Tax Peter As Youd Tax Pal

Present tax systems evolved when each country formulated its own tax policy and foc-used on the requirements of its domestic eco-nomy. Where tax treaties, agreements and conventions among nations were negotiated, they have essentially been within the framework of national sovereignty in tax policy.

The main challenge, therefore, is to make the tax systems more consistent with developments in the world economy, but without compromising the balance between the objectives of efficiency, equity, revenue generation and low administrative and compliance costs.

Trends in the world economy will impact future tax systems, in at least six major areas.

First, globalisation has greatly increased mobility of both capital and labour. While even in the 1990s there remained a strong correlation between domestic savings rates and investment rates, the relationship is quickly breaking down.

 

Capital markets in emerging economies are rapidly expanding and becoming more open. Critical information on risk is becoming more prevalent and property rights system are becoming less arbitrary. Demographic factors are also going to play an increasing role as the ratio of retired to working population increases in some countries and decreases in others. Countries with aging populations will need to make use of younger labour bases in other countries to survive. Either younger foreign labour will migrate in or capital will migrate out in search of higher returns where labour is available. Such trends are already appearing in Scandinavia, Germany, Japan, and Singapore where fertility rates are below those needed for population replacement.

These trends imply higher factor supply elasticities for any one tax-jurisdiction. Consequently countries will need to maintain basic compatibility in tax rates on profits, interests, dividends and capital gains with countries that are competing for capital. Otherwise they will see an erosion of their tax base, lower domestic investment and therefore subsequent lower total factor productivity.

In most developing countries, official development assistance (ODA) such as loans from the World Bank and other donor organisations, for which tax considerations are not important, is decreasing, while private capital flows, for which these considerations are important, are increasing. (The World Bank estimates that only 23 per cent of US $ 207.4 bn in long-term net resource flows to developing countries in 1994 was in the form of ODA; the rest was in the form of private capital.) This has created intense tax competition to influence location decisions between countries which were only a few years ago unwilling to give any concessions to foreign investment.

The use of tax policy to influence capital flows has taken two different dimensions. The first is the overall level of taxation. Here the trend is towards more uniform international treatment of capital and labour. The second is preferential tax treatment for specific segments of society, such as foreign or domestic investors. As trade barriers come down, more attention is being paid to investment barriers where taxes play an important role.

In the last round of World Trade Organisation (WTO) talks, one of the most contentious areas of discussion was how to liberalize investment regimes and narrow down, if not eliminate, the gap between the treatment given to domestic and to foreign investment. While most developed countries advocate uniform treatment of all investment, many developing countries still see a need to protect domestic investment and impose more restrictive investment regimes on foreigners.

On the flip side, tax holidays and other concessionaire measures are becoming effective tools for attracting investments. In the US, such measures have been extensively used for two decades by state governments in an attempt to attract investment. At the international level, many Asian countries such as Singapore and Malaysia have made wide use of preferential tax treatment and other implicit and explicit subsidies to attract MNCs to build their economies. China uses similar tax incentives in its special economic zones. Even Hong Kong, traditionally reputed to be a free-market economy, is considering active industrial policies.

Both free market advocates and economists have criticized differential taxation. However, legislation and international agreements are unlikely to be successful in this area. While there has been a trend towards transparency in tax systems, preferential treatment is often negotiated on a case by case basis and agreements are not made public. Hence, enforcement of any type of binding international rule becomes virtually impossible.

Furthermore, if limits are put on tax concessions, preferential treatment can easily move to exp-enditure concessions which are generally considered an area of local policy discretion. Nevertheless, intensive use of widespread incentives practiced by such rapidly growing economies as Singapore and Malaysia is likely to come under international scrutiny because of their distortive allocative and equity effects. The term fiscal dumping to describe such practices is slowly coming into vogue. For example, while mobile capital is increasingly rewarded in the recipient countries, mobile labour, particularly of the low-skilled type is increasingly taxed by them. This is only one of the aspects of asymmetry between the two.

Growing importance of portfolio investments, foreign-exchange-trading, and new financial and capital market instruments (such as index futures and various derivatives) are also creating complex problems for tax and regulatory authorities, and providing additional opportunities for tax competition. If problems are not addressed, large horizontal inequities are likely, as a major portion of economic activity will go untaxed or under-taxed.

Second, globalisation has increased the need for efficient and equitable treatment of firms and individuals operating in multiple tax jurisdictions. Current procedures used by most countries to allocate tax base between jurisdictions are highly arbitrary and cumbersome to administer.

With increased mobility of capital, and growing specialization in production of components in locations in different countries, intra-firm transactions, primarily among the multi-national corporations, are accounting for a growing share of world trade. One of the major issues of tax policy is the allocation of the tax base for these firms between countries. In most situations this involves placing some imputed value on the internal transfer of goods and services between operations in different countries. Such transfer pricing is often arbitrary, since no formal sales occur, and firms can play strategic games in an effort to lower their tax liabilities.

In the future, countries will not be able to treat the operations of MNCs in each taxing jurisdiction as a separate entity. The complexities of administration and enforcement will lead to the adoption of a unitary or world-wide tax base, with a system of tax credits or allocations procedures to prevent double taxation and to maintain competitiveness.

For example, profits or earnings subjects to taxation can be allocated based on the proportion of property, employment or sales in a particular country. Such systems are already widely used within countries like the US whi-ch have a high level of sub-national taxation and high levels of inter jurisdictional trade.

Tax credits have been a popular way to deal with double taxation at the international level, but their usefulness under a unitary tax depends on other countries using non-unitary bases or a fixed allocation system. Tax credits can also lead to large locational distortions. If firms get full credit for foreign taxes in their home country, then tax considerations become irrelevant in locating branch facilities in foreign countries.

For individuals, particularly high net-worth individuals, the proportion of income earned from foreign sources is increasing. As the foreign component is highly sensitive to tax regimes, erosion of the tax base and departure from the accepted principle that all income of the individual should be aggregated and taxed at the same rate (so-called global taxation) are occurring. Individual income is increasingly being taxed at different rates according to the nature of income, i.e whether it is in the form of wages, interest or dividends.

At some stage, regional or international agreement on allocation of tax bases will become necessary for global efficiency and equity and to mitigate revenue effects of fiscal dumping.

(Mukul G Asher is Associate Professor of Economics and Public Policy at the National University of Singapore; Thomas P. Snyder is Senior Fellow in Public Policy at the same institute)

To be concluded