The new tax reforms will perpetuate income, wealth, and intergenerational inequalities

There are three main criticisms of the proposed tax reform.

First, it is not directed at meeting the medium to longer-term government revenue and expenditure needs of Cyprus and is geared primarily to appealing to the short-term interests of larger businesses, in particular, and households as appears to be the want of President Christodoulides.

Next, the proposed structure of tax rates is unfair and will result in a more regressive tax system that will perpetuate income, wealth, and intergenerational inequalities.

And third, the proposed tax rates and incentives for the business sector are directed mainly at supporting the continued allocation of resources to, often inefficient, existing large companies, rather than providing tax incentives to spur innovation, entrepreneurship and equity investments in new firms, which are the lifeblood of a modern economy.

Raising sufficient revenue

Tax reforms take place only after many years with the last comprehensive tax reform for Cyprus occurring some 20 years ago.

Accordingly, a tax reform should take account of the need to raise sufficient revenue to meet not only the present expenditure requirements of the government, but most importantly should be directed at providing sufficient revenue to support medium-to-longer term expenditure needs.

Minister of Finance Makis Keravnos has stated that the tax reform should be “fiscally neutral”. Does this mean that increases in revenue from certain tax changes (raising corporate tax rate to 15 per cent) would be offset by decreases in revenue from other tax changes (increasing tax deductions for “green” investments) so as to keep revenue at levels projected in the medium-term budgetary framework for 2025 to 2027?

Unfortunately, this framework for budgetary spending entails a continued policy of fiscal austerity to produce sizable, but unnecessary, government surpluses, by curtailing spending on development and social needs including required outlays for the care economy.

Hence, it is essential for the tax reform to take into account the need to raise revenue to not only meet the requirement for much higher and responsible government spending on hard and soft infrastructure and social needs over the longer-term, but to surely have the revenue to finance the looming challenges of boosting defense and cybersecurity spending, addressing climate change, and dealing with the requirements of an aging population. Indeed, it will be the shrinking working age population that will have to provide the bulk of tax revenues including contributions to national health and social security systems, while the rising elderly population by living longer become an increasing drain on government resources with higher payments of pensions and health benefits.

And for effecting substantial increases in government revenues the tax base should be broadened through the much greater taxation of property wealth and the undertaking of serious action to combat widespread tax evasion and avoidance.

Fairness

The tax reform should aim at producing a more progressive tax system providing for a fairer distribution of the tax burden on individuals and corporations. Since the last reform the tax system of Cyprus has become increasingly regressive. Inflation has brought lower-and-middle income earners into higher tax brackets, the progressive Central Government tax on property was abolished in 2017, and the government has become increasingly reliant on flat rate indirect taxes such as the VAT and excises to generate revenue.

Unfortunately, the proposed structure of personal income tax rates in the reform hardly claws back the great loss of progressivity in the tax system that has taken place over the last 20 years.

Take the personal income tax free threshold, which was increased to €19,500 in 2008 for annual personal incomes, above the estimated annual median wage of around €18,000, meaning that probably about two-thirds of wage earners were not liable to pay income taxes. However, with inflation boosting personal incomes the annual median wage by 2024 had been increased to an estimated €24,000, above the tax-free threshold and resulting according to the Ministry of Finance in just over 40 per cent of wage earners not having the obligation to pay income taxes.

But, in the proposed tax reform the tax-free threshold is raised by a minute 5.1 percent to €20,500, which compares with rises in the Consumer Price Index and estimated median wages of 30 per cent and 27 per cent respectively, between 2008 and 2024. Although the new tax-free threshold would still be below the annual median wage, Finance Minister Keravnos claims that with the help of tax deductions including up to €1,000 for mortgage costs and €1,500 for green renovations of a house, around 60 per cent of persons would not have to pay income taxes.

