10. SME Taxation in Croatia

This chapter looks at the taxation of small and medium-sized enterprises (SMEs) in Croatia. It starts by providing some background on the SME sector and the tax system in Croatia and discusses conceptual issues in the taxation of SMEs, including the use of special tax rules for small businesses. The chapter then assesses the tax treatment of SMEs in Croatia – including both self-employed sole traders and incorporated small businesses.

    

Brief description of the SME sector in Croatia

There is no internationally agreed definition of SMEs and definitions vary across and within countries. The indicators used to categorise SMEs generally include the number of employees, annual turnover and/or net assets. The commonly used European Commission (EC) classification defines micro, small and medium-sized enterprises based on their number of employees and either turnover or balance sheet total. According to this classification, SMEs are enterprises that employ fewer than 250 persons and have an annual turnover below EUR 50 million and/or an annual balance sheet total below EUR 43 million.1

Based on the EC’s definition, SMEs account for the vast majority of companies, employment and value added in Croatia. SMEs account for 99.7% of the total number of firms in Croatia, a share that is very close to the EU-28 average of 99.8% (European Commission, 2017[1]). Large firms, on the other hand, represent a very small fraction of the total number of businesses, with only around 390 large companies registered in Croatia in 2016. Figure ‎10.1 also shows that Croatian SMEs account for over 70% of total employment (left panel) and generate almost 60% of overall value added (right panel). Croatian SMEs’ contributions to both value added and employment are slightly higher than in the EU-28 on average.

Figure ‎10.1. Share of total employment and value added by company size in 2016: Croatia and EU average
Figure ‎10.1. Share of total employment and value added by company size in 2016: Croatia and EU average

Note: Firm sizes are based on the EC classification.

Source: (European Commission, 2017[1]), 2017 SBA Fact Sheet-Croatia, http://dx.doi.org/file:///C:/Users/Perret_S/Downloads/Croatia%20-%20SBA%20Fact%20Sheet%202018.pdf.

The profile of Croatian SMEs varies widely. Micro companies represent more than 90% of the total number of businesses in Croatia, while small and medium-sized businesses account for the remaining 10%. Micro companies are a significant contributor to employment, as they account for almost one third of all jobs, but play a more limited role in the generation of value added (Figure 10.1). This reflects the typically lower levels of labour productivity in micro-businesses. Small and medium-sized companies account for large and roughly similar shares of employment (40%) and value added (42%). In comparison, in the EU on average, micro-companies account for 93% of the total number of businesses and generate about 30% of employment and 21% of value added; while small and medium-sized companies account for around 36% of both employment and value added.

SMEs operate in different sectors. The predominant sectors include wholesale and retail trade; professional, scientific and technical activities; accommodation and food services; manufacturing; and construction (Figure ‎10.2). SMEs also vary in terms of their growth and innovation potential. Only a minority of firms qualify as high-growth companies (European Commission, 2017[1]). In addition, while some SMEs are innovative, studies generally point to the comparatively lower levels of innovation in the Croatian SME sector (Božić and Rajh, 2016[2]).

Figure ‎10.2. Breakdown of the SME population in non-financial sectors in Croatia
Number of enterprises registered in 2016 (legal entities and natural persons)
Figure ‎10.2. Breakdown of the SME population in non-financial sectors in Croatia

Source: Structural Business Statistics, Croatian Bureau of Statistics.

Overview of the Croatian tax system

Main features of Croatia’s tax system

Croatia collects a relatively high overall level of tax revenues. Its total tax revenues amounted to 37.8% of GDP in 2016 (Figure ‎10.3) – a level that was slightly below the EU average of 38.9%, but above the OECD average of 34.0% of GDP (OECD, 2018[3]). Between 2006 and 2016, Croatia experienced a one percentage point increase in its tax-to-GDP ratio, an evolution that was similar to the increase in the EU average tax-to-GDP ratio during the same period.

Figure ‎10.3. Tax revenues as a share of GDP in 2006 and 2016 in EU countries
Figure ‎10.3. Tax revenues as a share of GDP in 2006 and 2016 in EU countries

1. Note by Turkey: The information in this document with reference to “Cyprus” relates to the southern part of the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is found within the context of the United Nations, Turkey shall preserve its position concerning the “Cyprus issue”.

Note by all the European Union Member States of the OECD and the European Union: The Republic of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in this document relates to the area under the effective control of the Government of the Republic of Cyprus.

Source: (European Commission, 2017[4]), DG Taxation and Customs Union, based on Eurostat data, https://ec.europa.eu/taxation_customs/business/economic-analysis-taxation/data-taxation_en (accessed 15 April 2019).

Consumption taxes, in particular value-added tax (VAT), account for a very large share of Croatia’s tax revenues. In 2016, VAT was Croatia’s largest source of tax revenues, accounting for more than a third (34.3%) of its total tax revenues (Figure 10.4). In comparison, VAT accounted on average for 18% of total tax revenues in EU countries. Croatia’s significant revenues from VAT are partly explained by its standard VAT rate of 25% – the second highest in the EU after Hungary – and efficient VAT enforcement. In 2016, Croatia was the EU country with the third lowest VAT gap, which measures the difference between the expected VAT revenues and the amount of VAT actually collected (European Commission, 2018[5]). In addition to VAT, other consumption taxes, which predominantly include excise duties, represent close to 16% of Croatia’s total tax revenues.

Figure 10.4. Composition of total tax revenues in 2016 – Croatia and EU-28 average
Tax revenues expressed as a share of total taxation
Figure 10.4. Composition of total tax revenues in 2016 – Croatia and EU-28 average

Source: European Commission, DG Taxation and Customs Union, based on Eurostat data, https://ec.europa.eu/taxation_customs/business/economic-analysis-taxation/data-taxation_en (accessed 15 April 2019).

Another significant feature of Croatia’s tax system is its high reliance on social security contributions (SSCs). SSCs accounted for 30.9% of total revenues in Croatia in 2016. This share was slightly below the EU average share of 31.1%, but above the OECD average share of 25.8% of total tax revenues (OECD, 2017[6]). High shares of SSCs are a common feature across many EU countries, in particular in Central and Eastern Europe. Regarding the composition of SSCs in Croatia, employer SSCs accounted for 53% of total SSCs while employee SSCs made up the remaining 47%, a split that is roughly similar to the EU average (56% of total SSCs from employer SSCs and 44% from employee SSCs).

High SSCs result in relatively high overall tax burdens on labour income, especially at low income levels. Figure ‎10.5 shows tax wedges – i.e. the sum of personal income tax (PIT) and SSCs paid by the employee and the employer (including payroll taxes) net of family benefits, expressed as a percentage of total labour costs – for single workers earning the average wage. Croatia’s tax wedge predominantly consists of employer and employee SSCs, whereas PIT accounts for a limited share of the total tax burden on labour income. While Croatia’s tax wedge for a worker earning the average wage is below the EU average (39.2% in Croatia compared to 40.8% in the EU on average), its tax wedge for workers at lower income levels is higher than the EU average. For instance, Figure ‎10.6 shows the tax wedge for single workers earning half of the average wage across EU countries. In 2016, Croatia’s tax wedge was 32.9%, slightly above the EU average of 32.5%.

Figure ‎10.5. Tax wedge for single workers earning the average wage across EU countries in 2017
Tax wedges expressed as a share of total labour costs
Figure ‎10.5. Tax wedge for single workers earning the average wage across EU countries in 2017

1. Note by Turkey: The information in this document with reference to “Cyprus” relates to the southern part of the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is found within the context of the United Nations, Turkey shall preserve its position concerning the “Cyprus issue”.

Note by all the European Union Member States of the OECD and the European Union: The Republic of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in this document relates to the area under the effective control of the Government of the Republic of Cyprus.

Source: OECD Tax-Benefit Models.

High tax wedges on labour income can discourage workforce participation and reduce incentives for employers to hire workers. High tax wedges can discourage workforce participation by reducing workers’ after-tax earnings. In general, empirical evidence highlights the higher responsiveness of low-income workers to these types of work disincentives. High employer SSCs also increase the cost of employing workers and can therefore negatively affect labour demand. Looking at Croatia, Deskar-Škrbić (Deskar-Škrbić, Drezgić and Šimović, 2018[7]) found that increases in the tax wedge have a statistically significant negative effect on employment.

High labour taxes in the formal sector also increase incentives for employers and workers to operate in the informal economy, especially at low income levels. The larger the difference between total labour costs and the return on labour after taxes are deducted, the greater the incentive for both employers and employees to avoid taxes by operating informally. High levels of informality may in turn negatively affect productivity, growth and trust in government institutions. In Croatia, informality is a persistent issue, with estimations of undeclared work varying between less than 10 % to more than 30 % of GDP (European Commission, 2017[8]). “Envelope wages” remain a common practice, with employers declaring the mandatory minimum wage as the taxable wage and providing the rest of their employees’ wages in cash to minimise SSC and PIT liabilities (Williams et al., 2017[7]).

Figure ‎10.6. Tax wedges for single workers earning 50% of the average wage across EU countries in 2008 and 2016
Tax wedges expressed as a share of total labour costs
Figure ‎10.6. Tax wedges for single workers earning 50% of the average wage across EU countries in 2008 and 2016

Source: European Commission tax and benefits indicator database based on OECD Tax-Benefit Models.

