When it comes to rationalising taxes on businesses
there are broader issues one needs consider: Worldwide vs. Territorial:
Most nations aim to impose taxes on economic activity
that takes place within their borders.
Such a system is called territorial.
Taxing businesses prudently is a very important economic management tool, as not only does it reflect the mindset of the government of the day, but more importantly it also helps businesses build a perception on how pro or anti-business a government really is. Pakistan’s Budget 2017-18, saw to it that the Corporate tax is reduced by 1% – not enough, nevertheless a good move – but then by the same token it undertook to increase turnover tax on businesses from 1 to 1.25%, and further it opted to retain super tax for yet another year – both totally counterproductive and adding confusion on what management philosophy the PML-N actually wants to pursue! On one hand by reducing corporate tax it gave a signal that it believes in correlation of tax-prudence with revenue generation and economic growth while on the other hand by resorting to an increase in turnover tax and by opting to retain super tax, it oscillated the opposite way. Meaning, when it came to the litmus test it lacked conviction. Not surprising though, since bold reforms require innovative thinking, a notion perhaps too much to expect from a finance ministry still largely stuck in the past. The world in the meantime has come a full circle, once again arguing the case of Arthur Laffer (Chicago School) and Simon Kuznets on the touted trade-off between lower taxation and higher tax receipts through enhanced taxable economic activity, albeit this time with enhanced focus on equity – “sometimes in order to kick start revenue-generation and growth in an economy it is necessary to facilitate tax payers and reduce tax slabs, especially where avoidance is ripe or where the space of small and medium sized firms stands stifled. High taxes at some point discourage both effort and investment ~ Galbraith.” Going by this it appears to be the ideal time to experiment new reforms in Pakistan where tax base is extremely narrow and people are afraid to enter the tax net owing to a complete lack of trust in the collector. To make matters worse, over the last four and a half years Mr. Dar’s myopic policies on revenue generation have put Pak economy at high risk by unleashing a culture where: The non-tax payer came at an advantage over the tax payer, in-turn resulting in an unprecedented rise in the un-documented sector; imports thrived at the expense of domestic manufacturing and exports; and small and medium sized firms became uncompetitive in-turn retarding job creation and equitable distribution. On a positive note though the new prime minister well understands the nuisances of modern day business and one hopes that he will take matters into his own hands.
Tax reforms in essence refer to vision of a government on how it plans to raise money and upend the incentives for private decision makers. The motivating force behind a business tax reform is always the belief by the policymaker that the prevailing rate is high, which in-turn encourages all kinds of perverse behaviour, such as flight of capital and inverting of corporate structures thereby shifting investment away from home to abroad or results in rise of the undocumented sector in an economy. According to Laffer, Kuznets and Schumpeter, often the urge to raise taxes ultimately takes them to a level where they instead become distortional; meaning a cut in the rate can actually raise revenues. Also, they argue that these very high corporate taxes depress wages for manufacturing workers. In a world where capital is mobile and labour is not, capital escapes from high-tax economies, leaving workers behind to bear the burden of lower productivity and reduced incomes. And this exactly seems to be happening today in our SME manufacturing sector, an unnecessary burden on the existing tax payers is subsequently manifesting itself in our rapidly declining exports.
When it comes to rationalising taxes on businesses there are four broader issues one needs consider:
Worldwide vs. Territorial: Most nations aim to impose taxes on economic activity that takes place within their borders. Such a system is called territorial. For example, the United States (US) has a worldwide corporate tax. If a US based company produces a product abroad and then sells it abroad, its treasury takes a cut of the profits when they are brought back into the US. This creates a negative incentive for corporate inversion and this is precisely what the Trump’s administration is proposing to correct. Pakistan also has a similar tax law and it perhaps requires modification on the lines being thought of by the US.
Income vs. Consumption: Many economists have argued that taxes should be levied based on consumption rather than income. Consumption taxes would do less to discourage saving and investment and would thus be more favourable to economic growth. In addition, consumption taxes are arguably fairer: They tax the standard of living people enjoy rather than the value of what they produce. This is a good and often used way to encourage investment. Consumption tax allows businesses to straight away deduct their spending on investment instead of depreciating it slowly over time. By exempting the income that businesses reinvest, the government essentially taxes consumed profits. A good model to follow in Pakistan where one often finds that people’s spending is not commensurate to their incomes.
Origin vs. Destination Taxation: Our current corporate tax system is origin based. It levies taxes on the profit from goods produced domestically, regardless of where they are consumed or sold. An alternate to this system is to tax all goods consumed locally, regardless of where they are made. This destination-based approach means that imports are taxed, whereas, exports are exempt. The immediate impact of such a tax regime would be to discourage imports and encourage exports. The main advantage of destination-based taxation is that it is easier to determine where a good is consumed than where it is produced. In a world where multinationals produce goods using parts from around the world, origin-based taxes invite firms to game the system with transfer pricing schemes. Destination-based taxation is less easily gamed. Pakistan facilitates fixed taxation on exports under section 115(4), but of late outright assessment on imports coupled with rampant under-invoicing have placed imports at an unfair advantage over the home industry.
Debt vs. equity: At present, firms can deduct interest payments to creditors, but they cannot deduct dividend payments to shareholders. This accounting treatment encourages firms to rely on debt rather than equity, making them financially more fragile than they would otherwise be. For example, in the new House Plan on tax reforms, under consideration now in the US, the proposal is to amend this accounting method in a way that it will no longer allow firms to deduct interest payments. A business’s taxes would be based on its cash flow: revenue minus wage-payments + investment-spending. How this cash flow is then paid out to equity and debt holders would become irrelevant. There is already a lot of debate on this, since quite a few businesses feel that such a step is too radical with high unintended but adverse long-term consequences.
To sum it up, the important thing is that regardless of which tax reforms a government decides to undertake they essentially have to ensure that they are: transparent; equitable to the tax payer; promote growth and investment; minimise the contact and control of the revenue collector; based on best management practices; provide benefit-of-doubt to the tax payer; and last but not least, are easily definable. Without a doubt any tax reform package will involve immense politicking, because any large tax change creates winners and losers, and the losers are sure to make their voices heard. However, this should not deter this new government from attempting the next level tax reforms, even if it feels it is left with little time on hand!
