Tax policy: options for restructuring public finance

What do we mean by the term tax? A tax is a compulsory contribution towards a country's expenses raised by the government from people's salaries, property and from the sale of goods and services, or in other words it is raising of revenues to finance government spending. It is not easy and simple to establish an efficient and fair tax system. Raising essential revenue without excessive government borrowing is the hallmark of an ideal tax system. Another characteristic of an efficient system is that it does not discourage economic activity.
An attempt to establish efficient tax systems in our country is confronting formidable challenges. A government usually finds resistance from those employed in agriculture or in small, informal enterprises. The reason is that they are seldom paid a regular, fixed wage, and their earnings fluctuate, and many are paid in cash, or "off the books." The base for an income tax is, therefore, hard to calculate. Nor do these workers typically spend their earnings in large stores that keep accurate records of sales and inventories. As a result, modern means of raising revenue, such as income taxes and consumer taxes, play a diminished role in our economy in the absence of non-recorded data.
Without a well-educated and well-trained staff, creation of an efficient tax administration is difficult. The problem becomes more complex when money is lacking to pay good wages to tax officials and to computerize the operation, particularly when the taxpayers have limited ability to keep accounts. Consequently, governments take a path of least resistance by developing a tax systems that allows them to exploit options, which are available rather than establishing rational, modern, and efficient tax systems.
Financial limitations and the informal structure of the economy makes it difficult to generate reliable statistics. Non availability of reliable data prevents the policymakers from assessing the potential impact of major changes of the tax system. Resultantly, rather than going for major structured changes, marginal changes are preferred. Consequently, inefficiency creeps in the system.
A hallmark of our economic system is that income tends to be unevenly distributed. In this situation, raising high tax revenues calls for the rich to be taxed more heavily than the poor, the economic and political power of rich taxpayers often allows them to prevent fiscal reforms that would increase their tax burdens. This explains in part why countries like us have not fully exploited personal income and property taxes and why the tax systems rarely achieve satisfactory progressivity.
Economic theory and especially optimal taxation literature have had relatively little impact on the design of tax systems in our country. In discussing tax policy issues, I draw on extensive practical, first-hand experience with provision of tax policy advice and decision making process.
TAX REVENUE LEVEL At a given level of national income what level of public spending is desirable? How much percentage of national income be spent by the government? After having answer to these questions, we can go ahead to ask where to set an ideal level of tax revenue; determining the optimal tax level is conceptually equivalent to determining the optimal level of government spending. And for that the existing literature on the subject provides little help. The riddle that how to integrate the optimal level of tax revenue with the optimal level of government expenditure very much exists there.
Whether the overall tax level is appropriate and consists of desired tax level in the economy as compared to the average tax burden of a representative group of both developing and industrial countries, will be determined while taking into account some of the' similarities and dissimilarities among these countries. This comparison indicates whether country's tax level, relative to other countries while taking into account various characteristics, is above or below the average level. This statistical approach has no theoretical basis and does not indicate the "optimal" tax level for any country. The most recent data shows that the tax level in major industrialised countries stands at 38% of the GDP as compared to Pakistan's 12%.
STRUCTURE OF TAX REVENUE The complexities of the tax system raise the issues such as the taxation of income relative to that of consumption and under consumption, the taxation of imports versus the taxation of domestic consumption. Both efficiency (whether the tax increases or decreases the welfare of those who are taxed) and equity (whether the tax is fair to everybody) are the core issues.
A belief that taxing income entails a higher welfare (efficiency) cost than taxing consumption is based in part on the fact that income tax, which contains elements of both a labour tax and a capital tax, reduces the taxpayer's ability to save. There is a rethinking on this belief. And existing considerations render the relative welfare costs of the two taxes (income and consumption) uncertain.
The choice between taxing income and taxing consumption involves their relative impact on equity. Taxing consumption has always been considered as more regressive (that is, more burden on the poor than the rich) than taxing income: There is a rethinking on this issue now. Theoretical and practical considerations suggest that the equity concerns about the traditional form of taxing consumption are probably overstated and that, attempts to address these concerns by such initiatives as graduated consumption taxes would be ineffective and administratively impractical.