The Croatian tax system is also characterised by low revenues from direct taxes, in particular from PIT. PIT revenues accounted for only 9.7% of total tax revenues in Croatia in 2016, a share that is very small in comparison to the EU average of 24.1%. The low revenues from PIT reflect in large part the high PIT exemption threshold relative to current wage levels. The standard monthly tax-free allowance is set at HRK 3 800 (EUR 507), which amounts to more than 60% of the average wage. In practice, more than 50% of individuals do not pay any PIT. The low revenues from PIT limit the progressivity of the tax system. Corporate income tax (CIT) also accounts for a small share of total tax revenues – around 5.9% of total taxation, but this share is relatively close to the EU average of 6.8%.

The high level of SSCs and the comparatively limited role of PIT suggests that there could be room to shift part of the tax mix – and the financing of social benefits – from SSCs to PIT. Heavy SSC burdens weigh particularly heavily on low-income workers, reducing incentives for them to work and for employers to hire them. Efforts to shift part of the financing of social benefits from SSCs to PIT could reduce those disincentives as well as enhance progressivity. The case for expanding the financing of social benefits beyond SSCs is strongest when the benefits received by taxpayers are only weakly linked to the amount of SSCs paid, as is the case with health insurance and family allowances for instance. On the other hand, benefits for retirement, disability and unemployment, which tend to be more strongly related to wage earnings, could continue to be financed in large part through SSCs.

Finally, property tax revenues are very low, mainly because Croatia does not levy a recurrent tax on immovable property. The introduction of a recurrent tax on immovable property was legislated and expected to come into force in 2018 but has been postponed since then with no indication of whether and when it may become effective (European Commission, 2018[9]). OECD research has found that recurrent taxes on immovable property are an efficient form of taxation, causing more limited distortions to long-run growth in GDP per capita than other taxes including CIT, PIT and VAT (Johansson et al., 2008[10]).

Croatia’s 2017 tax reform aimed at supporting SMEs and entrepreneurship

In 2017, Croatia introduced a comprehensive tax reform, involving significant changes to CIT, PIT and VAT. The standard CIT rate was reduced from 20% to 18%. The PIT rate schedule was revised, with a reduction in the number of tax brackets and rates from three to two. The reform package also included a decrease in the standard VAT rate from 25% to 24% as of January 2018, but the VAT rate decrease has been postponed. Box ‎10.1 describes in more detail the most important measures included in the 2017 tax reform.

A number of the measures included in this comprehensive tax reform specifically aimed at supporting entrepreneurship and SMEs. Croatia’s tax system currently has two thresholds at which special tax treatments apply to small businesses. A reduced CIT rate of 12% was introduced for SMEs with a turnover below HRK 3 million (approximately EUR 400 000). Businesses below the HRK 3 million threshold, which were already eligible for VAT cash accounting, were granted the possibility to use cash accounting for CIT purposes. For smaller businesses, the VAT registration threshold, or threshold above which VAT registration becomes compulsory, was raised from HRK 230 000 to HRK 300 000. Overall, the key tax support measures that are currently available to small businesses in Croatia are summarised in Table ‎10.1:

Table ‎10.1. Key tax support measures for SMEs in Croatia

 

Small businesses with a turnover below

HRK 300 000 (EUR 40 000)

Small businesses with a turnover below

HRK 3 million (EUR 400 000)

Income tax

  • Lump-sum tax: Unincorporated businesses can get a derogation from regular income tax and pay a fixed amount of tax. The amount of tax depends on their level of turnover. Bookkeeping requirements are also reduced.

  • Reduced CIT rate: A reduced CIT rate of 12% applies, instead of the normal 18% CIT rate.

  • CIT cash accounting: SMEs have the option to use cash accounting for CIT purposes. Under cash accounting, income tax is paid on revenues only when cash is received and input costs are claimed only when cash is paid out. This differs from accrual accounting, which requires businesses to recognise revenues and expenditures at the time when the transaction occurs, rather than when the cash payment is received or made.

VAT

  • VAT exemption threshold: Businesses are not required to register for VAT but may elect to do so. Businesses that are not registered for VAT are not required to charge and collect VAT and are consequently not entitled to deduct the input VAT incurred on their purchases of goods and services.

  • VAT cash accounting: SMEs have the option to use cash accounting for VAT purposes. Under cash accounting, VAT is paid on sales only when the cash is received and, similarly, input tax credits are claimed only when cash is paid on a purchase.

  • Quarterly VAT reporting: Below HRK 800 000 of turnover, businesses are eligible for quarterly instead of monthly VAT reporting.

Source: OECD Questionnaire on SME Taxation and IBFD.

Box ‎10.1. Main measures of the 2017 tax reform

Corporate income tax

  • The standard CIT rate was reduced from 20% to 18%.

  • A reduced rate of 12% was introduced for small enterprises (i.e. enterprises with annual revenues below HRK 3 million).

  • The CIT base was broadened by abolishing the tax incentive for reinvested profits. Accordingly, profits reinvested in long-term assets used in business activities are no longer exempt from CIT.

  • CIT cash accounting was introduced for small businesses that fall within the scope of the VAT cash accounting scheme (turnover below HRK 3 million), allowing small businesses to pay CIT on a cash basis rather than on an accrual basis.

  • The share of tax-deductible entertainment expenses was raised from 30% to 50%.

Personal income tax

  • The number of progressive tax rates was reduced from three (12%, 25% and 40%) to two; as a result, a 24% rate applied to monthly income up to HRK 17 500 (approx. EUR 2 300) and income above HRK 17 500 was taxed at a 36% rate. From 1 January 2019, the 24 % rate applies to monthly income up to HRK 30 000 (approximately EUR 4 000) and income above HRK 30 000 is taxed at the rate of 36%.

  • The standard monthly tax-free allowance was raised from HRK 2 600 to HRK 3 800 for all taxpayers.

  • The SSC exemption for author and artist income, as well as retiree casual work and other income, was abolished and SSCs on these earnings are now levied at reduced rates.

Value-added tax

  • The mandatory period for remaining in the VAT system once registered was reduced from five to three years.

  • The VAT registration threshold was raised from HRK 230 000 to HRK 300 000 as of 1 January 2018.

  • The standard VAT rate was supposed to be lowered from 25% to 24% as of 1 January 2018 but the reform has been postponed.

Overview of the arguments for and against special tax provisions for SMEs

This section briefly reviews the arguments for and against special tax provisions for SMEs. In assessing the need for special tax provisions for SMEs, the case in favour is generally based on arguments related to market failures and the positive externalities associated with SMEs. A second category of arguments for intervention claims that tax systems inherently penalise SMEs and that, in the absence of intervention, they will unfairly disadvantage them against their larger competitors. The case against granting special tax provisions to SMEs, on the other hand, considers the revenue and efficiency costs of doing so, including the risk of generating further distortions and complexity.

Special tax provisions for SMEs can take various forms. Tax preferences may lower the amount of tax payable by the SME, through special tax regimes, reduced tax rates, or additional deductions, credits and exemptions. Tax preferences may also reduce the tax payable by an investor or owner of an SME. Special provisions in the form of simplified tax obligations may also be introduced with the aim of reducing SMEs’ tax compliance costs. Table ‎10.2 provides a typology of common tax provisions for SMEs in OECD and EU countries.

Table ‎10.2. Typology of special tax provisions for SMEs

Categories of measures

Examples

Tax reductions

Business level

Tax allowances (e.g. accelerated depreciation; immediate expensing; R&D tax allowance; etc.)

Tax credits (for investment, R&D, employment, etc.)

Reduced CIT rate for small business profits

Investor level

Incentives for investments in SMEs or investments in venture capital funds

Capital gains tax preferences

Inheritance and gift tax preferences

Tax simplification

Income tax

Presumptive taxation

Simplified accounting (e.g. cash accounting)

Reduced tax filing requirements

Less frequent advance tax payments

VAT

Exemption (registration/collection) threshold

Simplified input tax credit calculation schemes

Cash accounting

Reduced tax filing requirements

Other taxes

Simplified calculation and remittance of SSCs and payroll deductions

Source: Based on (OECD, 2015[11]), Taxation of SMEs in OECD and G20 Countries, OECD Tax Policy Studies, No. 23, https://dx.doi.org/10.1787/9789264243507-en and (European Commission, 2007[12]), Simplified Tax Compliance Procedures for SMEs Final Report of the Expert Group, http://ec.europa.eu/enterprise/entrepreneurship/support_measures/.

Reasons for considering special tax provisions for SMEs

There are two main lines of argument in support of special tax provisions for SMEs. The first set of arguments focuses on the market failures that affect SMEs due to their small size. The second major justification is that tax systems tend to have a disproportionate adverse impact on SMEs (OECD, 2015[11]).

Market failure arguments

The first line of argument in favour of SME-specific tax provisions is related to market failures, centred on assumptions of positive spill-over benefits and financing constraints resulting from asymmetric information.

