Globalization and Tax systems: Implications for Developing Countries with Particular Reference to SouthEast Asia
by Mukul G. Asher* and Ramkishen S. Rajan**
* Professor, Public Policy Program, National University of Singapore. E-mail: email@example.com
** School of Economics, University of Adelaide, Australia and Institute of Southeast Asian Studies, Singapore. E-mail: firstname.lastname@example.org
We would like to thank Thomas Snyder and Gitte Heij for useful comments and Wasana Karunarathne for research assistance.
The unfolding globalization process centring on production and distribution networks, and on financial institutions, products, and transactions is having a profound impact on a wide range of policies and practices in both the private and the public sectors. This paper analyses the implications of the globalization and the resulting greater integration of the world economy on tax systems in developing countries in general and Southeast Asian countries in particular.1
Existing tax systems around the world have been shaped by historical, economic, political, social, ideological, and other factors; and they represent trade-offs among macroeconomic sustainability, allocation efficiency, equity, revenue generation, retaining and attracting economic activities to the concerned tax jurisdictions, and administrative and compliance effectiveness. Moreover, the present tax system evolved when each country formulated its own tax policy and focused on the requirements of its domestic economy. When tax treaties, agreements, and conventions among nations were negotiated, they were within the framework of national sovereignty in tax policy. The globalization process has changed this, particularly with respect to the level of taxation, mix of taxes, design of particular taxes, and the manner of their administration and compliance. Globalization thus has necessitated significant tax reform leading to major adjustments among the trade-offs inherent in the existing tax systems. Moreover, countries now need to exhibit much greater awareness of the tax changes being undertaken by their trading partners and competitors, reducing autonomy concerning their tax policies. (Tanzi, 2000, 1998; Lodin, 2000; Owens, 1998)
The globalization process is also expected to make divergence between what is desirable for a particular tax jurisdiction in a federal country or internationally on the one hand and what is desirable from overall national or global viewpoints much sharper. (Hufbauer,1999; OECD, 1998).
The need for international cooperation in taxation has therefore acquired much greater urgency but obstacles to such cooperation remain formidable. (Tanzi, 1999). Any major changes in tax structures will produce winners and losers. Some of the losers may have enough political power to block, delay or dilute reforms. Moreover, in a federal structure, ability of national governments to negotiate international tax agreements which may impact on the taxing powers of the lower levels of governments, is likely to be limited.
Adaptation of the tax systems to globalization is expected to be slow and subtle rather than discontinuous (Slemrod, 1995, p. 146). Tanzi has used the term “Fiscal Termites”2 to explain how globalization and technological changes will impact on the tax systems (2000). The conventional wisdom about appropriate tax policies and structures is therefore likely to undergo slow but perceptible change over time. It is also possible that even as the tax administrators confront challenges in administering current taxes, new types of taxes may become feasible with the rise of new technologies and activities (Tanzi, 2000, p.5).3 As always in tax policies, it is the details which are likely to prove more significant. Therefore the importance of broad superficial similarities in tax systems (such as reduction in top marginal rates of personal income tax rates, or introduction to some types of value added tax or VAT ) should not be exaggerated.
The main challenge for the developing countries in general and Southeast Asian countries in particular is to incorporate implications of globalization in their tax reform strategies and policies, and in their tax administration. This challenge would need to be met even as these countries cope with the economic, social and political impacts on the tax systems of the 1997 East Asian crisis on their fiscal systems in general and tax systems in particular (Asher and Heij, 1999).
Road map of the Paper
Globalization has greatly increased the international mobility of goods, services, factors (particularly capital), finance, and consumers (or more precisely consumption activities). The issue of international mobility and the resulting distribution of tax burden between mobile vs. immobile factors is analysed in the next section. Globalization and international factor mobility has implications for efficient taxation of firms operating in multiple tax jurisdictions. These are discussed in section 3. This is followed by analysis of the phenomenon of tax competition among various jurisdictions to attract Foreign Direct Investment (FDI) (section 4), and professional and technical manpower (section 5). Section 6 deals with the impact of globalization on indirect taxation, including international trade taxation. Section 7 briefly discuses tax implications of the internet and E-commerce, while taxation of global portfolio flows (i.e. non-FDI flows) is discussed in section 8. The final section concludes with an extended discussion of the impact of globalization on fiscal sustainability in Southeast Asia, and on ways to deal with the implications of globalization for the tax systems.