Reduction of import duties will lead to more competition from foreign enterprises. Whereas decreasing safeguards to domestic industries against foreign competition is an inevitable consequence, or even the objective, of a trade liberalisation programme: And decreased revenue income would be an unwelcome by-product of the said programme. Under the circumstances, feasible compensatory revenue measures always involve enhanced domestic consumption taxes. It is rare to increase the income taxes as the same is considered a viable option on the grounds of policy (because of their perceived negative impact on investment) and administration (because their revenue yield is less certain and less timely than that from consumption tax changes).
The ratio of income to consumption taxes in industrial countries has consistently remained more than double the ratio in developing countries. That is, compared with developing countries, industrial countries derive proportionally twice as much revenue from income tax than from consumption tax. The data also indicate a marked difference in the ratio of corporate income tax to personal income tax. Industrial countries raise about four times as much from personal income tax than from corporate income tax. Differences between the two country groups in wage income, in the sophistication of the tax administration, and in the political power of the richest segment of the population are the primary contributors to the existing disparity. On the other hand, revenue from trade taxes is significantly higher in developing countries than in industrial countries.
From international comparisons it is difficult to draw clear-cut normative policy prescriptions. As regards the income-consumption tax mix, a compelling implication revealed by the comparison is that economic development tends to lead to a relative shift in the composition of revenue from consumption to personal income taxes. The important tax policy issue for us is not so much to determine the optimal tax mix as to spell out clearly the objectives to be achieved by any contemplated shift in the mix, rather it is to assess the economic consequences (for efficiency and equity) of such a shift, and to implement compensatory measures if the poor are made worse off by the shift.
PICKING AN IDEAL TAX SYSTEM For allocating resources market forces are increasingly important. As such the design of the tax system should be as neutral as possible so as to minimise interference in the allocation process. Transparent and simple administrative procedure is needed for the system so that it is clear if the system is not being enforced as designed.
DIRECT TAXES
This tax has yielded relatively little revenue and the number of individuals subject to this tax (especially at the highest marginal rate) is small. The rate structure of the personal income tax is the most visible policy instrument available to underscore one's commitment to social justice and hence to gain political support for their policies. We frequently attach great importance to maintaining some degree of nominal progressivity in this tax by applying many rate brackets, and we are reluctant to adopt reforms that will reduce the number of these brackets.
However, the effectiveness of rate progressivity is severely jeopardised by high personal exemptions and the plethora of other exemptions or deductions that benefit those with high incomes. For example, the exemption of capital gains from tax, or generous deductions for medical and educational expenses, or the low taxation of financial income. Relief being granted in the form of deductions is self-defeating because these deductions typically increase in the higher tax brackets. Effective rate progressivity can be improved by reducing the degree of nominal rate progressivity, and the number of brackets by reducing exemptions or deductions. A reasonable equity objective asks for no more than a few nominal rate brackets in the personal income tax structure. Irrespective of political constraints that prevents restructuring of rates. However, a substantial improvement in equity can still be made by switching deductions with tax credits, and the same can deliver all benefits to taxpayers irrespective of tax brackets.
Effect of high marginal tax rate stands reduced by its often being applied at such high levels of income that a little income is subject to these rates. A taxpayer's income stands hundreds of times the per capita income before it enters the highest rate bracket.
The top marginal personal income tax rate exceeds the corporate income tax by a significant margin, providing strong incentives for taxpayers to choose the corporate form of doing business for purely tax reasons. Professionals and small entrepreneurs can easily siphon off profits through expense deductions over time and escape the highest personal income tax permanently. It may be kept in mind that a tax delayed is a tax evaded. A good tax policy, ensures that the top marginal personal income tax rate does not differ materially from the corporate income tax rate.
Beside the problem of exemptions and deductions, which narrow the tax base and negate a progressivity, the personal income tax structure is riddled with serious violations of the two basic principles of good tax policy: symmetry and inclusiveness. (It goes without saying, of course, that tax policy should also be guided by the general principles of neutrality, equity, and simplicity.)
