Tax policy for developing countries

Why do we have taxes? The simple answer is that, until someone comes up with a better idea, taxation is the only practical means of raising the revenue to finance government spending on the goods and services that most of us demand. Setting up an efficient and fair tax system is, however, far from simple, particularly for developing countries that want to become integrated in the international economy. The ideal tax system in these countries should raise essential revenue without excessive government borrowing, and should do so without discouraging economic activity and without deviating too much from tax systems in other countries.

In developing countries where market forces are increasingly important in allocating resources, the design of the tax system should be as neutral as possible so as to minimize interference in the allocation process. The system should also have simple and transparent administrative procedures so that it is clear if the system is not being enforced as designed.

Any discussion of personal income tax in developing countries must start with the observation that this tax has yielded relatively little revenue in most of these countries and that 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 most governments in developing countries to underscore their commitment to social justice and hence to gain political support for their policies. Countries frequently attach great importance to maintaining some degree of nominal progressiveness in this tax by applying many rate brackets, and they are reluctant to adopt reforms that will reduce the number of these brackets.

Tax policy issues relating to corporate income tax are numerous and complex, but particularly relevant for developing countries are the issues of multiple rates based on sectoral differentiation and the incoherent design of the depreciation system. Developing countries are more prone to having 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 economic regimes that emphasized the state’s role in resource allocation. Such practices, however, are clearly detrimental to the proper functioning of market forces (that is, the sectoral allocation of resources is distorted by differences in tax rates). They are indefensible if a government’s commitment to a market economy is real. Unifying multiple corporate income tax rates should thus be a priority.

While VAT has been adopted in most developing countries, it 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, or the credit mechanism is excessively restrictive (that is, there are denials or delays in providing proper credits for VAT on inputs), especially when it comes to capital goods. As these features allow a substantial degree of cascading (increasing the tax burden for the final user), they reduce the benefits from introducing the VAT in the first place. Rectifying such limitations in the VAT design and administration should be given priority in developing countries.

While granting tax incentives to promote investment is common in countries around the world, evidence suggests that their effectiveness in attracting incremental investments – above and beyond the level that would have been reached had no incentives been granted—is often questionable. As tax incentives can be abused by existing enterprises disguised as new ones through nominal reorganization, their revenue costs can be high. Moreover, foreign investors, the primary target of most tax incentives, base their decision to enter a country on a whole host of factors (such as natural resources, political stability, transparent regulatory systems, infrastructure, a skilled workforce), of which tax incentives are frequently far from being the most important one. Tax incentives could also be of questionable value to a foreign investor because the true beneficiary of the incentives may not be the investor, but rather the treasury of his home country. This can come about when any income spared from taxation in the host country is taxed by the investor’s home country.

Of all the forms of tax incentives, tax holidays (exemptions from paying tax for a certain period of time) are the most popular among developing countries. Though simple to administer, they have numerous shortcomings. First, by exempting profits irrespective of their amount, tax holidays tend to benefit an investor who expects high profits and would have made the investment even if this incentive were not offered. Second, tax holidays 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). Third, the duration of the tax holiday is prone to abuse and 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). Fourth, time-bound tax holidays tend to attract short-run projects, which are typically not so beneficial to the economy as longer-term ones. Fifth, the revenue cost of the tax holiday to the budget is seldom transparent, unless enterprises enjoying the holiday are required to file tax forms. In this case, 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.

Compared with tax holidays, tax credits and investment allowances have a number of advantages. They are much better targeted than tax holidays for promoting particular types of investment and their revenue cost is much more transparent and easier to control. A simple and effective way of administering a tax credit system is 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 bookkeeping entry. In all other respects the enterprise will be treated like an ordinary tax-payer, 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.

Providing tax incentives in the form of accelerated depreciation has the least of the shortcomings associated with tax holidays and all of the virtues of tax credits and investment allowances – and overcomes the latter’s weakness to boot. Since merely accelerating the depreciation of an asset does not increase the depreciation of the asset beyond its original cost, little distortion in favour of short-term assets is generated. Moreover, accelerated depreciation has two additional merits. First, it is generally least costly, as the forgone revenue (relative to no acceleration) in the early years is at least partially recovered in subsequent years of the asset’s life. Second, if the acceleration is made available only temporarily, it could induce a significant short-run surge in investment.

While investment subsidies (providing public funds for private investments) have the advantage of easy targeting, they are generally quite problematic. They involve out-of-pocket expenditure by the Government up front and they benefit non-viable investments as much as profitable ones. Hence, the use of investment subsidies is seldom advisable.

Indirect tax incentives, such as exempting raw materials and capital goods from the VAT, are prone to abuse and are of doubtful utility.

Exempting from import tariffs raw materials and capital goods used to produce exports is somewhat more justifiable. 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.

The cost-effectiveness of providing tax incentives to promote investment is generally questionable. The best strategy for sustained investment promotion is to provide a stable and transparent legal and regulatory framework and to put in place a 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. 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 minimized.

[Source : Speech delivered at National Tax Conference, Jaipur on 20-12-2009]