If you look up the word "system" in a dictionary, you will see that it means an organised, logical set of connected parts that work together as a whole for a particular purpose. This definition raises doubts as to whether the mass of taxes in Lithuania can be called a system. Lithuanian governments have kept introducing taxes without a clear vision of the system they were trying to create and without formulating any principles or requirements that taxes must meet. The tax code is far from being orderly and organised. Taxes overlap and cover one and the same tax base. These flaws are recognised by anyone who have had the misfortune to deal, one way or another, with the hotchpotch of taxes in Lithuania. The above considerations point to the conclusion that Lithuania has…no tax system.

The quality of a tax code is determined largely by the requirements, or principles, attached to it. The Lithuanian Free Market Institute (LFMI) has brought forward a proposal for a pro-liberal tax system which is based on the following principles:
- a fiscal (or revenue generating) as opposed to regulating role of taxes;
- a minimum effect of taxes on economic processes;
- tax fairness;
- a declining tax burden;
- single taxation,
- uniform tax rates for all taxpayers,
- tax transparency; and
- inexpensive and automatic tax compliance and administration.

These principles were presented in The Free Market No 4, 1997. The principle of tax fairness, which was omitted then, implies that the burden of government spending should eventually become the same for every taxpayer, but while switching to a new system it should be proportional. If the state chooses to pursue redistributive policies by supporting low-income and needy citizens, such projects should be financed, not by differentiated taxes, but by public expenditures. In other words, rather than reducing their tax returns, the state should provide social welfare recipients with benefits or allowances.

With the principles of taxation in place, the aim is to devise measures that will accommodate a switch from the existing mess of taxes to a system. The functioning taxes must be assessed from the point of view of how they comply with the requirements attached to the future tax system. Such analysis will prompt the path to reform and point out which of the present-day taxes should be removed and which redesigned and how.

Corporate Income Tax

In Lithuania the tax that faces most criticism is the corporate income tax, charged on firms with the status of legal persons (other entities are subject to a personal income tax). The nature of corporation tax and the rules of compliance run counter to the above mentioned principles. Corporation tax is invariably used by governments as the most common and reliable tool for interfering in economic affairs and undermining competitiveness. The Lithuanian corporation tax has suffered from all possible defects, starting with priority sectors and small and medium-sized firms and ending with tax breaks extended to foreign entities and penalties imposed on off-shore and foreign companies.

Even if a uniform, universal and proportional corporation tax is adopted, it will still have adverse effects on the economy, as the very idea of taxing corporate incomes requires that the state control the calculation of profits by imposing restraints on tax deductible costs of doing business. One or another procedure is adopted for income and cost recognition, a procedure that inevitably invites discretion and affects day-to-day business decisions. As a rule, government-set rules inflate artificially taxable profits.

The base of corporation tax is always disputable, for the rules of income and cost recognition cannot embrace the multitude of business-related developments and circumstances. Intransparent and inexplicit rules provide an open invitation to corruption and allow the state to work against individual companies (for both private and political purposes). The state uses corporation tax not only to constrain economic processes but also to stimulate priority sectors, small enterprises or even individual producers. Corporate welfare programmes discriminate against those without political connections, undermining free competition and leading to corruption and political favouritism.

The administration of corporation tax is fairly expensive, while receipts from the tax fail to offset the costs of compliance and administration. They account for a negligible and shrinking portion of the national budget. As compared to 13.7 percent in 1994, they dropped to 9.6 percent in 1995. The forecast for 1998 is 6.8 percent.

The Tax Burden on Labour

Personal income tax coupled with social security contributions account for a demonstrable part of labour costs (49 percent of marginal labour costs), resulting in a high level of unreported incomes. Shadow unemployment is now being replaced with shadow labour relationships. Competition, which is largely affected by labour costs, spawns the need to minimise tax returns and labour costs. If the state neglects to take measures in this direction, businesses and individuals do that on their own. Quite naturally, they prefer to work behind the state's back rather than suffocate under the intolerable weight of taxes.

Personal income tax may gain transparency if it is withheld from paychecks. But withholding is subject to numerous restraints and has a whole host of weaknesses. It is not applicable to payments received from individuals and to certain types of income, e.g. income from capital gains. A withholding tax is a hidden tax. Many know only the size of take-home pay while being ignorant of the amount withheld.

If applied to all residents and all types of income, personal income tax would require income declaration. In Lithuania income declaration has only recently taken off, but one does not need much experience to realise that income declaration is costly, complicated, and frequently unsafe.