Positive spillovers generated by SMEs

One of the arguments in favour of special tax provisions for SMEs is that small businesses generate benefits over and above those accruing privately to investors. The benefits may include innovations that can be applied elsewhere and positively affect economic growth. Other potential benefits include labour training and the upgrading of skills that can be applied subsequently in other businesses. In choosing the amount of investment to be undertaken, SME investors can be expected to consider only the private benefits and costs of their investment. By ignoring the social benefits that spill over to the rest of the economy, the expected outcome is under-investment in and by SMEs, relative to a socially optimally level. According to this view, tax incentives targeted at SMEs could encourage investment levels that would be closer to a social optimum.

However, a large proportion of SMEs are not significant job or innovation creators. There is a lack of empirical analysis showing that SMEs have a greater tendency to innovate or upskill than large companies, which suggests that externalities are not linked to company size. Although some self-employed individuals and SMEs display traits that characterise entrepreneurship – flexibility, speed, risk taking and innovation – the nature of the businesses which most small companies and self-employed persons operate in suggests that the majority have limited growth potential (Chen, Lee and Mintz, 2002[13]). In fact, in Croatia, only a small fraction of SMEs qualify as “high-growth” and the innovation performance of small businesses appears to be comparatively low (see Brief description of the SME sector in Croatia). In this context, granting favourable tax treatment to all small companies could be inefficient.

Financing constraints

Another market failure argument for providing special tax treatment to SMEs is that they generally face higher financing constraints. The limited information about the growth prospects of small firms can make it more difficult for them to obtain access to credit (Mirrlees et al., 2011[8]). However, except where information asymmetries affect access to finance, the more restricted access to credit, or higher risk premium, faced by SMEs may not be due to market failures, but to the inherently riskier and less profitable nature of some SMEs.

Tax concessions might not be the most efficient policy response to SMEs’ financing constraints. Non-tax measures may be a more efficient way of enhancing small businesses’ access to finance. For example, if on account of asymmetric information, capital markets are denying financing to SMEs in cases where funds would be provided under symmetric information, governments could seek to enhance transparency by increasing financial reporting requirements. Where governments choose to use tax measures, these should be targeted at supporting investment by small businesses (e.g. enhanced investment tax credits or allowances) as opposed to providing “blanket support” to all small businesses in the form of preferential tax rates for all small businesses, regardless of whether they invest or not (Mirrlees et al., 2011[8]).

Disproportionate impact of tax systems on SMEs

The second line of argument in support of special tax provisions for SMEs is that tax systems can be inherently disadvantageous for SMEs. The features of tax systems that may have a disproportionate negative effect on SMEs include the tax treatment of losses, the favourable tax treatment of debt finance, tax compliance costs and the international tax planning opportunities typically available to multinational enterprises (MNEs).

Tax treatment of losses and debt bias

The asymmetric treatment of profits and losses is one of the disadvantages that SMEs face in tax systems. Profits are taxed when they occur, while losses are typically not refunded when they occur, but carried forward and used against future income (or sometimes carried back and used against past profits). In many countries, however, losses can only be carried forward (or back) for a limited number of years, and there is generally no compensation for the time delay when losses are carried forward. This may disproportionately affect SMEs, which are more likely to record losses in their early stages of development. For firms that do not recover and generate income within the carry-forward period (which may be the case for younger enterprises in particular), the deferred loss cannot be utilised. These arguments have been used to justify more flexible carry-forward provisions for SMEs, the ability to refund losses at the time they occur, or the possibility to use losses to offset other income.

Another tax disadvantage faced by SMEs is related to their greater reliance on equity finance. Corporate tax systems generally provide interest deductions for the cost of debt finance but no deductions for the cost of equity. To the extent that SMEs have more limited access to credit and rely more heavily on equity finance, they tend to be penalised compared to large businesses. While an allowance for corporate equity can be provided to reduce the distortion between debt and equity finance, as with debt interest deductions, the allowance will not be of immediate benefit to firms in a loss position.

Compliance costs

While total business tax compliance costs tend to be higher for large companies, the compliance burden tends to be regressive relative to firm size. Tax compliance costs involve recording transactions, maintaining financial and tax accounts, calculating tax liabilities, making tax payments to the government, etc. Since compliance costs have a significant fixed component, they impose a relatively higher burden on smaller firms as a percentage of turnover or profit, or per employee. An EC study found that on average, a company with fewer than ten employees faces a regulatory burden that is roughly twice as high as the burden of a company with ten to 20 employees and about three times the burden of companies with 20 to 50 employees. For bigger companies, the burden per employee is only one fifth or one tenth of that of small enterprises (European Commission, 2007[12]). In certain cases, high compliance costs may discourage SME creation and growth. Tax compliance costs may also affect SME owners and operators’ decisions of whether to become self-employed, to employ other people or to operate in the formal economy.

In addition, SMEs often rely on external professionals, which increases their tax compliance costs. Larger companies are more efficient in dealing with tax requirements, and often have internal specialists. SMEs, on the other hand, generally lack internal tax experts, which means that they often hire outside professionals to deal with tax issues. The high cost of outside professionals increases the tax compliance burden of SMEs.

Tax avoidance by MNEs

Another inherent tax disadvantage that SMEs face is that certain MNEs have greater opportunities to engage in cross-border tax planning. Base Erosion and Profit Shifting (BEPS) refers to tax planning strategies by MNEs that exploit gaps and mismatches in tax rules to artificially shift their profits to low or no-tax jurisdictions where they have no or little real economic activity. While most of these strategies are legal, they undermine the fairness and integrity of tax systems because businesses that operate across borders can use BEPS strategies to gain a competitive advantage over enterprises, typically SMEs, which only operate domestically.

However, this issue should be addressed directly rather than indirectly by providing tax preferences to SMEs. The most significant global initiative to fight against tax avoidance by MNEs has been the OECD/G20 BEPS project, which led in 2015 to the delivery of a package of measures to equip governments with instruments to address BEPS. The OECD/G20 BEPS package contains 15 actions including new minimum standards, the revision of existing standards, common approaches that will facilitate the convergence of national practices, and guidance drawing on best practices. To ensure the consistent application of the BEPS package across countries, the Inclusive Framework on BEPS was created in 2016 and now brings together over 125 countries, including Croatia.

Caution in using special tax provisions for SMEs

Revenue loss

Tax preferences that reduce small businesses’ tax burdens, as with any other type of tax incentive, generate a loss in potential tax revenues, at least in the short run. Revenue losses will be particularly significant in the case of reduced tax rates and other tax preferences that are available to all SMEs. Revenue losses can be expected to be even greater when tax avoidance is prevalent or when the tax administration is weak, as businesses initially not intended to benefit from preferential tax measures might easily find ways to reorganise their affairs (e.g. by artificially splitting their business activity) to be eligible for SME tax preferences.

However, certain types of SME-specific tax provisions can be provided without leading to any revenue losses. Tax simplification measures aimed at lowering small businesses’ compliance burdens do not lead to losses in tax revenues. Moreover, in a context where informality is high, tax simplification measures may actually have a positive effect on revenue collection by incentivising small businesses operating in the informal economy to formalise their activities.

Challenges of targeting special tax provisions for SMEs

Many tax provisions targeted at SMEs may not achieve their intended objective. For instance, a number of small firms may not benefit from profit-based tax incentives because they need to be profitable before they can make use of the tax preferences. This is particularly problematic for small firms in their start-up phase when up-front costs are high relative to revenues. Similarly, while investment tax credits and tax allowances are more targeted, they may also be of limited use to companies making investments with delayed returns if carry-forward provisions (i.e. the possibility to offset future taxable income or tax liabilities with unused tax benefits) are inadequate.

More generally, size alone does not necessarily warrant intervention. Many of the market failure arguments discussed above do not apply to all SMEs, but to subsets of the SME population. For example, only a subset of SMEs tends to innovate, which means that tax preferences aimed at supporting innovation should be targeted to the SMEs most responsive to innovation incentives and that are likely to generate spillover benefits. Similarly, younger SMEs may be more specifically targeted as they are more likely to be affected by the asymmetric treatment of profits and losses in tax systems (OECD, 2015[11]).

Disincentives to firm growth

Generous tax preferences for SMEs can limit their incentives to grow. Tax preferences for SMEs, particularly those that significantly reduce their tax burdens, can encourage small businesses to keep their reported income or turnover below small business eligibility thresholds to continue taking advantage of the preferential tax treatment. In fact, many countries have found evidence of individual taxpayers and companies “bunching” below points of discontinuity (kinks or notches) in tax systems (Boonzaaier et al., 2017[14]) (Kleven, 2016[15]).

A critical consideration in designing tax incentives for SMEs is to avoid “cliff edge” effects. The disincentives to firm growth and the risks of bunching below thresholds depend on how sharp the increase in the tax burden is when transitioning from the SME to the regular tax regime. Tax incentives should therefore be designed in a way that smooths cliff edge effects when businesses transition from SME status (e.g. avoiding excessive tax burden differentials between SME and regular tax regimes, putting transitional measures in place).

