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1. CHAPTER I.1 A GLANCE AT EARLY PRACTICES IN TAXATION Client/Matter: -None- 2. REFERENCES Client/Matter: -None- 3. CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW Client/Matter: -None- 4. 1. INTRODUCTION Client/Matter: -None- 5. 2. THEORETICAL FOUNDATIONS OF TAXATION Client/Matter: -None- 6. 2.1 Principles of taxation Client/Matter: -None- 7. 2.2 Inter-temporal effects of taxation Client/Matter: -None- 8. 2.3 Should expenditure and income both be taxed? Client/Matter: -None- 9. 3. TAXATION OF CONSUMPTION AND PRODUCTION Client/Matter: -None- 10. 3.1 Retail sales tax and value added tax Client/Matter: -None- 11. 3.2 Excise taxes Client/Matter: -None- 12. 3.3 Environmental taxes Client/Matter: -None- 13. 3.4 Taxation of international trade Client/Matter: -None- 14. 4. INCOME AND WEALTH TAXATION Client/Matter: -None- 15. 4.1 Income and taxable income Client/Matter: -None- 16. 4.2 Designing the income tax Client/Matter: -None- 17. 4.3 Integration of personal and corporate income tax Client/Matter: -None- 18. 4.4 Taxation of capital gains, interest and dividends Client/Matter: -None- 19. 4.5 Source versus Residence Principle

Client/Matter: -None- 20. 4.6 Tax incentives Client/Matter: -None- 21. 4.6.1 Impact of tax structure on corporate behavior Client/Matter: -None- 22. 4.6.2 Impact of tax structure on FDI Client/Matter: -None- 23. 4.6.3 Impact of FDI on tax revenue Client/Matter: -None- 24. 4.6.4 Summing up tax incentives Client/Matter: -None- 25. 4.7 Complex elements of corporate income tax Client/Matter: -None- 26. 4.7.1 Cash flow as an alternate base Client/Matter: -None- 27. 4.7.2 Minimum alternate tax Client/Matter: -None- 28. 4.7.3 Taxation of the financial sector Client/Matter: -None- 29. 4.8 Special taxes Client/Matter: -None- 30. 4.8.1 Payroll tax Client/Matter: -None- 31. 4.8.2 Taxation of non-renewable resources Client/Matter: -None- 32. 5. TAXATION IN A DECENTRALIZED ECONOMY Client/Matter: -None- 33. 5.1 Conceptual basis Client/Matter: -None- 34. 5.2 Sources of revenue Client/Matter: -None- 35. 5.3 Property tax Client/Matter: -None- 36. 5.4 VAT in a decentralized economy Client/Matter: -None- 37. 6. CONCLUSIONS Client/Matter: -None- 38. REFERENCES Client/Matter: -None- 39. CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT Client/Matter: -None- 40. 1. INTRODUCTION Client/Matter: -None- 41. 2. THE DETERMINANTS OF DEVELOPMENT

Client/Matter: -None- 42. 3. TAX POLICY AND THE DETERMINANTS OF DEVELOPMENT Client/Matter: -None- 43. 4. CONCLUSIONS Client/Matter: -None- 44. REFERENCES Client/Matter: -None- 45. CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS Client/Matter: -None- 46. 1. INTRODUCTION Client/Matter: -None- 47. 2. BUOYANCY AND ELASTICITY OF ASIAN TAX SYSTEMS Client/Matter: -None- 48. 2.1 Measurement of buoyancy and elasticity Client/Matter: -None- 49. 2.2 Evidence on buoyancy and elasticity Client/Matter: -None- 50. 3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES Client/Matter: -None- 51. 3.1 Personal income tax Client/Matter: -None- 52. 3.2 Corporate income tax Client/Matter: -None- 53. 3.3 Domestic consumption taxes Client/Matter: -None- 54. 3.4 Import duties Client/Matter: -None- 55. 4. IMPROVING TAX ELASTICITY Client/Matter: -None- 56. 5. CONCLUSIONS Client/Matter: -None- 57. REFERENCES Client/Matter: -None- 58. CHAPTER I.5 TRENDS AND FUTURE DIRECTIONS IN TAX POLICY REFORM: A LATIN AMERICAN PERSPECTIVE Client/Matter: -None- 59. 1. INTRODUCTION Client/Matter: -None- 60. 2. TAX POLICY TRENDS OF THE 1980s Client/Matter: -None- 61. 2.1 The choice of particular taxes Client/Matter: -None- 62. 2.2 Trends in legislative changes in tax policy Client/Matter: -None-

63. 2.2.1 Personal income tax Client/Matter: -None- 64. 2.2.3 Value-added type taxes Client/Matter: -None- 65. 2.3 Performance in terms of tax-to-GDP ratios Client/Matter: -None- 66. 3. SELECTED TAX REFORM ISSUES FOR THE 1990s18 Client/Matter: -None- 67. 3.1 Minimum contribution to the corporate income tax Client/Matter: -None- 68. 3.2 Cash-flow tax Client/Matter: -None- 69. 3.3 Taxation of the financial sector Client/Matter: -None- 70. 3.4 Taxation of property Client/Matter: -None- 71. 3.5 Pollution and environment taxes Client/Matter: -None- 72. 3.6 Increasing role of withholding taxes Client/Matter: -None- 73. 3.7 Tax harmonization Client/Matter: -None- 74. 4. SUMMARY AND CONCLUSIONS Client/Matter: -None- 75. 4.1 Trends of the 1980s Client/Matter: -None- 76. 4.2 Issues in the 1990s Client/Matter: -None- 77. REFERENCES Client/Matter: -None- 78. CHAPTER II.1 INCIDENCE OF THE CORPORATION TAX IN INDIA: A GENERAL EQUILIBRIUM ANALYSIS Client/Matter: -None- 79. I. INTRODUCTION Client/Matter: -None- 80. 2. THE MODEL Client/Matter: -None- 81. 3. EMPIRICAL ANALYSIS Client/Matter: -None- 82. 4. CONCLUSIONS Client/Matter: -None- 83. APPENDIX Client/Matter: -None- 84. REFERENCES

Client/Matter: -None- 85. CHAPTER II.2 IS THE CORPORATE TAX SHIFTED? EMPIRICAL EVIDENCE FROM ASEAN Client/Matter: -None- 86. 1. INTRODUCTION Client/Matter: -None- 87. 2. A SURVEY OF FISCAL INCIDENCE STUDIES IN ASEAN AND A DISCUSSION OF ALTERNATIVE METHODOLOGIES Client/Matter: -None- 88. 3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED Client/Matter: -None- 89. 3.1 Generating figures for incomes of corporate and non-corporate sectors Client/Matter: -None- 90. 3.2 Deriving factor incomes by sector Client/Matter: -None- 91. 3.3 Corporate tax figures Client/Matter: -None- 92. 3.4 Discussing element values Client/Matter: -None- 93. 4. EMPIRICAL RESULTS Client/Matter: -None- 94. 5 CONCLUSION AND POLICY IMPLICATIONS Client/Matter: -None- 95. APPENDIX Client/Matter: -None- 96. REFERENCES Client/Matter: -None- 97. CHAPTER II.3 THE GENERAL EQUILIBRIUM THEORY AND CONCEPTS OF TAX INCIDENCE IN THE PRESENCE OF THIRD OR MORE FACTORS Client/Matter: -None- 98. 1. INTRODUCTION Client/Matter: -None- 99. 2. THE MODEL AND ITS SOLUTION Client/Matter: -None- 100. 3. INCIDENCE CONCEPTS Client/Matter: -None-

CHAPTER I.1 A GLANCE AT EARLY PRACTICES IN TAXATION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.1 A GLANCE AT EARLY PRACTICES IN TAXATION

CHAPTER I.1 A GLANCE AT EARLY PRACTICES IN TAXATION1

Perhaps the earliest known references to taxation-based conduct of governance are found in the Indian epics, the Ramayana and Mahabharata, that emerged in the evolved Hindu tradition, replete with guidance for governance based on appropriate taxation while, much later, Kautilya’s Arthashastra written during the Maurya period, comprises direct instructions for how to tax and govern. Further to the East, Lord Shang of China and, to the West, Plato of Ancient Greece, provided comparable treatises, albeit founded on different tenets of governance, reflecting the mores of society in which they lived and foresaw. Subsequent to Hinduism and Buddhism, declared religions which were founded in rural societies also stipulated rules and guidelines, for example, in the Bible, Guru Granth Sahib2 and the Quran. In combination, they comprise a formidable set of insights through the manner of living, interacting, taxing, administering, and dying in those societies of yore.

The Ramayana, as recounted in Ramrajya, or the Rule of Ram, in which there were no lies since people did not know dishonesty and where the virtuous, godlike king3 represented his people through every aspect of kingship.

Muniapan and Satpathy (2010) assert that the seven books in Valmiki’s Ramayana contain multiple dimensions of life and governance including ‘philosophy, spirituality, politics, economics, sociology, culture, literature, language, poetry, (and) technology’ (p 645).

When Rama leaves for the forest and assigns Bharata,4 his brother, to govern in his absence, he instructs Bharata to take the responsibilities of the art and craft of governance. On fiscal prudence, he implores,

O, Bharata! I hope your income is abundant and your expenditure, minimum... I hope your treasure does not reach undeserving people. I hope you are regularly giving your army the daily provisions and suitable salary without any delay... I hope that you seek to conciliate by gifts, a loving mind and polite words, the aged, the children and the foremost physicians... Are you cherishing all those who live by agriculture and cattle rearing, O, dear brother,... providing them what they need and abstaining from what they fear? All the citizens are indeed to be protected by the king through his righteousness.5(pp 651-59)

The popular understanding of the Mahabharata6 is as an epic of sacrifice and war, of which the Bhagwat Gita, or the Song of God, is the most universally familiar. Here, He (Krishna) relates to man (Arjuna) the craft of war and the justification to conduct it under certain circumstances. However, as the longest known epic produced by humankind, it constitutes eighteen parvas or books spanning major other facets of societal governance. For example, the Rajdharma or kingship and statehood focus of Shantiparvam that relates to peace, is spread over one hundred and thirty chapters. It comprises the counsel of Bhishma, sage and uncle to the Pandavas - the victors over the Kauravas, their cousins - at the Kurukshetra War. This part could be viewed as a treatise for post-conflict government formation and its functioning, with details of the roles and responsibilities of a dutiful king and the sphere of state act ivity (Sharma, 2003).

In terms of economic progress, the king should encourage the development of commerce and industry, impose appropriate taxes within prescribed limits of income,7 institute penalties for tax evasion, and ensure the welfare of his subjects. In carrying out his responsibilities, the king should be advised by a five member council, with particular attributes and characteristics, while there should be a thirty seven member cabinet comprising different castes with commensurate expertise and portfolios. The king should be vigilant and may have to engage in espionage to contain the activities of enemies and to assess the moods of his subjects.

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The king should be firm but, unless Rajadharma was practised genuinely, ‘the Mahabharata explicitly sanctions revolt against a king who is oppressive or fails in his function of protection, saying that such a ruler is no king at all, and should be killed like a mad dog,’ (Basham, 1967, pp 88-89 in Sharma, 2003). Anarchy should be prevented at any cost. Indeed, a kingless state might even invite an invading king to avert such a possibility.

To cite other examples of taxation in Vedic times, Taxation finds its references in Manu Smriti. Manu, an ancient sage and lawgiver, speaks of a variety of tax measures that the king could undertake according to the Shastras and advises that taxes should relate to the income and expenditure of the subject. He says, ‘As the calf and the bee take their food little by little, even so must the king draw from his realm moderate, annual taxes’. The prevalence and necessity of taxation is recorded also by Kalidasa in the ‘Raghuvansha’ when he says thus of King Dileepa, ‘It was only for the good of his subjects that he collected taxes from them, just as the Sun draws moisture from the Earth to give it back a thousand fold’ (Directorate of Income Tax, 2012, p 1).

Kautilya’s Arthashastra appeared in a later era. It emerged in the process of consolidation of small kingdoms in the vicinity of Magadha around 500 BC that linked the power of the state to governance, the central objective being internal peace, with economic wealth and military power assuming a central place. The essential elements of the Mahabharata’s Shantiparvam are also found in the Arthashastra, with two crucial differences. First, the latter is not a work of political philosophy while the former could be perceived to be so (Niaz, 2008). Second, the latter does not sanction or recommend the removal of the king, leave alone in the forbidding manner suggested in the former, though the king is described in the latter as a servant of the state who should have no personal preference (Sharma, 2005).

In the Arthashastra, the ruler was the embodiment of the state, diligent, and a just and efficient administrator. Kautilya emphasised economic and financial discipline in running the state in an efficient and fruitful manner.

To quote Kautilya from Shome (2002):

A wise Chancellor is one who collects revenue so as to increase income and reduce expenditure. He shall take remedial measures if income diminishes and expenditure increases. (Arthashashtra, Book 2, Chapter 6, Verse 28)

To quote Niaz (2008):

Although taxes on land were the largest source of revenue, the efficient operation of state-owned businesses, the promotion of domestic and international trade, anti-corruption measures, and strict accounting procedures, merited the sovereign’s attention... the ruler and his servants had sound factual knowledge of the economic assets controlled by the state. They must also have the means to punish violations of taxation discipline with fines, confiscations and imprisonment. This discipline extended to a host of indirect taxes on leisure act ivities, such as liquor and gambling, as well as service charges for irrigation, transport and technical support. Royal monopolies over mines were particularly critical.

Financial discipline was to be maintained through budgeting, accounting, auditing and espionage, with senior officers held personally liable for any major discrepancies... The ruler (should) reward upright financial administrators who increase the revenues without resorting to heavy-handed or arbitrary measures... A country can indefinitely sustain a moderate level of taxation... An overly high level of taxation destroys the basis of future productivity, deprives people of their subsistence and provokes rebellion, thereby making the state vulnerable to external pressure. (Thus) laxity in financial administration breeds chaos and disintegration of the country. (pp 5-6)

Kautilya’s emphasis on internal management rather than on diplomacy revealed his apparent conviction that the existence of a state depended far more on its internal dynamics and economic equilibrium rather than on foreign influences. The relevance of his writings carries on intact as the imperatives of economic and financial discipline and of political disequilibria reverberate across the globe today.

The need for firmness in statecraft is pervasive in historical texts. With overarching ramifications for fiscal

Page 3 of 4 CHAPTER I.1 A GLANCE AT EARLY PRACTICES IN TAXATION federalism, Lord Shang,8 who lived during the era of the Warring States when decentralization to feudal heads was occurring, cautions in his Book, ‘Benevolence and righteousness are not sufficient for governing the empire,’ while Plato, in Laws, indicates, ‘For that state in which the law is subject and has no authority, I perceive to be on the way to ruin’ (Spengler, 1969, p 450).

The basis for Spengler’s contemporary hypothesis is that,

increasing political stimulation of man’s wants beyond his capacity to supply them has generated forms of disorder. Wants generated by political means are bound to outstrip a community’s economic capacity to satisfy such wants and hence must give rise to increasing frustration of man’s expectations. This ascendance of political over economic want-generation, together with the disorder which comes in its wake, may be numbered among the progeny of the two Pelopennesian wars which sundered the world of European civilization and polity between 1914 and 1945. (p 451)

The observation resonates strongly in India’s prevailing politico-economic environment, as if foreseen by Spengler while placing it in historical context. And, interestingly, while Kautilya wrote over a large, expansive and consolidating land empire, Plato’s world reflected the concerns of small sea faring city states, and Sheng’s comprised the preoccupations with unfolding federalism, these early thinkers from across the known world all found common solace in ultimately emphasizing the need for, if not praising, the incipient importance of authority, severe if called for, the non-application of which would result in anarchy, possibly the ultimate sin that a society could commit. In this sense, they seemed to have come close to Webster’s (Webster’s II, 1984) description that governance is government while attaching important responsibilities to the ruler though not providing conditions for his ouster unlike in the case of the Mahabharata.

In more recent times, the system of progressive taxation perhaps owes its origin to emperor Krishnadevaraya of Vijayanagar who maintained that taxes should not be levied at flat rates and the amount of tax levied must depend on the income of the farmer (Directorate of Income Tax, 2012, p 2).

Arguably the most well developed system of governance established by Indians was that by the Moghuls. Their fiscal system was comprehensive, ‘taxation being justified as the monarch’s reward for the government and protection of his subjects’ (Grapperhaus, 1998, p 141). Land comprised the main tax base, as well as import and export duties, and tributes from controlled states. There was jizya, a progressive income tax on non-Muslims with an exemption for minimum wagers. Akbar, the Great Moghul, was uncomfortable with religious segregation and abolished it. Aurangzeb, his great grandson reinstated it. Mansabdars, or rankholders, were civil servants whose remuneration could take two forms, salary plus fringe benefits, or the allotment of a jagir or land area from which tax could be collected which was, however, shared with the monarch. The jagir system of compensation was, therefore, preferred by and large by the ruler. Here too, Grappelhaus confirms, ‘... the slightest weakness of the imperial authority could give cause for rebellions... order was therefore maintained, ie, the taxes were collected with a rod of iron, with the assistance of the army’ (p 138). Historical experience, therefore, confirms the supremacy of power in the practice of tax collection.

To conclude, rules of governance supported by guidance for taxation and government expenditure, have been documented since the beginning of the written record. Evolved and declared religions were quintessentially founded on matters of governance. A sweep of history reveals a central emphasis on authority and able decision making, buttressed by a cabinet and intelligent fiscal and taxation systems, a forceful army and use of espionage for the success of government and, surrounding it, a recognition of justice, fairness and equanimity towards farmers and the vulnerable. Strong punishment usually awaits a ruler and the ruling class if governance fails due to negligence or defeatism. Keeping in mind the time machine of Man and ideas, how has the debate over taxation progressed in the modern era? Indeed, its dimensions have broadened in many directions. This is what we proceed to examine in this Compendium.

1 It may not be incorrect to believe that no scholar can master a contemporary matter without adequate exposure to its genesis and history. The chapter reflects that conviction. I have excerpted short portions from Parthasarathi Shome, ‘Governance: History, Contemporary Debate and Practice’, Policy Making for Indian Planning, Festschrift in Honour of Montek S. Ahluwalia, Academic Foundation, New Delhi, 2011. Permission was sought from and granted by Academic Foundation, New Delhi to reprint.

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2 ‘Gentle and compassionate shall be governance’, instructs the scripture of the Sikh religion. Governance aspects in the Bible and Quran are more commonly known, though the political advancement of the Sikhs was also carefully charted with practices of governance under Guru Gobind Singh and consolidated later by Maharaja Ranjit Singh who ruled over most of Punjab that straddles present day India and Pakistan. 3 Rama is like Vishnu in bravery, godlike in benevolence and justice, attractive like the full moon. He equals the earth in perseverance but is like the conflagration fire in his wrath. 4 Note that Bhaarata is also the address for ancient India. 5 However, one aspect of Rama’s governance remains controversial, that of Agnipariksha, or test by fire, of Sita, his wife, to test her chastity, at the behest of his citizens. Sita, in her vicissitude, eventually is received back by Mother Earth who had gifted her to mankind. Hence the question remains, how far should the responsibility of a ruler extend to represent his people even to his own, or his family’s, detriment. 6 Or, the Greatness of India. 7 Sharma (2008) describes in some detail the specification of a six per cent income tax in Kalidasa’s Abhignanshakuntalam, reputed to be Adiparva, or earlier epoch, of the Mahabharata. Tax revenue inculcates responsibility in the king and is to be used for the pursuance of the common good, that is, provision of basic amenities and security. 8 Shang Yang (390BC-338BC) was an important statesman of the State of Qin during the Warring States period of Chinese history.

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.1 A GLANCE AT EARLY PRACTICES IN TAXATION

REFERENCES

Basham, AL, 1967, The Wonder that was India, Rupa and Co, New Delhi, reprinted in 1995.

Directorate of Income Tax, 2012, 150 Years of Income Tax, Government of India, New Delhi.

Grapperhaus, Ferdinand HM, 1998, ‘Taxation in the Empire of the Great Moghuls,’ in Tax Tales from the Second Millennium, International Bureau of Fiscal Documentation, Amsterdam, pp 109-158.

Muniapan, Balakrishnan, and Biswajit Satpathy, 2010, ‘The Relevance of Valmiki Ramayan in Developing Managerial Effectiveness,’ International Journal of Indian Culture and Business Management, Vol 3, No. 6, pp 645- 68.

Niaz, Ilhan, 2008, ‘Kautilya’s Arthashastra and Governance as an Element of State Power,’ Strategic Studies, Vol 28, No. 2, pp 1-16 The Institute of Strategic Studies, Islamabad.

Sharma, Sanjeev Kumar, 2003, ‘Good Governance in Ancient India: Remembering Kingship in Shantiparvam in Mahabharat,’ Journal of Political Science and Public Administration, Vol 6, No. 1, pp 109-23, India.

______, 2005, ‘Indian Idea of Good Governance: Revisiting Kautilya’s Arthashastra,’ Dynamics of Administration, Vol 17, No. 1-2, pp 8-19, India.

______, 2008, ‘Spheres of Public Governance in Ancient India: Reflections on Abhignanshakuntalam of Kalidasa,’ Journal of Political Studies, Vol 2, No. 1, pp 6-16.

Shome, Parthasarathi, 2002, India’s Fiscal Matters, Oxford University Press, New Delhi.

Spengler, Joseph J, 1969, ‘Kautilya, Plato, Lord Sheng: Comparative Political Economy,’ Proceedings of the American Philosophical Society, Vol 113, No. 6, pp 450-57.

Webster’s II, 1984, New Riverside University Dictionary, Houghton Mifflin Company, Boston.

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CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW

CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW1

1 This chapter comprises the fifty-second Anniversary Lecture, delivered at the Central Bank of Sri Lanka, Colombo, on August 29, 2002. It surveys the principles of taxation as they stood at the begining of the century. Excerpted from Parthasarathi Shome, ‘Tax Policy and the Design of a Single Tax System’, Bulletin for International Fiscal Documentation, Vol 57 (3), pp 99-121, Amsterdam, 2003, Journals IBFD, cited IBFD, http:www.ibfd.org. Permission was sought from and granted by Bulletin for International Taxation, the Netherlands, to reprint.

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1. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW

1. INTRODUCTION

A government needs tax revenue to carry out its societal functions. Nevertheless, taxes are generally perceived as confiscatory rather than contributory despite their intended beneficial use.2 Thus, a government has to be mindful of taxing its residents through a system that minimizes the likely adverse ramifications of taxation for private decisions to consume and invest, ie, the welfare cost of taxation.3 A vast literature leads inevitably to the conclusion that the central characteristic of such a tax system should be simplicity. It is from this widely accepted premise that notions of a single tax system or a unique tax system have emerged. They have occasionally been simplistically interpreted, however, as a single tax or unique tax (monotributo/ impuesto unico in Latin America), and caution needs to be taken against this. It is the author’s intention to traverse the grounds of a tax system, and the motivations and policies behind it, its implications for private decision-making, the nature of the arguments favoring a simple tax system and what, in practice, could approach such a notion without being overtly simplistic.

Before embarking on the tax system as such, it may be useful to underline that governments may not necessarily be aware of how high the welfare cost of taxation might be. Often, when faced with a rising deficit, their immediate reaction is to introduce new tax measures, rather than curtailing unproductive expenditures to the full extent possible - in effect expanding the size and role of government. This is because, between two unpalatable alternatives, the government can take quick act ion on tax measures, while expenditure policy has tended to become increasingly constrained through debt service and other fixed liabilities, and expenditures such as subsidies on petroleum products, food programs or agricultural inputs such as fertilizers, may be considered politically difficult to cut back, limiting the overall possibilities to manoeuvre. In a broader context, there is also the notion of ‘ownership’ of fiscal policy that allows the government to take more direct fiscal policy action in a milieu in which monetary policy is increasingly constrained by the de facto independence of central banks and by moves to liberalize the capital account in the medium term.

It is therefore with some regularity that, throughout the era of modern public finance, governments have undertaken tax reform with the objective of achieving greater simplicity in the overall tax structure while anticipating additional tax revenue. Indeed, the countries in Latin America and East Asia which undertook tax reform between the mid- 1980s and mid-1990s experienced a 2 per cent to 4 per cent increase in their tax/GDP ratios, despite having reduced tax rates but doing away with complex provisions in both income and consumption taxes. In general, these countries not only reduced the tax rates but also expanded the base by limiting exemptions and incentives in income taxation, and they replaced distortionary production taxes on turnover by a broad-based consumption tax on value added (VAT).4 Subsequent to such tax reforms, from the second half of the 1990s until the present, the tax reform movement slowed down considerably, and many countries suffered a decline in their tax/GDP ratios.5 Economies in transition that initiated the process of integration into the international market economy also encountered obstacles in their reform agenda.6

Two broad characteristics appear through this experience. First, the tax reform movement is led by major countries for smaller countries to follow. The 1986 tax reform in the United States set the stage for fundamental changes in global thinking regarding taxation and its optimal form, scope and role. The tax reform in Argentina, Brazil, Colombia and Mexico was followed by smaller Latin American countries, though in varying degrees. The tax reform in South Korea, Thailand and Indonesia was studied by smaller East Asian and Pacific Island countries. Thus, it is very important for the front-line economies not to introduce distortive taxes that other countries are likely to follow. In the subcontinent, Bangladesh, Bhutan, India, Pakistan, Nepal and Sri Lanka often look to one another for their movements, albeit incremental, in tax matters. The second characteristic is that a reformed tax system has a relatively ephemeral life. Interests guised as objectives of social improvement, economic development, export

Page 2 of 2 1. INTRODUCTION orientation, and commensurate politically motivated responses begin to erode a newly improved tax structure. It is time to re-examine the tax system in five to six years after the completion of reform.

For purposes of this chapter, the author asked himself what he has learned over the years that should ideally comprise a simple, or a single, tax system, yet not a simplistic one; what are the essentials of a modern tax system within the reality of globalization; what are the possible areas of simplification; is equity a feasible principle of taxation in the globalized environment; or is efficiency to be the overriding principle to guide the design of a successful tax system? The discussion below culls extensively from the author’s earlier work, the hypotheses he has proposed, the conclusions he has drawn, and the policies he would recommend on their bases. The discussion first reviews some of the theoretical underpinnings of taxation; second, it examines the issues relating to the design of a system comprising taxes on consumption, production, trade and income, and, third, the discussion mentions the matters relating to tax assignment among different levels of government. From these various aspects, the author draws conclusions regarding the feasibility and appropriate nature of a tax system that is simple, compatible with minimizing efficiency costs, not too inequitable in its effects, and adequate in terms of revenue productivity.

2 Taxes are unlike social security or pension contributions that are deemed to be in the nature of a social contract (or ‘contractual savings’) or user charges that are directly linked to benefits and are not pooled for general budgetary revenue. Such contributions and user charges, however, may also be compulsory in nature. 3 In the 1980s, it was popular to estimate the welfare cost of taxation - defined as the excess cost to society of collecting revenue. It was estimated to be as high as 50 per cent in the United States. See, for example, Ballard et al, 1985, Hansson and Charles, 1987. 4 See Chapter I.5. 5 See Chapter VI.3. 6 See Tanzi, 1991, and Chapter VI.2.

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2. THEORETICAL FOUNDATIONS OF TAXATION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW > 2. THEORETICAL FOUNDATIONS OF TAXATION

2. THEORETICAL FOUNDATIONS OF TAXATION

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2.1 Principles of taxation P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. THEORETICAL FOUNDATIONS OF TAXATION

2.1 Principles of taxation

The three principles of taxation developed over a period of time are efficiency, equity and stabilization.7 The efficiency cost of a tax may be explained as follows. When taxed, a consumer loses financial income. Over and above that, he loses ‘welfare’ because of the change in pretax and post-tax relative prices of taxed and untaxed commodities. The tax induces a shift in demand and, in turn, a shift in resources to untaxed, from taxed, goods that would not have taken place in the absence of the tax. The higher the tax rate on, and the price elasticity of demand for, the taxed goods are, the higher is the loss in efficiency or welfare. This phenomenon has been termed ‘deadweight loss’ by Harberger.8

Equity in taxation relates to the relative treatment of taxpayers. Does the tax system treat taxpayers with similar incomes equally (horizontal equity) and those with unequal incomes differentially (vertical equity)? The incidence of a tax is the determination of where its final burden falls. For example, does a 35 per cent company income tax rate imply that, when all the economic effects of the tax work themselves out, each corporation bears a 35 per cent tax, or do all capital owners (including those in the non-corporate sector) bear some tax, or do other factors of production, such as labor and land, also bear some of the burden of the corporate tax?9 Along the same lines, neutrality requires that, under the tax system, similar transactions be treated in like manner. In the corporate income tax, for example, investment act ivities and depreciation allowances (for similar equipment) in different sectors should not be treated differently so that all activities bear an equal burden of taxation. (The burden of taxation in this context could be measured as the effective tax rate after appropriate cost calculations.)

Addressing the principles of taxation in a tax system in a superficial or simplistic manner is likely to lead to a complex tax structure. Yet one branch in the literature on taxation has emphasized that minimizing efficiency costs may be achieved through what has been termed ‘optimal taxation’. The lower the elasticities of demand are, the higher the optimal tax rate on a commodity - the inverse elasticity rule - resulting in an array of tax rates. Minimizing efficiency loss would thus require setting up various tax rates in inverse proportion to the elasticities of demand for the taxed commodities. That this might clog the consumption tax structure with multiple tax rates does not seem to be too forbidding in this line of thinking. Indeed, it was not unknown for international tax experts in the 1980s to recommend such tax structures to developing countries.

The critique that optimal tax rules may lead to a regressive tax structure (since, for example, the consumption of staples tends to be characterized by low elasticities of demand) led to incorporating the income maintenance elements into the rules.10 Thus, an income subsidy may be built into an optimal tax rule that, by itself, could be regressive across income levels. This led to further complexity. In the personal income tax as well, maintaining equity in the traditional sense may require too many brackets and progressive rates in the individual income tax structure, which are incompatible with the criterion of simplicity. And, in the case of the corporate income tax, ensuring the intended incidence, or that nominal and effective taxation approximate each other, would require linking the tax rates to the elasticities of factor-substitution, among other parameters. In combination, this would result in a tax structure with different rates for different sectors of production in the overall tax structure.

Stabilization as a principle of taxation played an important role in tax system design. A design that is elastic11 and robust in terms of revenue during the upward phase of the economic cycle is an automatic stabilizer. A tax structure that is progressive or adheres to the concept of vertical equity is characterized by such a feature. In the 1960s and

Page 2 of 2 2.1 Principles of taxation

1970s, however, it was found that highly progressive tax structures result in a likely occurrence of tax evasion. Thus, there are limits to how far a tax system may be used to improve equity through progressivity in the rate structure.

Further, there are some inherent conflicts among the various objectives of a tax system if we think of them as simplicity, efficiency, equity, stabilization and revenue adequacy. Equity could conflict with simplicity since the deductions, exemptions and progressive rates that might enhance equity would reduce simplicity or increase complexity. Equity conflicts with adequacy since exemptions may be equitable but erode revenue. Efficiency could also conflict with simplicity since depreciation allowances could enhance efficiency but add complexity. A progressive rate structure would improve equity and stabilization but reduce simplicity. Early tax structures may be characterized as complex systems with multiple rates and bases which addressed the policymakers’ intentions to minimize efficiency loss, inequity and the uncertain incidence of the tax system and to maximize its power as an economic stabilizer. At the same time, policymakers attempted to address multiple, often conflicting, economic objectives - of enhancing employment, investment and exports and developing preferred industries and priority sectors - and to achieve the social goals of optimal family size or enhancement of charity - all through the tax system.

With the realization that a single tax system could never achieve so many objectives, ideas of reforming the tax system began to appear with force in the 1980s. For example, Tanzi laid out the general principles and diagnostic tests for a simple, reformed tax system.12 Hall and Rabushka proposed the idea of a ‘low tax, simple tax, flat tax’.13 Stern promulgated a general theory of tax reform.14 And Tait elaborated on why the VAT could be a comprehensive simple tax that could replace many distortive taxes on production.15

7 Musgrave, 1959. 8 Harberger, 1974, explained it as a loss of consumer surplus as a result of the tax. This cannot be defined simply as the amount of tax revenue because the monetary compensation with which the taxed consumer would have to be compensated to make him as well off as before the tax would exceed the tax revenue. 9 A debate between Musgrave, 1959, and Harberger, 1962, on the methodology for analyzing incidence led to varying results regarding the incidence of the corporate income tax in the United States. This, in turn, resulted in the development of alternative models and approaches to study the problem by researchers who further established the likely complexities in the effects of a tax system. See Shoven, 1972, Pechman and Okner, 1974, Mclure, 1975, Meerman and Shome, 1980, and Whalley, 1984. See also Chapters II.1, II.2, II.3 and II.4. 10 Atkinson and Stiglitz, 1980. 11 An elastic tax yields a higher percentage increase in revenue as a result of a given percentage increase in the tax base. 12 Tanzi, 1983. 13 Hall and Rabushka, 1983. 14 Stern, 1987. 15 Tait, 1988.

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2.2 Inter-temporal effects of taxation P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. THEORETICAL FOUNDATIONS OF TAXATION

2.2 Inter-temporal effects of taxation

Recent developments have demonstrated the possible detrimental effects of taxation such as on savings, economic growth and capital accumulation. The premise of Ricardian Equivalence (RE) is that a current tax cut financed by government debt (purchased by savers)does not affect the economy’s growth path since rational individuals expect to be taxed later.16 In contemporary terms, for life cycle models that specify bequests to be the motive for savings, the RE premise would hold. This is because posterity must eventually face taxation in order for the government to finance its debt service obligations. But if savings by the present generation are for their own retirement income, RE would break down since the saver could escape taxation during his lifetime. Thus, taxation would affect savings.17

An inefficient tax could be a good revenue-raiser in the short run but be detrimental for economic growth in the medium term and, in turn, for tax revenue in the long run. Endogenous growth models have linked long run growth to present and future tax measures and to expectations of future events, suggesting that the detrimental growth effects of taxation could be permanent rather than temporary as previously believed.18 The tax treatment of capital income affects capital accumulation and growth. Changes in the after-tax interest rate, prompted by capital income taxation, could have dynamic effects such that savings may no longer be represented as a stable function of the contemporaneous return on capital.19 And the welfare cost of capital taxation can turn out to be high in such a dynamic context. As theories of growth incorporate the effects of technological change, human capital accumulation and similar growth-inducing factors, newer insights are being obtained on the ramifications of taxation for economic growth. Therefore, here too, the solution must lie in the realm of a simple tax system, one that minimizes detrimental effects on the long run growth potential of the economy.20

16 Seater, 1993. 17 Summers, 1981. 18 Xu, 1994. 19 Tanzi, 1991. 20 Jones et al, 1993.

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2.3 Should expenditure and income both be taxed? P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. THEORETICAL FOUNDATIONS OF TAXATION

2.3 Should expenditure and income both be taxed?

In microeconomics, a novice student of economics is taught that a consumer (firm) faces a budget constraint within which he can undertake consumption (investment). In the macroeconomics class, he learns that the economy’s income-expenditure identity comprises two sides of the same coin. An intelligent student could then find it somewhat perplexing that both income and expenditure are taxed in most tax systems. Indeed, there has been considerable debate over this issue.21

The answer lies in how we want to treat savings within the tax structure. If savings remain outside the tax base, taxation could cause an undue burden on wage earners. It may not be feasible to construct a progressive expenditure tax structure without making it quite complex. Reflecting both these aspects, an expenditure tax is generally considered to carry the seeds of regressivity.22 In two countries that debated or applied the expenditure tax in the 1960s - India and Sri Lanka - the definition of the tax base itself floundered, and the tax, if not its conceptual basis, was eventually revoked. Even an income tax that is based on a comprehensive definition of income - such as the Haig-Simons definition as the accretion of power to consume - can turn out to be complex. Thus, exclusivity has not been practiced between an income tax and an expenditure tax mainly on practical grounds.

In practice, the income tax has been commonly implemented. And a more narrowly defined expenditure tax - in the form of a consumption tax, in particular, the VAT - has been added by more than 120 countries to their list of taxes. A few countries, such as Uruguay, have replaced their income tax by a VAT altogether, but most countries maintain both. In most Latin American countries, however, possibly with a few exceptions such as Mexico, the VAT was gradually emphasized over the income tax during the 1980s. Many Asian countries also introduced the VAT during the late 1980s and 1990s, and African countries followed. Thus, tax practitioners have used both income and expenditure taxation, though, on a purely conceptual basis, it may appear to be double taxation.

Gentry and Hubbard asked what kind of tax reform would minimize tax-induced alteration to equilibrium decisions.23 Looking at the differential roles of an integrated (individual and corporate) income tax and consumption tax, they found a critical difference between these taxes is that the consumption tax gives firms an immediate deduction for capital outlays instead of depreciation allowances as given by the income tax. Nevertheless, although tax reform can affect organizational form, capital structure and timing decisions, they found that the two types of taxes they considered have similar effects on business financial decisions because both types effectively integrate corporate and individual income taxes. Both eliminate tax differentials between equity and debt financing. Both eliminate investor-level taxes on financial assets; thus, they both reduce the effects of taxes on the timing decisions associated with financial assets, such as the timing of corporate dividends. Therefore, they reduce the current incentives for tax-motivated financial planning. The authors think that a comprehensive income tax and consumption tax should not be treated as polar opposites. Rather, both have similar salient features that, among other advantages, could be structured to minimize tax planning.