2. International Factor Mobility and Burden of Taxation
The degree of international mobility varies among the factors of production. Labour is typically less mobile than capital, though certain types of professional and technical human resources have not only become moderately mobile but have also become more sensitive to cross-border differentials in tax burdens. Financial capital is considered highly mobile and sensitive to tax- induced changes in net returns. Foreign Direct Investment (FDI) has increasingly become more “footloose” as globalization has led to production-distribution chain being divided among many tax jurisdictions. Globalization has thus enhanced the power of capital, and of net capital-exporting countries, while the relative power of labour and of capital importing countries has declined. This is of particular relevance to developing countries in general and to Southeast Asia in particular. In Southeast Asia, only Singapore is a net lender abroad. Some of developing countries such as Brazil, Malaysia, and India are net capital-importing countries, but they nevertheless have significant investments in selected sectors abroad.
Factors or activities with low mobility Include types of labour which have little demand internationally, domestic country-specific investments, possibly due to prohibitively high sunk costs, asymmetric information, absence of minimum size or level of operations, and natural resources and real estate.
High degree of capital mobility has created intense tax competition among developing countries with the objective of influencing location decisions (section 4). The intensity has been given added impetus by the declining importance of flows, which are not sensitive to tax factors, such as official development assistance. In the federal countries, inter-state tax competition has also intensified, increasing the weight of tax factors in location decisions within a country. Tax competition has also spilled over to the expenditure side, providing further advantage to fiscally strong jurisdictions. At the extreme, many financial transactions such as those involving foreign exchange and derivatives have been virtually untaxed, despite being potentially lucrative sources of global tax revenue (section 8).
In the case of labour, demographic factors are 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 the huge pools of young and skilled labour in other developing and transition countries to remain cost competitive. Such trends are already appearing in many East Asian countries, such as Japan, Taiwan and Singapore, where fertility rates are below those needed for population replacement.4 On the other hand, unskilled labour remains relatively immobile, and less responsive to tax considerations. For instance, most East Asian countries (such as Japan, Korea, Taiwan and Singapore) have maintained very tight restrictions on unskilled foreign workers, using them as a buffer to even out business cycles (Freeman and Mo, 1996 and Rod and Williams, 1996). Moreover, the unskilled labour is taxed heavily in the recipient countries, particularly in Singapore, and Malaysia (Asher, 2001).
Freeman and Mo (1996) have made reference to the immigration goals and policies of the East Asian countries as being characterized by the ‘3-S’ strategy of skilled, short-term and sect orally targeted migration. There are indications that the inflows of immigrants (as percentage of respective host country populations), peaked in 1990, and has been declining ever since (The Economist, November 1, 1997, p.91). Social security arrangements of cross-border migrant workers within the Asian region have also not received much attention (ADB 1999). Tax and social security administering agencies in Southeast Asia may consider greater cooperation in this area.
Implications for Distribution of Tax Burdens
The above discussion suggests that globalisation implies higher supply elasticity by any one tax-jurisdiction for footloose factors such as capital and skilled labour, while increasing the (derived) demand elasticity for immobile factors such as land and unskilled labour. What are the consequent implications for tax policy? At least three issues are of relevance here.