Increased complexity and opportunities for tax arbitrage

The introduction of special tax measures targeted at SMEs can add complexity by requiring additional record-keeping, monitoring, or registration processes. Complexity is even greater when multiple tax preferences with different thresholds are available. Over time, there is also a risk that special tax provisions that are initially only targeted at SMEs may give rise to pressure for such provisions to be extended to all businesses, particularly if there is no clear rationale for limiting them to SMEs (see Alt, Preston and Sibieta, 2010[14] for an example of how the R&D tax incentive for small businesses was extended to large firms in the United Kingdom).

In addition, SME tax preferences create opportunities for tax arbitrage. Caution must be exercised to ensure that taxpayers not intended to benefit from a tax preference, particularly a tax reduction, are not able to reorganise their affairs in such a way as to benefit from the provision. For example, a non-qualifying firm may reorganise itself into two or more new business entities to access tax relief conditional on firm size, determined on the basis of turnover, profit and/or capital. Tax preferences may also affect a small business’ decision to incorporate. In countries where incorporated SMEs are granted a reduced CIT rate and the taxation of distributed dividends is low, the tax system may encourage the incorporation of profitable firms. Ultimately, the potential tax saving from converting wages into distributed profits can encourage a shift away from employment within large firms and towards contracting between large firms and small owner-managed businesses (Mirrlees et al., 2011[8]).

Concluding remarks on the use of special tax provisions for SMEs

Overall, this review of the arguments for and against special tax provisions for SMEs highlights the need to exercise caution when considering such measures. Many of the arguments in favour of special tax provisions for SMEs have clear limitations, while some of the risks associated with SME tax preferences have been confirmed empirically. A number of policy conclusions can be drawn from the assessment of the pros and cons of special tax provisions for SMEs:

  • The taxation of SMEs needs to be assessed within the context of the overall tax system. A simple, efficient tax system that is conducive to business growth is of great advantage to SMEs and reforming the general tax system to make it more business-friendly is typically preferable to special tax provisions for SMEs. Tax preferences for SMEs should not be used to compensate for weaknesses in the tax system that should be addressed directly, such as a high standard CIT rate. In this case, the most efficient approach is to lower the standard CIT rate rather than to introduce a reduced CIT rate for SMEs.

  • The benefits of SME tax incentives should be carefully weighed against their potential negative effects: If tax preferences – in particular tax reductions – are provided, they should be considered against the revenue and efficiency costs of doing so, including the risk of creating further distortions or barriers to growth, and increasing complexity.

  • Alternatives to tax preferences should be considered first: The use of special tax provisions – in particular tax reductions – to correct perceived market failures or size disadvantages should be carefully considered against other options. Generally, the first-best approach is to consider whether and how issues can be addressed directly and avoid relying on tax preferences to address obstacles to SME growth that arise outside of the tax system.

  • Where special tax provisions are introduced, they should be specifically targeted to ensure the attainment of the policy objective: Size is often used as a proxy for other features that governments may wish to address through the tax system (e.g. spillovers, financing, start-ups). If the goal is to support specific activities undertaken by some types of small businesses, tax measures should be targeted at supporting those activities and/or specific types of SMEs. For instance, instead of granting preferential tax rates to all small businesses, tax advantages could be provided for verifiable expenditures that are closely related to the activities that governments want to promote (Mirrlees, 2011[16]). Targeting should be done carefully, however, to make sure that it reaches the intended audience but also minimises complexity and distortions (e.g. lack of incentives to outgrow targets).

  • The area where there is a strong rationale for special tax treatment based solely on company size is compliance costs. As discussed, tax compliance costs are clearly regressive relative to firm size. Freedman (2009) concludes that assistance with compliance costs is the only intervention that “is clearly justified on a size basis as opposed to some other test” (cited in (OECD, 2015[11])). In addition, tax simplification measures have the added advantage of generally not leading to any revenue losses.

Assessment and recommendations for the taxation of SMEs

This section assesses the taxation of SMEs in Croatia and provides a number of recommendations to improve small business taxation. This section reviews the income taxation and SSC rules that are applicable to small unincorporated and incorporated businesses. Unincorporated businesses are businesses that are not established as separate legal entities from their owners, while incorporated businesses are businesses where the company is a separate legal entity from its owners. Their tax treatment typically differs. This section also covers issues related to the VAT registration threshold, tax administration and tax compliance costs.

The taxation of unincorporated small businesses

This section looks at unincorporated small businesses and focuses on physical persons carrying out self-employment activities including crafts and trades, free professions, and agriculture and forestry. These businesses are subject to specific income tax and SSC rules. This section presents and assesses these tax provisions.

The taxation of unincorporated businesses is complex and gives room for tax arbitrage

Small unincorporated businesses can opt to be taxed under a simple lump-sum tax regime. Unincorporated businesses carrying independent activities of crafts, agriculture and forestry with an annual turnover below HRK 300 000 (approximately EUR 40 000) can opt to be taxed under a lump-sum tax, which replaces regular income taxation. The lump-sum tax liability is based on small businesses’ total turnover, with different lump-sum amounts depending on different turnover brackets (Table ‎10.3). The level of the tax liability in each bracket is determined so that small businesses at the bottom of each turnover bracket are taxed at around 2.8% of their turnover while businesses at the top of each turnover bracket are taxed at around 2.1% of their turnover (Figure 1.7). A key advantage of the lump-sum tax is its simplicity. In addition to paying a fixed amount of tax, small businesses that opt for lump-sum taxation are not subject to any bookkeeping requirements (but they keep records of turnover).

Table ‎10.3. Lump-sum tax for small businesses
Tax base and tax liability calculations for 2018

Total revenue

Annual tax base

Annual tax liability

Monthly tax liability

Monthly tax liability including the 18% to city of Zagreb

From 0 to 85 000

12 750

1 530.

127.50

150.45

From 85 000 to 115 000

17 250

2 070

172.50

203.55

From 115 000 to 149 500

22 425

2 691

224.25

264.62

From 149 500 to 230 000

34 500

4 140

345

407.10

From 230 000 to 300 000

45 000

5 400

450

531.00

The Zagreb municipal surtax is levied on the central tax liability at a rate of 18%.

Source: Ministry of Finance.

The lump-sum tax has a regressive design and weighs more heavily on businesses with lower levels of profitability. Figure ‎10.7 shows how the implicit tax rate on turnover evolves when business turnover increases (up to HRK 300 000) under the lump-sum tax. Because the lump-sum tax is not linked to actual earnings but levied as a fixed amount for businesses in the same turnover bracket, it is regressive as a share of turnover in each bracket. In addition, a tax based on turnover imposes a higher tax burden on businesses with lower profit margins. Figure ‎10.8 shows how the lump-sum tax liability measured as a share of profits increases for a business with a turnover of HRK 300 000 when it becomes less profitable (i.e. when its costs increase). Similarly, the lump-sum tax imposes a relatively high effective tax rate on profits during downturns in business activity when profits are low or negative, which can generate cash-flow difficulties for small businesses. It should be mentioned, however, that the lump-sum tax is optional, which mitigates its regressive impact.

Overall, however, the lump-sum tax is low, which creates incentives for small businesses to remain under the HRK 300 000 threshold. As the amount of the lump-sum tax is low, the increase in the tax burden when small businesses reach the HRK 300 000 threshold and move into the regular income taxation system is significant. This may discourage small business growth and/or encourage small businesses to rearrange their affairs to continue being taxed under the lump-sum tax (e.g. split their activities into two businesses). Figure ‎10.8 compares the effective tax rates on profits that unincorporated businesses with a turnover of HRK 300 000 pay when they are subject to the lump-sum tax and when they are subject to regular PIT. It shows how these effective tax rates vary when business costs increase, i.e. when business profitability decreases. At high profitability levels (i.e. when business costs are low), moving from the lump-sum tax to PIT generates a significant jump in the effective tax rate on profits. At lower profitability levels (i.e. when business costs are high), the gap narrows and eventually shifts. This implies that the increase in the effective tax burden from moving from the lump-sum tax to the regular income tax regime is particularly large for high profitability businesses.

Figure ‎10.7. Small businesses’ average tax rate on turnover under the lump-sum tax
Figure ‎10.7. Small businesses’ average tax rate on turnover under the lump-sum tax

Note: The implicit tax rate includes the 18% Zagreb surtax.

Source: Authors’ calculations.

Figure ‎10.8. Average effective tax rates on profits under the lump-sum tax and the personal income tax when business costs increase
Tax rates for an unincorporated business with a turnover of HRK 300 000
Figure ‎10.8. Average effective tax rates on profits under the lump-sum tax and the personal income tax when business costs increase

Notes: Average effective tax rates correspond to the total tax liability due by businesses as a share of their income. The calculations are based on the 2018 central government PIT rates: 24% tax rate on monthly income up to HRK 17 500 (approx. EUR 2 300) and 36% tax rate for income above HRK 17 500. The tax rates include the 18% Zagreb surtax.

Source: Authors’ calculations.