To sum up, the practice of taxation has to introduce tax reform intermittently, eliminating undesirable features in the prevailing tax system and incorporating new concepts developed through the progress of tax theory. Thus, it has been common practice to tax both income and expenditure, using different revenue sources, mainly to ensure revenue adequacy. Nevertheless, the overall focus of the tax reform experience has been to keep at bay a

Page 2 of 2 2.3 Should expenditure and income both be taxed? proliferation of taxes by narrowing down on major revenue sources only, keeping the structures of the selected taxes as simple as possible and selecting taxes in such a way as to maintain revenue adequacy while balancing the principles and overall objectives of taxation. The concept of a single tax system alludes to such a simple and adequate tax structure that attempts to minimize conflicts among its various goals.

21 Pechman, 1980. 22 See Chapter II.5. 23 Gentry and Hubbard, 1998.

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3. TAXATION OF CONSUMPTION AND PRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. TAXATION OF CONSUMPTION AND PRODUCTION

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3.1 Retail sales tax and value added tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. TAXATION OF CONSUMPTION AND PRODUCTION

3.1 Retail sales tax and value added tax

The most familiar general consumption tax is the retail sales tax (RST). It is a tax on the consumption of goods and services that is collected at the retail level. If the retail sector is sufficiently organized so that the tax can be collected relatively easily at the retail level, this is a good tax. This is the case in the United States, where the US states levy retail sales taxes at their own rates - typically ranging from 0 per cent to 7 per cent. In countries in which the retail stage of distribution may not be very organized, such as in developing countries, collection of the same tax revenue may be undertaken more efficiently at different stages, as value-added is generated along the chain of production and distribution of the same commodity. Such a tax is the VAT, which could be perceived as equivalent to the RST except that the VAT is collected at various stages of production and distribution, while the RST is collected at the final stage only.

The VAT is seen to reduce the phenomenon known as cascading in the tax literature. In the case of a turnover tax regime, a tax on input is not typically set off against a tax on output. Thus, the valuation of taxable output at any stage includes the tax paid on its inputs at earlier stages. When the output turnover is taxed, the input tax in its base is also taxed. A tax is taxed. The VAT eliminates this phenomenon. The VAT is structured in such a way that, while a seller collects tax from the purchaser on the basis of the gross value of his product, what he passes on to the exchequer is the tax he collected minus the tax he paid when he purchased his inputs. Thus, at his stage of production or distribution, he is taxed only on his value-added (output minus input) rather than on the value (output) of his product. The subtraction of input tax is referred to as ‘input tax credit’. Since inputs do not enter the tax base at any stage, cascading is eliminated.24 The VAT is also imbued with a built-in mechanism that is helpful in reducing tax evasion. Since the input tax credit is allowed only on the basis of act ual purchase invoices, the purchaser has an incentive to demand an invoice from the seller. The popularity of the VAT in replacing turnover taxes in reforming countries is, therefore, not entirely surprising.25

This is not to say that there can be no complications in the design and administration of the VAT. First, adequate time must be allocated to prepare for introducing the VAT. Experience has revealed that, in countries as diverse as the Czech Republic and Nepal, lack of adequate discussion or preparation by taxpayers led to withdrawal, albeit temporary, or unforeseen delay in introducing the VAT.26 Second, if there are multiple rates of VAT, its administration becomes difficult. The maintenance of accounts by taxpayers becomes demanding, and evasion becomes easier. Third, if too many items of consumption, such as services, are excluded from the VAT, revenue productivity suffers. Thus, to begin with, selected services should be included in the VAT base in the form of an exhaustive list of services that are to be taxed (positive list), and later the list should be replaced by a negative list which identifies only those services that are to be excluded from the VAT. Fourth, if an item (an output) is exempt from the VAT, no input tax paid earlier can be credited out, since there is no output tax. If the item is zero-rated, the input tax credit is given even though the output tax rate is zero. The higher the number of items in such categories is, the greater the potential structural and administrative complications in the VAT. Fifth, leaving machinery within the tax base results in some cascading. Thus, if no tax credit is allowed for inputs - raw materials or machinery - such selectivity vitiates the equivalence between the RST and VAT.

A consumption VAT, equivalent to the RST, must therefore allow full crediting for all inputs.27 Yet not all countries that have introduced a VAT abide by this principle. For example, Brazil, which was one of the first countries to introduce a VAT in the late 1960s, did not allow an input tax credit for machinery until the mid-1990s.28 In Colombia,

Page 2 of 2 3.1 Retail sales tax and value added tax a credit was allowed only for machinery that had to be imported and was not produced domestically, a feature corrected in the mid-1990s.29 In the VAT-like structure implemented by the Central Government of India, machinery was allowed a credit at the beginning, but the credit was subsequently spread out over two years for short run revenue considerations. All such digressions from the correct VAT structure result in economic inefficiencies, administrative difficulties and reduced taxpayer compliance - robbing the VAT of its essential attraction as a simple revenue-productive tax.

In fact, a methodology for measuring VAT evasion was developed,30 and it was subsequently applied in many countries. Usually the estimates for VAT evasion are somewhat lower than income tax evasion. Nevertheless, evasion of the VAT, which is claimed to have a built-in advantage in terms of compliance, is striking. Several practical difficulties in VAT administration are the subject matter of Chapter IV.3. A useful criterion - VAT productivity - is defined as a comparison of the VAT revenue/GDP ratio with the VAT rate. Thus, a VAT collection of x per cent of GDP may be considered to be highly revenue productive with an x per cent VAT rate. Chile and New Zealand, with an 18 per cent VAT rate, collected almost 9 per cent of GDP in VAT revenue in the 1990s. This is the highest VAT productivity rate in any cross-country comparison. It is common to find ? x per cent of GDP in collection. But x per cent of GDP would indicate poor VAT collection, possibly reflecting a combination of a structure comprising too many exemptions leading to a narrow base, exacerbated by limitations in tax administration and poor tax compliance.

It may be surmised why the VAT has remained a popular tax despite its problems. The reason is that VAT is better than other taxes which are more prone to base erosion and difficulties in administration. In many Latin American countries, VAT has become the mainstay of the tax system, and many Asian countries have also introduced robust VAT structures. African countries have had a similar experience. And the EU member states are required to introduce VAT. The VAT, however, is difficult to design and operate at the level of provinces in a decentralized economy. This point is touched upon later.

24 Zee, 1995. 25 Tait, supra Note 15; Ebrill et al, 2001; also see Chapter I.5. 26 Khadka, 1996. 27 A VAT that does not allow an input tax credit for machinery is referred to as a ‘production-type VAT’. Such a tax uses value as the tax base ie, greater than the value-added. It cascades, and is not a VAT. Similarly, if a VAT allows an input tax credit for machinery, not immediately, but only over time (eg, following a depreciation schedule over a number of years), it is referred to as an ‘income type VAT’. Again, these types of VAT are strictly not a VAT since the tax base exceeds the valued added. 28 See Chapter IV.4. 29 See Chapter IV.2. 30 See Chapters IV.1 and IV.2.

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3.2 Excise taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. TAXATION OF CONSUMPTION AND PRODUCTION

3.2 Excise taxes

Prior to the advent of the VAT, excises - selective taxes on production - were widely used in lieu of consumption taxes in developed countries, such as the Scandinavian countries, France and the United Kingdom, as well as in developing countries. Taxes levied at specific rates at the production point were found to be relatively easy to administer - counting the bottles - as opposed to the ad valorem method which required more advanced account keeping.31 Financial, as opposed to physical, control methods became preferable in the process of modernizing the tax administration. In addition, excises became more selective and began to be applied to a narrower range of goods. Today, apart from the RST or VAT, excises are generally levied on a few commodities, including demerit goods, such as tobacco and alcohol whose consumption society would like to limit, and non-renewable resources, such as petroleum products.

Commodities on which excises are typically applied tend to have low elasticities of demand. Thus, the welfare loss attached to high excise rates is expected to be low. The inverse elasticity rule of optimal taxation theory may thus be conveniently applied in setting excise rates. Excises may also have good revenue productivity, though this should not be their primary objective. Excises may be justified on selected luxuries, such as yachts and private airplanes, simply as a luxury tax irrespective of their elasticities of demand. An important caveat, however, is to avoid proliferation of the total number of excises and to maintain their selective nature.

31 Mukhopadhyay, 1995.

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3.3 Environmental taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. TAXATION OF CONSUMPTION AND PRODUCTION

3.3 Environmental taxes

Environmental taxes are levied to internalize (account for) externalities (costs that are not reflected in the market prices) that are caused by environmental factors such as pollution. Such taxes, sometimes referred to as ‘Pigouvian taxes’ after Pigou, the classical economist who conceptualized them, attempt to increase the private costs of provision to the higher level of the social costs of providing such goods. The latter include, for example, the cost of cleaning up river or air pollution caused by a private factory which (cost) is not included in its own cost calculation. The government thus taxes the factory for that cost, the government’s intention being to spend the equivalent funds to clean up the environment which the factory should ideally have done. Thus, in the extreme, a Pigouvian tax should eliminate pollution if an adequate tax is imposed and appropriately earmarked for the purpose rather than being absorbed by the general revenue pool. Few developed or developing countries use Pigouvian taxes. In Asia, Singapore, a developed city-state, uses ‘electronic road pricing’ (ERP), a user charge based on a graded system - reflecting the time of day and the zoning (business/ residential) of the district - for maintaining a clean environment. This is a pioneering venture that is being contemplated in some cities in developed countries, such as London, though, on the whole, environmental taxes remain unpopular because of industry interests that drive political power in most countries.

The lack of success in implementing appropriate environmental taxes reflects, to no small extent, a moral hazard since all countries feel that they can continue to consume freely out of global resources, exhaustible and non- renewable though the resources might be. Thus, the issue deserves attention on a global scale, but certain developed countries, while being heavy consumers, are as yet unwilling to take the lead in formulating and implementing environmental taxes, such as global carbon taxes.32

32 See Chapter V.2.

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3.4 Taxation of international trade P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. TAXATION OF CONSUMPTION AND PRODUCTION

3.4 Taxation of international trade

As countries have become economically integrated with a phenomenal rise in international trade and finance, the traditional arguments of the 1950s and 1960s for protecting infant industries have met with increasing disfavor.33 With the advent of the World Trade Organization (WTO), the member states have reduced the levels of their customs tariffs. Indeed, there is an argument that the countries which experienced rapid growth in the 1980s and 1990s were those that reduced average tariffs the most. Examples are East Asian and South-East Asian economies.34

Similarly, exports of traditional commodities such as tea, coffee, rubber and minerals once yielded significant revenue from the export duties that were imposed on them. In 1980, 67 countries imposed export duties; following the WTO, they would eventually abolish them. They had been rationalized on several grounds, such as improving the terms of trade, substituting income taxation, stabilizing export revenue, and taxing windfall gains. But most studies negated these views, and export duties were later seen to have damaged the long run viability of export industries themselves, reflecting the detrimental effects they had on the international competitiveness of the products.

Greater international competition, which could be possible only with lower taxes on international trade, was perceived to improve economic links and transfer of technology and to result in improved products and diversification of output and exports. Protectionist policies would have the opposite effect. In this context, of course, recent policies of developed countries to reintroduce protective import duties render the evolution of a rational global consensus on tax policy for international trade difficult.

A matter of some interest in the ability of governments to pick winners or leading sectors of economic and export growth may be pointed out. Early critics of the infant industry argument pointed out that: (1) protectionism assumes that governments can ‘pick winners’ to determine which industries to support; and (2) in reality, experience has revealed that the beneficiaries of protection tend to devote resources to rent-seeking act ivities aimed to maintain, if not extend, the existing protection. What is interesting is that, at the same time, it is also true that the East Asian and South-East Asian economies that eschewed high customs tariffs in their early phase of development focused on select ‘engine of growth’ industries with a comparative advantage in production.35 In other words, these economies too opted for a policy of picking winners. Thus, it seems that it is not the policy of picking winners that is good or bad. Rather, it is the ability to quickly compete in the world market for products which a country chooses to produce that becomes an indicator of the economy’s potential to adapt and grow.

It is for this reason that there is universal acceptance today that taxes on international trade are not helpful, in the long run, for economic growth. It is better to substitute them with an income tax on global income and a consumption tax on both imports and domestic consumption. Since such taxes are on final income or consumption, they are less distortive than customs duties that are typically also levied on capital goods and raw materials. Some developing countries tend to impose temporary surcharges on imports to meet short run fiscal or external sector imbalances. These should be removed as early as possible. Over time, exemptions creep into the customs tariff structure, rendering it voluminous, complex, difficult to interpret, and therefore subject to corruption. In any event, if the prevalence of exemptions is high, it may be better to introduce a minimum tariff to capture all potential contributors.

Page 2 of 3 3.4 Taxation of international trade

There is one instance in which a tariff may be beneficial to a country if it has a monopsony in import markets. The example of steel may be useful to explain this situation. The import tariff can be the result of an optimal pricing strategy where it is determined by setting the benefits - government revenue and private profits - against the costs - domestic distortions and misallocation of resources.36 This can indeed be disguised as an anti-dumping measure by the levying country which may well know the gains to be reaped by imposing a tariff to the detriment of world trade and welfare. This is a position that a developed country might exploit for its own benefit since it is possible, though rare, for a few developed countries to exert considerable influence in the world markets of their own imports, reflecting their giant shares in international trade. Such protective customs duties on steel recently imposed by the United States have been counterproductive.37

The same countries may also act as an oligopoly for a range of products they supply to the world market, for example, pharmaceuticals. They can once again improve their terms of trade with the rest of the world by restricting or taxing exports. The rest of the world would, however, be worse off. These are experiences that dampened the enthusiasm for free trade in some countries, much to the alarm of economists who routinely recommend free trade to the developing world for economic growth and prosperity.

It has to be recognized that small trading economies, which cannot influence world prices, cannot gain through such anomalously termed optimal tariff policies. The new trade theory indicates that economies of scale and externalities decrease the average costs, and larger producers thus have a clear advantage over smaller ones. Producers that gain control over an international market tend to drive the smaller suppliers out. This is what is largely anticipated for major traders in the developing world for a range of commodities, further promoting the phenomenal economic growth they are already experiencing.

A factor that has affected most developing countries in how much protection they have provided is the extent of effective protection as opposed to nominal protection provided by the tariff structure. To the extent that tariffs apply to intermediate and capital goods, the domestic input prices increase, the value-added for the producer decreases, and the degree of protection diminishes.38 The higher the tariffs on non-final goods, the wider is the expected divergence between nominal and effective protection and the lower is the effective protection. Yet many developing countries that have used customs duties with the objective of encouraging infant industry through protection have systematically also levied relatively high customs duties on intermediate and capital goods (presumably for revenue reasons or even to foster domestic act ivity in these sectors), thereby coming closer to the concept of neutrality in a trade regime - equal protection across industries of tradable goods - and away from the original intention of fostering leading sectors or engines of economic growth.39

In practice, trade reform has emphasized the need to lower average tariffs. Indeed, Chile has introduced a low uniform tariff and removed all non-tariff barriers. The justification is based on the hypothesis that a low broad-based tariff has a small economic cost, which is the value of the output forgone due to losses in economic efficiency. But it is not just that. It is also based on minimizing the high administrative costs of a protection policy applied selectively to particular sectors or activities. Reform has also emphasized a reduction in the dispersion of existing rates because multiple rates increase the cost of administration and the likelihood of increased operations by special interest groups.

Optimal taxation does not, however, find itself at odds with a greater dispersion of rates. One view is that final goods should be taxed at higher rates than inputs. According to this view, tax-induced changes in the relative price of inputs can lead to the choice of inefficient technologies since some inefficient technologies may become more profitable to the extent they become cheaper than more efficient technologies. Extending the argument, there should be an ordering in the customs tariff structure, with the highest rate for final consumption goods, a middle rate for intermediate goods, and the lowest rate for capital goods. But a vast amount of information is required to construct an optimal tariff structure truly reflective of the use of imports and their elasticities of demand.40 To the extent such a structure could still cut back on the effective rate of protection, a policy of zero tariffs on all inputs could be followed. This is what occurred in some countries with a high proportion of manufactured exports.

Nevertheless, in the final analysis, the case for a single tariff structure is strongest on both efficiency and administrative grounds, given all the shortcomings cited above in relation to alternative policies. Ultimately, that rate can be reduced even to zero when the tax system can rely solely on the domestic consumption base and income base, as in Hong Kong and Singapore.

Page 3 of 3 3.4 Taxation of international trade

33 Shome, 2001. 34 Krueger, 2000. 35 Tanzi and Shome, 1992. 36 Subramanian et al, 1993. 37 See Chapter IV.7 for details. 38 The effective protection rate is, therefore, defined as the amount by which the value-added in a sector at domestic prices exceeds the value added in the sector at international prices, expressed as a percentage of the latter. 39 Across-the-board high tariffs are compatible with neutrality, though they would be distortive. Thus, neutrality is not an indicator of the efficiency loss from protection. Neither would such a regime provide much effective protection. 40 See Chapter I.4.

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4. INCOME AND WEALTH TAXATION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

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4.1 Income and taxable income P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.1 Income and taxable income

It would not be an exaggeration to say that the longest debate in taxation theory has pertained to the concept and design of the income tax - both personal and corporate. The early writings of G Von Schanz and RM Haig and, later, HC Simons41 have survived in the annals of that debate. The Schanz-Haig-Simons definition of income is the sum of the market value of the rights exercised in consumption and the change in the value of the total of property rights between the beginning and the end of the period in question. On this basis, the definition of comprehensive income equals consumption plus the net wealth accumulated during the period, the inclusion of net wealth lending the term ‘comprehensive’ to the definition.

Optimal income taxation considers both the equity and efficiency of the tax and the trade-off between them. For example, the optimal degree of income tax progressivity under alternative theories of distributive justice is based on the distribution of pretax income, the government’s objective to maximize social welfare using the income tax, and the disincentive effects or efficiency costs of individual work effort from the tax system. While these factors lie at the base of many personal income tax structures, their design often reflects goals other than just efficiency and equity. The personal income tax may be global or schedular. The concept of ‘taxable income’ - the treatment of different types of income, allowable deductions, exemptions, credits, the rate structure and number of brackets, and the neutrality to inflation - differs across personal income tax systems.

41 Simons, 1938.

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4.2 Designing the income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.2 Designing the income tax

Four characteristics embody tax liability: the choice of the taxable unit, the types of income subject to tax, tax preferences, and the tax schedule. The taxable unit - household or individual - interacts with the other features of the tax system - income subject to tax, income allowances, tax rates and tax credits - and yields a particular result in terms of equity and efficiency. The taxable unit for the corporate income tax - a company or business, as defined - is also affected by the characteristics of the structure, resulting in a particular mix of resource allocation and incidence of the tax.

Measurement is an important issue in the income tax. As much of the overall tax system has lost its redistributive policy content, an element of progressivity in the personal income tax remains the last important vestige of the equity goal, albeit within the practical confines of administrative feasibility and minimization of tax evasion which presently compete with the more esoteric equity and efficiency objectives. The definition and determinants of progressivity itself have varied, however. One measure, reflecting the distribution of taxes, may yield high progressivity as long as the incidence of the tax falls on a few, eg, the richest decile of taxpayers, even if the overall tax burden is low, eg, 1.0 per cent to 1.5 per cent of GDP. Another measure, based on the after-tax distribution of income, may indicate that the same tax structure reflects low progressivity. This has an impact not only on equity but also on the efficiency effects of the tax. The resultant debate on the appropriate measure of progressivity has not yielded a definitive conceptual preference.42 And due to the detrimental effects of progressivity on efficiency, it is also true that the rise of progressivity must remain limited.43 Countries that experimented with highly progressive rates also experienced high tax evasion.

In the case of a business or corporation, the correct valuation of assets and liabilities rests, first, on different criteria, including economic value, original cost, market value, value to the owner, replacement cost, or other bases. Second, assets and liabilities may be designated in nominal or real terms. An erroneous inflation adjustment will mismeasure profits. Third, a cash or accrual basis will affect taxable profits as the timing of income generation varies. Fourth, the rules on the carry-forward or carry-backward of losses will affect taxable profits and, in association, risk-taking. Fifth, the rules on how to depreciate different assets over their useful lives (the typical methods being the straight-line and declining-balance methods and accelerated depreciation), how to value inventories (the typical methods being last-in-first-out, first-in-first-out and period average methods), and how to treat exchange rate changes when business assets are designated in a foreign currency, will have implications for a company’s balance sheet and income statement.

In the context of concerns regarding financial restructuring after the East Asian crisis of 1997-1998, one feature of the design of the corporate income tax that emerged was the tax treatment of loan losses or of provisioning for possible loan losses, in particular by banks. Receipts associated with the risk of making loans are part of interest receipts and take place through the life of a loan, while loan losses may be concentrated in particular periods, reflecting the nature of business. As opposed to financial assets, the current value of loans and consumer credit cannot be easily ascertained when disposed of. Some loans may become worthless and uncollectable before maturity. It has been argued, therefore, that it is judicious to allow a tax deduction for setting aside provisions for loan losses on the basis of transparent rules since the tax treatment of provisioning is expected to affect the profile of bank loans and risk-taking by business. Two methods have been used. The charge-off method expends a bad debt only as it becomes wholly or partially worthless. The reserve method sets up a reserve account as an

Page 2 of 2 4.2 Designing the income tax allowance against the eventuality of a bad debt, while all receivables are recorded at face value until they become worthless.

42 Norregaard, 1990. 43 See Chapter III.1.

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4.3 Integration of personal and corporate income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.3 Integration of personal and corporate income tax

The issue of integration arises, first, when there is an incentive for an income earner to shift between the two forms of organization - corporate and individual business - in order to minimize taxation. It is for this reason that the top marginal personal income tax rate should be equal to the corporate income tax rate. Second, it could be argued that corporations are essentially a conduit through which income flows to individuals and, as such, corporations should perhaps not be taxed at all except as a withholding mechanism for the personal income tax.44 Since a corporation is merely a legal entity, the rationale for the corporate income tax is that it is easier to tax a corporate entity in the organized sector than taxing the ultimate income earner, an individual, who represents the correct tax base. This premise aims at eliminating the double taxation of income.

Some types of income, such as dividends, are taxed twice, once at the corporate level before they are distributed to individuals and a second time as individual income.45 To avoid such double taxation, full or partial relief may be given at either the corporate or the individual level. Indeed, double taxation in the income tax could be thought of conceptually as cascading in the case of domestic consumption taxation. Various forms may be devised to eliminate or reduce the extent of double taxation. Several countries have adopted at least partly integrated income tax systems.

Yet some countries have adhered to the classical system of non-integration. Two important examples are the United Kingdom and the United States. Expectedly, several Commonwealth countries have similar systems. Adherents take the position that there is no definitive proof that integration would lead to less business bankruptcies. But a more practical reason is perhaps the immediate revenue loss that a shift to integration would tend to cause. And the likely favorable effect in the medium term on economic act ivity and growth with a concomitant positive impact on tax revenue gets lost in this argument.

44 See Chapter III.4. 45 Messere, 1993.

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4.4 Taxation of capital gains, interest and dividends P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.4 Taxation of capital gains, interest and dividends

Comprehensive income should include capital gains on real property and on financial assets, such as stocks and shares. There is, however, also the premise that taxable income is a flow from capital sources, distinct from any changes to the value of those sources. In practical terms, there are concerns that a high capital gains tax could have detrimental effects on investment. Arguments are also offered regarding problems in measuring accrued capital gains. Thus, capital gains have usually been treated under special provisions in the tax statutes. Some components are often exempted or taxed at lower rates. Thus, gains from owner-occupied residences and government securities tend to be exempted. On the other hand, if gains are made on the sale of assets that were depreciated earlier, the tax system might ‘recapture’ the depreciation allowances already taken by taxing the capital gains as ordinary income.

If the tax treatment of income and capital gains is allowed to differ, issues of interpretation may arise as to whether a gain in business value is income or a capital gain. For example, should gains made because of exchange rate changes be treated as income or capital gains, especially if they are not taxable until realized? Should capital gains made by companies be differentiated from those by individuals? As a result of all these factors, capital gains typically have tax schedules with their own tax rates, thresholds, inflation adjustment, holding periods to ‘lock in’ investment, and rollover provisions.

Interest earnings and dividends pose related problems. Interest payments are deductible, while dividends may be partly deductible or may not be recognized in the calculation of taxable profits. This leads to a bias toward debt financing, which in turn leads companies to disguise payments of returns as interest. This is referred to as thin capitalization, a matter which assumes importance with multinational companies (MNCs) and their subsidiaries. Effective control by the tax administration to minimize tax avoidance by foreign subsidiaries necessitates tax provisions to limit thin capitalization.

Relatedly, transfer pricing rules are designed to limit the strategy of MNCS to distribute prices and costs across subsidiaries to minimize tax liability. Arm’s length transactions require parent companies and subsidiaries to set prices for internal transactions as if there were no mutual relationships. This is especially important given the relative size of the internal sale of goods or services in intra-firm trade. For example, about 85 per cent to 90 per cent of imports (exports) of US parent companies is made from (to) foreign affiliates. National tax authorities have to set appropriate rules without generating conflict with other jurisdictions. The OECD has developed guidelines based on a known comparable uncontrolled price at which an MNC sells to an unrelated party. It remains a major challenge for developing countries to cope with transfer pricing problems and to develop and implement appropriate arm’s length rules.

The tax treatment of branches and subsidiaries of MNCS leads to differential implications for choosing to operate as a branch or a subsidiary. For example, a corporation can fully deduct the losses of a branch against its home- country liability. A branch can repatriate its after-tax profits to the parent company without further taxation, such as a withholding tax. Usually, parent companies can transfer property to a branch without incurring a tax liability in the home country. Tax incentives are often applicable to a branch but not to a subsidiary. On the other hand, a parent company cannot defer home-country taxation on branch income, whether or not it is remitted to the home country. To limit tax avoidance through transfer pricing, host countries tend to grant less generous tax options to branches

Page 2 of 2 4.4 Taxation of capital gains, interest and dividends than to subsidiaries, such as for loss carry-forwards, loss carry-backs or deductions. Ultimately, for an MNC, whether to establish a branch or a subsidiary becomes a choice that must be based on many competing criteria.

Bartelsman and Beetsma (2000) found that policymakers in developed countries have to balance their need for tax revenue and the attractiveness of their jurisdiction for economic act ivity. ‘They act and react to each other’s corporate tax policies in finding the appropriate balance. International differences in corporate tax rates can affect tax revenue not only through shifts in economic act ivity, but can also alter revenue more directly through shifts in cross-country allocation of accounting profits.’

The effects of changes in corporate tax rates on transfer pricing seem to be considerable in developed countries. Profit may be shifted in two ways. One is through the capital structure of multinational firms. A firm can finance new subsidiaries in high-tax countries through debt contracts with parts of the company in low-tax countries. The other is through incorrectly pricing intra-firm deliveries of goods and services. Although the OECD Transfer Pricing Guidelines call for the use of the arm’s length principle, it may be difficult to apply, for example, in the case of intellectual property developed within the company.46

Bartelsman and Beetsma (2000) found that, on average, a unilateral one percentage point increase in the corporate tax rate does not lead to an increase in corporate tax revenues due to a more than offsetting decline in reported profits. The countries for which the estimated effects are largest are Japan, Portugal and Spain, followed by Denmark, Germany and the Netherlands. In principle, therefore, the rewards of stricter enforcement of the transfer pricing rules can be quite high. Tighter enforcement in a high-tax country, however, would mean that the net return of investment would fall and, hence, there is a risk that real activity would shift to other countries with lower taxes or lighter enforcement. Thus, without international coordination and cooperation, it is unlikely that transfer pricing safeguards could be implemented without detrimental effects.

46 The hypothesis of Bartelsman and Beetsma is that pure profit-shifting resulting from high taxes leads to a reduction in the reported value-added, given a scale of operations. To estimate profit-shifting, the authors apply a factor - the ratio of nominal value-added to labor compensation - to the differences in corporate tax rates between the OECD average and individual countries. By dividing by labor compensation, the authors control for the scale of operations, and obtain real act ivity shifts as a result of tax rate changes. Hence, the ratio of nominal value-added to labor compensation should decline if firms misuse transfer prices to counteract a rise in corporate tax rates.

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4.5 Source versus Residence Principle P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.5 Source versus Residence Principle

Under the residence principle, a resident must pay tax irrespective of the source of income. Some issues arise with this basis of taxation. For example, for legal entities, the establishment of residence is not obvious, though residence is increasingly tied to the location where the entity’s business act ivities are registered. Under the source principle, a country taxes any income arising within its borders irrespective of the residence of the person deriving the income. Countries usually use a mix, the residence principle for persons residing within the country, and the source principle for non-residents. The type of mix reflects the importance of investment and revenue objectives.47 But different mixes across countries may, and do, imply double taxation across international borders. The burden may be relieved unilaterally through foreign tax credits granted by a particular country or bilaterally through tax treaties that limit double taxation between countries.

If taxes were fully harmonized across countries, there would be little need for tax treaties. But despite the evidence of increased comparability of corporate income tax rates, the features of corporate tax systems remain diverse. Over time, therefore, the importance of tax treaties has grown, and they have diverged regarding concepts, structures and operating rules. They cover complex and conflicting concerns of the contracting parties about sharing taxing jurisdiction. They address, for example, the concept and definition of permanent establishment for tax purposes and the tax treatment of dividends, interest royalties and capital gains. They may include tax sparing, which allows a tax benefit accruing to a business in a capital-importing source country to be spared from being recouped in a capital-exporting residence country. Tax treaties also contain provisions for the exchange of information with tax implications between national tax jurisdictions. One benefit of tax treaties is effective tax harmonization, which tends to improve inter-jurisdictional equity, locational neutrality and taxpayer equity, while discouraging the short term destabilizing effects of tax competition that could affect global capital markets.48

47 The source and residence principles could be perceived as analogous to the origin and destination principles under a federal VAT that operates at the level of various states or provinces under the same umbrella. 48 The salient effect of tax competition is greater efficiency in the allocation and use of world public resources through the lowering of tax rates. Clearly, this has been the case with a global reduction in corporate tax rates.

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4.6 Tax incentives P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.6 Tax incentives

Many countries use tax incentives of one form or another to encourage investment - through both domestic savings and capital inflows. Incentives comprise tax rate reductions for priority sectors, tax holidays for a stipulated number of years, allowances with fast write-off of investment expenditure such as accelerated depreciation, and investment tax credits that allow an investment expense to reduce tax liability. There is much controversy over the usefulness of tax incentives. On the one hand, it is argued that dependability regarding the continuation of a tax structure and a low overall level of taxation are more attractive to an investor than intermittent tax incentives which give rise to tax planning and tend to benefit short term investment. Also, non-tax factors, such as economic and political stability, the availability of adequate economic infrastructure, access to natural resources and a well-trained labor force, may be more important than the tax factors. On the other hand, researchers have provided evidence that, under certain circumstances, especially in a region in which countries have similar environments represented by non-tax factors, tax incentives may indeed prove helpful in generating economic act ivity and supporting industrialization. Given the importance of tax factors in most tax systems, it is useful to briefly survey their role in the context of investment, dividend distribution, the tax treatment of remitted profits in the home country, the effect of tax structure on foreign direct investment (FDI) and, in turn, the effect of FDI on tax revenue.

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4.6.1 Impact of tax structure on corporate behavior P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.6 Tax incentives

4.6.1 Impact of tax structure on corporate behavior

In an early study, Iwamoto (1990) studied the effects of Japanese corporate tax policy on Japanese direct investment behavior. He showed that, based on 1984-1987 data, the higher cost of capital or tax wedge, which is caused by the corporate tax, increases direct investment outflows through parent company transfers. He, therefore, endorsed Japan’s 1989 tax reform that sought to reduce capital outflows and avoidance due to high rates.

Aurerbach, Hassett and Sodersten (1995) looked at the effect of the 1991 Swedish tax reform on corporate investment. Before the reform, the tax structure was so complex that the size and magnitude of the probable effects of any reform attempting to achieve a level playing field by curbing incentives to invest were unknown. Many provisions of the reform affected the tax treatment of business fixed investment. The underlying objective was to broaden the tax base while simultaneously lowering the statutory tax rate applied to it. This was similar to the objective of the comprehensive tax reform in the United States in 1986. In Sweden, the statutory corporate tax rate was brought down from 57 per cent to 30 per cent. At the same time, many of the incentives that had set Sweden’s tax system apart were eliminated, notably the ‘investment fund’ system. Indeed, there was a contemporaneous sharp drop in investment, but the authors did not attribute this fall to any impact of reform.49

While the opportunity to reduce taxes through investment funds made them attractive, constraints were applied to them. Sometimes they were not allowed to be removed. Maximizing accumulation in the fund also reduced the cash dividends a firm could pay. Firms could distribute only to the extent of their after-tax profits, taking into account their investment fund contributions. Since the distributions were taxed at the individual level, however, there was a built- in disincentive not to distribute.50 The reform did away with all these anomalies and reduced distortions. But given that the overall intention of the reform was to maintain reveneue neutrality, the authors found that ‘the tax reform likely had little effect’ on corporate investment behavior.

Relatedly, Mintz and Tsiopoulos (1994) found that the value of the corporate tax holidays given by Central and East European countries to attract foreign investment depended on whether a multinational firm paid corporate income tax to the home government on income remitted from abroad. Hines (1994) also found that tax laws encouraged firms to defer dividend payments from foreign subsidiaries to their parent companies. Knowing this, firms were prone to limit the initial investment so that later generations of profits could be reinvested before their repatriation. Hence, large transfers of equity investment from parent companies to their subsidiaries may not be easily observed. In fact, Hines found very few dividends paid by subsidiaries to their parent companies. Thus, he concluded that ‘tax policy exerts an important effect on the financial policy that accompanies foreign direct investment, which is one step toward determining the influence of taxation on the level and direction of the real act ivities of multinational firms’ (p 341).

49 The intent of the reform was to keep the overall tax burden on corporate investment the same, but to reduce the behavioral distortions associated with the various incentive schemes. Before the reform, the investment fund system

Page 2 of 2 4.6.1 Impact of tax structure on corporate behavior

allowed firms to contribute up to a proportion of their pretax profits to an investment fund and to take a tax deduction for doing so. It also required, however, that, for each Swedish krona contributed to the firm’s investment fund, krona b ` 1 would have to be deposited in the central bank (without interest). When investment funds were withdrawn for investment, the deposit b was recovered. In addition, firms recieved a small investment grant (g) for investment financed by the investment fund. Thus, the firm’s net investment cost was reduced to (1 - b - g). Such investments could not be added to the book capital stock, nor could they receive any other investment grant. 50 Nevertheless, since this was the only way firms could distribute cash dividends to their shareholders, the firm was in a ‘trapped equity’ regime in which the dividend tax was ‘capitalized’.

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4.6.2 Impact of tax structure on FDI P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.6 Tax incentives

4.6.2 Impact of tax structure on FDI

From time to time, multilateral organizations such as the International Monetary Fund and the Organisation for Economic Co-operation and Development have carried out comprehensive examinations of the effect of tax policy on FDI.51 The OECD study focuses on the corporate income tax and foreign investment. It points out that policymakers strive to ensure that their tax systems are internationally competitive and that impediments to FDI have been removed.

Corporate income tax is at the centre of this debate. It is recognized that the corporate tax system plays an important withholding function, collecting revenue on income derived in the host country. The desire to tax this income, while not discouraging foreign investors, raises difficult questions concerning the appropriate design of various tax rules, including the tax incentives that together determine the host-country tax burden. It is of some interest, therefore, to look at the potential effects of the host-country tax incentives.

In this regard, the impediments which inhibit investment and whether they can be addressed in a cost-efficient way through the use of tax incentives should be considered. Often, where taxation is identified as a significant factor influencing FDI, transparency, simplicity, stability and certainty in the application of the tax law and in tax administration are ranked by investors ahead of special tax incentives. Tax relief may enhance the attractiveness of a potential host country, but experience shows that in many cases the relief provided would be insufficient to offset the additional costs of investing there if a poor business environment or other such constraints exist.

Where, however, a firm is able to generate profits by undertaking certain business act ivities in a given host jurisdiction, tax incentives may be successful in attracting additional FDI and may be viewed as necessary if similar relief is being offered by another (eg, neighbouring) jurisdiction also competing for foreign capital. This raises the question of the appropriate form and scale of tax incentive relief and also whether such incentives would be necessary in the absence of tax competition. As indicated above, policy coordination would be beneficial across tax jurisdictions to minimize revenue losses as well as windfall gains to foreign investors.

Further, where additional FDI resulting from tax relief can be expected, it is important to undertake a cost-benefit analysis. This entails examining whether the stream of benefits from increased FDI, including host-country taxes collected on profits from an increased capital stock and other spillover effects such as an increase in employment, can offset the stream of costs associated with the tax incentives.