It is a widespread belief that corporate income tax may be abolished effectively by shifting to a single income tax charged on all of residents' incomes. Under this scheme, however, personal income tax inherits all defects of corporation tax. Repealing corporate and retaining personal income tax would provide an incentive to channel all possible expenses through firms. To prevent this, enterprises would be obliged to continue tax accounting, which means that administrative costs would not shrink. Furthermore, the relentless itch for all kinds of tax relief and concessions would inevitably impede the process of establishing the tax base of personal income tax. So it becomes obvious that this path will not lead to simple, transparent and universal tax rules.

Although state social security is called social insurance, it is not based on insurance principles and is merely an additional redistributive mechanism. Social security contributions are not labelled as a tax. Yet, they possess all features of regular taxes and must therefore meet all of the tax principles discussed above. As social taxes are in most cases paid only from wages and salaries, they impose a heavier tax burden on labour force (at the stage of costs planning) and provide incentives to lower official labour costs. Redistribution and unfairness are especially severe under systems when social security contributions are levied on all income without the upper earnings limit and when the size of future benefits is virtually unrelated to the level of contributions paid.

Value Added Tax

Of all the taxes functioning in Lithuania, value added tax would be the easiest to redesign according to the above discussed principles. VAT is an automatic tax which can hardly be used as a tool for regulating the economy. As noted earlier, if it operates alongside direct income taxes, VAT covers the same tax base. Despite the fact that the rate of VAT is much lower than those of direct income taxes, VAT revenues constitute the lion's share of the national budget, 43 percent. So if properly remodelled, VAT could become the main source of budget revenues.

Defects of Property Taxes

In Lithuania there are land tax, real estate tax charged on enterprises and organisations, and inheritance and gift taxes. It is a common fallacy to think that property taxes are levied on sources other than those covered by other taxes. It is true that an altogether new object is used to compute the tax. This object is the value of property. However, there is only one real source from which taxes, whatever they are called, are paid. This source is value created. All this leads to the conclusion that the rhetoric about taxing "different sources" is a cloak for the true size of the tax burden.

Property taxes are destructive in so far as they infringe on the foundations of private property and family. They also discourage business initiatives. Property taxes must be paid even if people have no sources-that is, current or past incomes-from which to pay them.

Another problem is with property valuation. The market value of an asset, as we all know, is determined only when the asset is sold. This value is momentary and unique in each individual case. In computing a property tax, the property is estimated based on directively set indicators. This results in a groundless level of tax returns and provides conditions for the tax to be used for regulatory purposes. Tax breaks and exemptions, which are invariably adopted, lead to tax avoidance and run counter to the notion of economic neutrality of taxes.

Property taxes are loss-making. A labour-consuming process of property valuation inflates the costs of tax compliance and administration. Tax receipts fail to offset the costs of labour that goes into computing and administering property taxes.

Custom Duties: Protectionism Without Borders

Protection of multifarious producer interests is not confined to the domestic market. The purpose of protectionism-both open and covert-is to safeguard domestic producers from foreign competitors. But the inclusion of custom duties in prices harms everybody alike, be they consumers or producers. The smaller the country, the more important the free trade and unfettered imports of the cheapest possible materials and goods.

Import duties thwart such opportunities, increasing the cost of imports and leading to the squandering of resources. Such policies are by no means the salvation of protected companies. Shielded from international competition, they start sinking and eventually lose. Export duties are intended to safeguard producers and consumers, but in reality they undermine competitiveness and the benchmarks for future production. Custom duties cannot be "neutralised", for they are meant, by their nature, to regulate.

Custom duties represent additional hidden taxes. Take, for instance, the notorious sugar law. Custom duties on sugar allow Lithuanian manufactures to sell sugar at prices higher than world ones. Let us imagine, for the sake of argument, that custom duties on sugar are removed. Consequently, the market is filled with cheap imported sugar, forcing domestic enterprises to cut their prices. When the enterprises start to languish, the government steps in and covers their losses by extending a subsidy of, say, 1 percent of income tax. Such evident government largesse would no doubt provoke an outburst of indignation from the public. However, the same is happening now, only the subsidy is invisible… High custom duties make people buy expensive Lithuanian sugar and thus pay-only directly, by circumventing the budget-part of incomes of sugar producers. The consequences of custom duties are much greater than the direct benefit derived by the budget.

Excise Duties

Historically used as taxes on luxury goods, excise duties have turned into a fiscal instrument which violates almost all requirements that taxes should meet. They undermine rational allocation of resources and fail to remove the habits which they are ostensibly supposed to prevent. There is ample evidence that excise duties have become a popular tool for government protectionism. Excise duties present a stimulus to contraband and illegal trade. The higher the duty, the bigger the gain one can derive by avoiding it and the more attractive the prospects of shadow undertakings.

Excise duties charged on imported goods are calculated based on their price, VAT, and custom duties. For Lithuanian products the size of excise duties depends on their sale price excluding VAT. The effect is that excise duties exacerbate price disproportions triggered by custom duties.

