The policy brief has been prepared as of the situation in March 2005
Controlling the Income of Individuals in Latvia
Two significant problems at present make controlling the income of physical persons in Latvia an important issue. First, huge amounts of tax money are not collected by the State Treasury; some economists estimate that this sum annually exceeds 680 million Lats. Secondly, the fight against corrupt state officials is hindered, because they have the possibility to register their illegal income and property in the name of other persons.
What is the problem? The main tax administrator of Latvia – the State Revenue Service (SRS) – has no specific calculations on how much money passes by the state budget as unpaid personal income tax and social tax. SRS only points to the share of grey economy in our country, according to different studies it varies from 15% to 40% of the GDP.
The economists, comparing the official income and the actual expenditure that is reflected by other statistical data, have calculated that in 2003 companies have paid to Latvian population “in envelopes”, i.e. without paying the income and the social tax, 840 million Lats – which is only 2.5 times less than the total national budget. It means that in the said year 686 million Lats were not collected as taxes. For comparison – in 2003 the income from personal income tax (PIT) in the state was twice less – 367 million Lats.
It is the municipalities which lose the most because of uncollected PIT, as they receive 73% of this tax; however, the health care system was also affected, since up until 2005 it was receiving the remaining part of the PIT (now it is simply transferred to the national budget).
The pensions also suffer because of the “salaries in envelopes”- unpaid social tax means both that the state has less money to pay the pensions now and that the present tax-payers in their old-age will receive smaller pensions, because the amount of the social tax paid is directly proportional to the amount of their pensions.
From the perspective of fighting corruption, the greatest problem is the inability to prove the illegal income of the public officials. The income of the officials themselves is under comparatively stricter control – since 1995 it is their duty to declare their income and property. However, quite frequently the officials register their income or property in the name of a relative, and here the chain of control stops, because anyone now may refer to a previously gained income, for example, from growing tulips in the past or something of the like. Since individuals do not have to submit their tax returns and keep all the documents proving their income, it is impossible to prove the illegality of their income. This problem also restricts the possibilities for SRS to control any individual, with regard to whom suspicion exists that he or she has gained illegal or even criminal income (from drugs, smuggling).
Why is it impossible to control income?
SRS and the Corruption Prevention and Combating Bureau (CPCB) consider as the main causes of poor control drawbacks in legislation and insufficient resources of both institutions. The main drawbacks of legislation are considered to be the following:
1) SRS has no rights to control and to impose payment of taxes due and fines for unpaid taxes for a past period exceeding three years;
2) Individuals are not obliged to keep all the documents proving their income;
3) The declaration of transactions and savings in cash is insufficient;
4) The sanctions for the detected violations are too lenient;
5) Lack of legal presumption in tax cases – the individual is not obliged to prove the legitimacy of his or her income.
CPCB mentions as another drawback the fact that the system of annual personal tax returns, which functions in many Western countries, has not been introduced in Latvia. This could serve as a means by which the population’s income could be controlled for taxation purposes.
On the other hand, the insufficiency of the administrative resources for carrying out income control of individuals is reflected by the fact that out of approximately 5,000 SRS employees only 240 are tax auditors, whose duties include also the control of legal entities (e.g. companies). Less than 20 CPCB employees control the income of public officials, and these employees also have other responsibilities.
80% of SRS resources are allocated for VAT control, which leads to the conclusion that the taxes paid by the individuals are not a SRS priority. SRS explains this allocation of resources by the huge VAT amount and the fact that VAT refund possibility is more often used for tax frauds.
To a certain extent, the poor control of personal income tax is explained by the fact that the majority of the personal income tax revenues is paid to the local authorities, thus the state is not so interested in collecting it. However, this argument is contradicted by the fact that part of this tax was allocated to the sensitive health care budget. The Association of Local Authorities admits that the local authorities have not exerted sufficiently strong pressure to improve the collection of personal income tax. However, the local authorities do not have sufficient authorization to do so, even though formally Riga, Liepaja and Ventspils collect the personal income tax themselves, the local authorities nevertheless have to turn to SRS in case they identify some discrepancies, since the local authorities do not have the rights to deal directly with the personal income tax payers.