Host countries may give tax incentives in several forms:

1. A reduction in the statutory tax rate, which reduces the amount of host-country tax on taxable profits; 2. A reduction in the rate of the dividend withholding tax on distributed profits, which also reduces the tax burden; 3. A tax holiday, which exempts newly established firms from the corporate income tax and possible other taxes for a number of years;

Page 2 of 2 4.6.2 Impact of tax structure on FDI

4. Capital cost allowances, including accelerated and enhanced write-offs for qualifying capital costs, which reduce taxable profits; and 5. Investment tax credits, which provide a direct reduction in the corporate tax otherwise payable; unlike an enhanced deduction from income, the value of this incentive directly reduces the tax.

Investment expenditures may respond positively to each of these incentives. A reduction in the tax rate per se, such as in (1) and (2), benefits both new and existing capital. The other incentives would benefit newer investments.

The potential impact of tax incentives on investment behavior can also be expected to vary across business activities and sectors, across host jurisdictions, and over time. The impact would also be greater the more competitive an investment location is on a pretax basis. If two competing jurisdictions have similar non-tax characteristics (labor laws, nature of institutional bottlenecks or quality of business practices) and business costs (such as for labor, material, energy or capital), the FDI response to a given amount of tax relief could be expected to be greater. In other words, a narrowing of the differences in non-tax business costs and pretax profit rates across competing locations tends to make the tax differentials a more important factor in locational choice.

The trend toward increased trade and investment liberalization and increased competitive pressures accompanying globalization could also be expected to increase the potential role of taxation in influencing investment behavior. Globalization has increased the opportunities for cross-border investment and expanded the number of possible investment flows that incentives seek to attract. This has led to a unilateral scaling back of statutory corporate tax rates across the globalized world.

With increased liberalization and competition where profit margins have become thin, tax relief should play an important incentive role. Where economic rents are made possible in protected markets with output restrictions, tax incentive considerations tend to take second place. Tax relief may alter the realized rates of return but, where these rates exceed the required rates of return, the importance of such relief is diminished. These considerations summarize the potential effects of host-country tax incentives.

51 International Monetary Fund, 1990; OECD, 2001.

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4.6.3 Impact of FDI on tax revenue P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.6 Tax incentives

4.6.3 Impact of FDI on tax revenue

In a direct question, Gropp and Kostial (2000) asked whether FDI is eroding corporate income tax revenues. They obtained comparative data for 13 OECD countries for 1988-1997 and linked FDI to the corporate tax rate, exemptions, tax credits,52 growth rate, inflation, expected real depreciation, and openness of the economy. They found that both FDI inflows and outflows are significantly affected by the tax systems in the host and home countries and thereby established a link between FDI and corporate tax revenues. They related FDI flows to the base of the corporate income tax (ie, the profit rate) and found that it is positively (negatively) affected by FDI inflows (outflows).

In addition, in order to see how the harmonization of tax rates in the European Union affected tax revenues in selected EU member states, they undertook revenue simulations. The magnitude of the revenue gain or loss depended on the significance of the change in the corporate tax rate as well as on the revenue elasticity in a given country. The simulations suggest that FDI flows have possibly contributed significantly to the revenue erosion in Germany and may have reduced Italy’s revenue/GDP ratio by as much as 1 per cent of GDP per annum.

The simulations also found that tax rates have important effects on the direction of FDI flows in OECD countries. Tax harmonization in the European Union would entail that FDI deficit countries, such as Germany and Italy, move to a balanced FDI position. Moreover, the low tax rate on manufacturing in Ireland appears to have contributed greatly to the country’s success in attracting FDI. Gropp and Kostial point out, however, that the determinants of FDI should include other country characteristics. Countries compete for FDI on the basis of ‘bundles’ of public services and taxes, rather than taxes alone. This would be combined with including other taxes, in particular taxes on labor (which the simulations do not consider) that could play a significant role in the locational decision of FDI.

On the whole, the central message of Gropp’s and Kostial’s analysis remains that the revenue effects of FDI flows are likely to be substantial. This is an important consideration for governments to keep in mind, but something over which they may not have much control as economies are opened up to FDI. Alternative tax handles, such as a broad-based consumption tax, may be the revenue-productive alternative that they would have to utilize.

52 They used dummy variables to represent exemptions and tax credits.

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4.6.4 Summing up tax incentives P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.6 Tax incentives

4.6.4 Summing up tax incentives

The majority view on the effects of the corporate income tax and associated tax incentives on foreign investment is in the direction that FDI flows are affected by the structure of the corporate tax regime. The tax incentives offered by a country, however, are likely to be more effective when its competitor countries have similar prevailing non-tax characteristics and business costs. If they do not, non-tax factors begin to take precedence over tax factors in determining FDI.

Recent empirical work using improved FDI data and sophisticated estimation techniques offers evidence that host- country taxation influences investment flows. The influence increases over time given the steady reduction in the non-tax barriers to FDI flows. There is, however, a paucity of information on the elasticity of the responsiveness of FDI to the effective corporate tax rate in the host country.

Nevertheless, policymakers should not underestimate the tax planning initiatives of investors and should assess the strength and adequacy of the provisions for protecting the domestic tax base, particularly if a tax holiday or similar measures are being considered. It is also important to consider the amount of incremental tax relief that is ultimately realized by investors and the additional amount of investment that can be expected. The first issue involves ‘tax interaction effects’, where the tax rules of several countries will often factor into the relevant investment structure (eg, where financing is through an offshore affiliate).

Thus, there are various factors that tend to either offset or reinforce host-country tax relief. The factors to be considered include: (1) the sources of funds used to finance FDI at the margin, (2) the possible ‘mixing’ of foreign- source investment income for foreign tax credit purposes and the possibilities for deferring home-country taxation, (3) the use of tax havens to shelter foreign-source income, but this could be challenged through the application of CFC (controlled foreign company) rules that could offset host-country tax relief (so that the incentives would effectively result in a transfer of tax revenue from the host country’s treasury to that of the home country), and (4) A related factor pertains to the ‘tax sparing’ arrangements between the host and home countries, which are important for protecting the host country’s tax incentives.

In sum, it may ultimately be better to lower the statutory corporate tax rate, especially if the rate is much higher than that in the competitor countries.53 This would spur investment by rewarding the productive use of inputs in generating profits rather than by subsidizing the purchase of inputs, as is the case with most tax incentives. A lower rate should also reduce tax planning pressures on the domestic tax base. If however, tax revenues are derived largely from an existing capital stock that would enjoy a windfall benefit from a rate reduction, the loss of revenue may be large. Thus, policy decisions would essentially have to depend on the amount of existing versus new tax base that would benefit from the rate reduction.

53 See Chapter III.5 for a realistic assessment of the usefulness, or otherwise, of tax incentives.

Page 2 of 2 4.6.4 Summing up tax incentives

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4.7 Complex elements of corporate income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.7 Complex elements of corporate income tax

Economists tend to agree that the corporate income tax has become complex in its construct. In order to remedy this, they have proposed simpler bases such as cash flow, rather than the profits of a company, or minimum tax contributions if the regular tax calculations yield little revenue.

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4.7.1 Cash flow as an alternate base P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.7 Complex elements of corporate income tax

4.7.1 Cash flow as an alternate base

Three variants of cash flow have been suggested as a base for a corporate cash-flow tax (CCFT).54 The first is the real (R) base in which the tax base is the net real transactions (the difference between sales and purchases of real goods and services). Here, immediate expensing of capital outlays is allowed, but deductions for interest payments are not. The second is the real plus financial (RF) base in which the tax base includes, in addition to the R-base, non-equity financial transactions (the difference between borrowing and lending). Here, borrowing and interest received are taxable, while retirement of debt and interest payments are deductible. The third is the shareholder (S) base in which the net flow from the corporation to shareholders (dividends plus purchases of shares minus issues of new shares) is taxed. The third variant treats the government as a silent partner in any investment, so to speak.

The CCFT avoids grappling with the definition of economic depreciation, measuring capital gains, valuing inventories, and adjusting for inflation. But the main disadvantage is the narrowness of the tax base, however defined. The three variants have relative advantages and disadvantages. The non-deductibility of interest from the R-base eliminates incentives for debt financing. Its exclusion of financial transactions obviates any need for inflation adjustment. Yet the inclusion of financial transactions gives the RF-base the advantage of a larger base. The S- base is claimed to be administratively simple, but is more restrictive to the extent it could imply a tax rate of higher than 100 per cent. In practice, no country has introduced the CCFT to replace the corporate income tax, though a few, such as Mexico, base the taxation of small entrepreneurs or the agricultural sector on the cash flow of businesses.

54 See Chapter V.3.

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4.7.2 Minimum alternate tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.7 Complex elements of corporate income tax

4.7.2 Minimum alternate tax

One unwarranted result of the growing complexity of corporate tax laws has been a decline in revenues, reflecting tax planning and other tax avoidance schemes. Revenues also get subdued because of generous depreciation allowances in certain industries that require heavy capital investment, such as mining and oil exploration. In addition, incentives may become much too complicated with time, cluttering the tax system with deferrals and exclusions and affecting tax compliance adversely. Unfortunately, despite the recognition that such complexities should be weeded out, the authorities may not be able to do so for lack of political will, strong industry lobbies or powerhouses. Also, once the authorities realize that little tax revenue accrues from capital-intensive act ivities, they may have reason to step back from giving away generous benefits in all cases. And they certainly have legitimate grounds to contain the revenue erosion effects of tax planning and similar strategies.

Under such circumstances, it is useful to legislate a minimum alternate tax (MAT) to ensure that businesses or individuals with economic income do not regularly avoid tax. By improving compliance, a MAT also improves the horizontal equity of the income tax. In North America and Europe, for example, the United States, Canada, Denmark and Norway have a MAT based on alternative deductions from income. In the United States, the MAT is computed by making certain adjustments and adding selected tax preferences to income. Generally, this results in fewer deductions than a calculation based on the regular income tax schedule. In Latin America, Argentina, Ecuador, Mexico and Peru have legislated a MAT based on gross assets. Other countries, such as Colombia and India, have based their MAT on net worth. This version, however, suffers from base erosion since it is easier for businesses to manipulate net worth (because of the allowable deductions) than gross assets.55 Another variant is to base the MAT on fixed assets - land, plant and equipment - but this would discriminate against certain forms of assets and, in particular, against heavy industry, such as shipbuilding and oil exploration which are generally encouraged through generous incentives. Several African countries have introduced a MAT based on sales since sales or turnover is the most easily measurable financial variable for a business and can be made conveniently available to the tax administration. Also, the service sector may have low gross assets but high sales, and a turnover-based MAT may be appropriate for it.

A MAT based on gross assets is appealing since economic income could be expected to bear a systematic relationship to assets. Ideally, the base should include cash and securities, receivables, inventories, land and other fixed assets at a depreciated value and intangible assets at an amortized value. Mexico has used the MAT as a significant revenue earner. The MAT liability is designed to be roughly equal to a taxpayer’s income tax liability (rather than a minimum) by allowing the MAT paid to be carried forward or back for several years and set off against the taxpayer’s income tax liability.56 If a taxpayer is assumed to earn a 6 per cent return on assets and the corporate income tax rate is 35 per cent, a 2.1 per cent MAT (35 6/100) is the equivalent. In the long run, the tax administration may expect to receive the equivalent of 2.1 per cent of gross assets - not just as a minimum - in corporate tax revenues.

This is the same as saying that industries that cannot earn 6 per cent on their gross assets must eventually shift capital to a more productive economic activity that yields a 6 per cent return. This is not feasible in some countries,

Page 2 of 3 4.7.2 Minimum alternate tax given labor laws that prohibit capital owners from closing operations without the government’s permission and requiring them to pay wages even when running at a loss. Here, obviously, the issue is a matter of political choice: either to make labor laws more market friendly or to carry on with inefficient resource allocation at the cost of productivity and economic growth.

In the case of India, the Advisory Group on Tax Policy and Tax Administration for the Tenth Plan57 recommended to the Indian authorities that the MAT be based on a mix of stock and flow concepts. It may be worthwhile to quote its view here:

As the statutory corporate tax rate declined significantly since 1987, India developed a history of presumptive taxation - s 115J of the Income-tax Act through Finance Act, 1987; s 115JA through Finance Act, 1996; s 115JB through Finance Act, 2000, which provided for a minimum tax of 7.5 per cent on ‘book profit’ (defined as commercial profit).58 A major shortcoming of the MAT is the fact that it continues to be on reported income, unmindful of the widely prevalent practice of underreporting. ‘Book profit’- a flow concept - can be easily manipulated since it is amenable to accounting changes/practices and subject to the existing tax incentives. The base of the MAT could combine a stock and a flow to appropriately reflect a plausible taxable capacity of the company. The 20 per cent dividend tax could be abolished, and the MAT could be reconstituted as a tax equal to the aggregate of 0.75 per cent of adjusted net worth plus 10 per cent of the dividend distributed.59 The MAT should be allowed to be carried forward for set off against future tax liability in excess of the MAT as provided in s 115JAA. The adjusted net worth for tax purpose would be the average of capital employed as on the first day and the last day of the previous year. While the 2001-02 Union Budget brought down the dividend tax rate to 10 per cent, no step was taken to restructure the MAT.60 The proposed base would be efficient since, first, it is neutral between retained earnings and dividend distribution. To the extent dividends are distributed, currently they suffer a higher rate of tax in the year of distribution. In the proposed base, if the company chooses to retain its earnings it will be penalized by the capital market and still end up paying tax on it since it would result in an accretion to net worth. Second, the greater is the performance shortfall of a company, the greater is the excess of the implicit tax rate on act ual income over the prevailing corporate tax rate. The proposed base would be equitable since it would remove the bias through depreciation allowances in favor of the manufacturing sector vis--vis services. The stock-flow combination also minimizes base erosion from inflation. When net worth is eroded by inflation, the real tax loss is partly compensated by the capital gains tax paid by shareholders. (Recall the recommendations made to improve capital gains taxation). Further, if assets are revalued periodically, the increase is reflected in an increase in the net worth. If a company chooses otherwise, it will end up paying a substantially larger liability upon liquidation.

Thus, the Advisory Group attempted to look at both the efficiency and equity aspects in its MAT proposal. The Ministry of Finance, while acting on several recommendations of the Advisory Group in the 2002-03 Annual Union Budget, did not, however, take measures reflecting the Group’s MAT proposal.

Finally, another aspect of the MAT is the possibility of using it to reduce the corporate tax rate with the objective of increasing investment, rather than merely to improve its efficiency. Estache and Van Wijnbergen (1992) evaluated the MAT on corporations with the possibility of having a broad base with a low rate for enhancing investment. They analyzed Brazilian data and concluded that the interplay of uncertainty with the MAT plays a decisive role in the latter’s evaluation. Uncertainty over the rate of return is much more likely to be increased by macroeconomic uncertainty than by the introduction of a MAT which, in turn, traces back to fiscal imbalances. High-risk firms tend to be high rate-of-return firms, and the latter element reduces the impact of a MAT. Thus, concern that a MAT would discriminate against the most innovative but riskiest firms seems unwarranted. One may conclude that a MAT should, therefore, be a positive factor in encouraging investment. Estache and Van Wijnbergen (1992) also indicate that a MAT, with its simple tax code, is an appealing short cut to a comprehensive tax reform whose revenue effects could be substantial in countries like Brazil.

55 Net assets are gross assets less debt-financed liabilities. 56 McLees, 1991. 57 Government of India, 2001. See also Chapter V.4.

Page 3 of 3 4.7.2 Minimum alternate tax

58 And, through subsequent further changes, finally a rate of 18.5 per cent in s 115JB from Assessment Year 2012-13 onwards. The effective rate of corporate tax has been commonly estimated to be around 21-22 per cent as against the statutory rate of 33.99 per cent. 59 The rate of dividend distribution tax is 15 per cent as of this writing. 60 The MAT’s base has been subsequently expanded at the margin in intermittant steps, but not adequately.

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4.7.3 Taxation of the financial sector P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.7 Complex elements of corporate income tax

4.7.3 Taxation of the financial sector

Many considerations give rise to special details in the corporate income tax. One good indicator is the multiple provisions that typically comprise a corporate income tax statute, both the law and the rules. A few aspects of immediate relevance to the financial sector are mentioned below.

First, taxation of the financial sector by itself is quite complex in terms of the timing of income. The corporate income tax applies on an accrual basis. Governments often require financial institutions to set aside minimum funds for bad loans, which may not necessarily match and will probably fall below the act ual payment needs. Insurance companies also set aside actuarially determined funds for future payments. How much of the funds should be tax deductible is an issue.

Second, taxpayers owe tax on investment income net of costs, but the costs of services not related to investment are not deductible. Financial institutions may find themselves unable to separate the two cost components, and this may lead to an understatement of taxable income.

Third, the fact that a deposit represents a liability, not income, needs to be recognized in calculating taxable income. An insurance company’s income is derived from premiums and investment income. Premiums may represent both a payment for services and a deposit for investment. Only the former should comprise income since the latter component must be returned. In practice, the separation of the two components may be difficult in the case of insurance companies. For banks, however, deposits can be more easily identified.

Fourth, digressing from the corporate income tax, taxing financial transactions such as bank debits occurred widely in Latin America in the 1990s. Important countries such as Argentina and Brazil introduced a tax on financial transactions as an instrument of short term revenue mobilization, and smaller economies such as Colombia, Ecuador and Venezuela followed. Peru also used the tax during the early 1990s. But experience reveals that it is a distortive tax since it tends to drive financial transactions underground. Thus, its evasion increases and its revenue productivity declines over time. It should, therefore, be eschewed in the medium term.61

Fifth, taxing financial services under the VAT is also an issue. In principle, they should be taxed as long as they comprise consumption. The use of invoices in the VAT requires that VAT liability be attributed to each transaction. This is not feasible for banks since the financial services they provide do not have specific charges attached to them. Charges result from differences in the interest rates charged and paid. Value-added would have to be measured by the ‘addition method’ ie, adding the right components of value-added: profit, wages, rent and interest. Only a few countries, such as Israel, attempt to do so.

For insurance companies, value-added cannot be appropriately measured by the value of premiums or claims since this includes a component that comprises redistribution from one policy holder to another. Thus, value-added has to be measured by the ‘loading charge’ or the earnings of the insurer over and above the claims paid, eliminating the

Page 2 of 2 4.7.3 Taxation of the financial sector savings component. In sum, taxing the financial sector under the VAT involves complex treatments, often resulting in its remaining exempt.

61 See Chapter V.1. Indeed, India used a Bank Cash Transactions Tax (BCTT) for a year from 2006 with the objective of tracking money laundering.

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4.8 Special taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.8 Special taxes

There are a few taxes that are, or should be, levied for specific objectives rather than to finance the government’s overall budget. One such important tax is the payroll tax which is levied in particular to finance social insurance. A second such tax is an environmental tax, though it has not yet been popularly levied.

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4.8.1 Payroll tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.8 Special taxes

4.8.1 Payroll tax

A tax on payroll is generally earmarked for supporting social insurance programmes, such as social security and insurance for health, unemployment and disability. Ideally, the tax is taken from the payroll of salary earners, and the revenue is destined for benefiting them through appropriate transfers. This relationship makes the tax unlike other taxes whose revenue accrues to the general budget.

Social insurance systems may be financed on either a pay-as-you-go or a funded principle. Under the pay-as-you- go (PAYG) system, current workers effectively transfer resources to current beneficiaries. Under the fully funded (FF) systems, the contribution of each taxpayer is accumulated in an individual reserve account to cover future benefits. Payroll tax structures tend to be simple, with no exemptions from gross wages, and the tax is levied as a flat percentage of an employee’s gross wages up to a limit (thereby often attracting the criticism that it is regressive) and at a single rate, though the rates are different for employee and employer contributions. The final incidence of the tax is generally perceived to be passed on by employers (capital owners) to the employees, though the extent to which this occurs depends on the elasticities of demand and supply of the factors of production. Again, if the final incidence is on employees, the tax could be perceived as doubly regressive. Despite this, governments see fit to impose the tax to ensure that a minimum social insurance coverage is maintained in society. And governments chose to impose it as a tax based on the benefit principle rather than one that is financed from the general budget.

In developed economies with an aging population, PAYG tends to lead to a rapid growth in current and future liabilities. This has resulted in a heavy burden on the working population, especially as declines in the growth of productivity have tended to stagnate the tax base. Given the implicit nature of their inter-generational social contracts, however, it is mainly developed countries that have used PAYG. Recently, there was considerable discussion on the rationale for shifting to an FF system over a period of time. On the other hand, in developing economies with a vast labor pool, PAYG should be more viable. Yet developing countries in Asia have by and large opted for an FF system. Countries such as Singapore, Malaysia, India and Sri Lanka have operated individual account-based provident funds.

While PAYG tends to build up small, if any, surpluses, an FF system comprises a combination of contractual savings and insurance coverage and has the potential to mobilize significant resources.62 Historically, the provident funds of Asian countries have done so, and governments, such as in India and Sri Lanka, typically legislated a requirement that the majority of these funds be invested in government securities. The original intention of financing development later became subject to the criticism that retirees were receiving low, though riskless, returns. Later, it was claimed that provident fund investments were not entirely riskless. In Singapore, provident fund contributions can be withdrawn after a specified period for purchasing either government-built or private housing. This has enabled 85 per cent of the population to purchase property. Early studies typically assessed this to be a perspicacious development policy.63 There emerged a different view, however, that retirees may be wealthy in terms of the valuation of their assets, but were cash-poor and tended to have insufficient retirement insurance coverage.64 There was also a continuing worry of the possible decline in property values brought on by the contagion effects of a global recession. Thus, provident funds attracted critical attention in terms of their opportunity costs.

Page 2 of 2 4.8.1 Payroll tax

It is worth mentioning Chile’s experience since it privatized its social security system, which is now based on individual accounts. Nevertheless, privatization is not a panacea that solves all problems relating to the use of payroll taxes. Privatized systems can meet only limited objectives while steering clear of the underlying philosophy of a social contract. Also important is the experience that the investment of the funds, managed by a private body, is open to the volatility of the international capital markets, with no underlying guarantee by the government that a minimum coverage will be provided if the investments do not yield the expected returns.

In sum, the need for payroll taxes continues to hold. The basis - a PAYG or FF system - has to be selected according to the particular needs of a society. Both systems have advantages and disadvantages, and both have come under at least some criticism. Therefore, the system must be designed carefully. Privatization is not necessarily a solution to the difficulties. They have to be solved by appropriately modifying the system as needed over time.

62 Shome and Squire, 1983. 63 Shome and Saito, 1980. 64 McCarthy et al, 2001; Asher, 2002.

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4.8.2 Taxation of non-renewable resources P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. INCOME AND WEALTH TAXATION

4.8 Special taxes

4.8.2 Taxation of non-renewable resources

If the government owns mineral or petroleum resources, it is cast in a dual role: it is an owner of taxable resources as well as a sovereign taxing power. As the owner of mineral rights, it will seek the maximum return on its assets as payment for resource extraction, separate from any income tax. The receipts depend on the timing of income. The auction of a mining lease provides immediate revenue, but may not provide revenue on a continuing basis. Royalties are based on the volume or value of extracted resources. Royalties are a more continuous source of revenue. Yet the conventional view is to limit the use of royalties since they raise the marginal cost of extraction, obvating marginal projects. An alternative view is that, since royalties reflect the opportunity cost of resource extraction, they are not distortionary. This is the correct view: if companies cannot meet this price, the resources should be left in the ground. Indeed, a case can be made that much over-exploitation of natural resources has occurred globally due to the lack of adequate reflection or recognition of the opportunity costs of extraction in nominal cost calculations. This has had, and continues to have, deleterious cross-country and inter-generational ramifications.

Royalties are easy to administer and monitor. They should be calculated using a transparent formula based on the commodity price at the mine or well-head. The difference between the commodity price and the cost of extraction should comprise the royalty. In some countries, royalties are based on the f.o.b. -free on board- export price adjusted for extraction and other intermediate costs. Such a downstream price is used since it is easily observable. Royalties should be a deductible cost for income tax purposes since they are a cost of production.65

As the tax authority, however, the government should subject mineral resources to the same taxation as other taxable assets. Income taxation involves the correct matching of income and expenses. Expenditures that yield income over more than one tax period should be capitalized and written off over their useful life. Reflecting the large initial capital outlays in the mineral sector, it is important to establish the capital deductions and the permissible debt-equity ratio in order to preserve an adequate tax base. The occurrence of ‘earnings stripping’ through artificially high debt-equity ratios has to be minimized. This problem tends to be exacerbated because of the overwhelming presence of MNCS, which increases the likelihood of transfer pricing practices. To enforce the arm’s length rules, the tax authorities should require taxpayers to provide, in their tax returns, details of domestic and international transactions with related parties.

The resource rent tax is one method of taxing natural resources which has been conceptualized as an application of the cash-flow tax. It collects a proportion of a company’s returns in excess of the opportunity cost of capital. The investor receives a threshold return after which the government receives revenue. In this sense, revenue collection by the government is ‘back-ended’. Thus, the tax should not distort resource allocation. It also provides good revenue in highly profitable projects. This advantage could turn into a disadvantage, however, if investors are discouraged because of the realization that any success would be highly taxed. Thus, the expected rate of return from exploration is reduced by this tax. On the other hand, from the government’s point of view, there is the possibility that resource development could ultimately yield little revenue despite its providing various facilities and, thus, any successful returns should be appropriately taxed. This tax could therefore supplement royalties in

Page 2 of 2 4.8.2 Taxation of non-renewable resources improving the buoyancy of revenue in highly profitable projects, but the tax cannot be the sole revenue-generator from non-renewable resources.

A major issue for developing countries and for many economies in transition and emerging economies is the ability to negotiate contracts with MNCS which can adequately safeguard national interests and, at the same time, make it lucrative for the companies to undertake exploration. In the past, many, if not most, developing countries did not have appropriate skills for negotiations. With globalization, such skills seem to be spreading more widely, though the experience with WTO negotiations reveals a continuing need for developing those skills.

65 Nellor, 1995.

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5. TAXATION IN A DECENTRALIZED ECONOMY P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

5. TAXATION IN A DECENTRALIZED ECONOMY

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5.1 Conceptual basis P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

5. TAXATION IN A DECENTRALIZED ECONOMY

5.1 Conceptual basis

This part of the discussion touches, in a nutshell, upon the crucial issue of the design of a tax system and the assignment of taxes to various levels of government in a decentralized economy. Revenue from the same tax is also shared among the different levels. The rationale for decentralizing fiscal responsibility derives from the premise that the welfare generated by providing public goods and services is maximized by reflecting, as closely as possible, the preferences revealed by the population at the sub-national levels of government.66 The essential function of a central government must remain that of redistribution, while the main function of sub-national governments must be allocation. The central government must also remain ultimately responsible for overall macroeconomic stabilization and maintain appropriate control mechanisms over sub-national governments to ensure it.

Recent research reveals that there is a salient impact on growth and governance if the expenditure-allocational- functions are decentralized while keeping intact the stabilization efforts of the central government.67 This translates to saying that lower level governments should be responsible for all appropriate expenditure functions, and upper level governments should ensure the adequacy of funds. Thus, the idea that a vertical imbalance in the mix of revenue collection and expenditure responsibilities is somehow to be changed toward greater balance is to be eschewed. Australia, India and the United Kingdom represent this approach. Other countries, such as Argentina, Brazil, China (People’s Rep.) and the United States, follow a pattern in which the state or provincial governments collect substantial revenue; and some may even pass some of it upstream to the central government.

66 Tiebout, 1956. 67 De Mello et al, 2001.

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5.2 Sources of revenue P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

5. TAXATION IN A DECENTRALIZED ECONOMY

5.2 Sources of revenue

For sources of revenue, local-municipal-governments should use taxes on immobile bases such as landed property because, otherwise, their taxes would encourage flight of the tax base. Local governments also typically utilize user charges since such charges can be collected immediately upon the use of a service. They receive grants that may be earmarked (block grants) for particular projects. They could also be allowed to borrow. The ability to borrow by sub-national governments is a contentious issue since it could have adverse ramifications for the consolidated fiscal deficit. The United States has had the experience of financing local infrastructure projects for over a century through bond issues by local governments. In India, selected local governments were rated by rating agencies for the issue of bonds. Nevertheless, there is the dilemma that, in a freewheeling democratic environment, this could result in a constitutional right for all sub-national governments to issue paper if they so wish.

There must be a limit on or control of such a possibility if economic stabilization remains a central goal. Countries such as Argentina and Brazil, where the provincial governments had independent powers to borrow and effectively issue money, both experienced economic crises with internal turmoil and global contagion effects.68 In India, the states cannot borrow independently if they have debt to the central government. The 1990s have, however, witnessed its subversion, with the states managing to mobilize funds by borrowing through public enterprises owned or managed by them.

While the income tax has traditionally been assigned to the central level in most countries, Musgrave in his early work suggested assigning it to the states or provinces.69 Indeed, the United States assigns it to both levels, with the states ‘piggybacking’ or structuring their own income taxes on the basis of the federal income tax. Customs duties and selective excises are assigned to the central level since customs duties are collected at points of entry to the country while excises, being collected mostly at the manufacturing point, would benefit only particular states to the exclusion of others if they were assigned to the state level.

These taxes, assigned to the central level, are often subject to revenue-sharing. With the progress of decentralization, more and more revenue is being subject to sharing. This is the right policy direction, but it can have unwarranted implications for economic stabilization unless the Central Government is able to scale back its administration expenditures. This has proved a difficult task in some Latin American countries, such as Colombia, where decentralization and increased revenue-sharing have led to significantly higher central deficits in recent years.

It is important therefore, to have stable systems for determining the revenue-sharing formulae. India’s institution of the Finance Commission has provided this stability. It forms quinquennially, recommends how much, and how, central revenue is to be distributed among the states, and disbands. Its temporary nature has given it some dignity and efficiency, and the record is that Parliament has always accepted its recommendations. The lack of such a stable arrangement has obliged the federal governments in Argentina and Brazil to enter, time and again, into protracted negotiations with the provinces or states to arrive at temporary ‘pacts’, often to be abrogated before their legal termination and giving rise to a new round of negotiations.

Page 2 of 2 5.2 Sources of revenue

68 Ter-Minassian, 1997. 69 Musgrave, 1959.

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5.3 Property tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

5. TAXATION IN A DECENTRALIZED ECONOMY

5.3 Property tax

A good local tax is one whose burden cannot be exported from a local jurisdiction elsewhere. The property tax fits this bill perfectly. The benefit principle is satisfied since the local government provides law and order and maintains property rights, while ownership of property indicates an ability to pay. But there are practical problems. An accurate assessment of fair market value for an acceptable tax base is difficult. In India, for example, its determination by tax experts and legislators has not been accepted by the judiciary. It is possible for this reason that very few developing countries have been successful in using the property tax adequately as a tax instrument. Nevertheless, the property tax needs to be revived to finance urban renewal since many urban areas in developing countries are suffering serious decline and upper level governments do not have adequate financing available to attend to it.

Historically, taxes on land and property have featured among the oldest forms of taxation. Local governments in the United States have been successful in using the property tax as their primary source of revenue. Interestingly, in Brazil, urban localities collect their own property tax, and the federal government collects it for rural counties. Many urban municipal corporations, especially large ones such as the city of Sao Paulo (often called the New York of the Southern Hemisphere), have been quite successful in their efforts. The success reflects reasonable tax rates (0.5 per cent to 0.7 per cent) and a tax base that uses sales value rather than an esoteric concept of fairness. The argument that adequate cadastral surveys do not exist has been generally exaggerated. To arrive at a practical solution, older properties probably have to remain outside the tax net - in a manner comparable to leaving certain taxpayers below the threshold for the income tax or the VAT or leaving them out above a ceiling in the case of the payroll tax. Once introduced, the property tax has to be applied without exception.

In order to simplify the scope of the property tax, intangible property (eg, life interests and annuities), personal effects, businesses and shares, as well as bequests in the form of a gift or inheritance, should be excluded. These kinds of property have yielded very little revenue in most developing countries, tending instead to clutter the tax system. Even in developed countries, these kinds of property have given rise to ‘generation-skipping’, whereby bequests are made only to grandchildren to minimize the estate duty on bequests. If these simple guidelines are followed, it would not be surprising to experience some success in using the property tax as an effective tax instrument in developing countries.

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5.4 VAT in a decentralized economy P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

5. TAXATION IN A DECENTRALIZED ECONOMY

5.4 VAT in a decentralized economy

There are particular issues that constrain the operation of a VAT at a decentralized level. Nevertheless, some fiscally federal countries have introduced such a VAT. Brazil introduced the earliest VAT in the mid-1960s, and it was at the level of the states. While it has been the major revenue earner in the panoply of taxes, the VAT structure became complex over time and reforming it has proved difficult.70 Canada introduced a provincial VAT in the mid- 1990s, but not all provinces participate in it.71 The European Union has been operating a temporary VAT whose design is not final. The Indian states have labored for almost a decade under an ‘Empowered Committee’ of their finance ministers to design a state-level VAT.72 After a series of postponements, the Empowered Committee agreed to introduce it in 2003. However, the VAT was finally introduced in India in April 2005 with cooperation from its Central Government in the form of a guarantee for monetary compensation for three years to states that might lose revenue from the VAT’s introduction. Argentina has considered a provincial VAT, but act ual progress on the matter has been slow. Considerable research exists in the United States, but the possibility of introduction of a state-level VAT is poor, if not non-existent.

What is it that makes a state-level VAT difficult to operate? The difficulty comes from two inter-related premises: (1) since the VAT is a tax on consumption, its incidence must fall on the final consumer, and (2) when a good is produced in a state and the VAT is collected in that state, there has to be a mechanism for the tax collected in the producing state to be passed on to the state in which the good is consumed. The transfer would ensure what is termed the destination principle in the context of a state-level VAT. The mechanism through which such a transfer would take place is not easy to design. Countries have usually tended to use the origin principle in which the producing state simply keeps the tax revenue it collects on the sale of the goods. This has been the case in Brazil and the European Union. The appropriate design for redirecting revenue among the states has not been resolved in Canada or India.

A method proposed by Versano (1999) has become popular in the international discussions on this issue. In practice, in any VAT return, there would be two columns, one for intrastate transactions and one for inter-state transactions. The former would be controlled by the tax administrations of the individual states. The latter would be taxed at a common rate by all the states. The net VAT payable on inter-state transactions would be remitted by every taxpayer to an overarching all-state administration or to the central tax administration. The revenue would be distributed at the end of the period according to the consumption size of the states.73 This would be a good mechanism for a destination-based VAT. None of the above-mentioned decentralized VATS, however, has so far opted for a fully destination-based VAT. They are basically dependent on the origin principle while discussions on the final objective of a destination-based VAT continue.

70 Silvani and dos Santos, 1996. 71 Bagchi, 1997. 72 Shome, 2002.

Page 2 of 2 5.4 VAT in a decentralized economy

73 This is one example of the ‘clearing house’ mechanism that could be operated by the states themselves or by the Central Government.

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6. CONCLUSIONS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW

6. CONCLUSIONS

The final question to be posed is, how have tax policy and tax reform fared over the years and across global regions.

Policymakers often ask for the nature of cross-country experiences in tax reform and to view the extent of common trends and divergences. Especially as the transition economies of Eastern Europe and the Former Soviet Union undertook reform, it was interesting to compare their experiences with tax reform patterns in market economies. In market economies, tax reform experiences have formed certain patterns. Their patterns have also changed with time; for example, the 1960s and 1970s were quite different from the 1980s. The patterns also differ according to geographical region; for example, trends of Latin America may be distinguished from those of Europe and Asia. In the 1990s, the concerns in carrying out tax reform in ex-Socialist or transition economies were again quite different. Overall, among market economies, it can be said that, in the new century, the VAT is universally accepted as an economically efficient and administrable tax. The bases have been broadened and there is a recognition that a small number of rates is better than multiple rates. As dependence on the tax has grown, however, so have the rates. The number of selected excises has diminished, the main ones being on tobacco, alcoholic beverages, and petroleum products, even though other excises continue. Customs tariffs have been scaled back and export duties have been mostly eliminated. Income tax rates and rate dispersion have decreased, while top marginal rates apply at lower levels of per capita GDP. In the 2000s, rates of taxation affecting international flow of capital have also come down. While there is a consensus that the income tax base should be broadened and made more transparent while headline rates should diminish, there has been less success in scaling back tax incentives. Many developing countries are introducing presumptive taxes, minimum contribution requirements, and withholding taxes to obviate the negative revenue effect of a variety of tax preferences that they fail to abolish.

Modern tax policy has taken shape in transition economies. They have come a long way from the system of revenue collection and transfers that were typical of a command economy, usually not reflecting market impulses. Nevertheless, it would be pertinent to note that transition economy tax systems are acquiring complex features, with several conforming neither to a broad-based tax structure design nor to a simple - even if distortionary - interim tax structure focused on closing the fiscal deficit. As a result, their systems tend to need much improvement.

To list some of the causes, first, transition economies were operating their own complex tax/transfer mechanisms - reflecting social considerations as well as priority act ivities - before the emergence of change. Some of the current practices - even though modified - reflect old centralized operations in favor of intervention and differential treatments. Effort has to be made to steadily reduce such an approach. Second, many transition economies continued to cast their tax policies in the model of (or as a reaction to) the Russian Federation for quite a long period after formation. Third, transition economies tend to receive technical assistance from diverse sources. Their tax policies reflect a mix of such advice. For example, European thinking on the VAT with the accommodation of multiple rates is different from that based on wider experience, inclusive of Latin America and Asia, which tends to indicate that multi-rated VATS are difficult to administer. Or, some experts may think that a modified cash-flow tax may be ideal in a fresh environment, while others may think that it may be quite complex as a starter. Fourth, experience in Western Europe reveals that tax reform is a complex process and may be expected to be similar in transition economies.