Similarly, middle-income earners that were required to pay taxes at the marginal rate of rate of 20 per cent in earlier years have been pushed by their inflated incomes into higher tax brackets. Indeed, under the proposed tax reform there would be little relief to most tax payers that have had their real disposable incomes eaten up by inflation. Furthermore, with the proposed new tax rates likely to be “set in stone” for many years and prices expected to trend upwards take-home pay will continue to be eroded by inflation making a mockery of the proposal to raise the tax-free threshold for personal incomes by just 5.1 percent for the coverage of the tax system over the next decade or more.

Accordingly, it is recommended that Cyprus in common with certain EU countries index tax brackets to inflation rates so as to protect disposable incomes and social benefits from inflation. Austria, Denmark, and the Netherlands have automatic annual adjustments for income tax thresholds, while Belgium, Finland, France, Germany and Sweden make periodic adjustments without automatic indexing. 

Currently, the personal income system of Cyprus is far from progressive with a top marginal personal income tax rate of 35 per cent well below the EU average of 42 per cent and that of Greece at 44 per cent. Yet, incredibly the government proposes to lessen significantly the progressivity of the personal income tax system by applying the current top marginal rate of 35 per cent to annual incomes exceeding €80,000 instead of the current level of €60,000. This means that those persons earning between €60,000 and €80,000 will enjoy tax saving by moving to lower tax brackets. Undeniably, it is the rich that will inevitably benefit most from the changes in personal income tax rates.

Hence, to take account of the impact of inflation and to impart greater progressivity into the tax system it is recommended that the tax-free threshold be adjusted upwards initially from the current €19,500 for taxable annual personal income to €20,500, but be indexed to the rate of inflation along with lower and middle-income tax brackets from 2027 onwards. On the top marginal tax rate this should be increased at the outset of the tax reform from 35 per cent to 40 per cent on annual personal incomes above €65,000.

Cyprus has a high and rising level of wealth inequality with the wealthiest 10 per cent of the population owning around two-thirds of the country’s net personal wealth according to the “World Inequality Report 2024” of the Swiss bank “UBS”. And it is the tax system in Cyprus which unabashedly favors the rich that has been most instrumental in boosting wealth inequality. Taxes on wealth in Cyprus are extremely low by international standards with the Central Government progressive tax on immovable property having been abolished completely in 2017. Also, there is no inheritance tax and taxation of capital gains is very low.

However, despite the mounting, serious, negative consequences on wealth, income and intergenerational inequalities, including the inability of younger persons to afford decent housing, of the favorable tax treatment of the property sector and of foreign professionals domiciled in Cyprus, there is no evidence in the proposed tax reform of any real consideration being given to raising taxes on property wealth including levying higher taxes on purchases by third country nationals. This is a serious omission and at least a Central Government progressive recurrent tax on immovable property should be reintroduced even if it means delaying the timing of the implementation of the tax reform.

Promoting a modern business sector

The proposed tax reform places much focus on bolstering the financial position of existing businesses mainly through the provision of tax breaks. While the corporate tax rate has been increased from 12.5 per cent to 15 per cent the much-maligned deemed dividend distribution system is to be abolished, and the tax on actual dividend payments is to be reduced from 17 per cent to 5 per cent. 

Generous tax incentives are to be given for employing green and digital technologies to encourage the adoption of environmentally-friendly practices and digital transformations, including tax deductions of 100 per cent for losses from such investments for up to 10 years!

Notably, the tax reform keeps the special taxation treatment favoring foreign companies and professionals newly domiciled in Cyprus. The zero-withholding tax on dividends to non-residents is retained. In addition, high-income new residents will continue to enjoy a 50 per cent personal income tax break and be exempt from being taxed on dividends received.

But, tax and other incentives for promoting innovative technologies and entrepreneurship in areas apart from the green and digital transitions are largely lacking.  Furthermore, strong tax incentives for developing the dormant capital market including for the listing of new companies on the Cyprus Stock Exchange are missing. Thus, there is the question of whether the concentration on tax breaks to largely support existing corporations and their foreign employees will just allow many inefficient businesses to remain financially viable without raising their productivity and competitiveness. Such a development could in turn crowd out resources, including equity investments, for modernising the economy with more efficient firms and a flourishing capital market.