PRE-ELECTION ANALYSIS: It's the payroll tax, stupid (3)

(AFP/Scanpix)
Andrei Tuch
1/12/2015 12:08 PM
Category: Opinion

On March 1, Estonian citizens will head to the polls for a general election to fill the 101 seats of Parliament and determine the Cabinet and top job of prime minister. With a scant month and a half to go, it is time for a close look at the main contenders, their political platforms and promises.

The 2015 election comes at an awkward time for Estonia in geopolitical terms: the Ukraine crisis and Russia's belligerent behavior have driven the country into a shatterpause, a clenched and worried state where so much could change in a matter of a few days. At the same time, a major (and politically uncontested) defense procurement and a greatly expanded presence of allies have given Estonia every realistic assurance in regard to security.

In civilian policy matters, the one genuinely exciting political battle of 2014 was the Cohabitation Act, which legalized same-sex civil partnerships. That was a rare case of legislators voting with their conscience, not with their electorate. Nobody wants to hinge a campaign on the subject – not the proponents, who saw a lot of very vocal backlash, and not the critics, who can’t quite bring themselves to believe the poll numbers and remain fearful of the silent majority. Meanwhile, most voters cannot be made to care about important but unsexy stuff like infrastructure or agricultural subsidies.

Desperate for differentiation, the main contestants for the Riigikogu have settled on the key issue for this election: what to do about people’s salaries. Estonia’s tax code is mostly flat and simple, but the lack of many targeted taxes means that the payroll burden is quite high: an employee earning the national average takes home less than 59% of what their employer spends, with the other 41% going to the state.

With the first full parliament term since Estonia’s accession to the Eurozone drawing to a close, the country feels fully entrenched in the continental union. As its prices converge with those of Western Europe, the hope is that salaries will do the same. That also goes for public spending, as Estonia’s self-image is strongly Nordic: the Scandinavian welfare model is greatly admired, even if it has been seen as unrealistic, or at least a low priority, until now. This means changes both to the tax code, and to state spending.

Every serious contender for the Riigikogu has something to say about that, even though the multi-party coalition government model means it is unlikely specific pledges will survive in their original form.

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First out of the gate with a specific campaign promise has been the Pro Patria and Res Publica Union, commonly known as IRL. Their headline number: no income tax up to 500 euros!

This seems like a great thing for employees and an enormous burden on the national budget – possibly why the campaign has so far failed to find much traction. Estonians are a naturally skeptical bunch. Fortunately, IRL’s plan isn’t quite as mad as the deceptive headline suggests – the massive exemption does not apply to everyone:

  • Anyone earning under 500 euros is exempt from the 21% income tax.

o   They are still subject to the rest of the payroll taxes.

  •        For anyone earning over 500 euros, their exemption is decreased by one euro for every extra euro earned. Someone making 630 euros is not paying income tax on their first 500-(630-500)=370 euros, and the old flat 21% rate on the other 260 euros.
  •        The minimum exemption stays where it is – 154 euros (for 2015). Therefore, nobody pays more than they already do.  

o   The average Estonian would see no direct benefit from IRL’s plan.

o   The median Estonian would get 33 euros a month extra.

o   The most benefit any single taxpayer could get from this is 72 euros a month.

  •     Income tax applies to all earnings, so there’s no difference between drawing a salary and business/investment income.
  •        Total expected cost: 120 million euros per year.

IRL’s plan is ostensibly targeted at low earners, so it has a lot of appeal in terms of social justice – although there is a bit of a loophole: households file income tax statements jointly, and a household with two or more underage children can currently claim the full exemption for each of them. So the working parent in a family of four could end up paying zero income tax on a salary of 2,000 euros a month – something that the IRL marketing quietly neglects to mention. (Do they assume that anyone who can command that kind of salary is clever enough to figure it out anyway?)

Where the plan predictably falls down is in how to pay for it. Their one clear suggestion for covering the shortfall is to cancel the planned increase in the universal income tax exemption, which is currently set to grow by 10 euros per month every year. But that will barely cover 14% of the first year’s costs, according to IRL itself – the rest of the shortfall is expected to be covered by the usual nebulous hopes for economic growth and the positive impact this plan will have on people’s spending habits. So the best case scenario is that IRL’s plan will cancel further tax relief for medium- to high-earners, and absorb any extra money that the state would otherwise spend on defense, infrastructure, and the arts.