Long preparation is needed for major tax reform even in industrial economies in terms of tax administrator and taxpayer education, as well as in terms of fruition of the process - from tax policy design, to giving it legal form, to putting it into action - and administering it. In Eastern Europe, such as in the Czech Republic, or farther east in

Page 2 of 2 6. CONCLUSIONS

Nepal, the VAT had to be withdrawn after they were announced and published, to be ratified later in a modified form, through a referendum. In India, writing a new income tax code is approaching a decade since the beginning of the exercise in 2007 while, similarly, preparation for a GST covering the central and state governments is acquiring a comparable vintage. In several countries, a tax reform package proposed by the government’s executive branch may not be accepted by the legislative branch, as in Latin America. This simply implies that tax reform will be a slow process, as experienced in many countries in Latin America, Asia or Europe. In particular, the United States has been unable to introduce a national level VAT despite much research and reform proposals. Fundamental tax reform tends to take hold after decades of research, experimentation, and debate, if not frustration and disappointment. But the movement has to go on.

The steadfast goal is to enhance the neutrality of tax systems and, in line with the best international reform experiences, to improve the administrability of the tax code. Two courses of act ion comprise: (1) to simplify the structures of existing taxes (by reducing the number of rates, broadening the bases, and eliminating preferential treatment of particular economic agents or activities); and (2) to introduce simple taxes (such as a single-rate VAT) to replace old and complicated ones (such as a multi-rate turnover tax) that facilitates tax administration. To identify policy options to mobilize additional budgetary resources, the principle has to consist of designing measures that would generate adequate revenue to meet a country’s budgetary needs in as economically neutral a manner as possible. As circumstances warrant, however, interim measures may be needed that deviate in varying degrees from the long term goals of tax reform.

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.2 TAX POLICY AND THE DESIGN OF A SINGLE TAX SYSTEM: AN OVERVIEW

REFERENCES

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Bagchi, Amaresh, 1997, ‘A State Level Vat? Harmonizing Sales Taxes: A Comparison of India and Canada,’ in Shome, Parthasarathi, ed, Value-Added Tax in India, New Delhi: Centax Publications Pvt Ltd.

Ballard, Charles L, John B Shoven, and John Whalley, 1985, ‘General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States,’ American Economic Review, Vol 75, No. March 1985, pp 128-1381.

Bartelsman, Eric J, and Roel MW Beetsma, 2000, ‘Why Pay More? Corporate Tax Avoidance through Transfer Pricing in OECD Countries,’ Discussion Paper Series No. 2543, Centre for Economic Policy Research, London.

De Mello, Luiz R, and Matias Barenstein, 2001, ‘Fiscal Decentralisation and Governance: Across-Country Analysis,’ IMF Working Paper WP/01/71, International Monetary Fund, Washington, DC.

Ebrill, Liam, Michael Keen, Jean-Paul Bodin, and Victoria Summers, 2001, The Modern VAT, Washington, DC: International Monetary Fund.

Estache, Antonio, and Sweder van Wijnbergen, 1992, ‘Evaluating the Minimum Asset Tax on Corporations: An Option Pricing Approach,’ Discussion Paper Series No. 684, Centre for Economic Policy Research, London.

Gentry, William M, and R Glenn Hubbard, 1998, ‘Fundamental Tax Reform and Corporate Financial Policy,’ Working Paper No. 6433, National Bureau of Economic Research, Cambridge, Mass.

Government of India, 2001, Report of the Advisory Group on Tax Policy and tax Administration for the Tenth Plan, Planning Commission, New Delhi.

Gropp, Reint, and Kristina Kostial, 2000, ‘The Disappearing Tax Base: Is Foreign Direct Investment (FDI) Eroding Corporate Income Taxes?,’ IMF Working Paper WP/00/173, Washington, DC.

Hall, Rebert E, and Alvin Rabushka, 1983, Low Tax, Simple Tax, Flat Tax, New York: Mcgraw-Hill.

Hansson, Ingemar, and Charles Stuart, 1987, ‘The Welfare Costs of Deficit Finance,’ Economic Inquiry, Vol 25, Issue 3, pp 479-96.

Harberger, Arnold C, 1962, ‘The Incidence of the Corporation Income Tax,’ Journal of Political Economy, Vol 70, No. 3, pp 215-240.

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______, 1974, Taxation and Welfare, Boston: Little Brown & Co.

Hines, James R, 1994, ‘Credit and Deferral as International Investment Incentives,’ Journal of Public Economics, Vol 55, No. 2, pp 323-347.

International Monetary Fund, 1990, ‘Tax Policy and Reform for Foreign Direct Investment in Developing Countries,’ in Taxation and Capital Flows, Conference Volume of the IMF and OECD-sponsored Conference on Interaction between Tax Systems of OECD Member Countries, Paris.

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Jones, Larry E, Rodolfo E Manuelli, and Peter E Rossi, 1993, ‘Optimal Taxation in Models of Endogenous Growth,’ Journal of Political Economy, Vol 101(3), pp 485-517.

Khadka, Rup Bahadur, 1996, ‘A VAT for Nepal,’ International VAT Monitor, Vol 7(3), pp 134-140.

Krueger, Anne O, 2000, The WTO as an International Organization, Chicago: University of Chicago Press.

McCarthy, D, O Mitchell, and J Piggot, 2001, ‘Asset Rich and Cash Poor: Retirement Provision and Housing Policy in Singapore,’ Pensions Research Council, University of Pennsylvania, PRC Working Paper No. 200-10.

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McLure, Charles E, 1975, ‘General Equilibrium Incidence Analysis: The Harberger Model after Ten Years,’ Journal of Public Economics, Vol 4(2), pp 125-161.

Meerman, Jacob, and Parthasarathi Shome, 1980, ‘Estimating Counterfactual Incomes in Studies of Budget Incidence,’ Public Finance, Vol 35(2), pp 291-99.

Messere, Ken, 1993, Tax Policy in OECD Countries: Choices and Conflicts, Amsterdam: IBFD Publications BV.

Mintz, Jack M, and Thomas Tsiopoulos, 1994, ‘The Effectiveness of Corporate Tax Incentives for Foreign Investment in the Presence of Tax Crediting,’ Journal of Public Economics, Vol 55 (2), pp 233-255.

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Nellor David, 1995, ‘Taxation of Mineral and Petroleum Resources,’ in Parthasarathi Shome, ed, Tax Policy Handbook, Washington, DC: International Monetary Fund.

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______, and Benjamin A Okner, 1974, Who Bears the Tax Burden?, Washington, DC: Brookings Institution.

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______, 2002, India’s Fiscal Matters, New Delhi: Oxford University Press.

______, and KA Saito, 1980, ‘Social Security Funds in Singapore and the Philippines: Ramifications of Investment Policies’, Labor and Society, International Institute of Labor Studies, January, Geneva.

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Subramanian, Arvind, Ali Ibrahim and Luis A Torres-Castro, 1993, ‘Optimal Tariffs: Theory and Practice,’ IMF Working Paper WP/93/50, International Monetary Fund, Washington, DC.

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______, 1991, ‘Tax Reform in Economies in Transition: A Brief Introduction to the Main Issues,’ IMF Working Paper WP/91/23, International Monetary Fund, Washington, DC.

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Whalley, John, 1984, ‘Regression or Progression: The Taxing Question of Incidence Analysis,’ Canadian Journal of Economics, Vol 17(4), pp 654-682.

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CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT

CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT1

1 As concepts and applications of taxation took shape in the post-war era, a crucial question that emerged was whether the same principles applicable to developed economies could be realistically applied to, or expected to yield outcomes from, developing economies that tended to have unique characteristics which needed special treatment and solutions. This chapter is from that era, and is excerpted from Parthasarathi Shome, ‘Limitations of the Role of Tax Policy in Economic Development, in Ved Gandhi et al, Supply-Side Tax Policy - Its Relevance to Developing Countries, International Monetary Fund, 1987. Permission was sought from and granted by International Monetary Fund, Washington DC, to reprint.

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1. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT

1. INTRODUCTION

The role of taxation and associated incentives in development is one piece of a large puzzle. Tax incentives may assume importance if tax policy is seen to play an instrumental role in development. Tax policy, in turn, may have perceptible ramifications on the savings rate and, therefore, on investment in the economy which, in the traditional literature, is the kingpin in an economy’s development. There have, however, been structural positions regarding the force behind, or limiting, development. These are (1) the inadequacy of export markets due to protectionism abroad in the case of countries with a high degree of dependence on trade; (2) ‘investment’ in health, education, and other social infrastructure (even though this is treated as current expenditure by economists); (3) population control in countries such as India and China, or the lack of a large population (ie, the smallness of market size) in others; (4) the role of appropriate technology, that is, the choice of techniques; and (5) the role of agriculture (eg, land reform, extension services, innovation) independent of the effects of savings and investment. Therefore, in our attempt to study the effects of taxation on output - growth and development - we need to go back to the drawing board to see where taxation fits into the development picture and how important it is to the development process. Since the role of taxation is inherently linked to that of savings, this chapter begins by reviewing the treatment of savings in the development literature and then contrasts and compares it with the role of other measures of development. This is not to belittle the role of fiscal policy in economic development but to gauge it more comprehensively and to better understand its possibilities and limitations.

A perusal of the post-war literature reveals that, while the proponents of savings as a vehicle of growth were in the forefront of the discussions on growth, issues such as the role of economic infrastructure and social dynamics in the development process were being raised at the same time, even though the latter became more fashionable in the 1970s. At times the traditionalist view - savings and investment - of the development literature was perceived as an alternative to the structuralist view - financial intermediation, social infrastructure, population pressure, agricultural reform and adoption of modern technology, and factor-substitution problems.2 At other times, their roles were cast as complementary, for example, a better financial structure or a more educated public aiding in the savings performance of the economy. Whether treated as substitutes or complements, tax policy emerges as a modus operandi for the various tenets of development. Section 2 discusses the different factors that have been cast as instrumental in the development process and Section 3 assesses the role of tax policy in affecting these factors. Section 4 offers some concluding remarks.

2 More recently, Shome (2010) re-examined the role of savings and investment in India’s growth.

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2. THE DETERMINANTS OF DEVELOPMENT P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT

2. THE DETERMINANTS OF DEVELOPMENT

The savings literature is inherently connected with issues of external economies and of surplus labor and labor productivity, problems which are related to those of sectoral factor-proportions. The issue of surplus labor - removal of a laborer from a peasant economy does not diminish productivity - is usually set against the backdrop of a lack of sufficient capital for growth. The right technique of production, that is, the right combination of labor and capital, therefore, assumes importance in the debate on the determinants of development. Among the seminal works in this area are those of Lewis (1954), Eckaus (1955), and Sen (1960) for the factor-proportions problem3 and for the implication of a labor surplus on an economy’s development, and those of Rosenstein-Roadan (1943), Scitovsky (1954), and Bator (1958) for the effects of external economies and for the need for additional investment to internalize them.

Immediately, savings - and, consequently, investment - rise in significance in that savings form the scarce factor of production. Improved savings performance thus becomes the vehicle of growth since investment follows savings. Much of the related literature derives from Harrod (1939) and Domar’s (1946) early formulations of the relationship between savings and growth. The Harrod-Domar framework emphasizes the relationship between the savings rate and the growth rate of an economy by stipulating that, in an economy with v as the capital-output ratio and s as the savings rate, a unit of capital K, produces 1/v units of output Y, of which s/v is saved, that is, the rate of growth of capital stock. This is also the rate of growth of output g, if the capital-output ratio is kept constant.4

The early literature makes investment determine the rate of growth in a straight forward manner. However, the later literature sees the conversion of savings to investment as a possible bottleneck for development in the forms of external as well as domestic structural rigidities. For example, investment goods may have, necessarily, a foreign exchange component. In the event of foreign exchange constraints arising from export and import inelasticities, a country may be faced with a ‘foreign exchange gap’ even when its ‘savings-investment gap’ is closed.5 External constraints in the form of foreign exchange to transform domestic savings into investment, of which imported capital goods are an integral part, are considered by Chenery and Strout (1966), Joshi (1967), Atkinson (1969), and Nelson (1970) among others. The foreign exchange constraint is also caused by the nature of the primary commodities exported - tea, coffee, cocoa, jute - usually represented by inelastic supplies so that their price responsiveness is limited, and by various forms of protectionism against imports of light manufactured goods.

Domestic constraints on growth have several sources. First, as Nurkse (1952, 1953) in his discussion of savings and investment in developing economies points out, the problem in many developing countries is not a shortage of savings, but the limited size of the market leading to low investment: ‘Many articles that are in common use in the United States can be sold in a low-income country in quantities so limited that a machine working only a few days or weeks can produce enough for a whole year’s consumption’ (p 7). This problem of limitation is linked not only with the low standard of living in many populous developing countries but also with the low absorptive capacity of those developing countries that are sparsely populated.

Second, investment in machinery that produces consumer goods is seen as a leakage from the long run rate of growth by Mahalanobis (1953) and other ‘planner’ economists. In other words, varying the composition of capital stock - in its respective uses as producing consumption or investment goods - provides an extra handle to attain higher growth rates. If investment in the production of consumption goods cannot be decreased, that limits growth.

Third, the difficulties in the transfer of technology from developed to developing countries are seen to reveal the insufficiencies of savings for development. Brunton (1955), in a review of the Harrod-Domar models in the context

Page 2 of 3 2. THE DETERMINANTS OF DEVELOPMENT of developing countries, writes, ‘In the literature on economic development ... emphasis is always placed on the need for more and more capital. This is surely correct and was never a secret. It would appear, however, that, though more capital is a necessary condition for speeding up the rate of development, it is not a sufficient condition .... There is no reason at all to assume that (modern) technology ... can be bodily transferred to other countries’ (pp 335-36).

Fourth, the conversion of domestic savings or potential savings to investment is seen to be arrested due to the lack of adequate financial institutions by Patrick (1966), Gurley and Shaw (1967), Goldsmith (1969), Mckinnon (1973), and others. Gurely and Shaw (1967) emphasize four ‘technologies’ for savings mobilization and allocation: self- finance, taxation, debt-asset ratio, and foreign aid. Each technology has cost and yield components, the net yield being its ability to raise savings and investment, the economy’s capital stock and, thus, the flow of consumption. While they treat all of the technologies as substitutes, they assert that, in each phase of development, an economy has an optimal combination of savings-investment technologies, there being no optimal combination across space and over time. Patrick (1966) emphasizes the role of financial policy in encouraging savers to shift from tangible to financial assets and also in increasing savings, investment, and production. He calls this an approach of ‘supply- lending finance’ where financial institutions are established and instruments created even before the emergence of a perceptible demand for them in an effort to stimulate growth. Growth is thus cast as a direct result of an efficient financial system, whose success requires government participation and innovation as well as public confidence.

The literature since the 1970s focuses more on the role of government in the development of the financial sector, for example, Tanzi (1976), Bhatt and Meerman (1978), and Von Pischke and others (1983) have brought together a number of essays testifying to the importance of the role of ‘financial markets in rural areas, to their performance, structure, institutions, operations, costs, and the nature of their services to rural people’ (p 5). Thus, the ramifications of having a sound financial structure as an economy progresses along its path of development have been seen to be significant since at least the 1960s.

Other scholars such as Myint (1954), Myrdal (1968), Haq (1971), and Meier (1976) differentiate between concepts of growth and development; and expenditures in areas traditionally perceived as consumption, such as health and education, are perceived as causal factors in the development process, most notably by Streeten (1967). Thus, development is perceived by them as a mix of policy objectives comprising an increase in real per capita income sustained over a long time, pari passu with a minimally acceptable structure of income distribution (such that no one is below a clearly defined poverty line), attained through a process that generally increases social welfare. Associated with these concerns, infrastructure in education, social services and health, and other social concerns under comprehensive phrases such as ‘minimum needs strategy’ and ‘human resource development’ are emphasized.

In this broader context of development, additional structural factors in the development process may be listed. First, population has been perceived as a leading determinant of development. In the post-war literature this is addressed by Clark (1953), Ohlin (1967), Walsh (1970), and Chandrasekhar (1972) and later by Hauser (1979) and Birdsall (1980). Among demographers, the accelerating rate of world population growth - especially in developing countries - is seen as the one basic impediment to a nation’s progress since population strains an economy’s resources to the hilt. Countering this proposition is the argument that population growth makes market expansions possible6. Thus, population growth during the modern era has both positive and negative influences on economic development: China, the country with the largest population in the world, has modified its population policy significantly over the years, alternately stressing and relaxing, and once again stressing and relaxing population control in recent years, as reported by Coale (1981) and others. The adverse pressure of population on a country’s economic performance cannot be denied. In countries with high population densities, the economic outcomes may be reduced to one of perennially catching up with population growth.

Second, the impact of the agricultural sector on development is a much discussed topic. It cannot be adequately covered here except to note certain benchmark trends.7 While in the 1950s some, like Viner (1953) and Lewis (1954), envisage the agricultural sector as important, most economists, including these two, also perceive it as a means for industrialization. In the 1960s, however, agriculture was assigned a direct role in development (Eicher and Witt, 1964). It was realized that the squeeze on agriculture in the 1950s had negative ramifications for domestic demand as well as for exports during the 1960s. By the late 1960s, agricultural development became congruous with the concept of ‘development from below,’ and the literature of the 1970s, for example, Yudelman and others (1971), Lele (1975), Benor and Harrison (1977), Singh (1979), and Berry and Cline (1979), focused on land reform, extension work, technological change and innovation. The relevance of agricultural incomes is reflected in the concern for the agricultural and nonagricultural industrial terms of trade, predictably resulting in inconclusive

Page 3 of 3 2. THE DETERMINANTS OF DEVELOPMENT debates through the 1970s and 1980s. As in the case of rural-urban terms of trade, the debate over land reform did not yield clear conclusions either.

In spite of the above-mentioned uncertainties, the development of agriculture per se is understood to be a vital component in the improvement of the quality of rural life and, given that significant proportions of the population of developing countries remain rural, an independent determinant of development. Raising the rate of financial savings may often have little effect on an impermeable non-monetized agrarian sector, and the latter’s welfare may need to be addressed directly if the goal is the development of the country as a whole.

Third, the development literature, for example, Rhee and Westphal (1977), considers the question of relative factor- substitutability in production functions - the responsiveness to price signals - as a structural problem, employing linear programming techniques in the analysis of the modern sector of developing economies. If labor and capital were easily substitutable, population would not be such a limiting factor, and empirical evidence on the factor- substitution question is certainly not conclusive. The econometric approach, usually measuring the factor- substitution elasticity between labor and capital, is often termed as casual empiricism (Bhalla (1975), White (1978)). Little (1982), in a survey of the evidence on various country experiences, points out that low-income countries use more labor intensive techniques compared with middle-income countries and very often use machinery that is obsolete in the latter though, when production is for export markets where both compete, production factors should be similar for the same commodity. But this argument seems to be valid only when confined to goods that fit the argument.

In conclusion, one might say that the extent of factor-substitution possibilities in a developing economy depends on the pattern of its production. During the 1950s and 1960s, when many of these countries achieved independence, a significant number of them opted for prestigious, capital-intensive projects in both the manufacturing and agricultural sectors. As a result, and in the absence of domestic technology, the difficulty with factor-substitution was seen by many of them as structural, leading, in turn, to the belief that foreign exchange was the dominant gap in development, a consideration that was addressed above. By the 1970s, however, the often minuscule returns from such unsuccessful programs re-educated some of these countries regarding shifting techniques and production structures, even if through the endurement of newly appearing constraints and challenges.

3 These issues are inextricably linked with the structural feasibility or infeasibility of capital-labor substitutability - as posed by more recent literature - and are, therefore, addressed in this context, below. 4 See Sen (1970, pp 9-14). 5 Assume that the country has sufficient savings in domestic currency to finance its investment needs, or there is no savings-investment gap. However, some capital goods are not produced at home and need to be imported. There is a consequent requirement for foreign exchange. But its exports are lower than its imports and capital inflows are small, resulting in a foreign exchange gap. Thus it is constrained from converting domestic currency to foreign currency for importing all needed capital goods even though there is no shortage of domestic savings. 6 More recently, arguments in favor of a ‘demographic dividend’ emanating from a burgeoning young population have been made by some economists. India is favored in this light. However, such dividend is unlikely to materialize unless the youth is imbued with necessary health and education (Shome, 2011). 7 The authors cited here certainly do not comprise an exhaustive list of those who have addressed these issues.

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3. TAX POLICY AND THE DETERMINANTS OF DEVELOPMENT P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT

3. TAX POLICY AND THE DETERMINANTS OF DEVELOPMENT

If a comprehensive concept of development includes raising the rates of saving and investment in order to increase output, raising social investment in health, education and welfare, streamlining the rate of population growth with the rate of accumulation of capital stock, and safeguarding a reasonable terms of trade for the agricultural sector such that the latter’s growth is assured, the role of tax policy is automatically extended from one of aiding the first criterion to all the others as well. Indeed, under appropriate assumptions, tax policy can theoretically be a powerful instrument in targeting all of the above factors of development. Whether such policies result in complex tax structures, then becomes the question to ponder. Below we summarize the possibilities for and limitations of tax policy as a means of affecting the above-mentioned aspects of development.

Among the various means by which a developing economy may increase its investment rate is taxation. By taxation, the government reserves a portion of the national resources for itself, often for capital construction projects, or offers it to the private sector for similar purposes. The Union of Soviet Socialist Republics used a sizable turnover tax to finance capital formation. Japan, in its early development, used a land tax for the same reason. Several low-income and middle-income countries - especially in South Asia and Latin America - attempted to raise domestic savings through payroll taxes or compulsory social security schemes. While these endeavours have mostly been mired by inflation in the case of Latin America, they have been significantly successful in Asia - Malaysia, the Philippines, Singapore, and Sri Lanka - where provident and pension funds not only increased voluntary savings (Datta and Shome, 1981), but also made available to their governments long term investment funds for development purposes, as the accumulated funds of these institutions became the primary source of financing of public debt (Shome, 1986). Theoretically, they could also be used to maximize an economy’s utility from consumption at an equilibrium factor-proportion, that is, take an economy to its ‘golden path,’ with appropriate financing methods (Shome and Squire, 1983).

Tax policy has been used by developing countries to close their foreign exchange gaps through import tariffs, free trade zones, or income tax incentives for export diversification such as in the case of light manufacturing goods or, contrarily, export duties in the case of traditional primary exports with low elasticities of supply. Indeed, theoretically, export subsidies and import taxes can have the same effects as those of exchange rate policies since a 10 per cent ad valorem subsidy on all exports matched by a 10 per cent ad valorem duty on all imports has similar economic implications as a 10 per cent devaluation, with one difference: the devaluation affects all items of the balance payments, while the tax-subsidy mix affects only the mercantile items. Arguments that have been put forward in favor of a tax-subsidy mix are its selective nature and the lower inflationary pressure it generates.

The role of fiscal policy as a complement to the development of the financial sector has been discussed above. Tax policy is utilized to encourage financial intermediation through special tax treatment of both dividends, to encourage the development of the stock market, and interest, including interest from banks, governments, housing authorities, and insurance institutions, as well as from unit trusts and the like. Tax policy, to change factor-proportions, is also used widely through incentive packages including accelerated depreciation, income tax holidays, labor-utilization relief, deductions for research and development, and so on. Almost all developing countries boast a complex system of tax incentives, the ramifications of which are often difficult to trace through the economic system. Corporate tax incentives that tend to reduce the cost of capital and subsidize capital use exist side by side with labor-utilisation relief that should encourage labor intensity, the net effect of the two often being intractable. However, tax policy usually remains the main tool in a country’s cache of instruments in its attempts to modify the relative use of different factors of production.

Page 2 of 3 3. TAX POLICY AND THE DETERMINANTS OF DEVELOPMENT

Tax policy can similarly be used to affect other aspects of development. China uses a heavy tax on married couples who have more than one child. India and several other developing countries also experimented with the same type of tax in the early 1970s by offering higher personal income tax breaks for smaller families, or by reducing the number of children for which tax credits and allowances are given. Thus, tax rates can be manipulated to make the choice between having and not having children more dependent on an opportunity cost that reflects an economic rather than a social cost.

The issue of a favorable treatment for agriculture has been much debated in the literature on agricultural taxation. Indeed, in the early literature, several economists argued that agricultural taxation is necessary in developing countries to extract the agricultural surplus or for reasons of inter-sectoral equity. Gandhi (1966), for example, quantifies the ‘under-taxation’ of Indian agriculture relative to other sectors. According to World Bank (1982), in the previous two decades not only did the proportion of gross domestic product (GDP) accruing from the agricultural sector fall sharply in developing countries but so had the output per worker, affecting the differential in outputs per worker between agricultural and non-agricultural sectors. This type of reasoning brought about arguments for rehabilitating the agricultural sector with the aid of tax-subsidy policies, for example, export duty removal and import duty exemptions for tractors, seeds, and fertilizers. It must be noted in this context that even the United States utilized direct subsidies to the farm sector for leaving land fallow or reducing the production of milk in order to assure a domestically acceptable terms of trade for this sector.

Tax and expenditure policy is, of course, the primary vehicle through which human resource development - social welfare, education, nutrition - has been attempted. Many developed countries, especially those in Europe, have high social expenditures in relation to GDP and the ratio grew rapidly in the post-war era (Tanzi, 1986). Indeed, it has been argued that the huge deficits of European nations are now being caused primarily by social welfare coverage and that further taxation on this account is almost impossible (Mach, 1979). For developing countries, the use of fiscal policy to achieve the human welfare component of development is not yet exhausted. Countries such as Sri Lanka have demonstrated what can be achieved in terms of literacy and longevity when government fiscal policy takes these up as focal points of development, while others such as India have yet a long way to go.

Taxation has its limitations and difficulties, however. In general, the success of tax policy depends on four tenets: that everyone is covered by the tax regime, that the incidence of taxation is known, that the rate of a tax is correct, and that behavior is affected solely by price. If the first criterion is not met, for example as is the case in most developing countries where the rural sector hardly pays any income tax, experimentation with higher marginal tax rates on families with large numbers of children could be expected to have rather limited results for the country as a whole since a high proportion of the population may be rural. If the second condition is not satisfied - tax incidence is difficult to determine with certainty - then the tax may eventually fall on individuals or inputs far removed from the original intention of the tax. For example, if the corporate tax is passed on to labor, then an increase in the corporate tax rate may not reduce capital-intensity, but if the incidence is on capital, then capital bears the burden, matching the objective of the tax (Shome, 1978). The question of incidence becomes quite important in issues of factor-substitution. Third, if the rate of tax is not correct, its revenue potency is reduced or its disincentive effects may be high. Fourth, if behavior is price responsive but is also affected by other less observable and non-economic determinants, then the use of tax policy - by affecting price - to modify behavior may be vitiated. Sending children - especially female - to school to receive primary education may not depend on whether it is free but on whether it is frowned upon or permitted by society.

Actual experience bears witness to all these concerns with respect to the use of tax policy. Taxes on the poor are limited by existing poverty. Taxes on the rich may affect savings adversely and are often difficult to legislate beyond a point. In primarily agricultural countries, tax collection is a major hurdle as farmers are difficult to tax and often, marketed surpluses may be small as a proportion of production. Finally, not much attention is given to the issue of non-price determinants of economic behavior even as they cause greater concern to economists just as they have done to sociologists and anthropologists.

The limitations of tax policy may emerge from another direction. It is argued that if marginal tax rates are prohibitive, they may have detrimental effects on the rate of growth by truncating the rates of saving, investment, and labor supply. These concerns regarding the excessive use of tax policy have recently been revived under the banner of supply-side economics, which advocates the reduction of high marginal tax rates in order to release the forces of supply of savings, investment, and labor. As the supply of factors of production increases, output increases and so does the rate of growth. However, as Tanzi (1983) points out by citing the example of the United States, even if

Page 3 of 3 3. TAX POLICY AND THE DETERMINANTS OF DEVELOPMENT supply did respond to tax reform in the long run, tax policy by itself may not be able to yield supply side benefits in the face of non-complementary changes in other policies, such as those relating to the monetary and financial sectors. Also, whether or not lowering marginal tax rates is crucial to the success of tax policy remains an empirical matter. Thus, while economists have to, and indeed, do assign a major role to tax policy in enhancing development and growth, and sometimes successfully, it must be done with perspicacity and empiricism.

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4. CONCLUSIONS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT

4. CONCLUSIONS

The above review, albeit selective, attempted to put into perspective the role of the orthodox savings-investment strategy in the development process and addressed how tax policy could have an impact on the determinants of development. In that endeavour, the chapter touched upon some seminal works in the growth literature based on the effects of savings on growth, and forming the major building blocks in their application to the early development literature on surplus-labor economies. It then mentioned the ensuing literature on the limitations of this strategy, such as the foreign exchange gap, the lack of an optimal financial structure as well as of economic and social infrastructure, the population explosion, the role of the agricultural as opposed to the industrial sector, and the difficulties with neoclassical assumptions of factor-substitution. Indeed, it is found that the literature has often treated financial development, infrastructure, and agricultural development as alternative ‘technologies’ to development. Some economists have also emphasized the complementary roles that these elements can and need to play during the development process.

What emerges from this review for a study of the effectiveness of tax policy is that tax policy and, generally, fiscal policy form one component of the savings-investment strategy of development. There are many views, however, in the literature on which route to take for development, the savings-investment strategy being one among several or, at most forming a complement to other aspects. The role of tax and fiscal policy, therefore, should be seen in this perspective as an atomistic part of a much larger whole. Before placing excessive reliance on tax and fiscal policy, therefore, it is important to bear in mind the relative position of tax and fiscal policy as a determinant of development. This is not to belittle the role of fiscal policy, however. Once we have a clearer impression of its limitations, we may be better able to form objectives and pursue goals to be addressed by tax and fiscal policy.

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.3 THE ROLE OF TAX POLICY IN ECONOMIC DEVELOPMENT

REFERENCES

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Benor, Daniel, and James Q Harrison, 1977, Agricultural Extension: The Training and Visit System, Washington: World Bank.

Berry, R Albert, and William R Cline, 1979, Agrarian Structure and Productivity in Developing Countries, Baltimore: Johns Hopkins University Press.

Bhalla, AS, ed, 1975, Technology and Employment in Industry: A Case Study Approach, Geneva: International Labor Organization.

Bhatt, VV, and Jacob Meerman, 1978, ‘Resource Mobilization in Developing Countries: Financial Institutions and Policies,’ World Development (Oxford), Vol 6, pp 45-64, January.

Birdsall, Nancy, 1980, ‘Population and Poverty in the Developing World,’ World Bank Staff Working Paper No. 404, Washington.

Bruton, Henry-I, 1955, ‘Growth Models and Underdeveloped Economies,’ Journal of Political Economy, Chicago, Vol 63, pp 322-36, August.

Chandrasekhar, S, 1972, Infant Mortality, Population Growth, and Family Planning in India, Chapel Hill: University of North Carolina Press.

Chenery, Hollis B, and Alan M Strout, 1966, ‘Foreign Assistance and Economic Development,’ American Economic Review, Vol 56, pp 679-733, September, Nashville, Tennessee.

Clark, Colin, 1953, ‘Population Growth and Living Standards,’ International Labour Review, Vol 68, pp 99-117, August, Geneva.

Coale, Ansley J, 1981, ‘Population Trends, Population Policy, and Population Studies in China,’ Population and Development Review, Vol 7, pp 85-97, March, New York.

Datta, Gautam, and Parthasarathi Shome, 1981, ‘Social Security and Household Savings: Asian Experience,’ Developing Economies, Vol 19, pp 143-60, June, Tokyo.

Domar, Evsey D, 1946, ‘Capital Expansion, Rate of Growth, and Employment,’ Econometrica, Vol 14, pp 137-47, April, Evanston, Illinois.

Page 2 of 4 REFERENCES

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Gandhi, VP, 1966, Tax Burden on Indian Agriculture, Cambridge, Massachusetts: Harvard University Law School, mimeographed.

Goldsmith, RW, 1969, Financial Structure and Development, New Haven: Yale University Press.

Gurley, John C, and ES Shaw, 1967, ‘Financial Structure and Economic Development,’ Economic Development and Cultural Change, Vol 15, pp 257-68, April, Chicago.

Haq, Mahbub UL, 1971, ‘Employment and Income Distribution in the 1970s: A New Perspective,’ Pakistan Economic and Social Review, Vol 9, pp 1-9, June-December, Lahore.

Harrod, RF, 1939, ‘An Essay in Dynamic Theory,’ Economic Journal, Vol 49, pp 14-33, March, London.

Hauser, Philip M, ed, 1979, World Population and Development: Challenges and Prospects, New York: Syracuse University Press.

Joshi, Vijay, 1967, ‘Foreign Exchange Bottlenecks or Unwillingness to Save?’ Economic and Political Weekly, Vol 2, pp 485-86, March.

Lele, Uma J, 1975, The Design of Rural Development: Lessons from Africa, Baltimore: Johns Hopkins University.

Lewis, W Arthur, 1954, ‘Economic Development with Unlimited Supplies of Labour,’ Manchester School of Economic and Social Studies, Vol 22, pp 139-91, May.

Little, Ian MD, 1982, Economic Development: Theory, Policy and International Relations, New York: Basic Books.

Mach, EP, 1979, ‘Selected Issues on Health and Employment,’ International Labour Review, Vol 118, pp 133-45, March-April, Geneva.

Mahalanobis, PC, 1953, ‘Some Observations on the Process of Growth of Naitonal Income,’ Sankhya, Vol 12(4), pp 307-12, September, Calcutta.

Mckinnon, Ronal I, 1973, Money and Capital in Economic Development, Washington: Brookings Institution.

Meier, Gerald M, 1976, Leading Issues in Economic Development, 3rd ed, New York: Oxford University Press.

Myint, H, 1954, ‘An Interpretation of Economic Backwardness,’ Oxford Economic Papers, Vol 6, pp 132-63, June.

Myrdal, Gunnar, 1968, Asian Drama: An Inquiry into the Poverty of Nations, New York: Twentieth Century Fund.

Nelson, Richard R, 1970, ‘The Effective Exchange Rate: Employment and Growth in a Foreign Exchange- Constrained Economy,’ Journal of Political Economy, Vol 78, pp 546-64, May-June, Chicago.

Nurkse, R, 1952, ‘Some International Aspects of the Problem of Economic Development,’ American Economic Review, Papers and Proceedings of the Sixty-Fourth Meeting of the American Economic Association (Nashville, Tennessee), Vol 42, pp 571-83.

______, 1953, Problems of Capital Formation in Underdeveloped Countries, Oxford: B Blackwell.

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Patrick, Hugh T, 1966, ‘Financial Development and Economic Growth in Underdeveloped Countries,’ Economic Development and Cultural Change, Vol 14, pp 174-89, January, Chicago.

Rhee, Yung W, and Larry E Westphal, 1977, ‘A Micro, Econometric Investigation of Choice of Technology,’ Journal of Development Economic, Vol 4, pp 205-37, September, Amsterdam.

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CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS

CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS1

1 The discussions over the role of tax policy in development centered on the issue of how effective tax policy would be in a developing country in light of the fact that the economic response to tax policy was likely to be slow or small. This reflected various impediments to a robust response that are addressed in this excerpted chapter from Parthasarathi Shome, "On the Elasticity of Developing Country Tax Systems", Economic and Political Weekly, India, August, 1988. Permission was sought from and granted by Economic and Political Weekly, Mumbai, to reprint.

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1. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS

1. INTRODUCTION

This chapter is concerned with the buoyancy and elasticity of the tax systems of developing countries, with particular reference to Asia. It discusses the impediments to an automatic response of tax revenue to economic growth. We first point to a usual method for estimating the buoyancy and elasticity of taxes and then provide some estimates of these measures from selected Asian economies. It is argued that there is some built-in inflexibility in raising the elasticity of a typical tax system. Some measures for improving elasticity of taxes are recommended.

The need to raise revenues and concomitantly, tax revenues, becomes imperative in the macro environment that economies face. Asian economies are no exception. They have tried to ‘adjust’ in particular when economic crises hit the global scenario.2 This has entailed exchange rate depreciation, tighter credit policy, and reduction in the fiscal deficit. Often, only a sharp reduction in the fiscal deficit is compatible with the other criteria of an adjustment program.3 A reduction in the fiscal deficit calls for a substantial reduction in expenditure and/or increase in revenue. Targets are stipulated and projections are made. More often than not, revenue performance falls short of targets and projections, a manifestation of which is the commonly found shortfall in act ual revenue collected compared with revenue projections in a typical Central Government budget (in the short run) or the government’s plan documents (in the medium term). Time after time, and in country after country, changes in tax policy and tax administration appear to be unsuccessful in mobilizing additional resources adequately on a sustainable basis.