The symmetry principle refers to the identical treatment for tax purposes of gains and losses of any given source of income. If the gains are taxable, then the losses should be deductible. The inclusiveness principle relates to capturing an income stream in the tax net at some point along the path of that stream. For example, if a payment is exempt from tax for a payee, then it should not be a deductible expense for the payer. Avoiding these principles usually leads to distortions and inequities. The tax treatment of financial income is problematic. Two issues dealing with the taxation of interest and dividends are relevant:
-- Interest income, if taxed at all, is taxed as a final withholding tax at a rate substantially below both the top marginal personal and corporate income tax rate. For taxpayers with mainly wage income, this is an acceptable compromise between theoretical correctness and practical feasibility. For those with business income, however, the low tax rate on interest income coupled with full deductibility of interest expenditure implies that significant tax savings could be realised through fairly straightforward arbitrage transactions. To target carefully the application of final withholding on interest income will be important: in case of business income it may not be applied.
-- The tax treatment of dividends leads to double taxation issue. A simple solution for this problem can be either to exempt dividends from the personal income tax altogether, or to tax them at a relatively low rate, or through a final withholding tax at the same rate as that imposed on interest income.
CORPORATION TAX There are numerous issues in this regard, for example an important issue is that of multiple rates based on sectoral differentiation and the incoherent design of the depreciation system. Usually emerging market countries apply multiple rates along sectoral lines (including the complete exemption from tax of certain sectors, especially the parastatal sector) than industrial countries, possibly as a legacy of past centrally-controlled economic regimes that emphasise on the state's role in resource allocation. These practices are detrimental to the proper functioning of market forces.
Where a government's commitment to a market economy is real, such practices are indefensible. Unify priority should be to reduce multiple corporate income tax rates.
An important structural element is allowable depreciation of physical assets for tax purposes in determining the cost of capital and the profitability of investment. This practice leads to the following shortcomings:
(a) Too many asset categories and depreciation rates.
(b) Excessively low depreciation rates.
(c) A structure of depreciation rates that is not in accordance with the relative obsolescence rates of different asset categories. A high priority in tax policy deliberations should be to rectify these shortcomings.
I may add some guidelines for restructuring the depreciation system:
-- Classifying assets into three or four categories should be more than sufficient - for example, grouping assets that last a long time, such as buildings, at one end, and fast-depreciating assets, such as computers, at the other with one or two categories of machinery and equipment in between.
-- Each category be assigned only one depreciation rate.
-- Depreciation rates should generally be set higher than the actual physical lives of the underlying assets to compensate for the lack of a comprehensive inflation-compensating mechanism in most tax systems.
-- The declining-balance method should be preferred to the straight-line method on administrative grounds. The declining-balance method allows the pooling of all assets in the same asset category and automatically accounts for capital gains and losses from asset disposals, thus substantially simplifying book-keeping requirements.
SALES TAX (VAT MODE), EXCISES, AND IMPORT TARIFFS Sales tax frequently suffers from being incomplete in one aspect or another. Many important sectors, most notably services and the wholesale and retail sector, have been left out of the VAT net. The credit mechanism is excessively restrictive, especially when it comes to capital goods. These characteristic allow increasing the tax burden for the final user, and in this way, the benefits from introducing the VAT are substantially reduced.
We have adopted multiple VAT rates. These are politically attractive though, yet because they ostensibly - not necessarily or effectively - serve an equity objective. And the administrative price for addressing equity concerns through multiple VAT rates may be higher. This shortcoming of a multiple-rate system requires scrutiny.
Inappropriately broad coverage of products is the most notable shortcoming of the excise system - that is obviously for revenue reasons. The economic rationale for imposing excises is very different from that for imposing a general consumption tax. Sales tax is meant for broad-based levy in order to maximise revenue with minimum distortion, and excise is a selective levy, narrowly targeting a few goods mainly on the grounds that their consumption entails negative externalities on society. Typical goods deemed to be excisable include tobacco, alcohol, petroleum products, and motor vehicles etc; and these selective items are usually inelastic in demand. A good excise system is invariably one that generates revenue (as a by-product) from a narrow base and with relatively low administrative costs. A major policy challenge is to reduce import tariffs as part of an overall programme of trade liberalisation. There are two limitations in this regard:
(A) Tariff reduction should not lead to unintended changes in the relative rates of effective protection across sectors. For that, unintended consequence reduction in all nominal tariff rates by the same proportion whenever such rates need to be changed can be an effective way to handle the situation.