First, the inverse elasticity rule (so-called Ramsey Rule) suggests that on efficiency grounds, marginal tax rate should be inversely related to the elasticity of factor supply. Therefore preferential tax treatment for mobile factors relative to immobile ones – i.e. portfolio investment over physical investment; foreign and large domestic investment over small and medium sized domestic ones; and skilled over unskilled labour is justified on efficiency grounds. Relatively high supply elasticity of mobile factors implies that the burden of tax on these factors will fall primarily on the immobile factors.5 Indeed, at the extreme, complete factor mobility (i.e. perfect elasticity of supply) will imply that any tax on the mobile factor will fall solely on the immobile ones, as the mobile factors will relocate overseas unless there is corresponding compensation (through subsidies, reduction in other costs, etc.). Given the need to maintain a certain amount of public spending, particularly for increasingly elaborate and expensive infrastructure and human resource development, globalization will lead to lessening of progressively (increased inequity) of tax structures.6 Thus, taxes levied directly on relatively immobile factors would be welfare-enhancing in the sense of having the same incidence as taxes on the mobile factors, without leading to flight of the latter to evade and avoid the burden of the tax.7 Given the above, Tanzi (1995, pp.138-9) has noted that “…(a) although the economics of this conclusion is right, the politics of it is surely worrisome.” Without broad and sustained political support in both the developing and the industrial countries, globalization process will generate considerable conflict and may take forms which dilute its potential welfare gains.
Second, globalization has greatly reinforced the conventional wisdom explained by Musgrave (1959) that corporate income tax rates cannot be much lower than the top rate of individual income tax. This is to discourage individual or family business from incorporating to minimise the tax burden. Globalization has also reinforced the conventional wisdom that income tax rates in capital-importing countries should be no higher than those in the capital-exporting countries.
Table 1 provides data on individual and company income tax rates, and their respective number of brackets in six Southeast Asian counties. The highest marginal company income tax rates in Southeast Asia range from a low of 26 percent in Singapore to high of 32 percent in Philippines. Thus, the rates vary in a narrow range. These rates are also lower than the corresponding standard federal corporate income tax rate of 35 percent for the United States. Some states in the United States also levy corporate income taxes.
The range for individual income tax rates among Southeast Asian countries is somewhat wider. Thus, Singapore’s range of 2 to 28 percent with 10 brackets is much lower than 10 to 60 percent with 6 brackets for Vietnam (Table 1). Except for Vietnam, the top marginal rate is lower in Southeast Asia than the 39.6 percent federal rate in the United States. In addition, some states in the United States also levy individual income taxes.
It is however important to realise that effective tax burden (even if the economic incidence is not taken in to account) depends both on the tax rates and on how the tax base is defined. International variations, including among Southeast Asian countries, in definition of the tax base for corporate (or company), and personal income taxes remain quite considerable. In Singapore and Malaysia, income tax is partially integrated trough dividend–received-credit method; while the other Southeast Asian countries employ classical method of corporate taxation under which dividend income is double taxed (Das-Gupta and Mookherjee, 1998, ch11; Asher, 2001). These variations could lead to greater differences in effective rates than nominal rate comparisons along may suggest. Nevertheless, a close bunching of nominal income tax rates is observable for Southeast Asia, suggesting that these countries do take into account the rates in the neighbouring countries.
Third, loss of opportunity to tax some of the income base of mobile factors, and the political economy consequences of income tax regressivity of taxing immobile factors, suggests that there may be a move to replace taxes on income with those on consumption. The consumption taxes can be of the personal type (called expenditure tax) which recognise the specific tax paying attributes of individuals, such as the income level, and the family size. Alternatively, increased share of consumption taxes may involve such in-rem taxes as VAT and excise taxes, which do not take into account such attributes. While this debate has been ongoing in the US, the scope of increasing relative importance of consumption taxes may be limited in developing countries. This is because income taxes are currently narrowly based, both in terms of proportion of national income and in term of the proportion of labour force subjected to income tax. There is therefore scope for increasing the share of the individual income tax. The importance of in-rem consumption taxes also is usually quite high, though, even in this case, there is some scope for widening the tax base.
Among the Southeast Asian countries, Indonesia, Thailand and the Philippines levy a VAT at 10 percent, Singapore has a 3 percent VAT. Malaysia has been gradually broadening its manufacturing level sales tax and a tax on services as steps towards the eventual introduction of a VAT (Narayanan, 1998). Vietnam introduced a VAT in January 1999, at rates varying between 0-20 percent.8 All countries levy excise taxes on selected commodities.