One consequence has been that these countries have tended to depend increasingly on foreign as well as domestic debt for their development expenditures. In turn, as this dependence grows, their governments may face the predicament of having to bear a net outflow of funds as interest and amortization payments begin to exceed borrowing. Under such circumstances, revenues would need to rise rapidly, especially if expenditures - other than interest and amortization payments - cannot be curtailed. In this way, the need to raise revenue today is exacerbated by the failure to raise revenue in the past. In general, tax revenue comprises the major portion of Central Government budgetary revenues. The need to increase revenue, therefore, focuses itself on the means of increasing tax revenue.4 Typically, annual budgets tend to include lists of discretionary tax measures with the objective of making up, at least partially, for growing fiscal deficits. Yet, a gap usually remains in successfully designing a tax system that will automatically yield tax revenue with the growth of gross domestic product (GDP) that could remove the uncomfortable obligation of introducing usually unpopular tax measures in every annual budget.

The overall responsiveness of tax revenues to discretionary changes in tax rates and in the tax base in relation to GDP is called buoyancy of the tax system. It may be measured as the percentage change in tax revenues over the percentage change in GDP. If the ratio is above unity, revenues are said to be buoyant. Elasticity, as opposed to buoyancy, excludes the impact of discretionary tax measures on revenue. Despite discretionary action, however, the response of tax revenue is often slight. This is where the underlying elasticity of the tax structure comes in: if it is low, other than discretionary act ions, it would be difficult to raise the tax/GDP ratio as GDP grows.

The question that needs to be addressed, therefore, is to what extent a particular developing country’s tax system can be expected to be elastic. Are there any natural impediments to the automatic response of tax revenue to economic growth, leading to an inelastic tax system? If so, is it then too optimistic to expect the system to be elastic? Can anything be done to improve the elasticity of an inelastic system? For elasticity analysis, a further major hurdle remains in estimating elasticity values. This problem needs to be addressed before any policy recommendations can be made regarding improving the elasticity of the tax system.

Page 2 of 2 1. INTRODUCTION

In what follows, Section 2 presents a method for estimating the elasticity of taxes and provides available evidence on the buoyancy and elasticity of selected Asian tax systems. Section 3 argues that there may be some built-in inflexibility in raising the elasticity of a typical tax system. Section 4 indicates measures that could be taken to improve elasticity, despite the limitations of tax administration or the rigidities in economic structures. Section 5 offers concluding remarks.

2 Even energy exporters such as Indonesia and Malaysia had to adjust at times of decline in the international prices of energy. 3 This has been evinced, at the time of compiling this Compendium, even in Southern European economies as they continue to adjust after the Euro-zone crisis of 2011-12. 4 This is not to belittle the role of non-tax revenue. For example, it is often found that adjustments in fees and charges for public services tend to fall quite short of inflation rates or that the operations of public enterprises that generate non-tax revenue are inefficient. Improvements in the areas of pricing of public services and raising efficiency in public enterprise operations can result in significant increases in non-tax revenue.

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2. BUOYANCY AND ELASTICITY OF ASIAN TAX SYSTEMS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS > 2. BUOYANCY AND ELASTICITY OF ASIAN TAX SYSTEMS

2. BUOYANCY AND ELASTICITY OF ASIAN TAX SYSTEMS

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2.1 Measurement of buoyancy and elasticity P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. BUOYANCY AND ELASTICITY OF ASIAN TAX SYSTEMS

2.1 Measurement of buoyancy and elasticity

While tax policy changes may be ideally based on the estimation of buoyancy and elasticity, the procedures for estimation have limitations. The estimation of buoyancy is straightforward since it is simply a relationship between two trends. It may be estimated by a log-linear equation linking a time series on tax revenue to its corresponding GDP series. Elasticity is also estimated with a log-linear equation but the time series on tax revenue is reduced by any revenue from discretionary tax measures. The procedure for estimating elasticity is, therefore, based on some underlying assumptions which need to be made in order to clear the system of the effects of discretionary measures such that only the natural or automatic response of tax revenue to GDP is included.

The elasticity formula can be thought of as a product of two elasticities:

Elasticity of a tax with respect to GDP = Elasticity of a tax with respect to its appropriate base Elasticity of the base with respect to GDP.

First, it is of primary importance to define the base as closely as possible to the source from which the tax is collected. In practice, it is to be expected that data on appropriate bases may be difficult to obtain from the national accounts. Thus, proxy bases have to be used in place of the theoretically correct bases. Taxes involve exclusions, exemptions, and deductions. As a result, data on broad categories of bases obtainable directly from national accounts have to be modified by including approximations of the factors that cause base erosion. The more these approximations vary from the true exemptions, the further are the proxies from the tax bases they represent. Elasticity estimates based on such proxies could, therefore, be expected to be imprecise. Nevertheless, appropriate substitutions may be made in order to improve the elasticity estimates so that meaningful policy conclusions may be drawn. For example, if agriculture falls virtually outside the income tax net, the GDP of agriculture should be removed from the income tax base. Similarly, an income tax on wages alone could be related to domestic - net of agricultural - wages and salaries. Appropriate definitions for such bases for major taxes appear in the Annexure Table.

Second, the most commonly used method of elasticity estimation proposed by Prest (1962) has its shortcomings.5 While the numerator in the tax-to-base elasticity - the tax revenue series in question - is adjusted for discretionary changes in both the tax base and the tax rates, the denominator - the base itself - is not adjusted for any of the discretionary measures. Thus, not even the discretionary measures with respect to the tax base are incorporated directly as an addition or subtraction to the base, and its consequences, in turn, are not applied to the tax revenue series. Thus, discretionary measures on tax rates are assumed not to affect the tax base, either through the natural reactions of the taxpayers to the resulting changes in relative prices or through a change in the degree of evasion or of administrative efficiency. For example, a significant increase in the import tariff could affect taxable imports, viz, the tax base, adversely; unless this is taken into account, the potential yield from the increased duty rates would tend to be overestimated. Similarly, a large increase in income tax rates, especially in the upper income brackets, could increase the incidence of tax evasion or avoidance, again adversely affecting the income tax base. All attempts at elasticity estimates to date ignore these elements and the estimates cited in this chapter are subject to the same criticism. When using elasticity estimates for policy conclusions, therefore, one needs to bear their shortcomings in mind.

Page 2 of 2 2.1 Measurement of buoyancy and elasticity

5 For an assessment and alternative suggestions for estimation, see Choudhry (1975), Chand (1975) and Subrahmanyam (1983).

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2.2 Evidence on buoyancy and elasticity P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. BUOYANCY AND ELASTICITY OF ASIAN TAX SYSTEMS

2.2 Evidence on buoyancy and elasticity

While buoyancy may be estimated econometrically as indicated above, even an inspection of a time series on the tax/GDP ratio would indicate the nature of buoyancy of a tax system. For buoyancy to improve, the tax/GDP ratio would have to increase over time. The tax/GDP ratio in selected Asian economies appears in Table 1. The ratio has not exhibited a clear increase over time. Authorities typically express concern as to why, through the years, revenues have not been buoyant although substantial revenue raising measures are taken every year. Keeping in mind that the effects of presumably revenue yielding, annual discretionary tax measures are included in the revenue figures, what is disturbing is that the respective underlying tax systems must be quite inelastic.

Table 1

Tax revenue as percentage of GDP in selected Asian economies, 1981-85

Table 2 substantiates what may be concluded from Table 1. Table 2 presents available estimates of the buoyancy and elasticity of the tax systems of five Asian economies - Bangladesh, Malaysia, the Philippines, Sri Lanka and Thailand. It is found that, in general, the elasticities of Asian tax systems have been significantly below unity.6 Even their buoyancies have been below unity, with the exception of Malaysia and Thailand. A perusal of their annual Central Government budgets would reveal that the introduction of a menu of measures to the effect of about 1 per cent of GDP in a single year is not uncommon in this sample of countries. A unit value for buoyancy would thus indicate that substantial discretionary revenue measures are needed annually just to keep these economies at the same spot in terms of their respective tax/GDP ratios. This would seem to validate the argument that there is an urgent need to improve the elasticity of their tax systems, as emphasized by tax reformers as well as by the authorities themselves.

Table 2

Page 2 of 2 2.2 Evidence on buoyancy and elasticity

Estimates of buoyancy and elasticity of taxes in selected Asian economies

Buoyancy Elasticity

Bangladesh (1979/80-1984/85) 0.99 0.71

Malaysia (1976-82) 1.23 0.501

Philippines (1980-85) 0.80 0.502

Sri Lanka (1978-84) 0.75 0.733

Thailand (1977-85) 1.13 0.92

Notes: 1. For import duties and major excises.

2. Elasticity estimate is for 1978-85.

3. Elasticity estimate is for 1978-82; it is the weighted average of elasticities of the personal income tax, import duties, and the turnover tax, which together comprised over half of tax revenue.

Source: International sources.

6 For estimates of individual tax elasticities for India, Nepal and Pakistan, see Chakraborty (1981), Bagchi and Rao (1982), Dahal (1984), Gillani (1984), and Sury (1985).

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3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES

Discretionary measures usually take the form of tax increases rather than base expansions; as a result, they contribute little to enhancing the revenue elasticity of the tax system. In fact, a close examination of discretionary measures often reveals that many of the measures in the income tax area erode the tax base and, therefore, its revenue elasticity is reduced. Also, the structures of customs duties, the sales tax, and excises, which often account for two-thirds to three quarters of tax revenue in the Asian countries, have certain built-in inflexibilities. Finally, patterns of consumption and production themselves explain why elasticity is difficult to raise. These issues are discussed below for individual taxes.

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3.1 Personal income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES

3.1 Personal income tax

The personal income tax should be elastic in a progressive income tax structure. However, structural rigidities and discretionary measures tend to erode the potential elasticity of the tax. Among the former set of causes, it may be mentioned that, while the largest contribution to the personal income tax usually comes from wages and salaries, the latter’s growth is likely to be constrained to below the inflation rate, for example, during periods when a country has embarked on a stabilization programe comprising demand management policies. Thus the base of the tax cannot be expected to grow with GDP during such periods, when the need for revenue generation may be especially high. Of course, if the tax rates are progressive, then they counter the base erosion to some extent.

Experience reveals that discretionary measures have tended to reduce elasticity through the authorities taking steps in many countries to reduce the average tax rates on income, the reductions generally exceeding the rise in the consumer price index (CPI).7 Further, the percentage reduction might increase as one moves up the income brackets. At the same time, personal allowances, standard deductions, and the like also have tended to adjust more than the CPI, so that revenue yield would be adversely affected. Finally, over time, the number of allowances and exemptions - for example, for education, life insurance, provident fund contributions, mortgage interest, and so on - also tends to increase. While such measures might be taken to provide incentives at the top and equity at the bottom, these objectives can be fulfilled only at the cost of adjusting the revenue goal downward.

7 This is done not only with the purpose of easing tax administration but also as a manifestation of supply-side policies which became popular since the 1980s.

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3.2 Corporate income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES

3.2 Corporate income tax

In general, raising corporate income tax revenue can also be expected to face severe constraints. Often, in a developing country the manufacturing sector is the leading growth sector. In its nascent stages, the profitability of this sector can be expected to be low. Further, manufacturing enterprises often belong to the public sector and it is not uncommon for parts of the financial sector also to be nationalized. While there is no reason why public enterprises cannot be efficiently run, the history of the financial performance of public enterprises bears witness to their low profitability. Both these factors might account for the rate of growth of corporate profits falling short of the growth in GDP, resulting in a low base-to-GDP elasticity for the corporate income tax.

State enterprises often receive substantial tax exemptions or lenient arrangements with the tax authorities. Thus, not all growth in net operating profits of public enterprises would be captured in the tax net because of their tax exempt status. Similarly, typically the manufacturing sector is the recipient of substantial tax incentives. National investment boards often grant incentive packages for the growth-oriented segments of the manufacturing sector. Again, the encouragement of infant capital markets through stock exchanges and the like might call for reduced tax rates for dividends of registered firms. Thus a large part of the sector which leads in GDP growth and is organized in the corporate form stays out of the corporate tax net. It may be unrealistic to expect a substantial reduction in the role of tax incentives if the manufacturing sector or financial markets are considered to need higher encouragement compared to other economic act ivity.

Other factors also influence the collection of the corporate tax adversely. For example, while features in the tax structure that reduce double taxation may have merit, they tend to reduce revenue. Also, small companies are difficult to tax. Usually, a small number of companies tend to report taxable profits and account for a substantial portion of corporate tax revenue. These are grounds for expecting the tax-to-base elasticity of the corporate income tax to be low. In combination, the above reasons account, possibly somewhat unexpectedly, for a low corporate tax elasticity in the sample Asian economies. Further, if these factors should be growing in their power to influence, the elasticity of the corporate income tax, if estimated over different time periods, could even be anticipated to fall over time.

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3.3 Domestic consumption taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES

3.3 Domestic consumption taxes

Developing country tax systems depend heavily on domestic consumption taxes, namely, excise duties and various forms of the sales tax. A substantial portion of excise revenue is usually derived from three sources: petroleum, cigarettes, and alcoholic beverages. The consumption of tobacco and alcoholic beverages is inherently inelastic in relation to income growth; conscious of their health effects, the authorities frequently tend to curb their consumption further by using campaigns and extremely high tax rates. But, developing countries have tended to subsidize domestic petroleum prices to significantly below international prices. Ad valorem or not, typically the tax rates are levied on artificial prices at the manufacturer stage. The list of prices is issued by the tax authorities with little observable relation or a slow adjustment to the associated price indices. Petroleum consumption can be income elastic but continuing energy conservation measures have tended to contain the growth of revenue from this source. The resulting changes in the patterns of smoking and drinking habits as well as of petroleum consumption would lower the growth of the base of these major excisable products.

In the break-up of the overall elasticity into tax-to-base elasticity and base-to-GDP elasticity, the latter, in general, may be expected to be around unity, indicating that the consumption of these items might grow in proportion to GDP since, as the economy grows, the consumption of excisable items would tend to grow in tandem.8 Yet, in spite of the growth in the theoretical base, ie, consumption, the long lags in adjusting tax rates to the price index will often result in the tax-to-base elasticity to be very low. Together, it is not unusual for excise taxes to be inelastic on the whole.

The sales tax, in whatever form, or up to whichever stage, usually exempts unprocessed foods and basic necessities and, in developing countries, the share of these items in total consumption is likely to decline in the long term. This should make the sales tax revenue elastic. However, one hindrance to the lack of growth in the sales tax base is the predominance of small traders. Their total contribution to sales may be high but their sales may be low on an individual basis, requiring them to be taxed on a presumptive basis. Presumptive taxation tends to lag behind the rate of inflation for a variety of reasons because it depends heavily on discretionary decision-making for necessary modifications in its structure.9

8 This might happen even if the overall marginal propensity to consume is lower than unity, if sufficient shifting occurs from the consumption of basic items toward manufactured goods subject to excises. 9 Presumption also leads property tax assessment to fall behind the inflation rate, often leading to sharp reductions in its base.

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3.4 Import duties P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. EXPLAINING LOW ELASTICITY OF TAX STRUCTURES

3.4 Import duties

Developing countries depend heavily on import duties for tax revenue. The rate of growth of the revenue from import duties is partly affected by the structure of tariffs and partly by the industrial strategy of the country. First, intermediate and capital goods as well as raw materials are usually taxed at lower rates than are final goods. As the share of the manufacturing sector in GDP increases, the share of imports of intermediate goods vis--vis the imports of finished products would tend to increase. This would be the case especially if the growing manufacturing sector is primarily dependent on imported capital and intermediate goods which is quite likely to be the case. Thus, the share of lower-rated to higher-rated imports goes up and this reduces the growth rate of import duty revenues. Second, if the manufacturing sector and the public sector - especially state enterprises - expand and they enjoy exemptions from import duties, as is likely, the share of exempt imports in total imports grows. Thus, as industrialization progresses, the built-in elasticity of import duty revenue declines. Finally, as the countries promote export oriented growth, more of the commodity taxes - both domestic and imports - have to be refunded to export oriented firms. This erosion from potential tax revenue caused by duty drawback systems is exacerbated since duty drawback is usually based not on act ual duty paid but on sector-wise formulae for duty drawbacks which are used for administrative convenience.

Discretionary measures also tend to affect the import tax base. Occasionally, import duty application shifts from ad valorem toward specific basis, in pursuit of greater administrative simplicity. Also, as industries mature, the rates of nominal protection are frequently reduced over time, which reduces the growth rate of import duty revenues. Finally, it is not uncommon to use artificial exchange rates for import duty valuation which further reduces potential revenue. There is, therefore, a number of impediments that stand in the way of a naturally growing revenue base from imports. The role of customs duties is considered in detail elsewhere in this Compendium.

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4. IMPROVING TAX ELASTICITY P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS

4. IMPROVING TAX ELASTICITY

Despite the various limitations to increasing the elasticity of developing country tax systems, it is obvious that any improvement in tax elasticity would have to come from a sustained expansion of the tax base. This would entail an expansion of coverage, a regular adjustment in the tax rates reflecting inflation, possibly a conversion from specific to ad valorem rates wherever feasible, as well as a reasonable degree of progressivity in the system as a whole.

To achieve elasticity gains for individual taxes, certain methods may be employed. For the corporate income tax, coverage is difficult to expand since traditional small scale sectors remain excluded for all practical purposes until major structural changes take place in the economy. The individual income tax structure could be made more progressive but this would go against prevalent thinking regarding disincentive effects of income taxes. The solution, therefore, lies in speedily minimizing, if not getting rid of, various exemptions, allowances, and deductions that tend to creep into the income tax to meet competing objectives. The ideal would be to have as broad a base with as few special considerations built into the structure as possible. Another solution would be to improve collection techniques. This could be achieved through reducing collection lags by making taxable units file returns more often, and increasing the use of the withholding mechanism - not only for wages and salaries, but also for interest income - and of presumptive taxation, for example, for the self-employed and professionals, and for those below a certain threshold income level.

For taxes on goods and services, the need for the improvement of elasticity is even more important given, first, their usually lower elasticity than for income taxes and, second, the fact that in developing countries, reliance on taxes on goods and services tends to be greater than on income taxes. Again, here, broad coverage of a general sales tax is important. Even while basic consumption items may need to be excluded, all possible non-basic items have to be included in the base. Also, the closer to the retail level ie, as downstream a stage as possible in the production- distribution chain that can be brought under taxation, the wider is the scope of the tax base that is covered. Thus, while broad-based sales taxes such as the value added tax have tended to be introduced initially only up to the manufacturer-importer stage in Asian economies such as India, taxation has to extend as quickly as possible to the wholesaler-retailer stage. Finally, prudent use of differentiated rates has to be made through the excise system in order to fetch more revenue from products whose demand exhibits high income elasticity or low price elasticity. It is more difficult to improve the elasticity of import duties since their rates should be linked more to industrial strategies than to revenue productivity. In fact, even where revenue from import duties may currently dominate total revenue collection, the objective in the medium term has to be to reduce reliance on this source.

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5. CONCLUSIONS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS

5. CONCLUSIONS

In the sample Asian economies, as in a typical developing country, the strategy of growth including the choice of the leading sectors, the structure of production, the role of the public sector, especially state enterprises, the pattern of consumption, the organization of the services sector with its preponderance of small traders, and the political realities that force tax policymakers and administrators to compromise, combine to limit the elasticity of the tax system. While all possible measures to improve the revenue elasticity of different taxes have to be taken if governments are to meet growing social, infrastructural, and developmental expenditures without resorting to significant deficit financing, it is perhaps impractical to expect sudden or large improvements in revenue elasticity.

Despite the above limitations, improvements in the elasticities of tax systems may be made through sustained expansions in coverage, judicious use of differentiated rates, regular adjustments for inflation, minimization of collection lags, and increased utilization of withholding as well as presumptive taxation. Such improvements can be successfully introduced provided the authorities possess the resolve to do so. Countries themselves have to recognize that, without such basic improvements, the underlying elasticities of the tax structures would remain low and that annual discretionary revenue measures would not be sufficient to generate the needed overall revenue. This is borne out clearly through the experiences of many developing countries that fail to meet their revenue targets. It is heartening to note that many of them have been carrying out significant reforms in their respective tax systems, with equity, efficiency, simplicity and revenue productivity as the central objectives.

Annexure Table

Method of elasticity calculations

Page 2 of 2 5. CONCLUSIONS

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.4 ON THE ELASTICITY OF DEVELOPING COUNTRY TAX SYSTEMS

REFERENCES

Bagchi, Amaresh, and M Govinda Rao, 1982, ‘Elasticity of Non-Corporate Income Tax in India,’ Economic and Political Weekly, Vol 17, pp 1452-58, September.

Chakraborty, Baidyanath, 1981, ‘Corporate Income Tax-Its Trend and Elasticity,’ Indian Economic Journal, Vol 28, pp 70-84, April/June.

Chand, SK, 1975 ‘Tax Revenue Forecasting: An Approach Applied to Malaysia,’ International Monetary Fund, DM/75/24 (unpublished).

Choudhry, NN, 1975, ‘A Study of the Elasticity of the West Malaysian Income Tax System, 1961-70,’ Staff Papers, International Monetary Fund, Vol 22, pp 494-509, July.

Dahal, MK, 1984, ‘Built-in Flexibility and Sensitivity of the Tax Yields in Nepal’s Tax System: A Case of Negative Elasticity of Land Tax,’ Economic Journal of Nepal, Vol 7, pp 1-31, April/June.

Gillani, SF, 1984, ‘Elasticity and Buoyancy of Federal Taxes in Pakistan,’ Pakistan Institute of Development Economics, Research Report Series, No. 141, pp 1-15, December.

Prest, AR, 1962, ‘The Sensitivity of the Yield of Personal Income Tax in the United Kingdom,’ Economic Journal, Vol 72, pp 576-96, September.

Subrahmanyam, Ganti, 1983, ‘Some Implications of the Popular Approach to Tax Elasticity Estimates,’ Quarterly Journal of the National Council of Applied Economic Research, Vol 16, pp 30-36, October.

Sury, MM, 1985, ‘Buoyancy and Elasticity of Union Excise Revenue in India: 1950-51 to 1980-81,’ Margin, Vol 18, pp 40-68, October.

Tanzi, V, 1987, ‘The Role of the Public Sector in the Market Economies of Asia,’ Asian Development Review, Vol 5, No. 2.

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CHAPTER I.5 TRENDS AND FUTURE DIRECTIONS IN TAX POLICY REFORM: A LATIN AMERICAN PERSPECTIVE P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > I. Overview > CHAPTER I.5 TRENDS AND FUTURE DIRECTIONS IN TAX POLICY REFORM: A LATIN AMERICAN PERSPECTIVE

CHAPTER I.5 TRENDS AND FUTURE DIRECTIONS IN TAX POLICY REFORM: A LATIN AMERICAN PERSPECTIVE1

1 Speech delivered at the annual Centre for Inter-American Tax Administrations (CIAT) Conference, Montego Bay, Jamaica, June 15-19, 1992. Amidst the many challenges to formulating effective tax policy in developing economies, one region represented by middle income economies, Latin America, was more successful in introducing dynamic concepts and applications in tax reform. Pertaining to that experience in the 1980s, this chapter is excerpted from Parthasarathi Shome, ‘Trends and Future Directions in Tax Policy Reform: A Latin American Perspective’, International Monetary Fund Working Paper, WP/92/43, June 1992. Permission was sought from and granted by International Monetary Fund, Washington DC, to reprint.

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1. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

1. INTRODUCTION

Latin America has been the crucible of new concepts in taxation and of tax reform over the decades. Some ideas have been path breaking while others distortionary. It appears that new administrations have entered with fresh thoughts and that the presidential system of government in the continent has not only enabled experimentation but has also facilitated enactment. The 1980s were a decade that was dynamic in this respect. With this in view, this chapter reviews the Latin American experience with tax reform during the 1980s. It also discusses selected tax reform issues that were anticipated to be in the forefront of Latin American debate and discussion during the following decade.

Fundamental tax reform can take several years to be fully implemented, and it effectively constitutes an aggregation of many annual discretionary changes. On the whole, tax reform in the 1980s de-emphasized steeply progressive rate structures of income and property taxes that were conceptually optimal from the point of view of equity and stabilization objectives but were difficult to administer. It emphasized, instead, broadly based, low-rate taxes on domestic consumption, such as the value added tax (VAT), for their administrative ease based on a self-monitoring feature, as well as for their ability to raise revenue (as seen in terms of their ratios to GDP).

Between 1980 and 1991, the number of Latin American countries that operated a VAT increased to 15 from 8; they usually supplemented the VAT with a list of excisable items. The top marginal personal income tax rate in these countries fell from 48 per cent on average to 35 per cent. The average exemption level increased from about half of per capita GDP to one and a half times per capita GDP. The average corporate income tax rate fell to 36 per cent from 44 per cent, even though many countries continued to maintain progressive rate structures. The top marginal personal income tax rate approached the corporate income tax rate. Withholding taxes on foreign companies fell, on average, to 11 per cent from 17 per cent.

Thus, there was a widely held view that tax reform efforts in the 1980s established certain new trends that included: (1) changes in the relative use of different taxes, specifically greater dependence on the value-added type taxes; (2) reduction of individual and corporate income tax rates pari passu with an effort to expand their bases; (3) a more neutral approach to the taxation of capital - including the treatment of debt and equity financing; and (4) changes in the structures of taxes on personal income and corporate income to render the decision to retain or distribute profits tax neutral. These propositions, together with other experiences in tax policy during the 1980s decade, will be discussed in Section 1 of this chapter as a backdrop to specific issues in tax reform that became important during the 1990s.

The tax-to-GDP ratio across countries increased by 1 percentage point, on average, since the 1980s. However, tax reform is not always carried out with a revenue objective nor does it necessarily push a country to a significantly higher tax-to-GDP ratio. Similarly, a country with a high tax burden does not always represent one that has undertaken fundamental tax reform. Nevertheless, countries that have undertaken tax reform have, in general, experienced a greater revenue gain in terms of GDP than the overall sample of countries. Consumption tax revenue increased in terms of GDP in reforming countries, while income and social security taxes remained stagnant. Reliance on international trade taxes declined slightly - with wide variations across countries - while property tax revenue remained insignificant.

The main reforms of the 1980s left some obvious gaps in their scope and coverage, with concomitant revenue implications. For example, the movement away from heavy reliance on income taxes, albeit resulting from a sluggishness in direct tax revenue, made tax policy experts think increasingly of a minimum income tax contribution

Page 2 of 2 1. INTRODUCTION by taxpayers. Such a contribution could take the form of a low-rate tax on gross assets, net worth, physical assets, or gross receipts. Second, there was the belief by a considerable number of tax economists that the typical corporate tax structure - with the inclusion of inflation adjustment, incentives, and other factors - had become rather complicated; that its base bore little resemblance to income; and that it resulted in distortionary economic effects. Therefore, corporate taxation should be simplified by substituting the profits tax with a tax on the cash-flow of enterprises. Third, there was a continuing difficulty in including the financial sector in the taxable base, whether by income tax or value added tax (VAT) and economists perceived an implied need for taxing this sector through some other means. Fourth, the virtual failure to tax property gave rise to a growing awareness that greater effort must be made to tax property if the devolution of fiscal responsibility to lower levels of government was to be considered a matter of importance, and if the traditional assignment of the taxation of property to those levels of government were to remain in place. Fifth, as environmental awareness increased across the world, taxes with the objective of preservation of the environment should assume importance. Sixth, experience increasingly demonstrated that there was an increasing interdependence between tax policy and tax administration. Withholding as an administrative mechanism should be better able to bring different sources of income into the tax net than a theoretically well- defined but impractical global income tax structure based on a compulsory - but not administrable - declarations method. Seventh, as regional tax harmonization proceeded in Europe, North America, and the newly founded Commonwealth of Independent States (CIS) of the ex-Soviet Union, Latin American countries also considered tax harmonization and international compatibility of direct tax structures - and even overall tax structures - as an issue to be reckoned with. These comprised selected tax policy concerns - some shared with developed countries (eg, taxation of the financial sector) and some with developing countries (eg, increasing use of withholding) - that affected many middle-income Latin American countries during the 1990s.

In the 1990s, Latin America continued to debate a minimum income tax; alternative forms of corporate taxation, such as a cash-flow tax or an assets tax; ways of capturing bases that are difficult to tax, such as financial intermediation and property; environmentally oriented taxes; the extension of withholding as a taxing mechanism; and tax harmonization across countries. In what follows, the main tax reforms undertaken in the 1980s resulting in perceptible trends are covered in Section 2. Possible directions for Latin American tax reform that were anticipated for the 1990s are the focus of discussion in Section 3.2 Section 4 provides a brief summary and concluding remarks.

2 In addition, the 1990s addressed selected continuing concerns of the 1980s. These included: the restructuring of customs tariffs to reduce protection and improve international competitiveness of traded goods; the restructuring of social security systems (including taxes) to match revenues with an increasingly heavy benefits burden; and the need for caution to ensure that the tax system was not riddled with multiple objectives such as redistribution, differential regional or sectoral development, and the like.

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2. TAX POLICY TRENDS OF THE 1980s P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. TAX POLICY TRENDS OF THE 1980s

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2.1 The choice of particular taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. TAX POLICY TRENDS OF THE 1980s

2.1 The choice of particular taxes

Two factors seem to have affected the choice of particular taxes as the major revenue generators during the 1980s. First, a growing conservative attitude reflected through a position opposing high levels and steeply progressive rate structures of taxes helped move the emphasis from income taxes to consumption-based taxes. Tanzi (1988), for example, points out, ‘While the present conservative trend has slowed down the growth in the level of taxation in many countries, ...[it] has had a greater impact on the structure of tax systems than on the levels of taxation’ (p 271). The Latin American experience examined in the next section could be significantly explained by this observation.

Second, practical and structural constraints that operated with respect to particular taxes had an effect on the choice of taxes that were given an important (or less important) role in the reform process.3 The diminution in the roles of the personal and corporate income taxes can be seen in this light. In the case of the personal income tax, reformers have found it difficult to tax adequately those sources of income other than wages and salaries. As far as the latter are concerned, their growth is likely to be constrained to below the inflation rate, for example, during periods when a country has embarked on a stabilization program comprising demand management policies. Thus, the base of the tax cannot be expected to grow with gross domestic product (GDP) because of the stance of macroeconomic policy. Also, in the case of the personal income tax, personal and family allowances, and the spectrum of exemptions and deductions for education, life insurance, provident fund and savings, mortgage interest, charity, medical expenses, and the like, are subject to political decisions, and often result in adjustments higher than the consumer price index (CPI). Such measures might admittedly be taken to provide incentives at the top and equity at the bottom, but they certainly have a negative influence on revenue. In addition, growing difficulties with tax administration as economies have become more complex and factors of production more mobile, have increasingly tended to move the 1980s tax reform experience away from focusing on the personal income tax.

Raising corporate income tax revenue can also face several constraints. A progressive corporate income tax structure has little conceptual basis and, if imposed at high levels, is likely not to be internationally competitive. In a developing country, in particular, the manufacturing sector is often the leading growth sector which receives various and substantial tax incentives. Significant portions of the public corporate sector may fail to generate taxable profits. The encouragement of infant capital markets might call for reduced tax rates for retained profits and dividends of registered firms. Nationalized segments of the corporate financial sector may operate with other than pure efficiency or profit objectives. These factors, even while resulting in the rate of growth of corporate profits to fall short of GDP growth, are unlikely to be reconsidered or modified by the legislature solely with the objective of revenue generation in mind. Finally, a high proportion of corporate tax revenue has historically been collected from a relatively small number of companies. Even as the incomes of companies increase, revenue from the increased tax base does not necessarily increase at the same rate. The cause could be legal means of tax avoidance, reflecting the ability of larger firms to use transfer pricing mechanisms, to make more advantageous use of tax incentive laws, or postponement of tax payment.

Historically, developing countries depended heavily on international trade taxes for tax revenue. The rate of growth of revenue from import duties is partly affected by the structure of tariffs and partly by the industrial strategy of the country. As the share of manufacturing in GDP increases, the ratio of imports of intermediate goods to those of finished products tends to increase. As a result, the share of lower-rated to higher-rated imports goes up, arresting

Page 2 of 2 2.1 The choice of particular taxes the growth of import duty revenues. As industries have matured, discretionary act ion reducing the rates of nominal protection has been introduced in many countries. These and other factors have tended to narrow the reliance on international trade taxes during the 1980s in many jurisdictions, even though some continue to rely on customs duties as a relatively easily administrable source of revenue.

The taxes that have comprised the major focus of attention as a revenue source are those on domestic consumption of goods and services, namely value-added type taxes, coupled with selected excises. Experience has demonstrated that they are relatively easy to administer since the VAT is, to a great extent, ‘self-monitoring;’ also, a production-based excise system could be based on simple administrative mechanisms. In practical terms, their elasticities4 can also be high despite their structures not being based on progressive rates. For example, the consumption of, and therefore revenue from, excisable items such as petroleum and beverages, could be expected to grow faster than GDP if the tax rates are ad valorem. Also, if the VAT exempts unprocessed foods and basic necessities, its elasticity should be high. Under the VAT, because the credit principle - tax paid on output is net of the taxes paid on inputs - operates, there is less likelihood of tax evasion and avoidance (except at the last ie, retail, stage). Elastic or not, administrative feasibility, revenue productivity, and the hope of lowering economic distortions have rendered domestic consumption taxes a mainstay of tax reform in much of the cross-country tax reform experience of the 1980s.

3 For a qualitative assessment of tax reform in Argentina, Bolivia, Colombia, and Mexico, see Bird (1992). 4 Elasticity of a tax can be defined as its automatic revenue response to GDP growth and, especially, to growth in economic activity in particular sectors. See Chapter I.4 of the Compendium.

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2.2 Trends in legislative changes in tax policy P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. TAX POLICY TRENDS OF THE 1980s

2.2 Trends in legislative changes in tax policy

How are the above discussed premises reflected in the act ual tax reform experience of the 1980s? In this section a summary of the major tax policy changes of the 1980s is presented with a focus on Latin America.

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2.2.1 Personal income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. TAX POLICY TRENDS OF THE 1980s

2.2 Trends in legislative changes in tax policy

2.2.1 Personal income tax

In the 1980s, there was a clear tendency toward lower rates of taxation on the individual. Taking a representative sample of 18 Latin American countries for 1979-80 and 1990-91, it is apparent that they undertook reforms that resulted in lower marginal tax rates for the upper income brackets (Table 1). Some of the reforms may have been inspired by the objective of reducing disincentive effects of the high tax rates. Others may have been inspired by more practical considerations of reducing the incentives to tax evasion. It is also perhaps true that tax reform in the United States and Canada provided some guidance to that in Latin America. In 1979 the simple average of the high-income marginal tax rates was 48 per cent. By 1991, the rate had reduced to 35 per cent.

Most countries abandoned complex tax schedules with a great number of tax rates, in favor of a small number of tax brackets. This was the case of Argentina, Brazil, Costa Rica, Ecuador, Mexico, Peru, and Venezuela. Bolivia reformed its personal income tax rate to the most simple scheme: just a flat rate of 10 per cent.5 Only three countries had marginal tax rates of over 50 per cent for personal income in 1991: Dominican Republic, Mexico and Panama. In these three cases, the tax structure remained almost the same as in 1979. All countries that reformed the personal income tax during the 1980s scaled back the overall structure of rates. On average, the high marginal income tax rate of the personal income tax tended to approach the corporate income tax rate which is discussed below.

Table 1

Personal income tax: Rates, 1979 and 1991

(per cent of taxable income)

Country 1979 1991* Argentina 7-45 6-30

Bolivia 7-48 10% flat rate

Brazil 5-55 10-25

Chile 3.5-60 5-50

Colombia 10-56 5-30

Costa Rica 5-50 10-25

Dominican Republic 5-72 3-70

Page 2 of 8 2.2.1 Personal income tax

Country 1979 1991* Ecuador 10-50 10-25

El Salvador 10-60 10-50

Guatemala 40.75-58 4-34

Honduras 3-40 9-40

Mexico 3-55 3-35

Nicaragua 6-50 6-60

Panama 2.5-56 3.5-56

Paraguay Exempt 5-30

Peru 5-56 8-37

Uruguay Exempt Exempt

Venezuela 4.5-45 10-30

Simple average 7.1-48.1 6.5-35.4

Source: Secondary, published sources such as publications of tax summaries by Price Waterhouse, Coopers and Lybrand, International Bureau of Fiscal Documentation, International Financial Statistics (IFS) of the IMF, and other similar sources.

* Most represent 1990 laws. As such, they were applicable to 1991 incomes.

There was a tendency for the personal exemption level to rise (Table 2). Between 1979 and 1991, the average exemption level rose from less than half of per capita GDP to greater than one and a half times per capita GDP. On the other hand, the upper income bracket went down: during the same period, the average upper income bracket fell from about 110 times per capita GDP to about 89 times per capita GDP.