Overall, IRL’s plan is strong on hype but not too flawed – nothing here is fundamentally unrealistic; it just requires a fairly strong shift in how Estonia does things. IRL is not expected to do very well in the parliamentary elections, mainly because of their image problems and some high-profile defections, but there’s no reason why parts of their tax concept can’t be incorporated in the national fiscal strategy in the long term.

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The second party to put out a flashy headline were the Social Democrats: Increase the minimum wage to 800 euros per month! This is even more ambitious than IRL’s plan, as the current minimum wage is just 355 euros. But once you look at the details, it also becomes both less crazy and more improbable.

  •         The minimum wage would more than double.

o   The minimum wage doubled to the current level over nine years – it was 172 euros in 2005.

o   The minimum wage doubled over five years from 2003 to 2008 – when the world economy was doing great, and the Estonian economy was doing even better.

  •       The Social Democrats’ proposed increase would come over four years, in high increments. Minimum wage is already increasing to 390 euros a month in 2015; from then it would jump by 20% a year, reaching 800 euros a month in 2019 – just in time for the next parliamentary elections.

o   Similar percentage increases happened in 2007 and 2008 (at the peak of the real estate bubble, just before the global meltdown).

o   The minimum wage then stayed flat until 2012, and has been increasing by 10% since 2013.

  •       To offset the extra burden, the social tax rate will be decreased from 33% to 30% for companies outside Tallinn and the immediate area.

o   Minimum wage earners predominantly live and work in rural counties.

o   Social tax is paid by the employer on top of the official wage, so a decrease benefits the employer, not the worker – unlike a decrease in income tax.

o   Unless a prominent politician dies, the Social Democrats have no hope in Tallinn’s municipal elections.

  •  The cost to a company of employing someone at minimum wage would increase by around 125% between now and 2019.

o   SDE’s social tax plan, and the income tax changes that are already agreed, will only decrease the payroll cost by 3%.

  • The increase in spending power among low earners should strongly benefit the local economy – not much of that money will be spent abroad.

o   But there is a big risk of prices rising accordingly, so low earners won’t benefit that much, while the rest of the population suffers.

There is no doubt that the current minimum wage is laughable: the Social Democrats say that 40 000 people in Estonia today are employed, but take home a salary that is below the national poverty level. But SDE’s plan has two big problems.

For one, like IRL’s plan, it is mostly not funded. SDE might hope that the social tax decrease on everyone – even high earners – would lighten the overall burden on businesses outside Tallinn, but this is still a drop in the bucket. Rumor is that further drastic cuts in payroll tax could be introduced, along with a new tax on corporate profits to help the national budget – which isn’t actually lightening the burden. The party leadership needs to find a way to reconcile the interests of the budget and the taxpayers, and no clear strategy has been announced yet.

The other big problem is that even if SDE wins in a landslide, they can’t actually make this happen by force of will. The state has the power to change tax rates (a strong advantage of IRL’s plan), but the minimum wage is traditionally set in three-way negotiations between the government, the trade unions, and the employers’ association. Estonia’s trade unions are SDE’s traditional power base, but while they’ve had some success in recent years, they are still very weak by European standards, and it’s unclear what kind of leverage the government would have against businesses.

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Compared to the first two, the Reform Party has been mostly quiet. As the ruling party for the last decade, it is in the position to take credit for everything positive in Estonia. IRL promises to increase the income tax exemption? SDE promises to increase the minimum wage? Reform will say that it’s been doing all of that already, but in a way that is proven to work and doesn’t overwhelm the budget. The tactic of appearing unexciting but competent has served the party well, historically.

In the previous two general elections, the Reform campaign was largely built around the party leader and other highly visible politicians. But a recent cabinet reshuffle has left the country with a young and fairly unknown Prime Minister. While the other contenders are still led by their old guard, Reform hopes to appeal to voters who are tired of cult-of-personality politics.

Since 2005, the party has kept its grasp on power by mostly avoiding large-scale, highly public failures – although its medium-level ones have added up, and Reform may have a genuine struggle on its hands this year. After suffering the backlash from an ill-conceived commercial and a PR blunder by a senior minister, Reform has stayed mostly quiet. They have released only one headline policy so far: 300 euros a month for your third child.