Unincorporated businesses above the HRK 300 000 turnover threshold are subject to regular income tax. Under the PIT, self-employment taxable income is calculated as the difference between gross receipts and expenditures incurred during the tax period. Business expenses as well as up to 50% of business entertainment expenses (e.g. expenses for gifts, holidays, sporting activities) are deductible from taxable income. Income is taxed by the central government at the rates of 24% on monthly income up to HRK 30 000 (approx. EUR 4 000) and 36% for income above HRK 30 000. In addition to central government tax rates, municipalities can impose surtaxes,2 which currently range from 0% to 18%. Figure ‎10.9 shows that Croatia’s top marginal PIT rate (including the 18% Zagreb surtax3) is slightly above the EU28 average but has seen one of the strongest decreases in the last ten years.

Figure ‎10.9. Top statutory personal income tax rates (including surcharges) in 2008 and 2018 in EU countries (in %)
Figure ‎10.9. Top statutory personal income tax rates (including surcharges) in 2008 and 2018 in EU countries (in %)

1. Note by Turkey: The information in this document with reference to “Cyprus” relates to the southern part of the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is found within the context of the United Nations, Turkey shall preserve its position concerning the “Cyprus issue”.

Note by all the European Union Member States of the OECD and the European Union: The Republic of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in this document relates to the area under the effective control of the Government of the Republic of Cyprus.

2. For Croatia, the tax rates include the average crisis tax (2009-2011) and the surtax for Zagreb (maximum local surtax rate of 18%).

Source: European Commission, DG Taxation and Customs Union.

A specificity of the Croatian tax system is that unincorporated businesses can opt to be taxed under CIT, which increases complexity and leaves room for tax arbitrage. Self-employed businesses have the option to be taxed under PIT or CIT if they remain below a certain threshold.4 If they are above the threshold,5 they are automatically subject to CIT. This differs from standard practice in OECD countries where small businesses are usually taxed either under PIT if they are self-employed sole traders or under CIT if they are incorporated firms, although there are exceptions.6 The issue with giving unincorporated businesses the possibility to be taxed under CIT is that, in addition to making the tax system more complex, it enables them to minimise their tax burden. Figure ‎10.11 compares the tax burden on income depending on whether small businesses are taxed under PIT or CIT and depending on whether they distribute profits or not. It shows that the current system gives small businesses an incentive to opt for CIT and retain their earnings to lower their tax burdens, although opting for CIT increases compliance costs as businesses are required to maintain double-entry bookkeeping. Incentives to be taxed under CIT instead of PIT exist in other countries, but being taxed under CIT typically requires small businesses to incorporate, which implies legal changes and often additional reporting and accounting requirements.

The SSC system for the self-employed is regressive

As opposed to regular employees, SSCs for self-employed workers are not linked to actual earnings. For regular employees, the SSC base is equal to gross employment earnings. Employee SSCs include old-age pension contributions of 20%. In 2018, employer SSCs included a 15% general health contribution, a 0.5% occupational health contribution, and a 1.7% unemployment contribution. In 2019, the unemployment contribution and the occupational health contribution were abolished, while the general health contribution was raised from 15% to 16.5%; implying a decrease in total SSC rates from 37.2% to 36.5%. For the self-employed, the SSC rates are the same as for employees but the SSC base is not related to actual earnings. The SSC base is a lump-sum obtained as the product of the average national monthly wage from January to August of the preceding year (HRK 8 020 in 2018) and an occupation-specific coefficient (e.g. 0.65 for traders; 0.55 for farmers and 1.1 for professionals).

This system is distortive and regressive. This type of system may have some merit in a country where the tax administration has a limited capacity to check whether self-employed workers accurately report their earnings. It ensures that at least a minimum level of SSCs is collected. However, determining fixed amounts of SSCs is regressive, with the self-employed workers earning more contributing less as a share of their earnings. The way the contribution base is determined also means that in practice some self-employed businesses pay very low SSCs, which may in turn give some employees incentives to become self-employed.

Special independent activities benefit from special tax regimes

The income earned by journalists, artists and sportsmen falls under the category of “other income”, which is subject to a PIT withholding. In some cases, special tax allowances apply. A 30% lump-sum deduction is allowed for the incomes of journalists, athletes and artists. An additional exemption equal to 25% of the taxable base is granted for the income earned by artists, under certain conditions. Until 2017, author and artist income also benefitted from an SSC exemption. The exemption was abolished and these earnings are now taxed at reduced SSC rates.

Additional tax regimes exist for specific activities. Special rules apply to family farms. In particular, family farms are not subject to PIT if they have a total annual income of less than HRK 80 500. A special lump-sum tax also exists for the income earned by homeowners renting rooms and flats to travellers (up to 20 beds). The tax liability is determined based on the number of beds. This regime is particularly generous as the lump-sum tax is low, SSCs are not levied and renters are not subject to “fiscalisation” requirements (i.e. no obligation to issue receipts through electronic cash registers – see below for more details).

Recommendations

Overall, the assessment of the taxation of small unincorporated businesses could be better aligned with economic reality. First, the lump-sum tax could be transformed into a real turnover tax levied as a share of turnover to remove its regressive effects. However, a fixed turnover tax rate would still impose a relatively high effective tax rate on businesses with lower profit margins. To address this issue, some countries apply reduced tax rates on turnover in sectors where profit rates are on average lower or use different eligibility thresholds for different sectors, although this creates additional complexity. Alternatively, the presumptive tax could be progressive (i.e. the tax rates would increase with turnover). While this would also introduce more complexity, it would reduce “cliff edge” effects, as businesses with a high turnover would be subject to higher presumptive tax rates and the move from presumptive to regular taxation would not generate a significant increase in businesses’ tax liabilities. Progressive presumptive tax rates would also mean that lower tax rates could be levied on businesses with very low levels of turnover to encourage them to formalise their activities.

Additional reforms are necessary to simplify the taxation of small unincorporated businesses and limit tax arbitrage opportunities. The possibility for unincorporated businesses to be taxed under CIT could be removed to reduce complexity and tax minimisation incentives. In the longer run, Croatia could also consider levying self-employed SSCs based on actual earnings. Self-employed businesses with a turnover above HRK 300 000, which are taxed under the regular PIT or CIT, should pay SSCs on the income they report. This would require enhancing the exchange of information between the social security and tax administrations. For small self-employed businesses with a turnover below HRK 300 000, which are subject to the lump-sum tax, the lump-sum SSC payments could be kept, although they would continue to have regressive effects. Importantly, changes to the way self-employment SSCs are levied would need to be accompanied by a reform in self-employed workers’ social benefit entitlements.

Box ‎10.2. Presumptive tax regimes

A presumptive tax presumes a different tax base than income in the calculation of small businesses’ tax liabilities. Presumptive taxes may replace either only income tax or all the taxes that have to be paid by small businesses and may be accompanied by reduced bookkeeping or tax filing obligations. Presumptive taxes vary across countries but generally fall under one of three categories:

  • A lump-sum tax: a flat charge levied on firms below a certain threshold. Lump-sum schemes are often used for very small firms and the self-employed, where compliance costs are likely to be the highest and revenue considerations are minimal. This approach is common in Central and Eastern European countries.

  • An indicator-based tax: a tax based on indicators of firm size other than turnover or income. Examples of such indicators include the total number of employees, floor space, inventory values, electricity consumption and other variables that may be correlated with income. Indicator-based taxes are often used to target specific types of business activities (e.g. shipping or transport).

  • Turnover tax: unlike a lump-sum tax or an indicator-based tax, a turnover tax is levied on gross revenues.

The taxation of incorporated SMEs

Incorporated SMEs are small businesses where the business is carried on through a separate entity for tax purposes. Incorporated SMEs are taxed first at the entity level under CIT and then at the personal level when income is received by individuals. The taxation at the personal level depends on the form in which the income is received (e.g. dividends, capital gains or salary).

Incorporated SMEs benefit from a generous tax treatment

At the corporate level, small businesses are taxed at the preferential CIT rate of 12%, as opposed to the regular CIT rate of 18%. As mentioned above, in 2017, Croatia lowered its regular CIT rate from 20% to 18% and introduced a reduced rate of 12% for SMEs with a turnover below HRK 3 million. A number of countries provide reduced CIT rates for SMEs, although the design of these reduced tax rates varies significantly (OECD, 2015[11]). Overall, it should be noted that Croatia’s regular CIT rate was below the EU average of 21.9% in 2018 (Figure ‎10.10) and that its reduced CIT rate for SMEs is also relatively low compared to other countries that have similar preferential regimes for SMEs in the OECD (Figure ‎10.11).

Figure ‎10.10. Top statutory corporate income tax rates (including surcharges) in EU countries in 2008 and 2018 (in %)
Figure ‎10.10. Top statutory corporate income tax rates (including surcharges) in EU countries in 2008 and 2018 (in %)

1. Note by Turkey: The information in this document with reference to “Cyprus” relates to the southern part of the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is found within the context of the United Nations, Turkey shall preserve its position concerning the “Cyprus issue”.

Note by all the European Union Member States of the OECD and the European Union: The Republic of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in this document relates to the area under the effective control of the Government of the Republic of Cyprus.

Source: Eurostat.

Figure ‎10.11. Small business corporate income tax rates in Croatia and OECD countries in 2018
Combined (central and sub-central) corporate income tax rates
Figure ‎10.11. Small business corporate income tax rates in Croatia and OECD countries in 2018

Source: OECD Tax Database.