Table 2

Personal income tax: Exemption level and upper income bracket, 1979 and 1991

(multiples of per capita GDP)

Page 3 of 8 2.2.1 Personal income tax

2.2.2 Corporate income tax

During the 1980s, many Latin American countries reduced the corporate income tax rate. The simple average of tax rates diminished from about 44 per cent in 1980 to 36 per cent in 1991 (Table 3). Of the 18 countries in the sample, 8 countries reduced the corporate tax rate between 1980 and 1991, 5 countries increased the tax rate (though the increases were small), one country replaced the corporate income tax by a net worth tax, and the rest maintained the tax rates. In 1980, most sample countries had progressive corporate income tax rates. Of the sample, 11 countries had progressive tax rates and 7 countries had uniform rates in 1980. This proportion remained essentially the same in 1991 despite the realization that a uniform rate is easier to control than a progressive rate. However, the number of tax rates appeared to decline.

Table 3

Corporate income tax: Rates and structure, 1980 and 1991

(per cent of taxable profits)

Country 1980 1991 Argentina 33 20

Page 4 of 8 2.2.1 Personal income tax

Country 1980 1991 Bolivia 30 1/

Brazil 35 42.95-51.7

Chile 48.57 15

Colombia 40 30

Costa Rica 5-45 30

Dominican Republic 15-43 12.3-49.4

Ecuador 20 25-36

El Salvador 15.5-43 10-30

Guatemala 33.8-52.8 12-34

Honduras 3-40 15-40.3

Mexico 5-42 35

Nicaragua 6-50 40-50

Panama 20-50 20-50

Paraguay 25-30 25-35

Peru 20-55 30

Uruguay 25 30

Venezuela 18-50 15-50

Simple average 2/ 43.5 36.3

1/ Bolivia replaced the corporate income tax by a 3 per cent tax on net worth.

2/ For countries having progressive rates, the upper tax rate was used.

The treatment of capital gains also did not change in that 11 countries (though not the same ones) continued to treat capital gains as normal profits within the overall corporate tax structure (Table 4). The number of countries that exempted capital gains or taxed them at lower rates, likewise, continued to be similar. However, some changes in particular countries, of course, took place. For example, Bolivia and Costa Rica changed capital gains treatment from normal taxation to exemption. Others, like Argentina and Ecuador, switched in the opposite direction: from taxation of capital gains at reduced rates toward taxation as normal profits.

Table 4

Treatment of capital gains, 1980 and 1991

(per cent of capital gains)

Country 1980 1991

Page 5 of 8 2.2.1 Personal income tax

Country 1980 1991 Argentina 151/ Normal2/

Bolivia Normal Exempt

Brazil Normal Normal

Chile Normal Normal

Colombia Normal Normal

Costa Rica Normal Exempt

Dominican Republic Exempt Exempt

Ecuador 81/ Normal

El Salvador 6.8-21.51/ 5-151/

Guatemala Normal Normal

Honduras Normal Normal

Mexico Normal Normal

Nicaragua Exempt 1-151/

Panama 2% of price 2% of price

Paraguay 51/ 51/

Peru Normal Normal

Uruguay Normal Normal

Venezuela Normal Normal

1/ Less than normal corporate tax rate.

2/ ‘Normal’ throughout the table indicates that the prevailing income tax rate was applicable.

There was a slow yet steady movement toward requiring a minimum contribution toward the corporate income tax. A few of the countries in the sample introduced a minimum contribution requirement (Table 5). Argentina and Mexico calculated this minimum contribution as a percentage of gross assets. Other countries, such as Colombia, calculated the minimum contribution as a percentage of net worth. Bolivia completely replaced the corporate income tax by a tax on net worth. Some countries like Ecuador, El Salvador, and Uruguay had a tax on net worth or assets but not necessarily as a minimum contribution to the corporate tax. Others such as Costa Rica or Paraguay legislated taxes on fixed assets or real estate6 in addition to normal income taxes.

Table 5

Net worth or assets tax, 1980 and 1991

(in per cent)

Page 6 of 8 2.2.1 Personal income tax

In sum, in 1991, 3 countries out of 18 sample countries had a gross assets or net worth tax that was used as a minimum corporate tax, while 9 countries had some type of tax on assets or net worth that was applicable in addition to the normal corporate income tax. One country (Bolivia) replaced its corporate income tax by a net worth tax. Five countries did not have this kind of tax.

Most sample countries continued to apply withholding taxes on foreign remittances. Within the context of the host country, such withholding should not necessarily represent an additional tax burden on the foreign investor vis--vis the domestic investor if the host country has a ‘classical’ system in which no deduction is allowed for dividends from the personal income tax, that is, there is double taxation. However, looking at the problem from the point of view of the foreign investor and his tax liabilities in the home country, if there are tax treaties between the home and host countries, or if the host country’s withholding tax rate is higher than the foreign investor’s average tax rate at home, the withholding tax is likely to affect the investor’s decision to invest in the host country. Although the average

Page 7 of 8 2.2.1 Personal income tax withholding tax rate diminished over the years for the sample, the withholding tax was still prevalent.7 Normally, this tax was collected at the point of remittance. In 1980, the average tax surcharge on remittances was 16.6 per cent (Table 6). The high-tax countries were Argentina and Bolivia, with rates of 28.5 per cent and 30 per cent, respectively. On the other end of the spectrum, only 3 countries out of 18 - El Salvador, Nicaragua, and Panama - treated foreign investors the same as domestic investors. In 1991, the simple average tax on foreign remittances had fallen to 10.6 per cent. The high rates were around 20 per cent, with Argentina, Colombia, the Dominican Republic, and Venezuela applying them. The number of countries that treated foreign capital the same way as domestic capital increased from 3 to 6.

Table 6

Withholding taxes on foreign remittances, 1980 and 1991

(per cent of remittances)

Country 1980 1991 Argentina 28.5 20

Bolivia 30 -

Brazil 25 17

Chile 7.4 -

Colombia 20 19

Costa Rica 15 15

Dominican Republic 21 21

Ecuador 25 -

El Salvador - 11.4

Guatemala 10 12.5

Honduras 15 15

Mexico 21 -

Nicaragua - 20

Panama - -

Paraguay 10 10

Peru 30 10

Uruguay 20 -

Venezuela 20 20

Simple average 16.6 10.6

Page 8 of 8 2.2.1 Personal income tax

5 In effect, the Bolivian tax was not an income tax, but a tax on savings since the tax-payer could deduct all VAT paid (on consumption items) against this tax. 6 As opposed to a municipal property tax. 7 For a comprehensive treatment of the effect of tax policy on foreign investment, see Tax Policy Division, IMF (1990).

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2.2.3 Value-added type taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. TAX POLICY TRENDS OF THE 1980s

2.2 Trends in legislative changes in tax policy

2.2.3 Value-added type taxes

There was a clear tendency among Latin American countries to adopt a VAT. In 1980, 8 of the 18 countries in the sample had some form of VAT based on the credit principle (Table 7). In 1991, 15 countries had legislated a VAT. Countries such as Bolivia, Ecuador, Guatemala, and Nicaragua switched from a sales tax to a VAT. Other countries which had previously no sales tax, such as the Dominican Republic and Panama, introduced a VAT-type tax with some form of credit mechanism. El Salvador, had also sent VAT legislation to Congress, its parliament.

Of the 15 countries that had a VAT in 1991, 9 had a uniform tax rate. A uniform VAT rate is easier to administer than a multiple-rate structure. Other countries such as Brazil, Colombia, Honduras, Mexico, Nicaragua, Paraguay, and Uruguay attempted to use the VAT for objectives other than revenue raising, such as for income redistribution or regional development. For this, they used multiple tax rates. Typically, food and essentials were taxed at low rates or at a zero rate; normal goods were taxed at an intermediate ‘general’ rate; and luxuries were taxed at a higher rate. Also commodities destined for backward or border areas were taxed at a lower rate in selected countries. Compared to a uniform rate VAT, a multiple tax rate has higher monitoring costs and possibly leads to the loss of some tax revenue because of greater administrative difficulties.

Table 7

Taxes on domestic consumption: Rates, 1980 and 1991

(per cent of tax base)

Page 2 of 3 2.2.3 Value-added type taxes

Reform was also undertaken to broaden the VAT base, in order to raise the tax’s revenue-raising capacity, since many of the older VAT systems suffered significant base erosion over the years. Success in this respect depends on political will, but it would not be wrong to generalize that the VAT was increasingly used as a revenue raiser across Latin America through continuing attempts to broaden the base. The VAT base was, in general, complemented with a few excises, typically on gasoline and other petroleum products, tobacco products, alcoholic as well as non-alcoholic beverages, automobiles, and gambling. Some countries, however, continued to have a longer list of excisable items.

Before concluding this section, it may be worthwhile drawing the reader’s attention to Bolivia, the country that clearly stands out as having achieved a major simplification of the tax structure during the 1980s. It removed the exemption level from the personal income tax and imposed a flat 10 per cent tax. It abolished the corporate income tax, replacing it with a 3 per cent net worth tax8. Foreign enterprises were treated the same way as domestic enterprises for tax purposes. The capital gains tax was abolished. A flat 10 per cent VAT was introduced.

Page 3 of 3 2.2.3 Value-added type taxes

8 The debate over the efficacy of completely removing a tax based on corporate income is not yet over among tax economists, while a minimum contribution calculated on some other base is encouraged. More will be discussed on this topic in the next section.

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2.3 Performance in terms of tax-to-GDP ratios P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. TAX POLICY TRENDS OF THE 1980s

2.3 Performance in terms of tax-to-GDP ratios

Table 8 presents tax-to-GDP ratios of general (or, where not available, Central) Government for the sample countries.9 If the countries are grouped into high-tax (around 20 per cent tax-to-GDP ratio and above), low-tax (around 10 per cent and below), and medium-tax countries (10-20 per cent range), the sample is about equally divided. During the 1980s, there were six high tax ratio countries: Argentina, Brazil, Chile, Costa Rica, Jamaica, and Uruguay; and five low tax ratio countries: Bolivia, Guatemala, Nicaragua, Paraguay, and Peru. The remaining six countries have tax ratios within the 10-20 per cent range: Colombia, the Dominican Republic, Ecuador, Mexico, Panama, and Venezuela.10

Exclusive examination and comparisons of tax-to-GDP ratios is not enough, however, to draw conclusions on the nature of revenue performance. Some countries underwent significant changes in their tax ratios. For example, with a simplification of the tax structure and a significant fall in inflation, Bolivia almost doubled its tax ratio, but it still remained among the countries with the lowest tax ratios. On the other hand, Chile’s tax ratio fell slightly, reflecting, mainly, a shift of a major segment of the public social security system to the private sector; and to some extent, a reduction in the VAT rate from 20 per cent to 18 per cent. Yet it remains in the high tax ratio group. Two countries - Nicaragua and Peru - fell from the high to the low tax ratio group reflecting major structural economic policy changes. In general, however, countries tended to remain within their own groupings.

Tax reform is not necessarily carried out with a revenue objective. Tax does not necessarily push a country to the high tax ratio group. Nor does a country with a high tax burden reflect that it is the result of fundamental tax reform. Various types of experiences emerged. For example, Colombia, Ecuador, and Mexico experimented with tax reform; their tax-to-GDP ratios remained within the medium range. Argentina, Brazil, and Costa Rica debated tax reform, especially since the mid-1980s. They were able to introduce only partial reform, in small steps, rather than any wide-ranging fundamental tax reform. Yet, over the decade, their tax ratios have remained in the high range. Finally, Bolivia, which simplified its tax structure considerably, remained within the low range. Nevertheless, a common experience of all the countries that attempted to reform their tax structures was that their tax-to-GDP ratios increased by 2-4 percentage points, usually maintaining them within their overall band of tax ratios.11 The revenue impact, just as the reform measures themselves, took hold relatively slowly over time.

Comparisons regarding changes in the tax ratio, as well as of its distribution among different taxes, are of some relevance to assess the impact of a tax reform process. Leaving out Nicaragua and Peru, whose declines in tax-to- GDP ratios over the decade could be interpreted as exogenous; Chile, whose changes mainly reflected social security reform; as well as Venezuela, whose revenue dependence primarily on oil made its experience non- comparable with those of the others in the sample, it is seen that the overall tax-to-GDP ratio increased by 1 percentage point - from about 16 per cent of GDP to about 17 per cent - over the decade. This result pertains to a sample of 13 countries in some of which the ratio increased and, in the others, it decreased. Of course, as indicated above, those countries in which some form of tax reform was in progress experienced greater success in terms of revenue generation.

The shift in emphasis from income and payroll taxes to taxes on goods and services to meet a revenue objective is also verifiable from the sample. Leaving Jamaica out because its trend was markedly opposite,12 reveals that for the remaining 12 countries, the income tax to GDP ratio stagnated at just above 3 per cent, and the ratio of social

Page 2 of 4 2.3 Performance in terms of tax-to-GDP ratios security taxes to GDP just below 3 per cent during the 1980s; while reliance on goods and services taxes increased by almost 1 percentage point from about 5 to 6 per cent of GDP.13 Also interesting is the fact that those countries that introduced or cleaned up their VAT structures, such as Argentina, Bolivia, and Mexico, gained even more.

Finally, the reliance on international trade taxes - mainly customs duties - decreased slightly by less than one-half percentage point of GDP, from 2.7 per cent to 2.3 per cent, reflecting that some countries increased, while others decreased their reliance on trade taxes without, however, any major change in any of the sample countries.14 It is, therefore, interesting to note that no clear pattern seemed to emerge regarding the movement in the tax-to-GDP ratio of trade taxes.

In sum, the following conclusions may be drawn from the movements in tax-to-GDP ratios during the 1980s. (1) The sample countries as a whole increased their tax-to-GDP ratio by about 1 percentage point, while countries that carried out tax reform during the decade experienced a greater increase.15 An important exception was Chile which, while carrying out fundamental tax reform, decreased its VAT rate and transferred much of the social security system to the private sector. (2) There was a shift of emphasis toward taxes on goods and services from direct taxes: while income and social security tax revenue hovered around 3 per cent of GDP, those from goods and services taxes increased by almost 1 per cent of GDP, from 5 to 6 per cent.16(3) The countries that carried out VAT reform were represented by even greater gains in revenue generation from goods and services taxes.17(4) While there was a small - half percentage point of GDP - decline in the trade tax-to-GDP ratio, no clear pattern emerged, some countries having increased, and others decreased, their use of customs duties. (5) A fifth general conclusion might be added: property tax revenue in terms of GDP remained insignificant, usually less than half per cent of GDP.

Table 8

Tax-GDP ratios: Cross-country Comparison

High-tax countries

Table 8

Tax-GDP ratios: Cross-country Comparison

Medium-tax countries

Page 3 of 4 2.3 Performance in terms of tax-to-GDP ratios

Table 8

Tax-GDP ratios: Cross-country Comparison

Low-tax countries

Source: Various international publications, and own calculations.

9 Comparable data for Honduras were not available. 10 Much of Venezuela’s revenue derived from the oil sector. This is included in its high corporate sector revenue, resulting in a high number. 11 Of course, fiscal deficit reduction and public expenditure requirements are major determinants of the increase in tax revenue as a formal objective of tax reform. Accordingly, most tax reform studies undertaken in different countries recommend measures, the revenue outcome of which lies in a similar 2-4 percentage point range. 12 Jamaica’s dependence on income taxes increased while that on goods and services taxes decreased significantly. 13 Even including Jamaica indicates an increase in the dependence on goods and services taxes by a half percentage point of GDP (to 6 per cent), while the income tax to GDP ratio remained stable at just below 4 per cent. The impact of including Jamaica in the sample on the social security tax ratio is negligible. 14 Jamaica moved significantly in the direction opposite to the trend. Including it in the sample resulted in there being no change in the trade tax to GDP ratio during the 1980s for the sample of 13 countries. 15 Chile, Nicaragua, and Peru were excluded from the sample calculations. 16 Jamaica was excluded as mentioned above. Including it reduced the strength of the conclusion, but not the conclusion itself.

Page 4 of 4 2.3 Performance in terms of tax-to-GDP ratios

17 Even for European countries, the introduction of the VAT had a positive impact on the tax ratio. See Nellor (1987).

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3. SELECTED TAX REFORM ISSUES FOR THE 1990s18 P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s18

The introduction and reform (where it already exists) of VAT were a mainstay of tax reform of the 1980s. While selected concerns with the VAT, such as the difficulty in taxing the financial sector, continued, a greater preoccupation was the slipping away of the role of direct taxation even as VAT reform progressed. The design of new features in direct taxation, as well as a practical means of bringing the financial sector into the tax net, remained critical issues for tax reform in the 1990s. Also, focus of the 1990s emanated from the feasibility of administering taxes, rather than from the premise of designing theoretically correct tax structures. Thus, for example, minimum taxes or the withholding of a tax was emphasized as a tax instrument perhaps more so than the concerned tax itself. A discussion of some of these issues is the objective of this section.19

18 For another view of selected tax reform issues for the 1990s, see Bagchi (1991). 19 Khalilzadeh-Shirazi and Shah (1991) provide a slightly different stance on tax policy issues for the 1990s.

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3.1 Minimum contribution to the corporate income tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s18

3.1 Minimum contribution to the corporate income tax

During the 1990s, more countries opted for a tax that would be simple to administer and yet would make a minimum contribution to the corporate tax revenue. Initially, the corporate income tax was mostly being collected from a few large - often foreign - companies. Many companies did not pay income tax. There was a growing feeling among tax experts that all companies should be made to pay a minimum tax. The calculation of the minimum contribution may be based on gross assets, net worth, physical assets, or gross receipts. The tax rate would depend upon the tax base used (as well as the need for revenue, of course).

In Section 1, it was pointed out that three Latin American countries operated a minimum corporate tax while several others had similar taxes additional to the corporate income tax. Mexico was a pioneer in the minimum assets tax and made it applicable also to individuals who were engaged in business and were taxpayers under the income tax. This inclusion was carried out to obviate tax arbitrage.20

Simplicity is an attractive feature of the minimum tax based on gross assets. The income tax law needs to be modified in a straightforward manner by incorporating a feature indicating that tax due cannot be lower than an amount defined by the assets tax criterion; the assets tax could be credited against the income tax. The payment mechanism of the tax is also not complicated. All businesses could pay a percentage of gross assets per year; if the regular income tax calculation falls below this amount, the difference has to be paid. If the income tax is higher or equal to the minimum assets tax, no additional payment is required.

The minimum assets tax base can be defined such that no additional information to the corporate income tax is required. Thus, the base would be: inventories, plus accounts receivables and deposits (ie, financial assets excluding shares), plus fixed assets adjusted for accumulated depreciation (at normal rates) and for inflation, minus liabilities with domestic non-financial companies.21

It may be worthwhile pointing out selected aspects in the design and implementation of the minimum gross assets tax that became apparent with the Mexican experience. In order to stabilize tax revenue through a business cycle, Mexico allowed a complete carry-forward and carry-backward of the income taxes and minimum assets tax for a period of six years.22 Also, all values were inflation adjusted. In order to avoid double taxation, Mexico allowed the value of shares and investments in other firms to be deductible from the tax base. Mexico exempted firms that were liquidating. New business act ivities, mergers, and corporate reorganizations were exempt for two years. There was a strong need for precise regulation. For example, inventory valuation, treatment of losses in accounts receivables, and the general basis for monetary correction needed careful regulation, as did write-offs, amortization, and depreciation allowances.

A minimum tax based on net worth does not have the same revenue-raising capacity as one based on gross assets. In general, firms can reduce their tax liability by increasing their debt-equity ratio. Also, since smaller firms tend to have lower debt-equity ratios, the distribution of tax burdens between small and large firms is biased against small firms in the case of a net worth tax. Perhaps a better tax base is physical or fixed assets.23 However, here too the tax base is narrow and there are significant differences in the ownership of physical assets by type of business. Expanding the base to include all assets reduces the heterogeneity in asset ownership.

Page 2 of 2 3.1 Minimum contribution to the corporate income tax

Finally, given its simplicity of measurement, a minimum tax based on gross receipts has been used more commonly in African countries, while Latin American countries moved in the direction of assets as the base. Perhaps both bases - gross assets and gross receipts - whichever yields the greater revenue, could be used as a design for a minimum tax. Thus the two bases could be combined, and the more appropriate base would be applied to reflect the nature of activity, for example, manufacturing or services.

20 Note that India too has extended its minimum alternate tax (MAT) to cover the non-corporate sector, and calls it the alternate minimum tax (AMT). 21 The financial system is left out of the base, since most financial assets are corporate liabilities which are used to finance corporate gross assets. Taxing the financial sector would, therefore, comprise double taxation. Also, since banks usually have normal profits of 1-1.5 per cent of gross assets, a minimum assets tax of 1.5 per cent would probably represent a higher than 100 per cent tax. In Argentina, however, a similar tax was contemplated that included the financial sector in its base, and would tax 50 per cent of gross assets. Further, inter-company liabilities would not be deductible, implying double taxation. Real estate owned by businesses should be included in the tax base since it should not raise the nominal burden of taxation in these assets (since it would be deductible from the income tax). For a comprehensive discussion and a historical perspective, and appropriate base and rate structure of the gross assets tax as a minimum income tax rather than as a final tax, see Sadka and Tanzi (1992). 22 For details regarding the intricacies of this unique feature in the Mexican tax, see Mclees (1991). 23 Sadka and Tanzi (1992) argued in favor of fixed assets as the taxable base since other assets such as ‘cash balances, accounts receivable, inventories and other current assets are not inherent in the production process, nor do they constitute an integral part of the real economic nature of the firm’s act ivity’ (p 10). 18 For another view of selected tax reform issues for the 1990s, see Bagchi (1991).

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3.2 Cash-flow tax P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s

3.2 Cash-flow tax

Many experts have been of the opinion that the corporate income tax suffers from problems of definition, as well as conceptual confusion, reducing it to a tax that could hardly be called a tax on income. Therefore, a small, yet perhaps expanding, group of tax economists proposed that the basis of corporate taxation - which they felt was in general only linked precariously to income - be switched to its cash-flow. They offered many arguments in favor of the cash-flow tax. Argentina proposed legislation to Congress on a modified cash-flow tax, and other Latin American countries also considered it seriously, in the hope that it would perform better than the income tax whose revenues had remained stagnant. However, the cash-flow tax is also beset with problems, especially those pertaining to tax administration. These must also be considered.24

As a concept, the cash-flow tax is simple. The tax base is real transactions: (all receipts)-(current plus capital expenditures) per period. In contrast, ideally the corporate income tax base should be: (sales receipts from goods and services, financial incomes, and accrued capital gains)-(wages, economic depreciation, inventory costs, and real interest) which is more difficult to measure. In cash-flow taxation, measurement problems essentially disappear since the concept of economic costing is not used; for example, there is no role for capital gains and depreciation as legal concepts.

However, the cash-flow tax is associated with a number of problems, including: an uneven tax profile caused by immediate capital expending; tax arbitrage, through transfer pricing among affiliates; transitional problems as a result of eliminating interest deductions, leading to windfall losses for indebted firms; reflecting the narrow base, its revenue neutral rate being much higher than the corporate income tax rate; and, last but not least, the fact that the cash-flow tax is not creditable against the corporate income tax payable by foreign investors in their home countries, which might make it impractical in the prevailing backdrop of globalized taxation.

24 For a comprehensive coverage, see Mintz and Seade (1991); Abbin, Gordon, and Renfroe (1985); and also the chapter on this tax in this Compendium.

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3.3 Taxation of the financial sector P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s

3.3 Taxation of the financial sector

The financial sector is difficult to tax on conceptual and definitional grounds. Yet, it remains a potentially large tax base that should be captured. Efforts continued to be made for taxing the financial sector adequately. These efforts have been intensified as the financial sector makes increasingly large profits that remain untapped for tax purposes, often reflecting the high dependence of GDP growth on the willingness of the financial sector to make credit adequately available to the productive sector.

The combination of the relaxed financial regulatory structure and the difficulty or unwillingness to tax it adequately result in increased profits of financial institutions. In an inflationary environment, individuals will seek to keep any monetary assets that they decide to hold in shorter maturities and will increase the share of real assets in their portfolios. To achieve the latter objective, individuals will raise their level of borrowing. Short term deposit rates react slowly to rising rates of inflation due to institutional or regulatory reasons, whereas lending rates are often more responsive to market conditions. This widening interest rate, spread between deposit and lending rates, combined with buoyant demand for short term financing enables the financial institutions to earn significant profits. Short term interest-bearing assets of banks might be taxed but, in such an environment, the incidence of the tax could very well fall on depositors rather than on banks. Thus, it is likely to be a poor proxy for the target tax base, namely the rising earnings of financial institutions. Though the need for financial sector taxation during high inflation is clear, an appropriate form of taxation needs to tax earnings rather than deposits. In a low inflation environment, taxing short term interest-bearing assets would result in a shift to longer term deposits. Therefore, while this alternative does not retain much merit, other means of taxing the incomes of the financial sector must be sought.

Apart from the issue of financial sector incomes, there is also the need to tax the consumption of financial services just as any other service is taxed through the VAT. Given the definitional problems of including the financial sector in the VAT base, a substitute tax with a very low rate could be imposed on bank debits as was tried out, but revoked, in Argentina. Brazil also used such a tax though it later reduced its rate to zero. If it is defined as a tax on transactions rather than on money balances, its yield would not vary with inflation. Its popularity among a selected group of economists was manifest, for example, in Brazil which has been coping with high inflation. Further, conceptually the tax could be seen as a selected excise on a service, since the use of checks and credit cards offers greater safety and convenience than does cash or barter. The real danger seems to lie in high tax rates. If the tax rate increases to high levels, banking system operations could be damaged and alternative inefficient clearing mechanisms might appear. In conclusion, taxation of the financial sector, and especially financial services, is one area that continues to merit greater attention in the agenda of tax reformers.

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3.4 Taxation of property P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s

3.4 Taxation of property

One of the most remarkable facts about the Latin American experience is the relatively low use of property taxation. While this is perhaps true of most developing countries, it is also true that selected Asian countries have used this tax more intensively by undertaking reform in this area.25 Latin American countries - especially those in which fiscal federalism and associated tax assignment issues are important - would be successful in expenditure sharing with lower levels of government only if property taxes - placed under local jurisdictions - are realistically legislated and earnestly implemented.

What needs to be addressed is whether improvements in property taxation comprise solely a long term issue as is usually proffered as an argument in most tax reform packages. While cadastral surveys are lacking in many Latin American countries, others already have them, at least for the urban areas. The answer, therefore, is that property taxation is not just a long term issue. Countries with urban cadastral surveys can implement the tax seriously by realistically updating the assessed values of properties, for example, using a construction sector price index. Countries that do not have an urban cadastral survey are few. They could start with the capital city and extend it to smaller cities. Surveys could be based on property values in blocks of cities and towns at a very low tax rate to obviate overtaxing. As far as rural properties are concerned, property registrations tend to exist in several countries. A strong political will and guidance through regulation at the federal level could underline the beginning of serious implementation by lower levels of government. Given the prevalence of the need to curtail fiscal deficits and the continuing existence of this large untapped tax base - urban and rural property - property taxation has to comprise an essential element of the tax reform agenda.

25 See Tanzi and Shome (1992). Taiwan has successfully implemented a tax on the increases in property values. Singapore and Korea have also made progress in this area. Thailand initiated cadastral surveys for reforming property taxation.

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3.5 Pollution and environment taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s

3.5 Pollution and environment taxes

A wide variety of environment taxes has been discussed in theory and applied in practice for quite some time in developed countries. The question is, to what extent they are relevant for middle-income countries such as those in Latin America. The answer is that, given the rapid pace at which environmental awareness has grown across the world, Latin American countries cannot stay far behind on this issue. It will, therefore, comprise an important item of discussion as well as implementation in the future.

The competitive market thrusts producers toward producing at the least cost (reflecting the use of scarce resources) the goods that consumers want. The price of the product that emerges from the market may not reflect its social cost. There are cases such as environmental depletion - pollution of fresh air, natural forest and sea resource depletion - where social costs may not get fully reflected in the market price because clean air, green forests, and water resources have a low opportunity cost of use for the firms using them. This leads to their uneconomic use and to justified governmental intervention in the form of a custom-tailored price (a tax, a fee/charge) on polluting emissions, or a policy determined ceiling on the quantity of pollution (marketable permits, emissions trading).

Several forms of environmental instruments have been debated and utilized in the context of developed countries such as command and control techniques that directly control the amount and kind of waste; marketable techniques (trading of emission permits); regulations; and taxes. Environmental taxes and charges have been commonly used in Europe. France, Germany, and the Netherlands use systems of charges on water pollutants, and revenues are usually earmarked for improving environmental quality, for covering administrative expenses for water quality management, and to subsidize related projects. Charges are related to a range of variables including expected volume and concentration of use, size of municipality, desired level of treatment, and state of equipment.

Developing countries are increasingly being asked to embrace wide-ranging revenue systems aimed at environmental protection. In developed countries, the pollution problem can often be successfully addressed at a local or state level. In developing countries, this may not always be adequate, and greater Central Government regulation - even implementation - may be necessary. Pollution taxes ideally require continuous monitoring and measurement of waste discharges. The challenge, therefore, is how a realistic, yet behavior affecting system for environmental protection might be devised for Latin American countries. A new form of tax, the carbon tax, levied on the carbon emissions of vehicles may be practicable. Oates (1988) discussed the feasibility of a sulfur emissions tax, while the carbon tax forms a chapter in this Compendium.

Some general policy prescriptions may be made based on the experience of developed countries. First, the coverage and scope of pollution taxes have to be limited at the beginning, while an education campaign for industry and the taxpaying public is mounted. Second, earmarking of environmental tax revenue for environmental protection purposes, could be expected to generate greater cooperation from taxpayers. Third, specific targets will have to be identified for the levy of taxes such as gasoline over and above its being subjected to excise taxation, factory emissions, forestry companies, and establishments harvesting the sea. Fourth, in order to make the system feasible, proxy measures for emissions - estimates of sulfur emissions from knowledge of sulfur content of the fuel - and average (rather than marginal) rates of taxes would have to be used.

Page 2 of 2 3.5 Pollution and environment taxes

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3.6 Increasing role of withholding taxes P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s

3.6 Increasing role of withholding taxes

If the 1960s and 1970s firmed up the conceptual basis of taxation in the Haig-Simon tradition, the late 1980s (with continuation in the 1990s) began to question the feasibility and some of the administrative implications of the tax structures that emerged from purist concepts of equity, efficiency, and stabilization as objectives. Those objectives based on equal tax treatment of equals (horizontal equity) and unequal treatment of unequals (vertical equity) as well as of neutral treatment of different economic act ivities, generally led to the basis of global taxation with a progressive rate structure. All sources of income were to be grouped together, that is, globalized, and taxed under the same rate schedule, assuring equity as well as stabilization over the business cycle.

In its implementation, global taxation had to relegate to self declaration of many sources of income. Even after tax collection, auditing turned out to be cumbersome and often infeasible. Slowly, withholding taxes (at source) at low rates began to be introduced. Though not final taxes (whose rates were higher), withholding taxes assured a minimum tax contribution from income sources such as wages and interest.

A further stage has arrived in which withholding taxes are being levied at higher rates and as final taxes, mainly for administrative reasons. Conceptually correct global taxation seems to have given way to a more administratively feasible means of taxing major sources of income. The opinion seems to be forming that withholding taxes are able to subject all sources of income - such as wages, interest, dividends, payments to small suppliers, foreign remittances - to taxation, since several sources of income are likely to escape taxation altogether, if taxes were applied on a global basis. In that sense withholding, rather than the declarations method (which is more difficult to control), is increasingly perceived as being more able to approach the objective of global taxation. All indications are that greater use of withholding as a form of final taxation for an increasing number of sources of income may emerge with time. In such a scenario, a taxpayer would file a return only if a refund is elicited by him.

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3.7 Tax harmonization P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. SELECTED TAX REFORM ISSUES FOR THE 1990s18

3.7 Tax harmonization

During this era, various aspects of tax harmonization were contemplated and analyzed in the European Community (EC), the North American countries as well as the newly founded CIS, whether for scaling back customs tariffs, relief from double taxation in the corporate income tax and personal income tax, or a harmonized VAT. In the same vein, these issues were expected to appear as important elements in Latin American tax reform in the 1990s.

Growing economic integration within the EC, for example, increased the need to harmonize capital income taxes as capital became more mobile. Harmonization was to be based on a common tax base and a statutory minimum tax rate.26 Indeed, indications were that an EC-wide corporate tax may be in the offing.27 Similarly, the integration of personal and corporate taxes for the alleviation of the problem of double taxation within a harmonized tax system was an issue that was considered in the EC.28 Free trade agreements were designed among Canada, Mexico, and the United States.

Harmonization of the VAT, based on the ‘origin principle’ of taxation- the tax is levied in the state of origin, that is, production - was proposed for trade among EC countries. The CIS states attempted to harmonize most aspects of their tax systems - the corporate income tax, the VAT, as well as customs duties.

Thus, there was considerable progress in several areas of harmonization across the world at least in being analyzed thoroughly if not always achieved. Comparable issues assumed importance in the 1990s for MERCOSUL, the Andean Pact, and other groupings among Latin American countries.

26 See Tanzi and Bovenberg (1990) on this issue. 27 See item under European Community news in Tax Notes International, Vol 4, No. 13, March 1992. 28 See de la Fuente and Gardner (1990) on this issue. 18 For another view of selected tax reform issues for the 1990s, see Bagchi (1991).

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4. SUMMARY AND CONCLUSIONS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. SUMMARY AND CONCLUSIONS

This chapter reviewed the experience of Latin American countries with respect to tax reform and revenue performance during the 1980s. It also discussed selected tax reform issues that were likely to be discussed and debated in Latin America during the 1990s. Several important conclusions emerged from this review. They are summarized in this section.

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4.1 Trends of the 1980s P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. SUMMARY AND CONCLUSIONS

4.1 Trends of the 1980s

A noteworthy feature of tax reform in the 1980s was that steeply progressive rate structures in income and property taxes that were conceptually optimal from the point of view of the equity and stabilization principles of taxation but were practically unimplementable, were demolished. Instead, broad-based, low-rate taxes on domestic consumption such as the VAT were designed, more for their administrative case based on a self-monitoring feature, as well as for their relative dependability for revenue. Also, it came increasingly to be realized that fundamental tax reform can take years to be fully implemented and effectively constituted an aggregation of many annual discretionary changes.

The act ual experiences of Latin American countries between 1980 and 1991 bear witness to the above-mentioned overall premise. The number of countries that operated a VAT increased from 8 to 15. The objective of maintaining a simple tax structure resulted in 9 countries having a uniform VAT rate. Countries that attached other objectives than revenue - such as regional development or redistribution - to the VAT, used a multiple-rate VAT. To enhance its revenue raising feature, countries continually attempted to expand the VAT revenue base. In addition to the VAT, almost all countries imposed selective excise taxes at different and higher rates, typically on petroleum products, tobacco products, alcoholic and non-alcoholic beverages, automobiles, and gambling. Several countries continued with longer lists of excisable commodities, however.

Direct taxation at highly progressive rates was de-emphasized. The top marginal personal income tax rate fell from 48 per cent on average to 35 per cent. The dispersion in rates was narrowed. The number of rates was reduced. The average exemption level was increased from about of per capita GDP to 1 times per capita GDP.

Many countries reduced the corporate income tax rate, the average falling from about 44 per cent to about 36 per cent, even though some continued to maintain progressive rate structures. The top marginal personal income tax rate approached the main corporate income tax rate. Foreign companies continued to be subjected to withholding taxes. However, the rates were reduced, on an average, from 17 per cent to 11 per cent. Also, the number of countries that treated foreign and domestic capital equally increased from 3 to 6.

In order to assess the movements in the tax-to-GDP ratios of Latin American countries during the 1980s, they were divided into three (equal) groups: high-tax countries (around 20 per cent and above), low-tax countries (around 10 per cent and below), and medium-tax countries (10-20 per cent). One conclusion that emerged was that major tax reform was neither always carried out primarily with the revenue objective nor did it necessarily push a country to the high tax ratio group. Similarly, a country with a high tax burden did not always represent one that had undertaken fundamental tax reform. Nevertheless, countries that undertook tax reform - for example, Argentina, Bolivia, and Mexico - in general experienced a greater revenue gain in terms of GDP over the decade, as compared to the revenue gain in the overall sample. An exception was Chile which experienced a fall in its tax-to-GDP ratio as it transferred its social security system to the private sector and reduced its VAT rate. In most instances, however, the revenue gain still left the countries in the original country groupings to which they had belonged at the beginning of the decade.

For the sample as a whole, the tax-to-GDP ratio increased by 1 percentage point. Income and social security taxes each remained stagnant at around 3 per cent of GDP, while domestic consumption taxes increased, on average,

Page 2 of 2 4.1 Trends of the 1980s from 5 per cent to 6 per cent of GDP. The reliance on international trade taxes declined slightly, by per cent of GDP, reflecting no clear pattern in their use within the sample. Property tax revenue continued to remain insignificant, usually below per cent of GDP. These observations have significance for objectives that might be set for tax reform in other regions of the world.

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4.2 Issues in the 1990s P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. SUMMARY AND CONCLUSIONS

4.2 Issues in the 1990s

Given the experience of the 1980s, many new issues emerged for consideration during the 1990s. New concerns reflected a preoccupation that the role of direct taxation had slipped even as reform in the consumption tax area had progressed.