(B) Nominal tariff reductions are likely to entail short-term revenue loss. Through a clear-cut strategy, this loss can be avoided and separate compensatory measures may be looked into in sequence: first by reducing the scope of tariff exemptions in the existing system, then compensating for the tariff reductions on excisable imports by a commensurate increase in their excise rates, and finally adjusting the rate of the general consumption tax to meet remaining revenue needs.
INCENTIVES To promote investment grant of tax incentives is a common phenomenon. Its effectiveness in attracting incremental investments (above and beyond the level that would have been reached had no incentives been granted) is often questionable. One can met with a high revenue cost where tax incentives are abused by existing enterprises disguised as new ones through nominal reorganisation. The primary target of most tax incentives in attracting investment, (usually meant to attract foreign investors) and in order to force their decision to enter into the country on a multiple factors such as natural resources, political stability, transparent regulatory systems, infrastructure, a skilled workforce etc; And from this angle, tax incentives are frequently far from being the most important one. These incentives may be of questionable value to a foreign investor due to the fact that a true beneficiary of the incentives may not be the investor, it may rather be the treasury of his native country. Such events emerge when any income spared from taxation in the host country is taxed by the investor's native country.
Where incentives address some form of market failure, they may be justified, and noteable are those involving externalities (economic consequences beyond the specific beneficiary of the tax incentive). Incentives targeted to promote high-technology industries can be good example where incentives promise to confer significant positive externalities on the rest of the economy as being legitimate. Incentives are only justifiable for meeting regional development needs. And it may be noted that not all incentives are equally suited for achieving said objectives and some may be less cost-effective than others. But the fact is that most prevalent forms of incentives found tend to be the least meritorious.
TAX HOLIDAYS Tax holidays (exemptions from paying tax for a certain period of time) are the most popular among developing countries. However, they have numerous shortcomings. Tax holidays tend to benefit an investor who expects high profits and would have made the investment even if this incentive were not offered (by exempting profits). These measures provide a strong incentive for tax avoidance, as taxed enterprises can enter into economic relationships with exempt ones to shift their profits through transfer pricing, (for example, overpaying for goods from the other enterprise and receiving a kickback). Further, the duration of the tax holiday is usually abused in the form of extension by investors through creative redesignation of existing investment as new investment (for example, closing down and restarting the same project under a different name but with the same ownership). Projects are attracted by time-bound tax holidays.
These measures are not so beneficial to the economy as compared to longer-term ones. The revenue cost of the tax holiday to the budget is seldom transparent. The government must spend resources on tax administration that yields no revenue and the enterprise loses the advantage of not having to deal with tax authorities.
ALLOWANCES AND TAX CREDITS Tax credits and investment allowances have a number of advantages compared with tax holidays. For promoting particular types of investment, they are much better targeted than tax holidays and their revenue cost is much more transparent and easier to control. To determine the amount of the credit to a qualified enterprise and to "deposit" this amount into a special tax account in the form of a book-keeping entry can be a simple and effective way of administering a tax credit system. And an enterprise will be treated like an ordinary taxpayer, subject to all applicable tax regulations, including the obligation to file tax returns. The only difference would be that its income tax liabilities would be paid from credits "withdrawn" from its tax account. In this way information is always available on the budget revenue forgone and on the amount of tax credits still available to the enterprise. A system of investment allowances could be administered in much the same way as tax credits, achieving similar results.
ACCELERATED DEPRECIATION The least of the shortcomings associated with tax holidays and all of the virtues of tax credits and investment allowances is available by providing incentives in the form of accelerated depreciation - and it overcomes the latter's weakness to boot. Through accelerating the depreciation of an asset, the depreciation of the asset beyond its original cost is not increased, and little distortion happens in favour of short-term assets. Accelerated depreciation has other merits too. It is least costly. And where a temporary acceleration is made available, it may induce a significant short-run surge in investment.