3. Efficiency And Taxation Of Firms Operating In Multiple Tax Jurisdictions
Globalization and international factor mobility have increased the need for efficient and equitable tax treatment of firms operating in multiple tax jurisdictions. Current procedures used by most countries to allocate tax base between jurisdictions, and to avoid double taxation trough a network of more than 1500 bilateral double taxation treaties (DTAs) most of which are modeled after the OECD conventions (Owens, 1989), is not only cumbersome, but will also come under increasing pressure as the scope and volume of cross-border activities expands sharply. This is because the DTAs are based on the assumption of national sovereignty in tax policy, which will become less relevant as globalization progresses.
Each subsidiary of the parent country located in different tax jurisdictions is currently taxed as a separate entity. This provides incentives for firms engaged in activities in multiple tax jurisdictions to lower their worldwide tax liabilities through transfer pricing, i.e. manipulate costs of inputs imported from subsidiaries in different tax jurisdictions and through allocation of joint costs of the headquarters, and research and development.
Currently, the recipient (or host) country in which investment or activity is based has the first right to tax the resulting income. The sending (or home) country then has the right to tax the income (which it need not exercise) according to whether it follows residence principle or source (i.e. territorial) principle. Under the residence principle, a country reserves the right to tax the income of its residents regardless of where in the world it is earned. The countries however do attempt to offset taxes paid abroad (i.e. to avoid double taxation) through tax credit (so long as income tax rates abroad do not exceed the income tax rates at home), through deduction of foreign taxes paid from taxable income, or a combination of methods.
The tax credit method, if perfectly administered, and without deferring taxes on foreign income not brought back to the home country, implies that tax burden of an economic entity will be identical regardless of where in the world the activity occurs. So this is consistent with the notion of global efficiency and capital export neutrality (CEN). Even if a country uses residence principle, but permits foreign taxes to be deducted, it would meet requirement of national efficiency and not global efficiency of CEN. National efficiency requires that capital exports be carried to the point where the return after foreign tax abroad equals the before-tax return on domestic investment.
Under the source (or territorial) principle, capital income is taxed as income under the personal income tax, and the tax liabilities are assessed on the basis of where the income originates, regardless of whether it is by residents or non-residents. Thus, residents are not liable on their income earned abroad, but not brought into the territory. A source-based taxing, therefore, may be considered as a tax on investments. Insofar as the tax rates between countries vary, there will be an incentive to allocate savings differentially to profit from the different tax rates. Thus, it is in effect a tax on investment and does distort investment allocation, i.e., the marginal returns on capital pre-tax are not equalized. Consequently, the source-based tax does not fulfil the CEN criteria if applied at different rates. However, the source principle implies that all savers within a country face the same tax burden regardless of the country of residence. Under unfettered global capital flows, this will equalize the net returns to savers (inter-temporal marginal rate of substitution) across countries, hence ensuring that world savings are efficiently allocated. This notion of efficiency (of savings allocation) is referred to as the principle of capital import neutrality (CIN). In contrast, the residence principle is not consistent with CIN (unless, of course, it is levied at the same rate by all countries).
In conventional (closed economy) tax parlance, the residence principle may be viewed more as approximating the ability-to-pay approach to taxation while the source principle may be viewed as akin to the benefits approach to taxation. The principles of both CEN and CIN could also be theoretically attained if all countries choose a single tax principle (either one) and apply uniform proportional tax rate. In the absence of such harmonization/coordination, this outcome will not occur. The residence principle is seen as being preferable as a second-best alternative to tax harmonization, as it will not induce tax competition between countries to attract mobile factors, and will lead to maximization of global production. It therefore seems to satisfy the criteria for evaluating a country’s tax policy set out by Slemrod (1990), viz. how well resources are allocated internationally and how successfully a country is able to protect its revenue base against other countries.10
However, residence-based tax systems have very high informational requirements. In particular, it requires that either the authorities in factor-importing country provide the necessary information to tax authorities in the factor-exporting country, or that the mobile factors truthfully report their foreign incomes, both of which are highly unlikely. This makes it relatively unfeasible to impose such a system unilaterally by the home (capital-exporting) country.11 In cases where such information is freely available (such as in the case of state taxes in the US), the residence principle may result in limited intra-state tax competition, despite free inter-jurisdictional mobility of factors of production and no explicit attempt at tax harmonization (Tanzi, 1995, and Tanzi and Zee, 1998).12 In the US, national earnings of the corporations are allocated to different states on the basis of a weighted formula based on sales, expenses, and property of a corporation in each state. So each firm is not considered as a separate entity in each state. Each state is however free to set the rates of corporate income tax.