SMEs are also eligible for a number of corporate tax incentives. Table ‎10.4 gives an overview of these tax incentives. The types of tax incentives vary. They include reduced CIT rates as well as tax deductions (which reduce businesses’ taxable income). Some are available to all companies (e.g. accelerated depreciation, R&D tax allowance), while others provide more generous benefits or restrict eligibility criteria to SMEs (e.g. reduced CIT rate for investment; tax allowance for educational expenses).

Table ‎10.4. Corporate tax incentives available to SMEs in Croatia

 

Tax measures

Description

Specific rules for SMEs

CIT rate reduction

Investment incentives

CIT rate reductions conditional upon investment and job creation

Yes: For micro-entrepreneurs (less than 10 employees): 50% CIT rate reduction over five years if minimum investment of EUR 50 000 and at least 3 jobs created

Regional tax incentives

CIT rate reductions for investments in certain regions

No

Tax allowances

Accelerated depreciation

Doubling of regular depreciation rates

No

R&D tax incentives

Tax allowances for qualifying R&D expenses for R&D projects that include fundamental research, industrial research, experimental development and feasibility studies.

No

Tax incentives for investment in education

Tax base reduction by a percentage of expenses incurred on the general education and special education of employees

Yes: SMEs can reduce their taxable base by 70% of eligible costs for the general education and training of employees, and by 35% of eligible costs for the special education of employees.

Source: OECD SME Taxation Questionnaire and IBFD.

Overall, the system of corporate tax incentives is relatively difficult to navigate for small businesses. Different tax incentives pile up on top of each other. Besides, the definition of SMEs varies across tax concessions. A single definition of SMEs and standardised eligibility criteria for all small business tax concessions could be used to make the tax system easier to comply with and to administer.

Corporate tax incentives are generous, but not always well targeted. For instance, under the investment tax incentive, taxpayers may be taxable at a reduced CIT rate or exempt altogether, depending on their level of investment and job creation. For micro-entrepreneurs (less than ten employees), investment tax incentives are granted in the form of a 50% CIT rate reduction over five years if a minimum of EUR 50 000 is invested and at least three jobs are created. This means that the CIT rate is reduced from 12% (rate that applies to businesses below HRK 3 million) to 6% on all of their profits. For small, medium and large enterprises, investment tax incentives can be obtained for a period of ten years under the conditions described in Table ‎10.5. These tax incentives are generous but they may be of limited benefit for some new businesses, which might not generate profits in their first few years of operation.

Table ‎10.5. Investment tax incentives: eligibility criteria and CIT rate reductions

Investment amount (EUR)

Number of newly employed persons

CIT rate reduction (%)

150 000 to 1 000 000

5

50

1 000 000 to 3 000 000

10

75

Over 3 000 000

15

100

Source: Ministry of Finance.

In general, expenditure-based tax incentives should be preferred to income-based tax incentives. Tax incentives based on investment expenditures, such as accelerated or enhanced depreciation, immediate expensing of some proportion of capital costs and investment tax credits, provide a larger investment response for each unit of tax revenue foregone, compared to a CIT rate reduction, even if the one provided by Croatia is tied to a minimum level of investment and job creation.

As in most corporate tax systems, the treatment of profits and losses in Croatia is asymmetric. As already mentioned in this chapter, profits are taxed when they occur, while losses are carried forward and used to offset future profits for a limited number of years. In Croatia, tax losses can be carried forward and used to offset profits within five years following the year in which the losses were incurred and must be utilised in the order in which they occurred. Tax losses cannot be carried back. The asymmetric treatment of operating losses in the corporate tax system may put start-ups at a disadvantage relative to established businesses as it may take years before they become profitable.

The tax system encourages businesses to incorporate and retain their earnings

After taxation at the corporate level, the income from incorporated SMEs is subject to a second level of taxation at the individual level. Taxation at the personal level depends on the form in which the income is received. If the company distributes profits to shareholders who are individuals, this distribution is subject to a final 12% dividend tax and the municipal surtax (if applicable). If profits are retained and reinvested, on the other hand, they will be subject to capital gains taxation when the company shares are sold. The capital gains tax, which was introduced in 2016, is levied at a rate of 12% (increased if a municipal tax is applicable) and applicable only for holding periods of less than two years. Finally, if the income is distributed as a wage, the salary of the owner for the hours worked in the business is subject to PIT (but deductible for CIT purposes).

The current system provides incentives for businesses to incorporate and retain their earnings. Figure ‎10.12 compares the marginal tax rates on income depending on whether businesses incorporate or not and whether profits are distributed or not. If business income is taxed as self-employment, the top marginal PIT rate on income can go up to 42.5% (including the Zagreb surtax). The overall tax burden on dividend distributions (which takes into account CIT and PIT) is lower, amounting to either 29.6% or 24.5% depending on whether the 18% or the 12% CIT rate applies. This may encourage businesses to incorporate and to distribute SME income as dividends rather than as labour income. Retaining earnings and eventually receiving income in the form of capital gains upon the disposal of company shares is the most tax-favoured option, particularly if shares are held for more than two years, in which case capital gains are not taxed at the individual level. It also encourages them to incorporate and to move away from receiving SME income as labour income, as the combined impact of the dividend tax at 12% will be lower than PIT.

Figure ‎10.12. Marginal tax rates on self-employment income, dividend distributions and capital gains
Figure ‎10.12. Marginal tax rates on self-employment income, dividend distributions and capital gains

Notes: For the combined tax rates on dividends, the dividend tax at the shareholder level is levied at a rate of 12%. Municipalities apply different surtax rates. The Zagreb municipal surtax is levied on the central tax liability at a rate of 18%. The combined tax rate on dividends is calculated as follows: 18%+(1-18%)*12%*(1+18%). For the combined ETRs on capital gains, the calculations are based on the methodology of the OECD (2018) Taxation of Household Savings, assuming no inflation and an interest rate of 5%.

Source: Authors’ calculations.

Owner-managers of companies have been able to minimise their SSCs

The SSC system for the owner-managers of limited liability companies has allowed them to minimise their SSC burdens. The owner-managers of companies often declare working for a very small number of hours within their company and pay SSCs on that very small base of declared working hours. This has allowed owner-managers of companies to significantly reduce their SSC liabilities and ultimately made the system regressive as wealthy owner-managers have been able to minimise their SSCs while regular employees and self-employed businesses have not. As of 1 January 2019, however, minimum SSCs will be introduced: owner-managers will be required to pay SSCs on the same minimum base as crafts, i.e. the average national wage multiplied by 0.65.

Recommendations

Overall, the taxation of incorporated SMEs could be improved in a number of ways. Croatia could adopt a single SME definition for tax and non-tax purposes and standardise the eligibility criteria for small business tax concessions. Croatia could also consider turning the investment tax incentive into an investment tax credit or tax allowance, which would be more directly linked to the amount of investment rather than through a reduced CIT rate as is currently the case. The take-up of corporate tax incentives by small businesses should also be closely evaluated. More generally, the corporate tax allowances available to all businesses could be turned into tax credits as the value of tax allowances depends on the tax rate borne by the taxpayer. Indeed, the higher (lower) the CIT rate, the higher (lower) the amount of tax relief on a given amount of investment allowance claimed, meaning that large companies paying a higher CIT rate end up receiving a higher tax benefit. Croatia could also assess whether more flexible loss offset provisions targeted at small businesses could be helpful.

Additional reforms could be envisaged to limit tax arbitrage. Croatia could consider levying the capital gains tax upon the disposal of shares held for over two years, which would limit businesses’ incentives to retain their earnings and ultimately remunerate themselves through capital gains (although there would still be an incentive to receive profits as capital gains as it would defer taxation). The owner-managers of closely held businesses could also be required to pay themselves a minimum salary to prevent tax arbitrage (i.e. small business owners paying themselves a small salary but buying a car, house, telephone, etc. through their business and distributing themselves lower-taxed dividends when they need cash). This minimum salary could also serve as the minimum base on which to levy SSCs for owner-managers.

The VAT registration threshold is relatively high

The level of the VAT registration threshold in Croatia is comparatively high. VAT registration thresholds vary widely across countries. In the EU, VAT registration thresholds range between EUR 0 in Spain where there is no VAT registration threshold to close to EUR 95 000 in the United Kingdom. With a VAT registration threshold of HRK 300 000 (approximately EUR 40 000), Croatia has a comparatively high thresholds, but Croatia’s threshold is similar to those of comparable Central and Eastern European countries (Figure 10.13).

One of the explanations for Croatia’s high VAT registration threshold is its high standard VAT rate. Croatia’s high standard VAT rate encourages small businesses to stay or “bunch” below the VAT registration threshold to avoid charging VAT and remain competitive. This is especially true for businesses or sectors with lower levels of inputs relative to supplies to consumers such as labour-intensive businesses and businesses operated by sole proprietors. For these businesses, the amount of VAT paid on their inputs tends to be low and the advantage of being able to deduct input VAT if they register for VAT is limited. Having a high VAT threshold therefore helps these businesses remain competitive in a context where the standard VAT rate is high.

