Proposed tax reform is blatantly unfair

President Nikos Christodoulides has stated repeatedly that the proposed tax reform will “aim at reducing the tax burden on families and working people, modernising the economy, and encouraging competitiveness”.

However, the details of the tax reform indicate that it aims primarily at enhancing the tax-friendly environment for companies, foreign professionals and wealthy property owners, rather than trying to alleviate economic hardship and the tax burden on households by proposing a more progressive tax and distribution system.

Furthermore, the tax incentives proposed for businesses may just result in many inefficient companies surviving financially, rather than contributing to modernising the economy through raising their productivity and competitiveness.

The proposed reform comprises changes in taxation rates, directed at being popular with households and corporations, are most likely to further increase income and wealth inequalities over the longer term. The existing situation of Cyprus being a low productivity/wage economy will probably be perpetuated with the wealth of the rich likely to be further elevated by the absence of substantial and progressive taxes on immovable property and by weak tax administration.

Personal incomes

More specifically, the proposed tax reform fails to take sufficient account of the impact of inflation on real take-home pay and benefits since the last changes in personal income tax rates in Cyprus two decades ago. Quite strikingly, the impact of inflation on personal incomes has dragged a large number of individuals into higher tax brackets. This so-called fiscal drag, together with regressive taxes such as the VAT and excises, have inequitably boosted government tax revenues enabling it to generate considerable surpluses in recent years.

It is unbelievable that the last change in the personal income tax-free threshold was in 2008, when it was increased from a taxable annual income of €10,750 to €19,500 euro. And between 2008 and 2024 the Consumer Price Index and estimated median wages rose by 30 per cent and 27 per cent, respectively, yet according to the proposed tax reform, the tax-free threshold on annual personal incomes will be increased by a minute 5.1 per cent from the current €19,500 to €20,500.

In 2008 a person earning the median annual wage would pay no taxes, while under the proposed reform a person earning the estimated median wage in 2025 of about €25,500 would be obligated to pay around €1,000 in personal income taxes. Similarly, higher middle-income earners that were required to pay taxes at the marginal tax rate of 20 per cent in earlier years have been pushed into higher income tax brackets. Indeed, under the proposed tax reform there would be little relief to most taxpayers that have had their real disposable incomes eaten up by inflation.

In contrast to Cyprus, where the disposable incomes and social benefits of persons have not been protected sufficiently from inflation over many years, it is noted that in certain EU countries taxpayers have such compensation and income support largely protected from inflation through the indexation of tax brackets to inflation rates. Austria, Denmark and the Netherlands have automatic annual inflation adjustments for income tax thresholds, while Belgium, Finland, France, Germany, and Sweden make periodic adjustments without automatic indexing.

Currently, the personal income tax system in 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. Yet, the government incredibly proposes to lessen the progressiveness of the personal income tax system by applying the same top marginal rate of 35 per cent to annual incomes exceeding €80,000 compared with the current €60,000, meaning that those persons earning between €60,000 and €80,000 will enjoy tax saving by moving to a lower tax bracket. Indeed, it is the rich that will benefit the most from the proposed changes in personal income tax rates.

Accordingly, to take account of the impact of inflation and impart more progressiveness into the tax system it is recommended that the tax-free threshold be adjusted upwards from the current €19,500 for taxable annual personal income to €24,500, and that the top marginal tax rate be increased from 35 per cent to 40 per cent on annual personal incomes above €65,000.

Wealth

Cyprus suffers from a high and rising level of wealth inequality. According to data from the “World Inequality Report, 2024” of “Credit Suisse” (now UBS) the wealthiest 10 per cent of the Cyprus population owned 66.8 per cent of the country’s net personal wealth in 2023. And it is the tax system and its weak administration that overwhelmingly favours the rich that has been most important in boosting wealth inequality in Cyprus. Taxes on wealth in Cyprus are extremely low by international standards with the central government progressive tax on immovable property being abolished completely in 2017. Also, there is no inheritance tax, very low taxation of capital gains and minimum stamp duty on immovable property purchases and transfers in Cyprus.

With taxes on the property sector cheap, there is a very large allocation of resources to the up-market real estate sector aimed at selling house units to wealthy foreigners. This process together with the very favourable tax treatment of foreign professionals domiciled in Cyprus makes the purchase and renting of housing accommodation for many of the local population, particularly young persons, unaffordable.

However, despite the mounting serious negative consequences on wealth, income and intergenerational inequalities of the favourable tax treatment of the property sector, there is no evidence that any consideration is being given to raising and amending taxes on the property sector in the proposed tax reform. In fact, investment in the property sector is being further promoted with the reduction of the Special Defence Contribution (SDC) rate on rental income. Undeniably, the failure to raise progressive taxes on the property sector is a serious shortcoming of the tax reform and the issue of the appropriate taxation of the property sector should be addressed even it means delaying the timing of the implementation of the tax reform.

Business sector

The proposed tax reform places much focus on enhancing the financial situation of businesses mainly through the provision of tax breaks. While the corporate tax rate is to be increased from 12.5 to 15 per cent, the much criticised deemed dividend distribution system for tax purposes is abolished, and the tax on actual dividend payments is to be reduced from 17 per cent to 5 per cent.

And generous tax incentives are to be provided 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 favouring foreign companies and professionals newly domiciled in Cyprus. The zero withholding tax on dividends to non-residents is maintained. And high-income new residents will continue to enjoy a 50 per cent personal income tax break and be exempt from the SDC tax on dividends received.

But, tax and other incentives for promoting innovative technogies and entrepreneurship in areas other than the green and digital transitions are largely lacking, and one questions whether the concentration on tax breaks to support to corporations and their foreign employees will just allow many inefficient businesses to remain profitable without raising their productivity and competitiveness? Indeed, Christodoulides cites the need to modernise the Cyprus economy, but specific tax incentives to spur innovation and entrepreneurship, which are the lifeblood of economic progress, are prominent by their absence from the proposed tax reform.

Taxation affects productivity and competiveness by distorting the prices and allocation of the factors of production: land, labour and capital. The proposed tax reform by giving considerable tax breaks to existing businesses and foreign professionals and by continuing to provide very favourable tax treatment to the construction and real estate sectors and property owners is most likely to sustain the current massive allocation of resources toward further property development at the up-market end, to mass tourism, and to domestic consumerism. Indeed, such resource allocation together with the proposed more regressive tax system would keep productivity and take-home pay in the private sector low, exacerbate income and wealth inequalities, and make the housing market unaffordable for the young.

Christodoulides, his advisors and politicians voting on the proposed tax reform should realise that it is tax incentives, which can promote entrepreneurship and sizable investments in technogical innovation, that are important in raising the productivity and competiveness associated with a modernised economy.

And for the gains in productivity to be transformed into improving the standard of living for the bulk of the Cyprus population there should be a fair tax system, in fact, one that is at odds with the more regressive tax system being proposed by the Cyprus government.