Distributed Profits Taxation Would Be a Good Role Model for the EU’s 28th Regime

In a recent speech at the Davos Economic Forum, European Commission President Ursula von der Leyen announced plans to create a single set of rules for corporate law, insolvency, labor law, and taxation, under which companies could seamlessly operate across the European Single Market.

Instead of navigating the different legal regimes of the 27 EU Member States (and non-EU jurisdictions within the Single Market) the “28th regime” aims to provide a harmonized EU option for companies. The initiative is intended to attract and retain innovative start-ups in Europe, countering competitive pressures from markets like the United States. If carefully designed, such a framework could yield significant economic benefits.

A Single Set of Rules Must Be an Attractive Alternative to Member State TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
Policies

The proposed system could reduce compliance costs and stimulate cross-border investment. However, the increase in investment also depends on offering an attractive alternative to existing Member State tax policies and avoiding the pitfalls of previous harmonization attempts.

First, the “28th regime” must stay true to its promise to provide a real alternative to national rules, rather than adding another layer of compliance. Earlier initiatives for harmonized corporate tax rules, such as the Business in Europe: Framework for Taxation (BEFIT) proposal, fell short by requiring businesses to navigate both national and EU-level obligations simultaneously.

Second, policymakers must not just harmonize for the sake of uniformity but rather aim for designing economically attractive policy rules. This aspect has been neglected in earlier corporate tax harmonization proposals, such as BEFIT and CCCTB (common consolidated corporate tax base), by leaving crucial policy variables unspecified and proposing rules for cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages.
that would have negatively impacted investment incentives in most Member States compared to the status quo.

A well-structured corporate tax system should follow sound tax policy principles by being simple to administer and comply with and raise revenue with the fewest economic distortions. The success of the single regime depends on these features because the more businesses opt into the scheme and succeed economically, the better positioned Europe will be as a competitive hub for investment and innovation.

Distributed Profits Taxation as a Role Model for the 28th Corporate Tax Regime

While these principles may seem abstract, there are practical examples already in place within the EU that policymakers can learn from. The distributed profit taxes in Estonia and Latvia could serve as a role model for the 28th regime.

One tool to evaluate how closely corporate tax policies align with these design principles is the European Tax Policy Scorecard (ETPS), which scores the tax systems in 32 major European countries, including all EU Member States, on their competitiveness and neutrality. This allows policymakers to compare Member State policies and match policy proposals to best practices in Europe.

Among the 32 ETPS countries, the distributed profits taxA distributed profits tax is a business-level tax levied on companies when they distribute profits to shareholders, including through dividends and net share repurchases (stock buybacks).
systems of Latvia and Estonia, in which profits are not taxed annually but only upon distribution to shareholders, rank in the first two spots. This is not due to their statutory corporate rates, which lie close to the ETPS average of 23.6 percent, but due to their simple and efficient tax structure.

By shifting the timing of profits taxation from an annual to a distribution basis, moving from a traditional corporate tax to a distributed profits tax removes tax penalties on capital investment, as well as asymmetries in the treatment of profits versus losses and equity- versus debt-financing. Giving favorable treatment to all investment, irrespective of its kind, removes a drag on economic growth. It also makes profit taxation simple by removing the differential treatment of assets and business models as well as complex and distortionary incentives such as research and development tax credits or patent boxes.

Notably, the two Baltic countries have by far the highest score on cost recovery—the ability of businesses to recover the cost of their investments from taxation, which plays a crucial role in investment decisions. In the ETPS, countries are ranked on capital cost recovery based on a formula that combines seven policy variables. The poorer the treatment of these aspects, the more biased the tax code will be against new investment, creating a drag on economic growth.

Best Capital Cost Recovery in Europe

Moving from annual to distribution-based taxation of profits removes the partial inclusion of capital investment costs in the corporate tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
. Under a traditional corporate tax, depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment.
schedules determine the amount of capital investment costs a business can deduct each year from its revenue via depreciation, often over the economic life of an asset. This prevents businesses from fully deducting capital expenditures in real terms, which leads to firms making fewer capital investments, reducing worker productivity and wages.