In general, setting the level of the VAT registration threshold at an adequate level is a complex task. The main reason for excluding small businesses from the VAT system is that compliance costs for small businesses may be disproportionate compared to their turnover, and that the costs for the tax administration of having very small businesses pay VAT may be disproportionate compared to potential VAT revenues. On the other hand, a VAT registration threshold introduces competitive distortions between small businesses under and above the threshold. The VAT registration threshold should minimise competitive distortions and be set so that the revenues collected are higher than the administrative costs of ensuring that small businesses properly collect and remit VAT. In countries where the tax administration is weaker, a higher threshold tends to be more appropriate, which is partially confirmed by Figure ‎10.13.

Figure ‎10.13. VAT registration/collection thresholds in EU countries in 2018 (in EUR)
Figure ‎10.13. VAT registration/collection thresholds in EU countries in 2018 (in EUR)

1. Note by Turkey: The information in this document with reference to “Cyprus” relates to the southern part of the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is found within the context of the United Nations, Turkey shall preserve its position concerning the “Cyprus issue”.

Note by all the European Union Member States of the OECD and the European Union: The Republic of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in this document relates to the area under the effective control of the Government of the Republic of Cyprus.

2. Conversions based on exchange rates on 1 September 2018. 1These countries have a lower VAT registration/collection threshold for services.

Source: OECD Tax Database and IBFD.

An issue with a high VAT registration threshold is that it limits the “formalising” role of VAT. VAT theoretically creates positive “chain” effects incentivising economic agents to become formal. VAT can create positive incentives for informal sector firms with actual or prospective dealings with formal sector firms to enter the formal tax system in order to be able to claim tax credits and recover their input VAT. A recent study of small firms in Brazil shows that an individual firm is more likely to register for VAT if its suppliers and/or customers are registered (de Paula and Scheinkman, 2010[17]).

Croatia could consider revising the level of its VAT registration threshold in the future. Generally, tax administration improvements in Croatia have lowered the administrative costs of ensuring that small businesses adequately collect and remit VAT. As the tax administration’s enforcement capacity continues to be reinforced, Croatia could consider lowering its VAT registration threshold. In addition, with the rise of the sharing economy and the possible increase in the number of small operators below the VAT registration threshold, the revenue loss and distortions caused by a relatively high VAT threshold might become more problematic. However, the effects of an increase in the VAT registration threshold should be carefully assessed ex ante.

Tax compliance costs weigh heavily on small businesses

Tax compliance costs weigh heavily on SMEs in Croatia. Tax accounting, tax return filing and tax payment obligations are numerous and complex. In addition to being regressive relative to firm size, the costs involved in understanding tax rules, maintaining records and filing tax returns have generally required Croatian small businesses to rely on external accounting services because they lack the internal capacity to comply with all their tax obligations compared to large businesses, which have internal accounting services.

Croatia has a number of tax simplification measures targeted at SMEs. As mentioned previously, businesses with a turnover below HRK 300 000 are not required to register for VAT and are eligible for lump-sum taxation. Businesses with a turnover below HRK 800 000 have the possibility to report VAT on a quarterly instead of a monthly basis. This is in line with practices in other OECD and EU countries where SMEs are often allowed to file VAT returns on a less frequent basis. Businesses with an annual turnover below HRK 3 million can also opt for cash accounting for VAT and CIT purposes. Cash accounting minimises cash flow difficulties for small businesses as tax is payable when cash is received, as opposed to accrual accounting, which requires businesses to recognise revenues and expenditures at the time when the transaction occurs. Cash accounting is also simpler than accrual accounting, which requires accounting for expenses related to long-term assets (e.g. depreciation), inventory and pension liabilities on an accrual basis.

However, SMEs continue to face tax compliance difficulties, in particular in relation to advance tax payments. In Croatia, CIT, PIT and the lump-sum tax involve monthly advance payments that are calculated based on the tax owed in previous years. An option to reduce compliance costs, while at the same time easing firms’ cash flow constraints, would be to allow small firms to make less frequent advance tax payment instalments. This is common practice in many countries where, for instance, large firms are required to pay advance CIT instalments on a quarterly or a monthly basis, while small firms are allowed to remit CIT less frequently. In Croatia, advance tax payments could shift from a monthly to a quarterly basis for SMEs.

Regarding income reporting obligations, significant progress has been achieved but efforts should continue. Since 2014, employers have been subject to the obligation to submit a unified form (JOPPD form) to the tax administration to report employment income and SSCs. The form is also used by natural and legal persons to report other types of income, including property income, capital income, and insurance income. Overall, the JOPPD form replaced six different forms used before 2014. This initiative represents good progress, however, further simplification is needed. The form proved more burdensome than expected, due to its complicated codes and very short submission deadlines (Kovač, Ðulabić and Čičin-Šain, 2017[18]). Generally, the form has to be filled on the day the payments are made. In addition, the information collected through this form has so far only been used by the tax administration, so similar reports continue to be submitted several times (e.g. online registration of workers for tax purposes and paper registration of workers for healthcare). Efforts to exchange this type of information between different public administrations should be pursued.

Complexity and heavy compliance burdens also come from the numerous parafiscal fees that businesses are required to pay. There are about 250 parafiscal fees in Croatia, which apply to both self-employed and incorporated businesses, depending on their location and industry sector. Examples of such fees include fees for forest management, fire protection, water sanitation, the preservation of monuments, membership to the chamber of commerce, etc. They are calculated differently: some are based on turnover, while others are levied as fixed amounts or based on usage or services provided. These parafiscal fees are managed in an unco-ordinated way by different institutions. Overall, these parafiscal charges account for around 2.5% of GDP (Ministry of Economy).

Generally, there is scope for further reducing small businesses’ tax accounting, tax return filing and tax payment obligations. Regarding tax accounting, small businesses should be made more aware of the possibility to use cash accounting for CIT, as very few businesses have taken advantage of it so far. Regarding tax filing and reporting, there should be further efforts to streamline taxpayer obligations by sharing the information collected through forms by one public administration with other public bodies. Third-party information should also increasingly be used to pre-fill tax returns. Regarding tax payment obligations, Croatia should consider introducing less frequent advance payments for CIT, PIT and the lump-sum tax under a certain level of tax owed or under a certain turnover threshold. Finally, parafiscal fees should be reviewed and scaled back. The remaining parafiscal charges could be consolidated into a smaller number of payments.

Fiscalisation is a marked improvement but involves compliance costs for businesses

In Croatia, “fiscalisation” has been a major initiative to fight against the informal economy and VAT evasion. Since 2013, all businesses that accept cash payments are required to purchase and use a fiscalisation software that automatically reports every cash transaction to the government in real time through cash registers that are directly connected to the tax administration. The tax administration then checks if the receipts contain all the required elements and have been signed with a correct digital signature. Once these elements are validated, the tax administration attributes a unique receipt identification (JIR) to the receipt. This exchange is done within a few seconds and enables the printing of a receipt approved by the tax administration with a JIR. If there is an issue (e.g. no internet connection), the re-authorisation of receipts has to be performed within 48 hours.

While fiscalisation is a positive development, the burden imposed on smaller businesses could be minimised. Fiscalisation is particularly problematic for small businesses in remote areas (e.g. countryside, islands), where the internet connection is often absent or limited. The time limit for the fiscalisation of receipts could be extended to lower the compliance burden and risks of penalties for these businesses. Training support and special assistance to SMEs could also be provided more widely. Finally, the effects of fiscalisation on tax revenues and the performance of different sectors should be closely evaluated.

The tax penalty system might discourage new businesses

Businesses in Croatia are subject to the same penalties as large firms if their tax returns contain errors or are submitted late. This is in line with practices in most countries, where the size of enterprises usually does not have a direct influence on the level of penalties or fines (European Commission, 2007[12]).

The penalty system could take greater account of businesses’ past compliance in the application of penalties. While firm size is usually not taken into consideration, a past record of good behaviour is often taken into account to reduce the severity of penalties (European Commission, 2007[12]). In the United Kingdom, for instance, a points-based penalty system similar to that used with driving licenses is being established to address late or missing tax returns. This was set up in connection with HM Revenue & Customs (HMRC)’s “Making Tax Digital initiative” which is expected to put an extra reporting burden on small businesses and led to the idea that the penalty system should be less rigid. Penalty points will be given for late submissions and a financial penalty will be imposed after the number of points reaches a set threshold. Penalty points will expire after a period of good compliance, and may be waived if HMRC believes they are not appropriate, or if the taxpayer makes a successful appeal (HM Revenue & Customs, 2018[19]). An approach that takes greater account of businesses’ past compliance could be adopted in Croatia.

There is room for tax administration improvements

On the administrative side, taxpayer services targeted at small businesses could be improved. The SME sector – with its high turnover rates, varying levels of financial literacy, and greater exposure to the cash economy – poses specific challenges to tax administrations. In most countries, the specific characteristics, behaviours and risk profiles of different “segments” of the taxpayer population (e.g. large vs small businesses) have led to efforts towards more tailored responses from tax administrations. In Croatia, one approach could be to set up an SME portal or a webpage specifically dedicated to SMEs on the tax administration’s website to enhance small businesses’ access to information. This could also encourage the use of self-service and electronic channels, as is done in other countries (see Box 10.4). Efforts to enhance e-tax procedures should continue: electronic tax filing is compulsory for incorporated businesses as well as for self-employed businesses with at least three employees, but online tax payment is not available yet.

