19 percent, and very high pension, unemployment and health payroll taxes—themselves totaling approximately 45 percent and, until this year, legally falling on the employer12—labor effort and the hiring of labor has been discouraged.

24. The impetus for the PIT rate reform comes from this tax burden on labor. There is considerable concern with the need for job creation and reductions in official and hidden unemployment, which remains a major area to be addressed in the completion of Poland’s economic transformation. This is, however, a difficult problem to solve, in the context of heavy expenditure commitments currently and in future. Even the reduction of a single percentage point in the basic rate of personal income tax, which is the marginal rate applicable to almost all Polish workers, will be very costly in revenue terms. The proposed PIT rate reductions should be seen in the context of the ongoing reforms in the pension and social benefits system. Gradual increases in retirement ages, redefinition and tightening of disability benefits, and the shift from a pay as you go defined benefit system to a defined contribution pension system, are all designed to permit reductions in the tax burden necessary to sustain the social benefit system in the longer run.

G. Conclusion

25. The direct tax reforms just enacted and those to be proposed this year overall represent very positive steps in the evolution of the Polish tax system. There do remain some areas for additional structural improvement, even if planned amendments are made this year, as discussed in Section II. Further, the tax reform package as a whole is revenue neutral, though projected direct tax revenues will decline over the medium term. In the context of its planned medium term fiscal consolidation, in this light the government must stand ready to take additional fiscal measures if necessary, to secure the targeted consolidation.

Appendix I
Table 1.Poland: Basic Rates of Central Government Corporate Income Tax in the OECD

(In percent)

Country199119951998
United States343535
Japan383834
Germany 1/50/3645/3045
France 2/34/423333
Italy363637
United Kingdom343331
Canada282828
Australia393336
Austria303434
Belgium393939
Denmark383434
Finland232528
Greece 3/4635/4035/40
Iceland453330
Ireland434032
Luxembourg333330
Mexico34
Netherlands353535
New Zealand333333
Norway271928
Portugal363634
Spain353535
Sweden302828
Switzerland 4/4/104/108
Turkey492525
Source: OECD 1999.

The figures of 50 and 45 are rates on retained earnings.

34 percent is the rate on retained earnings in 1991.

The last column applies to 1997 rather than 1998.

The figure for 1998 is net-the federal tax is deductible from its base.

Note: Austria, Canada, Finland, Germany, Italy, Japan, Norway, Portugal, Switzerland and the United States also have sub-national corporate income taxes. Some countries also have special rates for firms with lower profits or in particular sectors.
Source: OECD 1999.

The figures of 50 and 45 are rates on retained earnings.

34 percent is the rate on retained earnings in 1991.

The last column applies to 1997 rather than 1998.

The figure for 1998 is net-the federal tax is deductible from its base.

Note: Austria, Canada, Finland, Germany, Italy, Japan, Norway, Portugal, Switzerland and the United States also have sub-national corporate income taxes. Some countries also have special rates for firms with lower profits or in particular sectors.

Prepared by Victoria Summers (FAD).

This raises a collateral issue. Local governments’ “own source” revenues consist to a large degree of shares of national income taxes, not indirect taxes. Thus the shift away from reliance on direct taxation seen in Box 2 above has implications for subnational government finance. This should be addressed in the context of the adjustment of the law on local governments which will take place later this year.

These problems arose in the context of the heated debate late in the year, and the accompanying introduction of hundreds of amendments to the original comprehensive legislation designed to stall the process of enactment.

Naturally, this approach also requires the inclusion in the single law of certain provisions that apply only to companies-an example would be in the area of reorganizations—and some that apply only to persons—for example, in the application of wage withholding. Such a system does not imply that rates applicable to individual earned income, unincorporated business income, and corporate income have to be the same.

Other such changes, in addition to improved drafting, include, in the CIT: simplification of the system for advance tax payments; some liberalization in the definition of “capital groups” for tax purposes; expansion of the substance over form doctrine of anti-avoidance; additional guidelines for transfer pricing (more in line with OECD guidelines); limited changes in the definition of allowable costs of doing business; limitation on deduction for charitable donations to 10 percent of income; reduction of the rate applicable to dividend income from participation in profits of other resident companies to 15 percent (down from 20 percent); and changes to the foreign tax credit mechanism. With respect to the PIT, changes in addition to those incorporated in the vetoed amendments included: extending loss carryforward provisions to correspond to those in the CIT; introducing parallel substance over form anti-avoidance provisions; abolishing a large number of exemptions from taxable personal income; introducing transfer pricing and related party provisions parallel to those in the CIT; eliminating relief for expenditures on private health care (in conjunction with the sweeping reform of the health care financing system); changing advance tax payments; freezing provisions for reliefs in special economic zones (in line with OECD and EU allegations of harmful tax competition); and widening the scope of taxation of capital income beginning in 2003, in line with draft EU directives (e.g., taxing interest on personal bank accounts and government securities).

The period for corporate taxpayers in Poland is currently 5 years, and the PIT reforms would appropriately extend the period for unincorporated businesses from 3 to 5 years.

Code of Conduct, 1998.

Guidelines on Harmful Tax Competition, 1998.

Though the contrary view could be supported on the ground that treating all taxpayers alike generalizes the tax competition through the entire economy, rather than restricting it to the particular area, say, of returns to mobile capital.

In the PIT, the bulk of the revenue effect comes from the reduction of the basic bracket from 19 to 18 percent, as almost all taxpayers fall into this bracket. The exact numbers would change with the postponement by one year, but the pattern and size would be close to these figures.

If the income of foreign investors sourced in Poland is taxed at substantially lower rates than those applicable in their home country, and if the home country provides double tax relief through the mechanism of the foreign tax credit, the benefit of the lower effective taxes may well not accrue to the investor. Additional home country tax will be imposed on the Poland source income sufficient to bring the total tax burden up to that which would apply in the home country were the income sourced there—only the tax actually incurred in Poland may be credited against the investor’s domestic tax, unless the home country includes “tax sparing provisions” in double taxation treaties, that permit the savings from tax incentives to be retained by the taxpayer.

The most salient feature of the dual income tax model is not that capital income is taxed at a lower marginal rate than labor income (though this is in fact universally the case) but rather that capital income is taxed on a schedular basis and proportionately, rather than progressively.

This now been legally split between employer and employee contributions.

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