The procedure for verifying the declarations of public officials is also ineffective. At present, public officials submit their declarations to the SRS, which carries out their quantitative control. The substantive verification of the declaration is started by CPCB, and, on identifying discrepancies, it requests SRS to carry out a tax audit, since CPCB does not have the mandate to do so. SRS, in its turn, for tax audit purposes does not use the declaration of the public official (SRS has no rights to use it for these purposes), but asks to fill in another declaration – the so-called “additional declaration”; SRS may ask any individual to fill it in if there are suspicions about illegal income. CPCB considers this process as being ineffective. First of all, sometimes SRS, after an assessment, refuses to carry out an audit. Secondly, the official can fill in the missing sum in the additional declaration, get a small penalty, and that is the end of it.
Even though SRS and CPCB are of the opinion that a very important tool for improving the control of income would be reversed burden of proof upon the individual, in reality the Article 29 of the Law on Preventing the Conflict of Interests is not presently applied in practice, this article already now envisages applying this principle with regard to public officials. SRS, however, is not applying it, considering that it does not pertain to their field of activities. The attempts of CPCB to apply it stops at the fact that there is no point of reference for measuring income, and thus it is impossible to prove that the sources of income indicated by an official are not legal.
Finally, one more explanation for the government’s reluctance to control the income of individuals is the party financing – if a stricter control on the individuals’ income is introduced, it will be more difficult for the parties to get financing, which occasionally comes from illegal sources.
What has been done to date? Insufficient control of the population income is not a new discovery in the policy of Latvia. The main gaps in the legislation have been known already from the beginning of the 90s. Within this period, the most frequently discussed topic has been the so-called “zero declarations”- one-off declaration by all inhabitants of their material status. The first draft law on this was developed by the Supreme Council in 1993, then two more draft laws followed, which thus far have not gained the politicians’ support. In 1994 and 1995, all inhabitants of Latvia had to submit an annual tax return. SRS indicates that part of the population did not submit their tax returns at all; part of them had drawn “dashes” throughout the table (i.e. submitting a blank declaration). Huge resources were needed for processing the declarations; however, it produced no results. The government responded not by enforcing the system of tax returns, but by abolishing it. Because of this certain doubts were voiced about the true willingness of the political and the administrative power to fight corruption in a situation when the state has not yet completed essential reforms and privatisation – the processes that create opportunities for accessing state and municipal property.
However, national and international pressure has achieved that at least public officials are declaring their income and property, and that these declarations are controlled.
The fight against “salaries paid in envelopes” first came into the foreground as the government priority during the time of Einars Repse’s government in 2003. Even though the direct tax income from the “intercepted” salaries in that year was estimated as only 680 thousand Lats, SRS was regularly reporting on the companies that had been found paying the salaries without taxes –“in envelopes”; as the result of this campaign, within a year, the income from personal income tax increased by 13.2%, social tax by 6.3 %. Presently, this campaign is not visible; however, SRS is claiming that the work continues as before.
The possible solutions are outlined by the concept document elaborated by CPCB this year on the improvements in controlling population income. The concept document offers three options.
I To extend the authority of the tax administration in controlling income
The main proposals for legislation:
1) To grant to SRS the rights to carry out control and to impose payment of taxes due and fines for a past period of 5 years;
2) Reversing the burden of proof in tax law upon the individual;
3) To increase the amount of information to be declared and the rights of SRS to verify it;
4) To introduce declarations of cash upon border crossing;
5) Introduce more severe penalties.
+ the solution can be implemented without large resources,
+ would make it more difficult to indicate unverifiable sources of income.
- the number of persons subjected to the obligation of declaring would not increase significantly, thus it nevertheless would be impossible to receive extensive information about the income and property of the largest part of the Latvian population.
- there would still be no point of reference for the control of personal income, hence the issue about possibilities to prove the illegality of income older than 5 years remain unresolved.
This option is supported by SRS.
