There is a heavyweight champion in the world of international tax competitiveness: tiny Estonia, whose economy is one-50th the size of Canada’s.
For 13 years in a row, Estonia’s tax code has led the Organization for Economic Co-operation and Development, according to the annual rankings of the Tax Foundation. Canada, meanwhile, is in the middle of the pack within the OECD, at a distant 15th.
There is a lot that Estonia gets right, but one of the biggest reasons that its tax code is world-leading is a radical – in the best sense – change to corporate taxation introduced a quarter century ago.
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On Jan. 1, 2000, the country began taxing companies on a distributed-profits basis, meaning that no tax would be paid so long as a company keeps those profits within its operations. Every year, that firm would have a few more dollars to invest that otherwise would had been paid out to government.
Only when those dollars are paid out as, say, dividends are they taxed. The hoped-for result is a virtuous circle of retained earnings that are recycled into investment, boosting profits – which can then be reinvested anew.
Estonia became the first, and is still just one of a handful of countries in the world, to take a leap to that much different approach to corporate taxation – one that uses the corporate tax system as an accelerant for growth, rather than a drag. It’s a lesson for any policy-maker in this country considering how to shake up the Canadian economy.
Closing the GDP gap
There’s no doubt that Estonia was ripe for an aggressive approach to tax reform by the late 1990s. Decades of stagnation under Soviet rule had ended by 1991, but the country had a long way to go in closing the gap with Western living standards.
As this chart shows, Estonia’s gross domestic product per capita in 1990 (based on 2015 U.S. dollars) was slightly less than 30 per cent of Canada’s. By 1999, the Baltic country had lost ground relative to Canada as well as to the average of the member states of the OECD.
But that started to change in 2000, the year of Estonia’s switch to distributed-profits taxation. There were ups and downs. But by 2021, the year before the economic dislocation caused by Russia’s war of aggression against Ukraine, Estonia had closed a substantial part of the economic gap.
That year, Estonia’s GDP per capita had risen to 48 per cent of the Canadian equivalent. Put another way: Estonian GDP per capita grew five times faster than in this country from 1990 through 2021.
Estonia joined the EU on May 1, 2004, and later adopted the euro as its currency in 2011.NICOLAS TUCAT/AFP/Getty Images
A boost to balance sheets, and productivity
Of course, Estonia’s distributed profits tax policy is not fully responsible for that dynamic. There were many moving parts, most notably the country’s transformation into a free-market economy and joining the European Union in 2004.
But researchers have found that the distributed-profits tax gave Estonia’s economy a boost on several fronts, including productivity and economic growth, investment and the liquidity of firms.
A 2011 study from the country’s University of Tartu found that the policy bolstered the balance sheets of firms, particularly smaller ones. Loans shrank relative to total assets, and liquid assets increased relative to total assets. As a result, the authors say, Estonian firms were better able to weather the great financial crisis of 2008-09.
Greater investment led to productivity gains, especially among smaller companies and those in the service sector.
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In a research paper issued earlier this year, the C.D. Howe Institute pointed to Estonia’s experience as a model for Canada. Annual investment growth in Estonia was boosted by 0.378 percentage points between 1999 and 2008, stacking up to an increase of one-third over those eight years. Estonia’s revenue from corporate taxation fell at first, dropping to €55-million in 2000 from €105-million in 1999. (That included the effects of a recession.) But from 2004 to 2010, corporate tax revenues averaged €205-million, the institute’s paper noted.
To be sure, the policy is not a panacea. Estonia, like the other Baltic countries, still lags the OECD average in GDP per capita. And its economy has sputtered in the past four years, courtesy of the disruptions from the Russia-Ukraine war, including surging energy prices.
Still, the distributed profits tax addresses several vexing and persistent problems in the Canadian economy: flaccid productivity growth, the chronic inability of small and medium companies to obtain financing and, from the progressive point of view, the propensity of firms to pay out the proceeds of tax cuts in dividends or share buybacks. As a bonus, it would reduce the paperwork of filing corporate taxes.
Estonia became the first country to take an approach to corporate taxation that uses the system as an accelerant for growth, rather than a drag.Pavel Golovkin/The Associated Press
Boldness pays
The C.D. Howe paper argues for a distributed-profits tax as a key part of its “Big Bang” approach to tax reform. Adopting such a system would mean getting rid of some of the most cherished tax breaks that act to distort corporate investment and economic growth.
The small business tax rate would be scrapped. Sector-specific tax breaks would also be eliminated. And the major tax reform that the federal Liberals have touted since late 2024 – writing off capital investment costs immediately – would be rendered irrelevant.
The authors of the C.D. Howe paper recommend tax increases in other areas to offset the cost of moving to distributed-profits taxation and other reforms. A far better approach would be to hack away at the welter of business subsidies that have built up, sedimentary layer by sedimentary layer, over decades. Businesses would be able to keep more of their own funds; in return, they should expect fewer dollars from taxpayers.
Such an approach would represent a major realignment in Canadian tax policy, away from a model that overtaxes and then proceeds to subsidize too much.
The lesson of Estonia’s experience – like that of Sweden’s, which we wrote about last month – is that tax reform can change a country’s economic path if it is bold enough. If Canada wants more than incremental results, it will need to do more than make incremental changes.
The Sunday Editorial