A small office focusing on tax simplification could also be set up. A small unit could be set up to monitor tax compliance procedures and burdens, as is done in some countries. For instance, the United Kingdom has an Office for Tax Simplification, which is an independent office in the Treasury responsible for giving advice to the government on simplifying the tax system. It conducts and publishes reviews on complex areas of the tax system and identifies options for reform, with a view to reducing tax compliance burdens on individual and corporate taxpayers.

Finally, reforms could focus on strengthening the exchange of information between public administrations. The exchange of information could help streamline small businesses’ reporting obligations, as information collected by one public administration, or by a third party, could be shared with multiple public bodies. The exchange of information should also be strengthened with a view to enhancing the detection of fraudulent behaviours. For instance, the information collected through the electronic cash registers (see above) could be crossed with data on businesses’ purchases to detect anomalies.

Box 10.3. Small business assistance programmes in Australia

Australian Taxation Office (ATO) app

The ATO app helps small businesses deal with their tax obligations. Some of its features include a list of due dates that can be saved as reminders in smartphones and tablets and a myDeductions function that can be used by sole traders to track business income, expenses and car trips. At tax time, businesses can upload this information to pre-fill their tax returns or email it to their tax agents. A benchmarking tool also helps small businesses compare their performance against similar businesses in their industry.

Small business workshops and webinars

Free face-to-face workshops and webinars are offered on a variety of tax topics including Goods and Services Tax (Australia’s value-added tax), activity statements, income tax deductions, home-based business, record keeping and more.

Business Assistance Programme

The programme offers one-to-one tailored support over 12 months for new small businesses, helping them understanding their tax obligations. This programme requires registration. As part of the programme, the tax administration gives taxpayers three calls to help them understand their tax, contributions and GST obligations. Each check-in phone call is an opportunity for small businesses to ask questions and understand how to meet their tax obligations.

Source: Australian Taxation Office website, https://www.ato.gov.au/.

 

Box ‎10.4. Tax reform recommendations

General recommendations

  • Shift part of the financing of social benefits from SSCs towards other taxes to reduce the reliance of the tax system on labour income taxes

  • Consider lowering the PIT exemption threshold

  • Consider levying the capital gains tax on shares held for more than two years

  • Turn income-based corporate tax incentives into expenditure-based tax incentives

  • Introduce online tax payments

Recommendations to improve SME taxation

Tax policy and SSC reforms

  • Adopt a single SME definition for tax and non-tax policy purposes and standardise eligibility criteria for all small business tax concessions

  • Consider removing the possibility for unincorporated businesses to be taxed under CIT

  • Consider reducing the VAT registration threshold, particularly if the standard VAT rate is lowered

  • Turn the lump-sum tax for self-employed businesses into a turnover-based presumptive tax, possibly with progressive rates

  • Consider levying SSCs for the self-employed and the owner-managers of closely-held corporations on their actual earnings (possibly with some caps)

  • Review and scale back parafiscal fees. Consolidate the remaining ones into a smaller number of payments.

Tax simplification and tax administration measures

  • Reduce the frequency of advance tax payments under a certain threshold of tax owed or turnover

  • Consider revising the tax penalty system by better taking into account taxpayers’ past tax compliance records

  • Strengthen the exchange of information between public administrations to streamline small businesses’ reporting obligations and enhance the detection of fraudulent behaviours

  • Enhance taxpayer services aimed at SMEs, create a webpage dedicated to SMEs on the tax administration’s website, and make better use of IT tools to reduce small businesses’ compliance costs

  • Extend the time period for the fiscalisation of VAT receipts and provide small businesses with support to comply with their fiscalisation requirements.

References

[14] Boonzaaier, W. et al. (2017), How do small firms respond to tax schedule discontinuities? Evidence from South African tax registers, https://vatt.fi/documents/2956369/4541479/wp85.pdf/9a45c0bd-7221-4f89-a1d8-f04e89a91c66/wp85.pdf.pdf (accessed on 10 December 2018).

[2] Božić, L. and E. Rajh (2016), “The factors constraining innovation performance of smes in Croatia”, Economic Research-Ekonomska Istrazivanja, http://dx.doi.org/10.1080/1331677X.2016.1168040.

[13] Chen, D., F. Lee and J. Mintz (2002), “Taxation, SMEs and Entrepreneurship”, OECD Science, Technology and Industry Working Papers, No. 2002/9, OECD Publishing, Paris, https://dx.doi.org/10.1787/013245868670.

[17] de Paula, Á. and J. Scheinkman (2010), “Value-Added Taxes, Chain Effects, and Informality”, American Economic Journal: Macroeconomics, Vol. 2/4, pp. 195-221, http://dx.doi.org/10.1257/mac.2.4.195.

[7] Deskar-Škrbić, M., S. Drezgić and H. Šimović (2018), “Tax policy and labour market in Croatia: effects of tax wedge on employment”, Economic Research-Ekonomska Istraživanja, Vol. 31/1, pp. 1218-1227, http://dx.doi.org/10.1080/1331677X.2018.1456359.

[9] European Commission (2018), Country Report Croatia 2018, https://ec.europa.eu/info/sites/info/files/2018-european-semester-country-report-croatia-en.pdf (accessed on 13 November 2018).

[5] European Commission (2018), Study and Reports on the VAT Gap in the EU-28 Member States: 2018 Final Report, https://ec.europa.eu/taxation_customs/sites/taxation/files/2018_vat_gap_report_en.pdf (accessed on 10 December 2018).

[1] European Commission (2017), 2017 SBA Fact Sheet-Croatia, http://dx.doi.org/file:///C:/Users/Perret_S/Downloads/Croatia%20-%20SBA%20Fact%20Sheet%202018.pdf.

[4] European Commission (2017), DG Taxation and Customs Union, based on Eurostat data, https://ec.europa.eu/taxation_customs/business/economic-analysis-taxation/data-taxation_en.

[8] European Commission (2017), European Platform tackling undeclared work Member State Factsheets and Synthesis Report.

[12] European Commission (2007), Simplified Tax Compliance Procedures for SMEs Final Report of the Expert Group, http://ec.europa.eu/enterprise/entrepreneurship/support_measures/.

[19] HM Revenue & Customs (2018), Technical note on late submission penalties - GOV.UK, https://www.gov.uk/government/publications/technical-note-on-capital-gains-tax-and-corporation-tax-for-non-residents-on-uk-property/technical-note-on-capital-gains-tax-and-corporation-tax-for-non-residents-on-uk-property (accessed on 10 December 2018).

[10] Johansson, Å. et al. (2008), “Taxation and Economic Growth”, OECD Economics Department Working Papers, No. 620, OECD Publishing, Paris, https://dx.doi.org/10.1787/241216205486.

[15] Kleven, J. (2016), “Bunching”, Annual Review of Economics, http://dx.doi.org/10.1146/annurev-economics-080315-015234.

[18] Kovač, P., V. Ðulabić and N. Čičin-Šain (2017), “Removal of Administrative Barriers through the Recent Procedural Simplifications in Slovenia and Croatia”, Economics and Social Issues Review, Vol. 8/4, pp. 207-228, http://dx.doi.org/10.1515/danb-2017-0014.

[16] Mirrlees, J. (2011), “Small Business Taxation”, in Tax by Design, https://www.ifs.org.uk/uploads/mirrleesreview/design/ch19.pdf (accessed on 10 December 2018).

[3] OECD (2018), Revenue Statistics 2018, OECD Publishing, Paris, https://dx.doi.org/10.1787/rev_stats-2018-en.

[6] OECD (2017), Revenue Statistics 2017, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264283183-en.

[11] OECD (2015), Taxation of SMEs in OECD and G20 Countries, OECD Tax Policy Studies, No. 23, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264243507-en.

[20] OECD (2015), Taxation of SMEs in OECD and G20 Countries, OECD Tax Policy Studies, No. 23, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264243507-en.

Notes

← 1. Within this definition, a small enterprise is defined as having less than 50 employees and a turnover or a balance sheet total of less than EUR 10 million; and a microenterprise is a firm with less than 10 employees and a turnover or balance sheet total below EUR 2 million (https://ec.europa.eu/growth/smes/business-friendly-environment/sme-definition_en).

← 2. Municipal surtaxes are levied on the central government tax liability.

← 3. The Zagreb municipal surtax is levied on the central tax liability at a rate of 18%.

← 4. If individual entrepreneurs choose to be taxed under CIT, they are obliged to pay CIT instead of PIT for the following three years. 

← 5. The total gross income of the entrepreneur is at least HRK 3 million (excluding VAT); or two of the following three conditions are met: the net income (gross income less expenses) of the entrepreneur is at least HRK 400 000; the entrepreneur employs on average more than 15 employees; or the value of the entrepreneur’s depreciable assets exceeds HRK 2 million.

← 6. One important exception is S-corporations in the United States, which are incorporated but income and losses are passed through to shareholders, and income is taxed at the individual level.

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