Trust Fund Taxes Reduce Redistribution

Trust fund taxes vary from other taxes in so far as they are not used for redistributing wealth. Trust fund taxes are charged on non-privatised public services (functions) and paid by the recipients of these services. The size of trust fund taxes should tally with the costs of services rendered and tax receipts should be used to finance these services rather than other government needs.

Stamp duties and road taxes are typical trust fund taxes, but in Lithuania they fall short of the above mentioned characteristics. The road tax, by way of illustration, is paid by all enterprises-regardless of whether they use public roads or not-as a percentage of total turnover. The size of stamp duties is not related to the costs of charging them, while revenues collected do not go toward financing the services for which stamp duty is paid.

Trust fund taxes have become a regulatory tool. The size and rules of charging stamp duties distort the purpose they are supposed to serve and undermine competitiveness. In addition to that, they obstruct market entry. If they met all of the above characteristics, trust fund taxes would help to lower redistribution. True, they would involve the problem of setting the prices of services. If charged in moderation, trust fund taxes can play a major role in providing a basis for privatisation of public services.

What to do?

As the analysis shows, VAT is the most prospective tax of all taxes in use, so reform efforts should centre around it. The first step should involve removing all VAT breaks and exemptions, as they complicate tax administration (except when charging of VAT on services would prove too complex). Equally important is the adoption of a single tax rate, a measure that will prevent VAT from turning into a regulatory instrument. Fiscal legislation should enforce cutbacks in the rate of VAT every year, thus matching a reduction in budgetary needs.

If income taxes are charged alongside VAT, the principle of single taxation is violated, and income taxation, with all the problems inherent in it, becomes pointless. Personal and corporate income taxes should be eliminated after adopting necessary changes to budgetary policy. While corporation tax exists, the law must prescribe explicit rules of tax compliance, approximating taxable profit to financial profit. All tax breaks must be repealed and a flat tax rate introduced. Deviations from providing an even playing field for all enterprises must be outlawed. Income tax rates should be made uniform, even though it would be impossible, due to social security contributions, to equalise the tax burden carried by individuals and companies. The rate of corporation tax must be reduced gradually, and, with necessary conditions in place (first of all the adoption of budget reform), the tax must be repealed.

While personal income tax exists, a flat tax rate, without any relief, must be charged on all types of income. This requirement translates first of all into the absence of tax-exempt minimums and exemptions for special segments of population or types of income. The use of personal income tax for redistributive purposes should be terminated and redistributive policies should be financed from the state budget, if at all. All incomes should be taxed at the same rate to the effect that people would stop being entangled into fruitless efforts to lift individual tax burdens.

Widespread exemptions from personal income tax (e.g. investments or the costs of purchase or maintenance of dwelling) should be abandoned, for they allow the authorities to manipulate of people's motivations and interfere in their most private affairs. They create special conditions for individual uses of income and severely inhibit tax administration. Every person turns into an "accountant" and every family into a fiscal agency and executor of the government's will. Under such circumstances the fiscal (revenue generating) role of taxes wanes, while the regulating role expands. Personal income tax, as long as it exists, must therefore be charged at the same and the lowest possible rate on all incomes. People must be free to spend their incomes as they wish, without any tax incentives thrust upon them.

It is imperative to limit the size of social security contributions to a certain upper earnings limit. True, this provision will not change the system. If redistribution is to be curtailed and other social safety methods are to be adopted, conditions for private fully funded pension insurance must be created. Private insurance premiums should not be inhibited by income and social taxes. It is also vital to gradually cut the rate of social security contributions so that people could obtain private insurance.

In order to secure consistent and logical pricing, excise duties charged on imported goods (expressed in percentage terms) should depend on the price of goods before custom duties. The charging of excise duties is in many cases determined by international treaties. It is recommended that EU member states impose excise duties on three categories of goods-alcohol, tobacco, and fuel. Excise duties can and must be repealed as soon as other conditions (first of all budget reform) are in place.

International agreements and unilateral decisions should be directed toward eliminating custom duties. Despite their proclamations of free trade, some international treaties may bring in restraints on free trade with regard to third parties.

A Pro-Liberal Tax Reform

If the proposed tax reform is adopted, a single tax modelled on the basis of VAT would become the sole source of budgetary revenues. The direct tax burden, a burden of taxes paid, would be clear and easy to assess. Tax cuts would dictate a decline in the overall tax burden. Trust fund taxes could operate alongside the single tax as long as people are forced to use public "services." But they would drop in line with the privatisation of government-rendered services. A tax system comprising a single, VAT-based tax and trust fund taxes is simple, clear, and inexpensive. In a word, a remarkable solution for Lithuania.