On average, businesses in ETPS countries can deduct 86.5 percent of the real investment costs in machinery, 82.6 percent of intangibles, and only 51.6 percent of industrial buildings.

Under a distributed profits tax, investment expenditures are excluded from the corporate tax base, allowing businesses to “recover” 100 percent of the real value of all capital investments by design. This approach minimizes the tax penalty on capital investment while also eliminating distortions between different asset classes. As a result, it boosts overall investment and directs it toward the most productive assets, rather than those that are merely tax-advantaged.

No Asymmetric Treatment of Profits and Losses

Distributed profits taxes remove the asymmetric tax treatment of profits and losses, which places a tax penalty on risk-taking, quickly expanding businesses, and investments with uneven income profiles under traditional corporate taxation. In traditional corporate tax systems, net-operating loss carryover provisions can help businesses “smooth” their risk and income, by letting businesses offset prior years losses against current taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
(carryforwards) or current losses against past income (carrybacks).

Under a distributed profits tax, the timing of profits and losses are less of a concern for investments, since firms do not calculate taxable income each year. Instead, businesses with riskier investments or more uneven income over time can smooth their taxable income by choosing to distribute profits less frequently.

When ranked in the ETPS, by multiplying the maximum carryover period with the annual ratio of taxable income available for loss offsets, the two Baltic nations gain the maximum value of 100.0 on both carryback and carryforward provisions, compared to averages of 43.0 for carryforwards and 6.5 for carrybacks.

More Neutral Treatment of Debt- and Equity-Financing

Finally, traditional corporate tax systems are biased toward financing investment projects issuing new debt instead of equity, since debt payments are deductible from taxable income but profit distributions to shareholders are taxed. In 2023, less than a third of ETPS countries took measures to ameliorate this bias, as also envisioned by the EU’s stalled DEBRA initiative. In contrast, distributed profits taxes are more neutral on the treatment of debt and equity, as investment can be financed by retained earnings tax-free and interest payments are not tax-deductible. Further, Estonia and Latvia implement the limits on excess borrowing prescribed by EU law by taxing interest payments above 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA) at the same rate as profit distributions to shareholders.

Economic Research Backs the Distributed Profits Tax

Tax Foundation research for the United States has found that implementing such a model would reduce business tax compliance costs by more than $70 billion each year and expand the size of the US economy by 1.7 percent in the long run, resulting in a 3.1 percent larger capital stock, 1.3 percent higher wages, and 412,000 more full-time equivalent jobs. A forthcoming research paper by Tax Foundation Europe finds that substituting Poland’s corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.
with a distributed profits tax would positively affect Poland’s GDP, investment, and wages by a similar magnitude, based on lowering the service price of capital and removing allocative inefficiencies between different types of assets. In addition to the simulation results, there would be large improvements to the treatment of losses and distortions from the country’s small business rate. Recent research on corporate taxation under financial frictions concludes that adopting a distribution-based corporate tax could increase the value of current and new private US firms by as much as 7 percent.

The distributed profits taxes in Estonia and Latvia still deviate from the theoretical ideals of cash-flow taxation, as capital increases are not deductible. A share transactions (“S”)-base cash-flow tax, the theoretical model that they match most closely, would tax net distributions of companies by taxing both dividends and share buybacks, but make capital increases deductible. However, this imperfection is less damaging than the traditional models currently in place in every other ETPS country.

The Baltics and Poland Can Lead the Way Toward Competitive Tax Policy

Looking to the Estonian and Latvian systems for inspiration isn’t new. Since 2019, Poland has been running a pilot model of the system for small businesses, which the government expanded in 2021 and has considered extending to larger enterprises. Rather than looking externally to countries like the United States for tax policy ideas, European policymakers should follow Poland’s lead and rely on efficient systems already in the European Union.

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