First, there was increasing realization that few - mainly large, and foreign - corporations paid corporate income tax, and that a minimum contribution to the corporate income tax should be made by other corporations. A judicious application of a minimum tax could also help contain the growth of the underground economy if, for example, the tax was applied to persons engaged in business who were subject to the individual income tax. While many Latin American countries already used some form of taxation of assets, few used it as a base for a minimum contribution to the income tax. Others had it on the books, but revenue tended to be minimal. Thus countries needed to carefully design and implement a minimum gross assets tax in order to raise the revenue raising capacity of income tax. Mexico successfully applied this minimum tax to both corporate and individual income taxes. It served as a model to other countries in the formulation of a good minimum tax based on gross assets. Other bases for a minimum tax such as net worth or physical assets were contemplated; but their bases were narrow and, consequently, their rates would need to be higher.

Second, a concern regarding the corporate income tax had been that it had tended to become a complex tax, ridden with incentives, subject to ambiguous interpretation, and difficult to administer. Some tax economists recommended its replacement by a cash-flow tax. This tax was debated in the 1990s as Argentina became the first country to attempt to implement a form of cash-flow taxation. Conceptually, there was little to complain about the tax (except that it came very close to the already existing VAT in most countries). Its problems lay, however, in administrative difficulties since it could be relatively easily avoided through transfer pricing and the like. Unless carefully designed, its revenue-neutral rate could turn out to be much higher than that of the corporation income tax. Also, foreign investors would not find this tax to be deductible against the corporate income tax that they had to pay in their home countries. Thus, unless developed countries made a concerted and simultaneous effort in the area of cash-flow taxation, it was unlikely to be successful in the developing country environment as well.

Third, a preoccupation among tax economists had been the relative lack of success in taxing the financial sector either through its income or in the form of the consumption of services that it provides. For example, during periods of high inflation, the financial sector may reap windfall profits. To capture this source of revenue, a tax on short term interest-bearing assets can be considered, but its incidence - whether on banks or consumers - remains unclear. Or, in order to compensate for the difficulty of taxing the financial sector under the VAT, a tax on bank debits, that is, on checks, was debated. While such a tax would imply a burden on financial intermediation, no clear view emerged, though Brazil introduced a tax on bank debit (as did India temporarily). There was general agreement, however, that the financial sector needed to be tapped for tax revenue. This remains on the agenda of tax reformers not only in the 1990s, but even during the following decade of the 2000s.

Fourth, countries generally neglected the area of property taxation even as the issue of fiscal responsibility at lower levels of government assumed greater importance. The pressure to narrow fiscal deficits and pursue much needed stabilization policies obliged this much pampered area of taxation to be brought out for closer examination and be made subject to greater and appropriate levies. There were immediate possibilities for improving revenue from

Page 2 of 2 4.2 Issues in the 1990s property taxation through consistent and frequent reassessment of property values based on existing information and initiating cadastral surveys. It was expected that property taxation would be an area of renewed attention in future decades.

Fifth, growing environmental awareness across the globe brought the plausible role of environment taxes to control pollution to the forefront of the tax policy discussion. Latin American countries would have to contend increasingly with environmental taxes in the 1990s. At the beginning, their coverage and scope would albeit have to remain modest, while revenues would need to be earmarked for environmental protection in order to earn the confidence of taxpayers that the revenues are being used toward the specific objective for which the taxes are imposed. Also clearly defined tax bases would have to be identified such as factory emissions and forestry companies, apart from traditional ones such as gasoline. Realistic tax structures and appropriate proxy measures for emissions measurement would have to be used, methods that should be practical for most Latin American countries.

Sixth, difficulties were faced in implementing the conceptually correct global tax bases - in which all sources of income are treated equally for tax purposes - based on voluntary declarations. The associated challenges tended to move implementation methods to withholding systems - at least as minimum payments - while retaining the overall global structures. Such withholding became more acceptable as experience revealed that withholding tends to bring the objective of global taxation closer to its goal compared to systems that are based on voluntary declarations but are supported by limited administrative capacity.

Finally, the 1990s were considered ready for major tax harmonization outcomes among Latin American countries such as among MERCOSUL and the Andean Pact and, perhaps, among even larger country groups. These efforts were likely to be in the areas of capital income taxes, double taxation of the personal income tax base, customs tariffs, as well as the VAT. Available models were those in operation or were being discussed among the EC, North America, or CIS states, in various areas of taxation with international ramifications. The efforts of CEPAL, the UN arm headquartered in Santiago de Chile, in bringing together Latin American countries for discussions and debate over tax policy reform on a regular basis, or of CIAT, headquartered in Panama, on tax administration matters, took the process forward with several member countries taking unilateral tax policy and administration measures following the trends emerging from not only the Latin American region but also from the rest of the world.

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

REFERENCES

Abbin, Byrle M, Richard A Gordon, and Diane L Renfroe, 1985, ‘International Implications of a Cash Flow Consumption Tax,’ Tax Notes, Vol 28, No. 10, pp 1127-38.

Bagchi, Amaresh, 1991, ‘Tax Reform in Developing Countries: Agenda for the 1990s,’ Asian Development Review, Vol 9, No. 10, pp 40-72.

Bird, Richard M, 1992, ‘Tax Reform in Latin America: A Review of Some Recent Experiences,’ Latin American Research Review, Vol 27, No. 1, pp 7-35. de le Fuente, Angelo, and Edward Gardner, 1990, ‘Corporate Tax Harmonization and Capital Allocation in the European Community,’ Working Paper No. WP/90/103, IMF: Washington DC.

Khalilzadeh-Shirazi, Javad, and Anwar Shah, 1991, ‘Tax Policy Issues for the 1990s,’ The World Bank Economic Review, Vol 5, No. 3, pp 459-71.

McLees, John A, 1991, ‘Fine Tuning the Mexico Assets Tax,’ Tax Notes International, pp 117-20, February.

Mintz, Jack M, and Jesus Seade, 1991, ‘Cash Flow or Income: The Choice of Base for Company Taxation,’ The World Bank Research Observer, Vol 6, No. 2, pp 177-90, July.

Nellor, David, 1987, ‘The Effect of the Value-Added Tax on the Tax Ratio,’ Working Paper No. WP/87/47, IMF: Washington DC.

Oates, Wallace E, 1988, ‘A Pollution Tax Makes Sense,’ in Herbert Stein, ed, Tax Policy in the Twenty-First Century, pp 253-65, New York: John Wiley.

Sadka, Efrain, and Vito Tanzi, 1992, ‘A Tax on Gross Assets of Enterprises as a Form of Presumptive Taxation,’ Working Paper No. WP/92/16, IMF: Washington DC.

Tanzi, Vito, 1988, ‘Forces that Shape Tax Policy,’ in Herbert Stein, ed, Tax Policy in the Twenty-First Century, pp 266-77, New York: John Wiley.

______, and A Lans Bovenberg, 1990, ‘Is There a Need for Harmonizing Capital Income Taxes Within EC Countries?,’ in Horst Siebert, ed, Reforming Capital Income Taxation, pp 171-97, Tbingen: Mohr-Paul Siebeck.

______, and Parthasarathi Shome, 1992, ‘The Role of Taxation in the Development of East Asian Economies,’ in Anne O Krueger and Takatoshi Ito, eds, Taxation and Development in East Asian Countries, pp 31-61, Chicago: Chicago University Press.

Tax Policy Division (IMF), 1990, ‘Tax Policy and Reform for Foreign Investment in Developing Countries,’ in Taxation and International Capital Flows, pp 163-235, Paris: OECD Press.

Page 2 of 2 REFERENCES

II. INCIDENCE AND DISTRIBUTION EFFECTS OF TAXATION

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CHAPTER II.1 INCIDENCE OF THE CORPORATION TAX IN INDIA: A GENERAL EQUILIBRIUM ANALYSIS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > II. Incidence and Distribution Effects of Taxation > CHAPTER II.1 INCIDENCE OF THE CORPORATION TAX IN INDIA: A GENERAL EQUILIBRIUM ANALYSIS

CHAPTER II.1 INCIDENCE OF THE CORPORATION TAX IN INDIA: A GENERAL EQUILIBRIUM ANALYSIS1

1 In the 1960s, a major movement took place in analyzing the effect of a tax on the distribution of income among economic agents, typically as owners of factors of production. A model was constructed to depict a simple economy represented by two productive sectors and two factors of production, and the equilibrium returns to the factors of production, as relative prices, were determined. A tax was introduced into the model and its impact on the relative prices or returns was obtained. This was called the incidence of taxation. This chapter applies the approach to the corporation income tax in India in the 1970s, and is excerpted from Parthasarathi Shome, ‘The Incidence of the Corporation Tax in India: A General Equilibrium Analysis’, Oxford Economic Papers, Vol 30 (1), pp 64-73, March 1978. Permission was sought from and granted by Oxford University Press, UK, to reprint.

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I. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

I. INTRODUCTION

The incidence of the corporation income tax has been analyzed, in the product market, as a relative burden between producers and consumers of the product concerned (Nevin, 1963); even where the analysis has been in terms of relative burdens between producers and laborers, ie, owners of different factors of production, only partial equilibrium techniques have been used (Lall, 1967). However, in order to study the incidence of the corporation income tax, it has generally been recognized that a long run, general equilibrium context is necessary. To quote from Musgrave (1959):

It is necessary... that we push beyond the partial equilibrium view and consider the general equilibrium adjustment process as a whole. This is a difficult task. One may readily understand the general interdependence of the pricing system as a concept or as a formal statement within the framework of the Walrasian equilibrium system. But it is quite another matter to formulate the problem so as to obtain specific results....A workable system of this sort remains to be devised before it can be applied to the determination of incidence. (p 347)

The first such general equilibrium tax incidence model was designed by Harberger (1962). Although several methodological insights and qualitative conclusions had preceded his model, with the advent of this general equilibrium approach, tax incidence could be explained not only between consumers and producers, but also between income receivers from various factors in the long run. Given his assumptions, Harberger showed that a US corporation income tax, that is a partial tax in the US corporate sector, imposed a 100 per cent burden on capital owners.

This chapter attempts to study the incidence of the Indian corporation income tax under similar assumptions of a general equilibrium setting with, however, a different model exposition. The theoretical approach followed in this chapter will not necessitate any assumption about the form of the production function2 or the elasticity of substitution between the two products, unlike Harberger’s model. Further, Harberger’s analysis studied the effects of the introduction of a corporation income tax, whereas this chapter will study the effects of a marginal change in an already existing corporate income tax.

In what follows, Section 2 presents the theoretical model and derives the conditions for incidence. Section 3 studies, empirically, the incidence of the corporation income tax in India, for the Financial Year 1971-72.3 The concluding remarks are presented in Section 4, bearing on some recent research on the Indian corporation income tax.

2 Harberger had to assume a Cobb-Douglas production function for his empirical analysis. No such restriction is necessary here. 3 All the data components necessary are not available beyond 1971-72.

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2. THE MODEL P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. THE MODEL

We retain the neoclassical structure of Harberger’s model, ie, we have perfect markets, full employment, inelastic supply of all factors, linear homogeneous and quasi-concave production functions, and perfect inter-sectoral mobility of factors. We assume that the two-sector economy produces X 1 in the corporate and X2 in the non- corporate sector. The former uses labor L1 and capital K1, the latter, labor L2 and capital K2, where L and K are total endowments of labor and capital respectively. Capital K1 in the corporate sector is being taxed and we assume that the government spends the tax revenue exactly as in the Harberger model, ie, at the initial prices, the government spends the proceeds of the tax such that the reductions in private expenditures on the two goods are just counter-balanced. This, together with the assumption of constant marginal propensities to consume each good, makes changes in demand a function of changes in relative prices alone.

Let be the amount of the ith input required to produce one unit of the jth good. The assumption of full employment then yields

Let pj be the price of the j th good, w the wage rate, r the rental of capital net of the tax, and r1 the gross rental. Defining a = 1 as one minus the tax rate, in view of perfect mobility of capital, r = r1a in equilibrium. An initial value of a b 1 implies a marginal increase in an already existing tax. An initial value of a = 1 implies an impact tax, as considered by Harberger. Since unit costs reflect market prices under competitive conditions, we have

The assumption of linearly homogeneous and quasi-concave production functions makes each input-output coefficient a function of input prices only.

Thus

Page 2 of 3 2. THE MODEL

where the functions are homogeneous of degree zero in input prices, ie, if all input prices change in the same proportion, the input-output coefficients remain unaltered.

On the demand side, we can specify the demand for either X1 or X2. Owing to the paucity of empirical evidence regarding E1 as compared with E2, the price elasticities of demand for X1 and X2 respectively, we take the demand equation for X2. Given our assumption that changes in demand depend on changes in relative prices only, we have

where the asterisk denotes a percentage change, eg, and E2 is = 0. On the other hand, Harberger specified the demand equation for X1, necessitating an assumption on V, the elasticity of product substitution between X1 and X2, in order to derive a value for E1 from an empirical estimate of E2.

Since the above equations in the model are expressed in terms of absolute prices and we are interested in relative price changes only, we introduce w, the wage rate, as our numeraire. Thus w* = 0. (8)

Coming to the incidence question, capital bears an equal burden of the tax in proportion to its initial share in income if the income accruing to it net of the tax in ratio to labor’s income remains unchanged, for which rK/wL should be a constant, or

Page 3 of 3 2. THE MODEL

Therefore, if r* = w*, the burdens are equal in proportion to their initial shares in income; since the price of labor is the numeraire, ie, w* = 0, r* = 0 is the condition.

Capital bears 100 per cent of the burden of the tax if the ratio of gross income of capital (ie, net income plus the tax revenue) to labor income

If a = 1, ie, initially taxation revenues are zero (as in Harberger) the right-hand side of (11) reduces to where T is the tax rate. If a b 1, the expression for incidence includes (Equation 11), so that the incidence of a marginal increase in an already existing tax, ie, a b 1, cannot be treated independently of the value of . Eliminating from (11) yields4

Expressions for r* given by (10) and (12) will be compared to determine whether capital bears the entire burden of the corporation income tax, or manages to pass on part of the burden to non-capital income earners. Capital bears ‘greater than’ or ‘less than’ 100 per cent burden according as r* from (10) is ‘less than’ or greater than’ r* from (12).

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3. EMPIRICAL ANALYSIS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. EMPIRICAL ANALYSIS

The incidence of the Indian corporation income tax is analyzed for the Financial Year 1971-72. The entire economy is divided into two sectors, namely, the corporate sector and the non-corporate sector. In order to do this, we first take the major sectorwise5 income accruing to capital, and the corporation income tax paid by each of these sectors.6 If the ratio (tax: capital income) is high (20 per cent or more) for a major sector, then we include it as a corporate sector. If it is low (10 per cent or less), then we include it in the non-corporate sector. These data are presented in Table 1. Thus we include the following sectors in the corporate sector: (i) manufacturing, construction, electricity, gas, and water supply, (ii) transport, storage and communication, trade, hotels and restaurants, (iii) banking, insurance, real estate, ownership of dwellings, business services, public administration, defence and other services. The non-corporate sector includes: (iv) agriculture, forestry and logging, fishing, mining and quarrying.

The above method of dividing the economy into the corporate and non-corporate sectors is commensurate with earlier general equilibrium analysis (Harberger 1962, 1966). However, it is important to bear in mind the connotations with which the terms ‘corporate’ and ‘non-corporate’ are used here. To quote from Harberger (1974): ‘The terms ‘Corporate’ sector and ‘Non-corporate’ sector are really misnomers: it might perhaps be better to call them the ‘Heavy-Tax’ sector and the ‘Light-Tax’ sector’ (p 166). In our current context, where the incidence of the corporation income tax is being analyzed, this classification may indeed be more relevant than a classification based on the legal corporate sector.

Having divided the economy into the corporate and non-corporate sectors, Table 1 calculates the income accruing to ‘non-capital’ factors (called ‘labor’ in Section 1) in each sector, by calculating the residual after capital income, from the sector’s contribution to Net Domestic Product (NDP).

Then we calculate the shares of capital and non-capital in NDP, divided between the corporate and non-corporate sectors. This is presented in Table 2.

From the values obtained in Table 2, we go on to calculate the elements and presented in Table 3. We obtain two sets of values (a) and (b) depending on the particular assumption regarding capital income in the agricultural sector. As an example of these calculations, we may cite the following:

is obtained by calculating the share of non-capital income in the corporate sector X1 out of total non-capital income (pertaining in both sectors). Similarly, has been calculated by dividing the noncapital income by total income in sector X1.

Apart from the elements calculated in Table 3, we need the parameter values , , and E2 for the calculations of r* from the Expressions (10) (solution of the model) and (12) (expression of 100 per cent burden). We assume that

Page 2 of 3 3. EMPIRICAL ANALYSIS

, the elasticity of factor-substitution in the corporate sector X1, is unity, since recent empirical studies (Zarembka, 1970, 1972) suggest that for most manufacturing industries the CES production function degenerates to the Cobb- Douglas production function. We assume the elasticity of factor-substitution in the non-corporate sector (predominantly agriculture), to be 1, as estimated in recent empirical work (Lianos, 1971).7 Finally, we assume that the demand in the non-corporate sector is relatively inelastic such that exactly as did Harberger (1962).8

Table 1

Table 2

India, 1971-72

(in Rs. lakhs)

Table 3

Values of elements

These parameter values and the values of the elements presented in Table 3 are then plugged into the expressions for r* in (10) and (12). Table 4 presents these values. Since a* b 0, it can be seen that capital bears just less than 100 per cent of the burden of the corporation income tax, irrespective of the assumption made regarding the income of capital (10 per cent or 20 per cent) in the agricultural sector.

Page 3 of 3 3. EMPIRICAL ANALYSIS

Table 4

Incidence of tax

5 We have divided the economy into four major sectors, as shown in Table 1. Though Harberger’s (1962) analysis used industry-wise data, we use sector-wise data due to the paucity of data. In a later analysis, Harberger (1966) uses sector-wise data for this same reason. 6 Source: All-India Income-Tax Statistics, 1971-72, Directorate of Inspection (Research, Statistics, and Publication), Mayur Bhavan, New Delhi. For the agricultural sector, however, the income accruing to capital is not obtainable from this source. In general, the author found it difficult to obtain this figure. From the different studies in this area (eg, Zarembka, 1972), from where some indication of capital expenditure may be obtained, it may be estimated that the income accruing to capital in the agricultural sector will lie in the range of 10 per cent to 20 per cent. We shall conduct the analysis, therefore, with this range in mind.

7 These estimates pertain to US data. Lianos estimated in the US agricultural sector to be in the range of 1.524 to 2.44. We take the lower estimate since Lianos felt this was a better approximation and also because higher values will only substantiate our conclusion all the more. Further, in the case of India, there is no reason to believe that this elasticity will be any less than in the US: the elasticity is an expression of how much factor intensities will move with a change in relative factor prices; in India, given the high capital costs, it may be expected that capital intensity would increase with lower costs for capital. 8 Our exposition of the model avoids the use of E1, which Harberger calculated by linking E2 with V, the elasticity of product substitution. The formula used was E2 = VP1X1/(P1X1 + P2X2). Then Harberger calculated E1, given V.

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4. CONCLUSIONS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. CONCLUSIONS

The prevalent impression regarding the incidence of the corporation income tax in India has been that the burden is usually passed on to the consumer. Nevin (1963), for example, asks rhetorically: ‘How far, for that matter, is the corporate income tax really paid by companies rather than by the final consumers?’ Lall (1967), too, concludes that the increase in the corporate tax rate has not adversely affected companies, their shareholders, or capital earnings other than profits; indeed the maintenance and increase of after-tax profitability (which Lall calculates) are used as a suggestion of more than 100 per cent shifting of the increase in tax to consumers and laborers. Finally, Gulati and Bagchi (1975), using these results as sufficient empirical evidence that ‘companies everywhere succeed in good measure in shifting their tax’, suggest that the base of the corporation income tax should be changed.

The analysis presented here comes to a different conclusion that only a small part of the corporation income tax is shifted to labor, as can be seen from Table 4. Indeed, the tax is designed to be borne by capital and this is very nearly achieved, though a small portion is indeed borne by labor. This occurs when all movements in capital and labor - that take place as a result of a change in the tax - are completed and the economy has reached a new, long run equilibrium.

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APPENDIX P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

APPENDIX

Reduction of Model to Reduced Form

Totally differentiating equations 1 and 2 in the text, we obtain, respectively

Note that due to our assumption of given employable supplies of factors of production, L* and K* drop out from the above equations.

Differentiating equations 3 and 4, we obtain, respectively9

Differentiating equations 5 and 6, we obtain, respectively

Substituting 5' and 6' into 1' and 2' we obtain

Page 2 of 2 APPENDIX

Equating 7' and 7 from the text, yields

A rewritten 8' - by replacing ?K and ?L - together with 3' and 4' now form a reduced system of three equations in three unknowns r*, p1*, and p2*:

9 Note that given factor prices, each competitive firm minimizes unit cost by equating marginal cost to zero. For sector X1, it implies And similarly for X2. This information is used in the derivation of 3' and 4'.

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

REFERENCES

Gulati, IS, and A Bagchi, 1975, ‘A Proposal for Reforming Corporation Tax,’ Economic and Political Weekly, Vol X, No. 5-7, pp 1271-76.

Harberger, AC, 1962, ‘The Incidence of the Corporation Income Tax,’ Journal of Political Economy, Vol 70, No. 3, pp 215-240, June.

______, 1966, ‘Efficiency Effects of Taxes on Income from Capital,’ in M Krzyaniak, ed, Effects of Corporation Income Tax, Detroit: Wayne State University Press.

______, 1974, ‘Taxation and Welfare, Boston: Little, Brown and Company.

Lall, VD, 1967, ‘Shifting of Tax by Companies,’ Economic and Political Weekly, Vol 11, No. 18, 6 May.

Lianos, TP, 1971, ‘The Relative Share of Labor in the United States Agriculture, 1949-68,’ American Journal of Agriculture Economics, August.

Musgrave, RA, 1959, The Theory of Public Finance, New York: Mcgraw-Hill.

Nevin, E, 1963, ‘Taxation for Growth-A Factor Tax,’ Westminster Bank Review, November.

Zarembka, P, 1970, ‘On the Empirical Relevance of the CES Production Function,’ Review of Economics and Statistic s, Vol 52.

______, 1972, Toward a Theory of Economic Development, San Francisco: Holden-Day Inc.

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CHAPTER II.2 IS THE CORPORATE TAX SHIFTED? EMPIRICAL EVIDENCE FROM ASEAN P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > II. Incidence and Distribution Effects of Taxation > CHAPTER II.2 IS THE CORPORATE TAX SHIFTED? EMPIRICAL EVIDENCE FROM ASEAN

CHAPTER II.2 IS THE CORPORATE TAX SHIFTED? EMPIRICAL EVIDENCE FROM ASEAN1

1 Following the approach used in Chapter II.1, this chapter derives the incidence of the corporation income tax in selected ASEAN economies in the 1970s. The results mirror those of the Indian case in that the owners of capital - in both the corporate and non-corporate sectors - are found to bear most of the burden, with very little passed on to labor. This chapter is excerpted from Parthasarathi Shome, ‘Is the Corporate Tax Shifted? Empirical Evidence from ASEAN’, Public Finance Quarterly, Vol 13(1), pp 21-46, January 1985. Permission was sought from and granted by Sage Publications, US, to reprint.

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1. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

1. INTRODUCTION

The importance of the corporation income tax in overall tax revenue is as high in ASEAN member countries - Indonesia, Malaysia, the Philippines, Singapore, and Thailand - as in selected developed countries such as the United Kingdom and the United States. This chapter surveys available fiscal incidence studies for ASEAN members and, after a critical evaluation of their methodologies, employs a two-sector general equilibrium model in order to study the incidence of the corporation income tax in ASEAN. It concludes that, except in Singapore, the tax is borne entirely by the owners of capital in contrast to the usual presumption that the tax is shifted. The policy implication of capital across the economy bearing the corporate tax is that double taxation of dividends - present, at least partially, in each ASEAN member - should be curtailed if these economies are to avoid the necessarily detrimental ramifications for capital formation.

The issue of corporate tax incidence has constituted an integral part of the literature on incidence for some time. The question of corporate tax incidence itself is important because of the differential policy implications of who ultimately bears the tax. For the Association of South East Asian Nations (ASEAN) economies, this question has not been addressed even though their reliance on the corporate tax is as high as in selected developed countries such as the United Kingdom and the United States. In the second section of this chapter, I will survey available fiscal incidence studies for ASEAN members and critically evaluate the methodology used in these studies as contrasted to the one used in this chapter. I use a general equilibrium tax incidence model as was employed in the previous chapter on India (hence that model itself is not repeated) in this chapter. In the following section, I discuss the sources of ASEAN data and associated problems. This is followed by a presentation of the empirical estimates and a concluding section that presents a summary of findings and resultant policy prescriptions.

The importance of corporate tax incidence can best be gauged by the general concern that has been expressed in the literature regarding its effects. Whether the decline in business profitability warrants corporate tax reforms - as has been contended time and again in the literature - depends very much on who really bears the tax.2 If capital owners, on whom the tax is supposed to fall, effectively pass the burden on to labor, the implications for corporate tax reform in order to increase capital formation and productivity take on a different meaning than if capital owners bear the burden of the tax. Hence, a study on corporate tax incidence assumes importance in the context of tax reforms.

In order to stress the importance of settling the issue of corporate tax incidence in the ASEAN economies, we compare their shares of revenue from the corporate tax in total federal tax revenue with those of developed countries in the hemisphere such as Australia and New Zealand, and also the United States and the United Kingdom, and find that they are comparable as shown in Table 1. It seems, therefore, that an estimate of corporate tax incidence, which is so controversial a topic in the developed countries, might also be attempted for ASEAN because the tax will have economic ramifications in the latter equally important as in the former.

Looking at corporate tax revenue of the different countries in Table 1, it is clear that, apart from Indonesia (which has royalties from oil included in its figures), Malaysia and Singapore have the highest reliance figures,3 whereas Thailand and the Philippines are in the same range as selected developed countries in general. The figure for Indonesia is awkward at 78 per cent due to oil royalties without which it declines to the lowest ratio - around 7 per cent - in the sample. Therefore, in the empirical analysis of this chapter, I have alternately computed corporate tax incidence with and without the oil company tax for Indonesia.

Table 1

Page 2 of 2 1. INTRODUCTION

Tax reliance ratios of the corporation income tax, 1981

(in per cent)

Before concluding this section one point needs to be made regarding the comparability of overall tax structures across the sample of countries. Similar corporation tax reliance figures for ASEAN and the developed countries in this sample do not mean that they have comparable overall tax structures as well. On the whole, the contribution of consumption taxes to total tax revenue in the ASEAN members as compared to the developed countries is much higher, as is to be expected in terms of the relative stages of their development.4 Indonesia, however, stands out again as an exception because, apart from the oil company tax, its use of other tax instruments including consumption taxes is the lowest (in terms of percentage contribution to tax revenue) among all the countries in the sample.5 However, although there is no doubt that the overall tax structures in ASEAN on the one hand and the developed countries on the other are quite different, their overall tax efforts and the relative size of the corporate income tax in total tax revenue are comparable. Given this, I will go on to study the incidence of the corporate tax in ASEAN as it has been analyzed for most of the developed countries mentioned above. I begin by a survey of available fiscal incidence studies for ASEAN in the following section.

2 For example, during the 1977-78 debates over the Roth-Kemp corporate tax cut proposals in the United States, Jensen and Meckling (1977) commented: ‘We believe the era of dramatic economic growth is over - not because of... technological constraints... energy... ecological disaster...but because government is destroying the individual incentives which are the wellsprings of economic growth. We see the large private corporation as one of the casualties of this process.’ The Congressional Budget Office (1978) offered the following: ‘Some supporters of the bill have argued that this change would substantially increase the productive capacity of the nation. If so it could sharply increase economic growth without aggravating inflation... (however) available evidence provides no reason for an optimistic answer to this question.’ But Kopcke (1978) counters: ‘The after-tax rate of return to non-financial corporate resources has been falling steadily since 1965... At the same time rates of return were falling, the rising cost of financial capital assets has steadily undermined investment incentives.’ 3 Tax reliance refers to the revenue collected from a particular tax as a proportion of total tax revenue. 4 Whereas in Australia and New Zealand the direct personal income tax constitutes 50 per cent or more of total tax revenue, in ASEAN it constitutes 15 per cent or less. Indeed, in Indonesia and Thailand it is significantly less than 10 per cent. As is to be expected, then, in these countries domestic consumption taxes on sales, turnover, or value-added and/or international trade taxes fill the gap. For example, domestic consumption taxes in Thailand and the Philippines constitute around 50 per cent of total tax revenue, even though for Singapore and Malaysia these domestic taxes constitute 20 per cent to 25 per cent just as in Australia and New Zealand. Taxes on international trade in Singapore and Malaysia are, however, much higher than in Australia and New Zealand, thus making up the difference. Thus, the contribution of consumption taxes to total tax revenue lies in the range of 80 per cent in Thailand, 70 per cent in the Philippines, 60 per cent in Malaysia, and 40 per cent in Singapore, compared to much lower figures of approximately 25 per cent and 30 per cent in New Zealand and Australia, respectively. 5 This is reminiscent of other comparable oil-rich countries such as Nigeria and Venezuela that, with a sudden rise in world oil prices, began to depend primarily on oil revenues in the 1970s and, consequently, fell behind others in comparable stages of development in fiscal effort through other taxes. Indonesia is now in the process of introducing alternative tax instruments among consumption taxes, such as the value-added tax, as a means of decreasing its dependence on the oil company tax without adversely affecting its overall tax effort. Venezuela is also considering introduction of the value-added tax as well as a reform of non-petroleum sources of tax revenue in general.

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2. A SURVEY OF FISCAL INCIDENCE STUDIES IN ASEAN AND A DISCUSSION OF ALTERNATIVE METHODOLOGIES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. A SURVEY OF FISCAL INCIDENCE STUDIES IN ASEAN AND A DISCUSSION OF ALTERNATIVE METHODOLOGIES

A number of fiscal incidence studies have been carried out in recent years for individual ASEAN members (for example, by Andic, 1977, Mclure, 1972, Meerman, 1979, and Salleh, 1977, for Malaysia; Booth, 1980, for Singapore; Krongkaew, 1975, and Salkin, 1974, for Thailand; and for the Philippines, studies by the Joint Legislative-Executive Tax Commission, 1974, and by Tan, 1975). There is no comparable study for Indonesia. The above studies, by and large, follow the methodology of the incidence studies on the United States by Pechman and Okner (1974), as well as by Musgrave et al, (1974) usually referred to as Comprehensive Statistical Studies (CSS) of incidence and, therefore, suffer from similar advantages and drawbacks as do the studies pertaining to the United States. Among the advantages is their ability to generate ballpark figures on tax incidence that could be used for policy formulation. On the other hand, they make procedural assumptions that may or may not be sound.

The cross-country comparison presented in the introductory section makes clear the importance of the corporate tax in ASEAN, comparable to developed countries. The issue of its incidence, therefore, assumes equal importance and must be analyzed carefully before one assigns corporate tax burdens in any budget incidence study. So far in the above-mentioned studies, such assignments have been based on best guesses by experienced researchers. Mclure (1972), in his study of West Malaysia, for example, assigned 90 per cent of the corporate tax burden to companies, and out of that two-thirds was assigned to non-resident shareholders based on surveys as well as on a general assessment of the economy.6 Using the 1964 Survey of Limited Companies, he found that almost of the company tax comes from rubber and tin mining industries, and all of this comes from profits. Of the remaining 25 per cent of the company tax, he assumed that only 40 per cent is shifted to consumers. Thus, he obtained the figure of 90 per cent corporate tax burden on (corporate) profits. Finally, based on the above survey, he proposed that two-thirds of the 90 per cent is borne by non-resident shareholders. The domestic burden is distributed proportionately between the top two income groups. Thus, incidence is based on assumptions that suffer from an additional difficulty in that it ignores the possibility that the corporate tax is likely to depress profits in the non- corporate sector as well.

Booth (1980) used Mclure’s assumption, more or less, for her analysis of tax incidence in Singapore. Similarly, Tan (1975) assumed two-thirds burden on stockholders for the Philippines, as did Krongkaew (1975) for Thailand. Again, typical of the CSS of ASEAN countries, in another study on India, Gupta (1977) made two alternative assumptions regarding corporate tax incidence: it is either shifted forward totally, or not at all. Needless to say, such alternative assumptions yield very different results on the overall incidence of the fiscal systems. It is hoped that this chapter will provide one missing link for such studies.

Thus, in their quest for the overall incidence of a fiscal system, all CSS assign tax burdens to different institutions - government, the corporate sector, and the household sector by income groups - based on broad-based assumptions, as I indicated for the studies by Mclure and Booth. Given that ‘few topics in public finance have given rise to so much controversy... as the company tax’, (Booth, 1980) I feel that an act ual estimation of corporate tax incidence in ASEAN may be of use for an overall understanding of the issue and as a first attempt toward using a more acceptable procedure for estimating tax incidence in these countries, albeit the incidence of one tax rather than of the fiscal system.

Page 2 of 2 2. A SURVEY OF FISCAL INCIDENCE STUDIES IN ASEAN AND A DISCUSSION OF ALTERNATIVE METHODOLOGIES

The methodology to be used in this chapter is a deterministic (two-commodity, two-factor, one-consumer) general equilibrium approach, that was used in Chapter II.1 pertaining to India hereinafter referred to as the GE-approach.7

Although they share some common problems, there are advantages in using the GE-approach rather than the CSS. First, the CSS assume that government activity does not affect relative prices. This is probably the most serious of its drawbacks. The GE-approach allows for all relative prices to change, a basic feature that should be included in any analysis that purports to study incidence or efficiency effects of taxes. The first problem leads to a second in that the procedure used in the CSS to define a ‘counterfactual’ or pretax state for comparison with the ‘observed’ post-tax state is incorrect as opposed to the one used in the GE-approach. This is because in order to obtain pretax incomes the CSS simply subtract the taxes from the gross incomes as they are in the post-tax state, even though the CSS assume (for example, in the case of a partial capital tax) that it act ually burdens all capital in part or in total. This gives an obviously erroneous estimate of the pretax capital income from the CSS. The GE-approach, by allowing relative prices to change, can arrive at a counterfactual that would actually have prevailed before the tax, even under specific assumptions regarding the nature of production function, as has been explained by Meerman and Shome (1980). For these reasons, I employ this approach for an analysis of corporate tax incidence in ASEAN.8

There are problems, however, in using the GE-approach for the analysis of tax incidence because it assumes, ceteris paribus, conditions for technology, labor supply, level of unemployment, and savings and investment in making incidence estimates. But these problems are all shared by the CSS and no better procedure currently is available than the GE-approach as in the latter relative prices are allowed at least to change, whereas in the CSS they are not. Meerman (1978) put them all together under the title RPTO incidence (relative prices, technology, output), out of which the GE-approach considers at least the relative price issue, whereas the CSS consider none at all. Having discussed alternative methodologies, I apply the same model of tax incidence as used in the previous chapter on India, to ASEAN economies.

6 Salleh (1977) makes three alternative assumptions about the shift between shareholders and consumers, one similar to Mclure’s. 7 Shoven and Whalley (1977) extended this approach to an m x n x q model for the United States, Whalley (1975) and Piggott and Whalley (1980) for the United Kingdom, and Piggott (1980) for Australia. 8 The econometric approach used by Musgrave and Kryzaniak (1963), the main problem of which is its short term nature, also needs a mention. The ensuing debate regarding competing methodologies between these authors and Cragg et al, (1967) clarifies some of the problems regarding the econometric approach.

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3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED

The model used is amenable for the study of the incidence of various kinds of taxes (such as a general tax on income, partial taxes on factor incomes, a partial commodity tax, or a general sales tax). Here I will utilize the model to study the incidence of a partial factor tax; that is, a tax on one factor (capital) in one sector (corporate). The general equilibrium model specification employed here was originally used in the context of international trade theory by Jones (1965) and Batra (1973) and applied to issues in public finance, in particular tax incidence, by Shome (1981). Although within the genre of relative-price incidence models (what we have termed the GE- approach models) by Shoven and Whalley (1977) for the United States and Piggott (1980) for Australia are more general in that they allow for more sectors and factors of production, lack of data on corporate tax contribution by sector for ASEAN, limits this study to the use of a two-sector two factor model.

At the outset it must be said that incidence in these models relates to the movements in the relative prices of factors of production in pursuance of the two-way division between labor and capital. Furthermore, given that incidence relates to prices, when a statement is made about tax-resultant movements in the price of capital, for example, it refers to the equilibrated price across both corporate and non-corporate sectors. Thus, the burden refers to the burden on capital (relative to labor) across both sectors rather than just on corporate capital. As mentioned earlier, although the CSS also assume that non-corporate capital can be burdened due to a corporate tax, they make no adjustment for such an assumption in the generation of pretax counterfactual (or non-observed) incomes. The GE- approach avoids this type of error because it allows relative prices to change.

Needless to say, availability of data that could be used in generating the values of factor shares is somewhat limited. Yet under plausible assumptions published data may be meaningfully utilized for our purposes. In this section, I will expand upon how I have generated different segments of the data required for the analysis.

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3.1 Generating figures for incomes of corporate and non-corporate sectors P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED

3.1 Generating figures for incomes of corporate and non-corporate sectors

All countries have sector-wise gross domestic product figures at current prices, published in their own National Accounts or in the World Tables, World Bank. I have utilized the National Accounts because their figures correspond better to wage income figures derived primarily from national sources. In the Appendix, I have listed the sources of data for the different categories.