II Introduction of compulsory annual tax returns
Alongside the aforementioned amendments to the legislation, it is envisaged that all Latvian inhabitants who receive income would be under the obligation to submit an annual tax return. To make it easier, SRS would send to each person a declaration that would include all the data at the disposal of SRS and other state institutions on the person’s income and property. In case of necessity, the person would make amendments, however, if none were needed, he or she would only sign the declaration and return it to SRS.
+ Alongside the advantages of the previous option, would be the creation of a point of reference and provision of information on the changes in the material status of the Latvian population. It would make controlling income easier and make it impossible to hide the income by registering it on somebody else’s name.
- Administration of declarations is expensive. According to the current estimates, together with the measures of the first option, it would cost 6.8 million Lats per year.
- The inhabitants might use the declaration process to legalise the previously gained illegal income or the illegal income planned for the future. However, this argument would never allow starting registration of income and effective control of it, which would be a far worse evil than the possibility that some would legalise such income with the declarations. Moreover, it is doubtful whether people will risk doing it, knowing, that the declarations will be checked, at least randomly, and that sanctions may be imposed for providing false information.
CPCB considers this to be the best option, however, because of the high cost involved, suggests starting with the third option (see below).
III Introducing mandatory income declarations for inhabitants with income above a certain threshold
Compared to the previous option, the number of persons who would submit their tax returns under this option is lower. Basically, these would be people with an income of at least 10,000 Lats or the savings of 5,000 Lats, or property with a value of the respective sums. If a person does not submit a tax return, it will be assumed that he or she does not have such resources or property.
+ Alongside the ones mentioned with regard to the previous option, a point of reference would be established and further information would be provided on the changes in the material status of a significant part of the Latvian population. That would make controlling the income easier and make it impossible to hide the income by using the name of another person.
+ It is possible to introduce an appropriate system of declaration without excessively large investments. According to the current calculations, this would be 3 million Lats.
- In the context of more popular needs, politicians might be reluctant to allocate 3 million Lats to impose such a new obligation upon the voters. However, this sum is not large, if it is assumed that afterwards the national budget could be increased by several million more.
CPCB supports this option as the most realistic. SRS considers that it is possible to ensure adequate control by introducing the amendments to the legislation as envisaged by option 1, and thus is against introduction of any additional annual tax returns, comparing it to the storage of wastepaper.
As yet there is no clarity with regard to the political support for the declarations; there is only one parliamentary party – New Era (Jaunais Laiks), belonging to the ruling coalition - that has taken the decision to support the option of introducing tax returns for persons above a certain income level, i.e. the third option of the concept paper. The other parties represented in the Parliament, havenot made decisions on this issue; however, their leaders, by mentioning various conditions, support the introduction of tax returns. The only parties that have not expressed support for the tax return are The First Party (Latvijas Pirma partija) and People’s Party (Tautas partija), to whom also the Minister of Finance, responsible for SRS, and the Prime Minister belong. However, the party officials have indicated that their decision is not yet final.
The concept paper developed by CPCB is currently being reviewed by the respective state institutions; it is not yet known when the government is going to discuss it.
Draft concept paper “On the Improvements in Controlling the Income of Physical Persons”;
Interview with the deputy director of SRS Main Tax Board Inara Petersone;
Interview with the deputy head of CPCB Alvis Vilks;
Interview with the economics advisor of the Association of Latvian Local Authorities Aleksandrs Lielmezs;
Interview with the head of the Municipal Income Board of Riga City Council Anda Putnina;
The estimates on “salaries in envelopes” were made by Roberts Remess, Economists’ Association 2010;
The opinions of the parties represented in the Parliamentwere expressed by Linda Murniece (New Era), Oskars Spurdzins and Arno Pjatkins (People’s Party), Juris Lujans (The First Party), Augusts Brigmanis (Green and Farmers Union), Dzintars Rasnacs (Fatherland and Freedom/LNNK), Jānis Urbanovics (People’s Harmony Party), and Jakovs Pliners (For Human Rights in United Latvia).