SUBSIDIES FOR INVESTMENT Though investment subsidies provide an advantage of easy targeting, yet they are quite problematic. Upfront they involve out-of-pocket expenditure by the government and provide benefits to non-viable investments. It is seldom advisable to use investment subsidies.
INDIRECT TAX INCENTIVES Indirect tax incentives, such as exempting raw materials and capital goods from the sales tax, are prone to abuse and are of doubtful utility. Justifiable is exemption given to raw materials and capital goods used to produce exports from import tariffs. The difficulty with this exemption lies, of course, in ensuring that the exempted purchases will, in fact, be used as intended by the incentive. Establishing export production zones, whose perimeters are secured by customs controls, is a useful, though not entirely foolproof, remedy for this abuse.
TRIGGERING MECHANISMS This mechanism can either be automatic or discretionary. The former allows the investment to receive the incentives automatically once it satisfies clearly specified objective qualifying criteria, such as a minimum amount of investment in certain sectors of the economy. The relevant authorities have merely to ensure that the qualifying criteria are met. The later mechanism involves approving or denying an application for incentives on the basis of subjective value judgement by the incentive-granting authorities, without formally stated qualifying criteria. A discretionary triggering mechanism may be seen by the authorities as preferable to an automatic one because it provides them with more flexibility. However, there are problems associated with discretion, most notably a lack of transparency in the decision-making process. And it can, in turn, encourage corruption and rent-seeking activities. The loss of discretion in handling exceptional cases may be the concern about having an automatic triggering mechanism. Hence the preferred safeguard would be to formulate the qualifying criteria in as narrow and specific a fashion as possible, so that incentives are granted only to investments meeting the highest objective and quantifiable standard of merit. It is advisable to minimise the discretionary element in the incentive-granting process in order to create a balance.
CONCLUSION For the promotion of investment the cost-effectiveness of providing tax incentives is generally questionable. A stable and transparent legal and regulatory framework offers the best strategy for investment promotion. This will bring the tax system in line with international norms. Some objectives, such as those that encourage regional development, are more justifiable than others as a basis for granting tax incentives. It may be kept in mind that not all tax incentives are equally effective. Accelerated depreciation has the most comparative merits, followed by investment allowances or tax credits. Tax holidays and investment subsidies are among the least meritorious. As a general rule, indirect tax incentives should be avoided, and discretion in granting incentives should be minimised.
CONFRONTING TAX POLICY CHALLENGES Economies like us need a higher tax level if we are interested to pursue a government role closer to that of developed countries, which, on an average, enjoy twice the tax revenue. Reliance on foreign trade taxes is needed to be reduced but, at the same time, not at the cost of creating economic disincentives, especially in raising more revenue from personal income tax. To meet these challenges, we will have to get our policy priorities right and to have the political will to implement the necessary reforms.
With the falling of trade barriers, the capital becomes more mobile, therefore, the formulation of a sound tax policy poses significant challenges. The need to replace foreign trade taxes with domestic taxes will be accompanied by growing concerns about profit diversion by foreign investors, which weak provisions against tax abuse in the tax laws as well as inadequate technical training of tax auditors who are currently unable to deter the tax evaders. A concerted effort to eliminate these deficiencies is therefore, of the utmost urgency.
In a world of liberalised capital movement, tax competition is another policy challenge. In the absence of other necessary fundamentals, the effectiveness of tax incentives is highly questionable. A tax system that is riddled with such incentives will inevitably provide fertile grounds for rent-seeking activities. To allow our economy to take proper root, it is advisable to refrain from reliance on poorly targeted tax incentives as the main vehicle for investment promotion.
Personal income taxes have contributed very little to total tax revenue. Apart from structural policy, and administrative considerations, the ease with which income received by individuals can be invested abroad significantly contributes to this outcome. Taxing this income is, therefore, a daunting challenge.
(The writer is an advocate and is urrently working as an associate with Azim ud Din Law Associates Karachi)