A major data problem exists in dividing the economy into corporate and non-corporate sectors. The usual approach, introduced by Harberger (1962) is to take the ratio of corporate tax to capital income in each industry or sector. Where the ratio is high - meaning that a major part of capital income is paid in corporate taxes - it is included in the corporate sector; others are included in the non-corporate sector. Thus, Harberger included real estate, agriculture, and some services with a ratio of 3 per cent or less in the non-corporate sector, and all others with a ratio of 20 per cent or above in the corporate sector. Similarly, Shome (1978), in a study of India, following the same methodology and using as the two cut-off points 10 per cent or less and 20 per cent or above, included agriculture, fishery and forestry, and mining and quarrying in the non-corporate sector, the remaining sectors going to the corporate sector. Although it was apparent that construction should ideally be included in the non-corporate sector, its appearance jointly with corporate tax data on manufacturing necessitated the former’s inclusion in the corporate sector.

Table 2

Income, factor incomes, and corporate tax

Page 2 of 2 3.1 Generating figures for incomes of corporate and non-corporate sectors

The decision regarding inclusion of sectors into the corporate and non-corporate sectors for ASEAN had to be based on the general information from the above studies and on perusal of available government surveys that indicate the major sectors that pay the corporate tax in ASEAN. Thus, the non-corporate sector is determined to include agriculture, fishery and forestry, construction, transport, communication, and other services. The corporate sector includes the rest: manufacturing, utilities, trade, and financial and business services. Although in India mining and quarrying was included in the non-corporate sector, in ASEAN it is included in the corporate sector because ostensibly it is a sector that yields considerable corporate tax revenue, for example, in Indonesia, Malaysia, and the Philippines. The domestic product figures of each category are pooled accordingly to yield the incomes of the corporate and non-corporate sectors (Table 2).

Once corporate and non-corporate sector incomes are obtained, I proceeded to divide these sectoral incomes into wage income and residual non-wage income. The corporate tax is assumed to be levied on non-wage income in the corporate sector and the query is whether it is borne by non-wage incomes in the economy as a whole or whether it is passed on partially to wage incomes across the economy as well.

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3.2 Deriving factor incomes by sector P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED

3.2 Deriving factor incomes by sector

Various sources of data have been utilized for the different countries in order to compute the wage incomes in their corporate and non-corporate sectors (Appendix). Sectoral wage incomes were available only for particular years for the different countries. This was the primary determinant of the year for which a country’s incidence analysis was performed.

For Singapore, in order to obtain wage income, I have multiplied within each sector its total employment with the average weekly earnings and the number of weeks (52). Non-wage income is then obtained as a residual from each sectoral income, as in all countries (Table 2). In the case of Malaysia sectoral figures for compensation to employees are available only for 1973 and are grouped into the corporate and non-corporate sectors. The same is the case for Indonesia and the Philippines.

For Thailand, although data on compensation of employees are available by sector, the same source lists ‘income from farms, professions and unincorporated households’ separately. It is not feasible to divide this latter portion into wage and non-wage income. So I have performed the incidence analysis by ignoring this portion of income for the calculation of compensation of employees. However, a reading of Table 3 should show that the element values thus obtained are in the range of values obtained for the other countries.9

9 I did try to divide ‘income from farms, professions, and unincorporated households’ into corporate and non-corporate labor income, but this was not successful because it includes returns to the non-labor input as well. As a result, the resultant element values were out of line from those of other countries. Ignoring this category of income seemed to be a second-best option, yielding comparable values of elements with those of the other countries.

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3.3 Corporate tax figures P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED

3.3 Corporate tax figures

Total corporate tax figures for the relevant years are available for Thailand, the Philippines, and Indonesia. These are assigned entirely in the corporate sector (as I have defined it) because figures for corporate tax contribution by sub-sector are not available. This subsumes that no enterprise in the sub-sectors included in the non-corporate sector paid any corporate tax at all. However, this does not seem to be an unwarranted assumption as I have included in the corporate sector, all major sub-sectors from where most corporate tax payments are made.

Indonesia’s figure for corporate tax payment is, of course, rather extraordinary because the oil company tax forms the major component of overall tax revenue. Table 2 shows that the non-oil company tax comprises slightly less than 10 per cent of total company taxes. Because the oil company tax is big enough to overwhelm the effect of the non-oil portion of the corporate tax, I have performed the incidence exercise with and without the oil company tax. As we see below, the incidence results obtained are similar for the two cases.

In the case of Singapore direct personal and corporate tax figures are lumped together in income tax publications. In order to obtain corporate tax figures, therefore, I have taken the percentage distribution of total income taxes assessed between 1976 and 1978 and used the average to determine the portion of corporate tax in total income taxes. Also, non-resident companies that pay about 10 per cent of total corporate tax have been ignored in this incidence analysis because, operating abroad, they would be unlikely to pass on any burden to domestic wage incomes.

Finally, Malaysian corporate tax figures are published independently of total direct tax figures only from 1976. As the analysis is constrained to 1973 due to the non-availability of sectoral incomes after that year, I have used the 1976 to 1978 average figures of corporate tax to total direct tax ratio in order to obtain a suitable figure for corporate tax contribution in 1973.

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3.4 Discussing element values P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3 A DISCUSSION ON DATA AND ELEMENT VALUES GENERATED

3.4 Discussing element values

Having obtained the raw data (Table 2), the element values are presented in Table 3. The value of |?| indicates the relative factor intensities of the corporate vis--vis the non-corporate sector. The negative sign for all countries indicates that the non-corporate sector is relatively labor intensive which, of course, is to be expected in developing countries. This is quite different from the United States where the corporate sector is the more labor intensive sector.10

Table 3

Although the negative sign for |?| is common to all countries studied here, a perusal of the values of λij for the different countries could enable us to draw conclusions regarding their sectoral factor intensities and, in effect, make some observations regarding their stage of development. For example, by looking at λLj we can say that the difference between λL1 and λL2 will be the widest where non-corporate act ivities (agriculture, forestry, fishery, construction, household services, etc.) are most labor intensive as opposed to corporate activities (manufacturing, mining, etc.), which are relatively less so. This nature of relative factor intensities is likely to exist in developing countries, the difference decreasing with development and reversing for developed countries such as the United Kingdom and the United States. A perusal of Table 3 makes obvious that the difference between λL1 and λL2 is the least in the case of Singapore and the most for Thailand. Between these extremes are the Philippines, Indonesia, and Malaysia. Similar observations could be made about the countries from other element values presented in Table 3.

Table 4

Incidence of the corporate tax

Page 2 of 2 3.4 Discussing element values

10 The relative labor intensities in the corporate sector vis--vis the non-corporate sector in the United States were calculated by Harberger (1962).

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4. EMPIRICAL RESULTS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

4. EMPIRICAL RESULTS

In order to derive the empirical results on incidence, I compared the value of r*, derived as a solution of the model (Expression 10 in Chapter II.1) with the value of r* that should emerge if no part of the tax is passed on to wage income (Expression 12 in Chapter II.1). These values are presented in Table 4.

Looking at Expression 10 it is obvious that r* depends on three parameters, E2, Ideally, these values should have been available from the ASEAN economies themselves, but they are not. Some estimates are available for individual developing countries as well as for cross-sections of developing and developed economies, which we use as proxies. But there is the lack of a wide array of studies producing estimates for these elasticities, and sometimes there seems to be rather little agreement among researchers regarding their values. Thus, I have had to pick them based on the best judgment possible.

The elasticity of factor-substitution in the corporate sector X1, is unity according to early empirical work by Zarembka (1970, 1972), who suggests that for most manufacturing industries the CES production function degenerates to the Cobb-Douglas production function. This is not to say that the value of unity for has not been questioned in the literature. As pointed out in a review of the literature by Berndt (1976), ‘cross- sectional data provide estimates which are quite close to unity, but time-series studies generally report lower estimates’ (p 59). Although he feels that the estimates are sensitive to differences in measurement and data construction, he goes on to say that ‘with our preferred set of data we obtain OLS and 2SLS time-series estimates... which are consistent with the cross-sectional evidence’. I, therefore, assume that is unity in the empirical work here.

There is some difficulty in choosing the value of , the elasticity of factor-substitution in the non-corporate sector. If we take the elasticity of factor-substitution in agriculture as a proxy, we still find a lack of agreement regarding its value in the literature. First, Lianos (1971) has estimated in US agriculture to be in the range of 1.5 to 2.4. Off-hand one need not expect to be less in ASEAN than in the United States because after all, the elasticity is an expression of how much factor intensities will move with a change in relative factor prices and by and large in these countries, given relatively high capital costs, it may be expected that capital intensity would increase with lower costs for capital. Between the values of 1.5 and 2.4, the lower the chosen value for , the higher will be the burden of the tax on capital as appears in the denominator of expression 10, and r* as a solution for the model would be less (given that a* is negative). However, in a cross-section study of the agricultural sector in selected developing and developed countries, Hayami and Ruttan (1971) claim, ‘Both in gross output terms and in value-added terms, the results of estimation are consistent with unitary elasticity of substitution’ (p 104). In their sample they include India, Mauritius, Mexico, Peru, the Philippines, and Sri Lanka among the developing countries. In deference to the above information I have used two alternative values, 1.0 and 1.5, for . Obviously, using the former yields a higher burden on capital than does using the latter.

Page 2 of 2 4. EMPIRICAL RESULTS

Finally, the value of E2, the elasticity of demand of the non-corporate good, must be obtained. Harberger (1962) had used the value of -6/7 implying a relatively inelastic demand. Pitt (1983) has estimated the own-price elasticity of demand for various agricultural commodities in Bangladesh.11 He estimates the elasticity of demand for rice to be exactly -6/7. Therefore, I continue to use this value as a proxy for E2.

Table 4 shows that, based on the value of = 1, the burden of the corporation income tax on capital is greater than 100 per cent. It may be useful to recall here that this does not imply that the price of the corporate good does not increase. Indeed, its price relative to that of the non-corporate good must increase, making the consumers of the former worse off. The incidence statement made above refers to the share of the burden among factor owners of capital vis--vis labor, rather than between producers and consumers. Even if one were to take the value 2sLK= 1.5, as shown in Table 4 (except in the case of Singapore) in all countries the corporate tax is almost entirely borne by capital. Given that a* is negative, Thailand is the only country in which capital act ually bears more than 100 per cent, Malaysia 100 per cent, and the others nearly 100 per cent; but all of them are around the mark of 100 per cent burden on capital, with Singapore the only exception.

Even in the case of Singapore, capital does bear the substantial portion of the burden of the corporate tax compared to labor. Obviously, if r* = w* = 0, capital and labor bear burdens in proportion to their initial shares in national income. Thus, given that for Singapore the solution of r* from the model is much nearer to the 100 per cent burden (on capital) mark than to the proportionate burden mark, one can safely conclude that the tax burden falls primarily on capital. One reason for the difference in results in the case of Singapore could be that Singapore is a significantly open economy with a freer inflow and outflow of capital. To quote from Booth (1980), ‘The first feature is the very high degree of foreign ownership and control of manufacturing and commerce.... in 1975, 58 per cent of manufacturing output was exported and over 90 per cent of direct exports of manufactured goods came from foreign-owned or joint-venture companies’ (pp 108-109). Given the open nature of Singapore’s economy, it may be possible for international capital to pass on some of the burden of the corporate tax to labor. On the other hand, Booth rightly cautions us by saying that foreign capital in Singapore may be rather inelastic ‘because they feel the package offered by Singapore is preferable to that offered by other potential host countries.’

All the country results substantiate Harberger’s (1962) theoretical assertion: ‘Only if the taxed industry is relatively labor intensive can labor bear more of the tax, in proportion to its initial share in the national incomes’ (p 228).12 In the ASEAN countries the untaxed non-corporate sector is the relatively labor intensive one. Then, according to Harberger, it is impossible for the tax to fall proportionately more on wage income than on non-wage income as we have found. Indeed the results show even more: not only does wage income bear proportionately less, it bears nothing or almost nothing of the corporate tax. This tax seems to be borne almost entirely by non-wage incomes in ASEAN.

11 The cited estimate is for ‘high expenditure households,’ that is, for those ‘without serious nutritional deficiencies’ (Pitt, 1983, p 107). 12 The empirical result for Singapore, therefore, can also be explained as follows. Earlier in the chapter, I pointed out that the difference between ?L 1 and ?L 2 is the least for Singapore - the labor intensity of the Singapore non-corporate sector is not as much higher than the corporate sector as compared to the differentials in the other countries. Harberger’s theoretical assertion would then imply that there is a higher possibility in Singapore for part of the corporate tax burden to be passed on to labor.

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5 CONCLUSION AND POLICY IMPLICATIONS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

5 CONCLUSION AND POLICY IMPLICATIONS

The issue of corporate tax incidence in the ASEAN countries is not a small one because, as we find in a comparative fiscal analysis of ASEAN and selected developed countries, tax effort as well as the contribution of the corporate tax to overall tax revenue are comparable in the two sets of countries. The economic ramifications of the corporate tax should, therefore, be equally important in both and this despite their overall tax structures being quite different, in that the ASEAN countries depend much more on consumption taxes than do the developed countries in keeping with their relative stages of development.

The result that capital bears the entire burden of the corporate tax in a developing economy may be somewhat controversial because in the absence of studies on corporate tax incidence in a general equilibrium framework, the usual presumption has been that the corporate tax is ‘shifted’. If this is interpreted as being shifted forward to consumers, capital owners may still bear the burden in their role as consumers and this cannot be a clear-cut division of burdens. Ideally, one must look at whether there is any shift of the burden from capital to labor as the corporate tax is a (partial) tax on a factor of production. This can be studied only in a general equilibrium framework as has been done here. The result obtained is that in almost all countries (except possibly Singapore) the corporate tax is borne by capital across the economy. Even in the case of Singapore most of the burden of the tax is on capital. The above results on incidence should, however, be interpreted within the confines of the limitations of two- sector, two-factor models. It should be kept in mind that uncertainty in production functions, the existence of more than two factors of production, the importance of income effects, and difficulties with the choice of elasticities all tend to modify the results that emerge from these models.

Given the result obtained in this chapter, however, its implication for CSS is that while allocating burdens of the corporate tax in pursuance of overall budget incidence, one can allocate all of it to the economy’s capital (in both corporate and non-corporate sectors). No separate allocation needs to be made to consumers as once we allocate all of the burden to capital (and none to labor) that part of the burden that capital owners bear in their role as consumers is already covered. This would imply different allocations of the burden compared to the earlier studies for ASEAN countries. Furthermore, in many of these studies, as indeed in most CSS in general (probably with the exception of Pechman and Okner, 1974), it is not clear whether the allocation of burden is made to corporate profits only or to non-corporate profits as well. As mentioned in the body of the chapter, if capital can move reasonably easily between the corporate and non-corporate sectors, the allocation of burden must be on capital in both sectors and not just on corporate profits.

Finally, I comment on the policy implications of this study and related issues in tax reform. Because the corporate tax falls on capital in both the corporate and the non-corporate sectors, the return to capital relative to that of labor is depressed across the economy. Although the assumptions of the model used in this study do not allow for long run effects on the economy’s factor supplies as a result of the tax, the fall in the price of capital relative to that of labor must have a negative impact on the long run supply of capital - investment in the economy is bound to suffer due to the tax.13

Should the conclusion of this study (ie, that capital bears the full burden of the corporate tax) be valid, a clear policy implication is the immediacy with which double taxation should be curtailed. In none of the ASEAN economies is there full integration of the corporate tax with the income tax. In Malaysia and Singapore there is partial integration through the withholding or the dividend received-credit method. Under this method retained profits are taxed but dividends, which are subject to withholding at the company level, are taxed only at the level of individual taxpayers. Indonesia, the Philippines, and Thailand follow the ‘separate entity system’ in which corporate profits are taxed at

Page 2 of 2 5 CONCLUSION AND POLICY IMPLICATIONS the corporate level and dividends are once again taxed at the individual level. This has several detrimental ramifications. It violates the equity principle due to the overtaxation of dividend incomes relative to other incomes such as interest on debt. Thus it encourages debt finance where interest is deductible, and the retention of profits rather than distribution of dividends. Therefore, it adversely affects efficiency as well.

Double taxation of dividends does provide higher governmental revenues in the short run. Thus, the impact of a move toward integration would lead to a loss of some tax revenue (Asher, 1983). However, the removal of double taxation should result in higher growth and productivity in the long run and, consequently, in a larger tax base - more than recovering the loss of revenue in the short run.

13 For an incidence theory of factor taxation under conditions of growth, refer to Marrelli and Salvadori (1983).

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APPENDIX P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

APPENDIX

Sources of Data

Page 2 of 2 APPENDIX

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REFERENCES P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

REFERENCES

Andic, FM, 1977, ‘Poverty and Tax Incidence in West Malaysia,’ Public Finance Quarterly, Vol 5, pp 329-350.

Asher, MG, 1983, ‘Some Issues in Corporate Income Taxation in ASEAN,’ Asian Pacific Tax and Investment Bulletin, Vol 1, pp 60-70.

Batra, RN, 1973, Studies in the Pure Theory of International Trade, London: Macmillan.

Berndt, ER, 1976, ‘Reconciling Alternative Estimates of the Elasticity of Substitution,’ Review of Economics and Statistics, Vol 48, pp 59-68.

Booth, A, 1980, ‘The Incidence of Taxation: A Preliminary Analysis,’ pp 100-130 in M Asher and O Osborne, eds, Issues in Public Finance in Singapore, Singapore: Singapore University Press.

Congressional Budget Office, 1978, Analysis of the Roth-Kemp Tax Cut Proposal, Washington, DC.

Cragg, JG, AC Harberger, and P Mieszkowski, 1967, ‘Empirical Evidence on the Incidence of the Corporation Income Tax,’ Journal of Political Economy, Vol 75, pp 811-821.

Gupta, AP, 1977, Fiscal Policy for Employment Generation in India, Delhi: Tata Mcgrawhill.

Harberger, AC, 1962, ‘The Incidence of the Corporation Income Tax,’ Journal of Political Economy, Vol 60, pp 215- 240.

Hayami, Y and VW Rattan, 1971, Agricultural Development: An International Perspective, Baltimore: John Hopkins University Press.

Jensen, MC, and WH Meckling, 1977, Can the Corporation Survive? Reprint Paper 6. Los Angeles: International Institute for Economic Research.

Joint Legislative-Executive Tax Commission, 1974, A Study of Tax Burdens by Income Class in the Philippines, Manila.

Jones, RW, 1965, ‘The Structure of Simple General Equilibrium Models,’ Journal of Political Economy, Vol 63, pp 557-572.

Kopcke, RW, 1978, ‘The Decline in Corporate Productivity,’ Kanas City Federal Reserve, (unpublished).

Krongkaew, M, 1975, ‘The Income Redistributional Effects of Taxes and Public Expenditures in Thailand,’ Phd dissertation, Michigan State University.

Lianos, TP, 1971, ‘The Relative Share of Labor in the United States Agriculture, 1949-68,’ American Journal of Agricultural Economics, August, pp 411-422.

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McLure, CE Jr, 1972, ‘The Incidence of Taxation in West Malaysia,’ Malayan Economic Review, Vol 17, pp 66-98.

Meerman, J, 1979, Public Expenditure in Malaysia: Who Benefits and Why, New York: Oxford University Press.

______, 1978, ‘Do Empirical Studies of Budget Incidence Make Sense?’ Public Finance, Vol 33(3), pp 295-312.

______, and P Shome, 1980, ‘Estimating Counterfactual Incomes in Studies of Budget Incidence,’ Public Finance, Vol 35(2), pp 291-299.

Musgrave, RA, and M Krzyzaniak, 1963, The Shifting of the Corporation Income Tax, Baltimore: John Hopkins University Press.

Musgrave, RA et al, 1974, ‘The Distribution of Fiscal Burdens and Benefits,’ Public Finance Quarterly, Vol 2(3).

Pechman, JA, and BA Okner, 1974, Who Bears the Tax Burden?, Washington, DC: Brookings Institution.

Piggott, JR, 1980, ‘A General Equilibrium Evaluation of Australian Tax Policy,’ Phd dissertation, University of London.

______, and J Whalley, 1980, ‘A Summary of Some Findings from a General Equilibrium Tax Model for the UK,’ Presented at the Carnegie-Rochester Conference on Public Policy.

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Salkin, JS, 1974, ‘On the Direct Measurement of Tax Progressivity in Thailand,’ National Tax Journal, Vol 27, pp 301-318.

Salleh, IM, 1977, ‘Tax Incidence and Income Distribution in West Malaysia,’ Phd dissertation, University of Illinois.

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CHAPTER II.3 THE GENERAL EQUILIBRIUM THEORY AND CONCEPTS OF TAX INCIDENCE IN THE PRESENCE OF THIRD OR MORE FACTORS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

P Shome - Taxation, Principles and Applications > P Shome - Taxation, Principles and Applications > II. Incidence and Distribution Effects of Taxation > CHAPTER II.3 THE GENERAL EQUILIBRIUM THEORY AND CONCEPTS OF TAX INCIDENCE IN THE PRESENCE OF THIRD OR MORE FACTORS

CHAPTER II.3 THE GENERAL EQUILIBRIUM THEORY AND CONCEPTS OF TAX INCIDENCE IN THE PRESENCE OF THIRD OR MORE FACTORS1

1 One area of investigation in the 1970s was whether the robust results of tax incidence derived from the models represented by two productive sectors and two factors of production were model specific, or whether they would carry over in a more complex model framework. This was tested in the context of a third factor of production used exclusively in one of the sectors. The chapter, demonstrating significant generalizable results, is excerpted from Parthasarathi Shome, ‘The General Equilibrium Theory and Concepts of Tax Incidence in the Presence of Third or More Factors’, Public Finance, Vol 36(1), pp 22-38, 1981.

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1. INTRODUCTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

1. INTRODUCTION

There are two purposes for this chapter. The first is to develop tax incidence concepts that would clarify the discussion of the burden of taxation in the presence of two or more factors. These concepts are referred to as the ‘relative’ and ‘absolute’ burden of tax. The term relative burden refers to the relative loss (or gain) in income in percentage terms of one factor compared to another following a tax change. The term absolute burden refers to the effect on the level of real income of a factor following a tax change. Thus equal absolute burden refers to the situation in which a factor’s real income declines by a fraction of the tax, where the fraction is the factor’s share in income. Similarly, concepts of hundred per cent absolute burden and ‘more than’ (‘less than’) equal absolute burden are also defined in the chapter. The second purpose of the chapter concerns the form in which well-known tax incidence results carry over following the introduction of third or more factors. This is achieved through the algebraic exposition of a model introducing a third factor used specifically in one sector, though the model is generalizable to more factors. While the general tax theorems carry over, the presence of a third factor is found to qualify results concerning the incidence of partial taxes in substantive ways. This is because, with the introduction of a third factor, factor substitutions generated by the switching of two taxes are no longer so simple as in the two factor case. The gain in income of the first factor (say capital) is no longer the same as the loss in income of the second (labor), since the income of the third factor (land) will change as the partial tax on capital is reduced and that on labor increased. The effects on the net price and income of the factors depend on the relative magnitudes of the elasticities of factor substitution. As expected, these results collapse to the Harberger-Mieszkowski case if we assume that the income share of the third factor, land, is zero, and that factor-substitution elasticities between land and labor, and between land and capital, are equal. This establishes our results as more general, with the Harberger-Mieszkowski conclusions as a special case.

The earliest attempts to analyze the incidence of taxes in a general equilibrium context were made by Musgrave (1953), Meade (1955), Wells (1955), and Johnson (1956). However, until Harberger’s (1962) exposition of a two- sector framework, no satisfactory general equilibrium model, capable of definitive analysis of tax incidence, had emerged. This framework was subsequently used by Mieszkowski (1967) to derive results on equivalences among general taxes as well as differential incidence of partial taxes.

A large number of authors have pointed out the restrictive nature of the assumptions characterizing the Harberger model and have attempted to isolate their effects. For example, Mclure (1971) has analyzed the implications when factors are imperfectly mobile. Mclure and Thirsk (1975) have analyzed expenditure incidence by considering income groups with different expenditure patterns. Ballentine and Eris (1975), and Vandendorpe and Friedlander (1976) have analyzed the role of finite taxes and excess burdens. Feldstein (1974b) has analyzed the implications of variable factor supply. Sato (1967), Krzyzaniak (1967), Feldstein (1974a, 1974b), Grieson (1975), and Ballentine (1978) have extended the framework to a growing economy. Ratti and Shome (1977a) have seperated incidence effects from efficiency effects. However, all of these extensions have retained the (2 commodity x 2 factor) nature of the original model.

It will be the purpose of this chapter to develop measures of tax incidence when there are more than two factors and to illustrate the generality of the Harberger-Mieszkowski results on tax incidence by testing tax incidence theorems in a three-factor context. The consideration of third factor would suggest itself from a reading of Harberger’s (1962) followed by Ratti and Shome’s (1977b) empirical work, where the low-tax, non-corporate sector is found to be made up primarily of two industries, agriculture and real estate, in which the return to the owners of land may not be small. The return to land in the high-tax, corporate sector, comprising mainly manufacture, is

Page 2 of 2 1. INTRODUCTION relatively insignificant. Therefore, land may appear as a third factor in the non-corporate sector. Other arguments can also be provided in justification of third or more factors in different empirical uses of this model.

While Harberger’s conclusions have been tested in the presence of three factors (Ratti and Shome, 1977b), Miezkowski’s theorems remain to be tested under this assumption, which is the objective of this chapter. Miezkowski assumes two factors, labor and capital, being used in each of the two sectors in the model. However, if the two sectors are defined as, for example, the agricultural and non-agricultural sector, the inclusion of land as a third factor in the non-corporate sector seems imperative,2 even though the return to land in the corporate sector may be insignificant.

As we shall find, all the general tax theorems carry over in the specific factor model. The partial, equal rate tax theorems also carry over unmodified, with some interesting corollaries. However, the partial, equal yield tax theorems are now modified and nothing can be said regarding the differential incidence of partial, equal yield taxes. Thus a surprising number of the theorems carry over under the assumption of a third, specific factor, revealing the strength of the framework. However, it must be admitted that the partial, equal-yield theorems, which do not carry over in this model, are extremely important for empirical tax incidence analysis in a general equilibrium context.3

In what follows, Section 2 describes the model, its solution, and the way different taxes are introduced into the model. Section 3 explains the concepts of tax incidence in the specific factor model with three factors. It will be seen that incidence, usually defined as the change in the relative prices between the two factors, now has to be reinterpreted in the context of the three factors for, now the relative change in the price of just one factor vis--vis the second may not mean much for tax incidence. Finally, Section 4 presents the tax incidence theorems, showing Mieszkowski’s case as a special case of this more general model.

2 Even if we define the two sectors as the corporate and the non-corporate sectors, as in Harberger (1962), we may note that the latter consists largely of the two sub-sectors, real estate and agriculture, in which the return to land may not be insignificant. From the Federal Housing Authority Trends, showing the share of private and commercial constructions, the Statistical Abstract of the US, showing the share of farmland and buildings in US farms, from several sample construction tables, etc. the author has come to the conclusion that the share of land in the value-added of the non- corporate sector is 15 per cent to 20 per cent. See Ratti and Shome (1977b). 3 Mieszkowski enumerated three effects on which tax incidence would depend: (a) source of income (demand) effect, (b) output (factor intensity) effect, and (c) factor-substitution effect. He pointed out that one or more of these effects may be zero under different conditions. For example, the output effect is zero when the two sectors have the same factor intensities. The factor-substitution effect is zero under fixed coefficients of production and the demand effect is zero when all groups have the same spending propensities. These effects may reinforce or work against one another, depending upon the particular tax and its incidence. Different parameters such as the elasticities of commodity demand and factor substitution affect incidence.

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2. THE MODEL AND ITS SOLUTION P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

2. THE MODEL AND ITS SOLUTION

We employ a general equilibrium framework, often used in the context of international trade theory a la Jones (1965) and Batra (1973).

We assume perfect markets, full employment, fixed factor supplies, linear homogeneous and quasi-concave production functions, and perfect inter-sectoral mobility of non-specific factors. The equations in the production side of the model are

(1)cl1x1 + cl2x2 = l (2)ck1x1 + ck2x2 = k (3)ct2x2 = t (4)w1cl1 + r1ck1 = p1 (5)w2cl2 + r2ck2 + n2ct2 = p2 (6)ci1 = ci1(w1, r1) (i = l, k) (7)ci2 = ci2(w2, r2, n2) (I = l, k, t) where xj(j = 1, 2) is the production of the j th sector, cij is the input-output ratio between the i th factor and the j th sector, l, k, and t are the total supplies of labor, capital and land respectively and wj, rj, nj, and pj are the wage rate, rental of capital, rent of land, and product price respectively in the j th sector. Equations (1)-(3) describe the full employment conditions of the economy, (4)-(5) are the price-cost equations of the producers, and (6)-(7) are the expressions of the input-output ratios as functions of input prices. Due to perfect competition, in equilibrium, each input price must be the same in both sectors.

(8)x1* = e1p* = e1(p1* - p2*)

Where e1 is the price elasticity of demand for x1, p = p1/p2, and * denotes a relative change, for example, x 1* = dx 1/x 1. Since there is no money in the model, we introduce p2, the price of x2, as our numeraire. Thus

(9)p2* = 0

Our model consists of 12 equations in 12 unknowns xj, cij, wj, rj, nj, and pj with parameters l, k, and t.4

With the introduction of taxes into the model, the net return to a factor must be equal in both sectors under assumptions of perfect competition. The tax parameter to be used, a, is defined as one minus the rate of tax, with a = 1 and a* b 0. Defining aij as the tax parameter for a partial factor tax on the ith factor in the jth sector, aj for a partial commodity tax in the jth sector, ai for a general factor tax on the ith factor, (i = l, k; j = 1, 2), ax for a general sales tax and ay for a general income tax, below we present the relationships between factor prices in the different sectors, and between producers’ and consumers’ product prices under different taxes.

Partial factor tax:

Page 2 of 4 2. THE MODEL AND ITS SOLUTION

(i) in x1 on capital and labor respectively: 5 r = r2 = ak1r1 w = w2 = al1w1 (ii) in x2 on capital and labor respectively:

r = r1 = ak2r2 w = w1 = al2w2

Partial commodity tax:

(i) on x1 : p1 = a1p1 (ii) on x2 : p2 = a2p2

General income tax:6

(i) on capital: r = akr1 = akr2 (ii) on labor: w = alw1 = alw2

General income tax: r = ayr1 = ayr2 w = ayw1 = ayw2

General sales tax: p1 = axp1 p2 = axp2 where r and w are the net returns to capital and labor respectively, p j is the consumer price and pj is the producer price such that pj = ajpj(j = 1, 2).

Given these price relationships after the introduction of taxes, equations (4), (5), (6) and (7) may change with different taxes, but the other equations will remain unaltered. For example, for a partial factor tax on l1, we have

(4) (w/al1) cl1 + r1ck1 = p1 (5)w2cl2 + r2ck2 + n2ct2 = p2 (6)ci1 = ci1(w/al1, r1) (7)ci2 = ci2(w2, r2, n2)

Here equations (5) and (7) do not change because the tax affects Sector x 1 only. 7 Noting these changes in the equations of the model, we solve the model, in the Appendix, for a partial tax on l1. The above system of equations is then reduced to a system of four equations:

where

Page 3 of 4 2. THE MODEL AND ITS SOLUTION

| v | = vl1 vk2 - vk1 vl2, vij is the proportion of the ith factor used in the jth sector, for example, vl1 = l1/l, and qij is the share of the ith factor in the income of the jth sector, for example,

where is the partial elasticity of substitution between the ith and the mth factors in the jth sector.

Expanding d, the denominator of the System (10), which is the (4 4) matrix on its left-hand side, it is seen that it depends on the signs of , |v | and e1, the elasticity of demand for good x1. 8 For the sake of simplicity and also to make our results independent of complementarity of factors, we assume that all factors are substitutes, so that Then given e1 is negative, d has the same sign as | v | if it is evaluated at al1 = 1, implying that there is no tax initially, an assumption made by Mieszkowski and Harberger, that remains with us. Thus d has the same sign as | v |. Now the system can be solved for w*, r*, and n* which we need for the incidence concepts. If the system is solved for any other tax, only the right-hand side of (10) changes, giving new values for r*, w*, and n*.

4 Note that r 1 = r 2 and w 1 = w 2 in equilibrium. 5 Note that (w/al 1) = w 1 is the gross wage rate in Sector x 1. In view of perfect mobility of factors, w 2 = w = w 1 al 1 and r 1 = r 2 = r in the case of a partial factor tax on labor used in x 1. 6 Since land is a specific factor to x 2, there will be a return to land only in this sector. Hence there are no relationships enumerated for the return to land in the two sectors. 7 These sets of equations can be worked out very easily for all taxes under consideration utilizing the different tax parameters introduced for the different taxes.

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3. INCIDENCE CONCEPTS P Shome - Taxation, Principles and Applications PARTHASARATHI SHOME

3. INCIDENCE CONCEPTS

The concept of incidence or burden of a tax in our model with the introduction of the third factor, will have to be distinguished from that of Mieszkowski’s two factor case. The distinction will be important in the general equilibrium, tax incidence results of partial taxes, as will become evident in Section 4. In the Mieszkowski analysis, tax incidence is always in the context of two factors. For example, capital bears an equal burden of the partial capital tax in x 1, in proportion to its initial share in income if the income accruing to it net of the tax in ratio to labor’s income remains unchanged, for which (rk/wl) should be constant ie, d(rk/wl) = 0, or rk/wl (r* - w*) = 0.9 If r* = w*, the burdens will be equal in proportion to their initial shares in income. In his analysis, Mieszkowski had the price of labor as the numeraire, that is, w* = 0. Therefore, r* = 0 is his equi-burden condition. Further, if capital and labor bear an equal burden in proportion to their initial shares in income, they are worse off in real terms as a result of the imposition of the tax.

In our three-factor model, however, with the introduction of land, several complications may arise. For example, as a result of the imposition of a tax, the income of land may fall by the value of the tax revenue whereas capital and labor’s shares in income remain the same. A further clarification is provided in Figure 1. The horizontal axis measures product x1 and the vertical axis, x2. The production possibility frontier is PP, the pretax production point being P1. For simplicity, if we measure total income by the ray from the origin to the production point, for example OP1, we can further divide its length into income shares. Thus, let OA be the income of capital, AB of labor and BP1, of land. Let us assume OA = AB = BP1. Now a partial capital tax in x1 is imposed and the production point shifts to P2, that is, there is now more of x2 produced and less of x1. The after-tax production point P2 having been decided we can say that the new income is OP2. Let the tax revenue be C'P2. The incomes of capital and labor fall to OA' and A'B' respectively but are still equal. Land’s income is now B'C' which is unequal to OA' and A'B'.

Figure 1

Therefore though the ratio of capital and labor’s income remains unchanged, those between land and each of the

Page 2 of 2 3. INCIDENCE CONCEPTS other two factors change. In this case, when the ratio of capital’s income (net of the tax) to labor’s income, remains unchanged, we shall say that capital and labor are bearing an equal relative burden. On the other hand, capital and land (or labor and land) bear unequal relative burdens in the above example. Thus a comparison of the factor shares of any two of the three factors, ignoring the third, will imply a statement on relative burdens.

With the introduction of the third factor land, we should then have as a constant for capital to bear an equal burden as compared to both labor and land, in proportion to their initial shares in income, that is

= 0. The solution then yields Thus r* = w* = n* = 0 is our solution for an equal burden between capital on the one hand, and labor and land on the other. In terms of Figure 1, this will be satisfied in the case OA' = A'B' = B'C'. We shall refer to this as an equal absolute burden on capital in proportion to its initial share in income, that is, when capital is being compared to the other two factors combined. Thus an equal absolute burden will imply proportionate tax burdens on all three factors, and a statement on absolute burdens will involve all three factors.

It is extremely important to note that in this three factor model, a statement on relative burdens may not mean much regarding the real burden that a factor bears due to a tax since in order to do this we must speak of all the factors together. Thus only absolute burdens will be meaningful for any comparisons regarding incidence.

Going over to the case of 100 per cent burdens, a factor bears 100 per cent of the relative burden of a tax with respect to a second factor if the gross income accruing to the first factor in ratio to the net income of the second remains the same, implying that the tax revenue has been fully accommodated by the former. For example, if the tax is a partial capital tax on k1, then

is the condition.10 With land too in the picture the condition changes to

The conditions for proportionate and 100 per cent burdens (both relative and absolute) on any factor due to any tax can be calculated similarly. Given these interpretations of tax incidence in our three-factor model we proceed, in Section 4, to analyze the tax incidence theorems derived by Mieszkowski (1967).

9 The basic definition of proportionate burdens may be given as follows: for any tax, a particular factor bears proportionate burdens (in proportion to its initial share in income) if the ratio of its net income to the net income of the other factor remains the same ie, d(rk/wl) = 0. 10 If the tax is a general capital tax on k, then the condition will be d {(r/ak)k/wl} = 0. Conditions for other taxes can be worked out.

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