  •   For every underage child in a household beyond the first two, the parents will get 300 euros a month from the state.

o   Benefits for the first two children are already increasing to 45 euros a month from the start of 2015.

o   Benefits for the third and subsequent child are increasing to 100 euros a month from the start of 2015, so Reform’s plan is to triple them.

o   The parents of four children would get 690 euros a month, etc.

  •        Imagine a family of five with only one working parent. The stay-at-home parent would get 390 euros a month – higher than the minimum wage (because these benefits are not subject to income tax).

o   Low-income families also get other benefits, but those are not very large.

o   These child benefits have no effect on the working parent’s ability to deduct income tax for their spouse, and all three children.

  •       Beneficial to households with all levels of income.

o   Existing maternity benefits and protections are relatively strong in Estonia, but run out soon after the child’s birth.

This plan is aimed squarely at a problem that is frequently discussed in Estonian politics: the negative birth rate, and the lack of desire for young people to start big families. The country’s population is falling alarmingly, but even successful professionals rarely have three or more children. The availability of daycare was a major issue in the last municipal elections.

The party says this plan should cost up to 70 million euros a year, and would currently affect around seventeen thousand households across the country. Other than the cost, perhaps the biggest criticism to be leveled against Reform’s plan is that it does not do enough for those most in need. This is not an expansion of targeted aid for large low-income families, and it’s not enough to compensate for a stay-at-home parent’s lost income – it appeals to middle-class professionals, generally seen as Reform’s power base. We shall have to see if enough of them show up to vote.

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The last of the four significant forces in Estonian politics is the Center Party. Earlier in the year, there seemed to be a chance of a successful palace coup, and a reinvigorated campaign with a young, female, generally liked leader could have made the Centrists a genuinely exciting option for voters again. Unfortunately, the party is still going into the general elections under the leadership of an aging populist with a talent for evasion. With no chance of an outright single-party majority in parliament (this simply does not happen in Estonia at the national level) and a near-certainty of an unhappy coalition between some combination of the other three, just to keep the Centrists out of power, this party is free to make any wild claims it wants – it will never have to back them up.

The Center party was the last one to reveal its platform this year, in a highly theatrical speech by its great leader. Despite a lot of bluster, only one specific campaign promise was mentioned: increasing the minimum wage to 1000 euros, as early as 2015. The party has so far declined to comment on how exactly it intends to do this.

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There is one more tax issue that has been widely debated in Estonia in recent times: that of social tax caps. The social tax, which mostly covers healthcare and pensions, is a very large part of the payroll tax bundle, at 33% of the official salary number (paid by the employer). It is seen as a strong deterrent to wage growth and the attraction of top-tier talent from abroad into Estonian businesses, as well as an incentive for tax evasion schemes. There is also a strong argument that it becomes unfair at the top end: someone earning double or triple the national average salary is paying for more healthcare services than they are ever likely to use, and your basic national pension does not get bigger if you’ve paid more social tax. (There is a separate, semi-mandatory proportional pension plan, financed through a separate tax; it has its own big problems.)

The suggested solution has been to cap the social tax. There would be a maximum level in euros, above which the social tax payment would never go, even as your salary increases. This would make Estonia’s payroll taxes doubly regressive: the income tax percentage gets smaller the less you earn, and the social tax percentage gets smaller the more you earn.

Nobody has seized on this concept for the 2015 electoral campaign. The Social Democrats might drop the overall social tax rate for businesses outside Tallinn. The Reform party is promising (but not very loudly) to drop the social tax rate across the country from 33 percent to 31 percent by 2019. But there has been no mention of caps. Why is that?

One argument could be that a high and broad social tax is a strong incentive to broaden the middle class. While it discourages the attraction of very well-paid expat specialists, it encourages the replacement of that competence with local talent. Fewer people in Estonia are likely to end up with very high salaries, but more locals are likely to be pulled up into middle-class professional jobs as a result.

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The political parties still have time to reveal further details of their campaigns, platforms and promises – but the elections are close: voting day is March 1, and online voting will start even earlier. Campaigning will start in earnest on January 21, at which time political street ads will be banned. Estonian voters do not have much time left to decide how they will vote. But with so little differentiation between the major parties, it’s unclear whether the choice will result in a significant difference.

Edited by K. Rikken

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