Impact of Thin Capitalization Rules on Tax Revenue in an Emerging Economy. Case Study: Latvia, 2000-2016

Abstract

Dwindling oil revenue in Nigeria has necessitated the need to generate more government revenue through other sources. A potential area to generate more government revenue is through taxes on corporate profits. However, the prospects of generating more tax revenues have been perceived internationally to be weakened by aggressive corporate tax planning amongst multinational companies especially through internal debt shifting from jurisdictions with lower tax rates to jurisdictions with higher tax rates for the overall reduction in group tax liabilities. The capital structure of an organization determines the level of interest expense deductions from taxable income. That is, a highly leveraged company would be able to deduct more interest expenses on debt compared to a lower leveraged company. As a result of this tax loophole explored by multinational companies, most countries have introduced thin capitalization rules to reduce base erosion and profit shifting. Currently, Nigeria has no thin capitalization rules in effect, there are many benefits from thin capitalization rules from regulatory perspective. This paper seeks to examine the effects of thin capitalization rules on tax revenue by using the Latvian economy as a case study. Latvia is an emerging economy and it is has implemented thin capitalization since 2003. Data on taxes on corporate profits, gross fixed capital formation annual percentage growth, short- term interest rates on loan in the Euro Area (EA) and adjusted net national income percentage growth for the period of 2000 to 2016 were obtained from the Organization for Economic Co- operation and Development (OECD) and the World Bank database. This paper applied the multiple regression model. The results show that the dummy variable for thin capitalization policy is statistically insignificant to tax revenue in Latvia, however short-term interest rate on loans in the EA has a significant impact on tax revenue in Latvia.