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 counter-productive and adding confusion on what management philosophy the PML-N actually believes in! On one hand, by reducing the corporate tax its leadership gives a signal that it believes in the correlation of tax-prudence and economic growth while on the other hand by resorting to an increase in turnover tax and by opting to retain super tax, it shows that it lacks conviction in its own belief and suffers from a lack of confidence in its governing abilities to practically test the national waters on the touted trade-off between lower taxation and higher tax receipts through enhanced taxable economic activity! Now this lack of self-belief does not come as a surprise and is quite understandable because we all know that though ringing latest tax reforms is always an important agenda for any government, sadly, with the PML-N it has clearly gone missing, as little attention has been paid to it in its 4 years of rule.
Tax reforms in essence refer to a vision of the 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 that shifts investment away from home to foreign shores or gives rise to the undocumented sector. Economists believe that often the urge to unnecessarily raise taxes ultimately takes them to a level that they instead become distortional; meaning a cut in the rate actually raises 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. This exactly seems to be happening in our SME manufacturing, manifesting itself in our rapidly declining exports. When it comes to rationalising taxes on businesses there are four broader issues one needs to look at.
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, by the way, also has a similar tax law to what is currently prevalent in the US and it also requires modification to give Pakistani companies a level playing field and to stop corporate inversion.
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. A good and often used way to encourage investment under this plan is to move towards a consumption tax by allowing businesses to deduct their investment spending immediately, rather than depreciating it slowly over time. By exempting the income that businesses reinvest, the government essentially taxes consumed profits.
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.
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 in the tax reforms being proposed 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 and investment spending. How this cash flow is then paid out to equity and debt holders would be irrelevant. As we know that there is already a lot of debate taking place on this, since quite a few economists feel that the step is too radical and carries a number of unintended yet adverse long-term consequences.
To sum it up, the important thing is that regardless of what reforms a government decides to undertake it essentially has 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 taxpayer; 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 mean that it is not be attempted!
The writer is an entrepreneur and economic analyst.
kamal.monnoo@gmail.com