The residence principle is, however, far from distortion-free. Apart from the failure to meet the CIN efficiency criteria noted previously, two problems arise. First, a perpetual deferment of profit or income repatriation from abroad will reduce the present value of the tax burden substantially, driving it to zero at the limit.13 Second, the requirement of “country of domicile” may be abused in the sense that individuals and firms may claim tax havens as their ‘tax address’ of residence.
Direct taxation gets highly convoluted in an interdependent world, as some countries adopt the residence principle, others the source principle or, as is most frequent, a combination of the two. For instance, France, Germany and Netherlands use the territorial approach to taxation; while Japan, Canada, the US and UK use the residence approach. In Southeast Asia, all countries have adopted source or territorial principle for income tax.
4. Tax Competition and FDI
The recognition of the importance of FDI for overall economic growth (Athokorala and Hill, 1999) implies that countries have and will increasingly compete with each other to attract investments by offering tax incentives and other fiscal and non-fiscal concessions. In analysing tax burdens, it may be useful to distinguish between the marginal effective tax rate (METR), the average effective tax rate (AETR), and the nominal tax rates. METR focuses on the present value of the accumulated cash flow that would be generated by an additional dollar of investment. The AETR is based on cash flow calculations, and measures the total amount of taxes payable divided by the total value of taxable input or output (Bird and Chen 1998 p.37). It measures ex-post performance, while the METR concerns the decisions at the margin. The nominal rates are the least satisfactory basis of comparison as they ignore the tax base. Moreover, the nominal rates are more susceptible of being used by business lobbies to pressure governments to reduce business taxes. Among the three, the METR is preferable on theoretical grounds, but its calculations require formidable set of assumptions and much greater data.
Bird and Chen (1998) have estimated METR for capital for East Asian countries. They find that METR was highest in Japan, followed by Taiwan, Singapore, China, Korea, Malaysia, and Hong Kong (1998, p.51). Ranking according to the METR are different from those based on the nominal tax rates. It should however be stressed that for business decisions, it is the METR specific to a firms’ project to which incentives are granted which matters rather than the METR of capital in general or of broad asset types.
While the theoretical literature on fiscal incentives and FDI is burgeoning (see review by Devereux, 1990), the empirical literature is lagging. However, the available empirical evidence to date suggests that such fiscal incentives are important at the margin in influencing investment decisions (see Chen et al., 1997 for a succinct review of the empirical studies).14 Fiscal incentives are likely to be effective when authorities essentially use them as signaling devices about the government’s country’s the welcoming attitude towards foreign investment; their determination to ensure commercial success in targeted areas; and to improve on overall business environment. Tanzi and Shome (1992) draw this conclusion in the case of East Asia. Conversely, tax incentives will be least effective when used as substitutes for necessary investment-conducive policies, such as overall macroeconomic policies, infrastructure and supporting facilities and the like.
Fiscal incentives however will continue to be demanded and supplied, particularly in the developing countries (Bird and Chen, 1998, p.35). it is therefore important that they be designed appropriately to impact on the investment decisions at the margin; be a part of a transparent process; and that a competent and effective post-incentive evaluation division be set up in investment promotion agencies ( Asher and Heij, 1999).
To address issues relating to a global efficiency and protection of legitimate tax base, it is also essential that countries do not engage in what the OECD has called “harmful tax competition’ (1998). The OECD’s 1998 report does distinguish between simple tax heavens and more sophisticated fiscal incentive regimes in certain sectors of non-tax heaven countries. Regimes of the countries engaging in harmful tax competition are not structured to attract foreign direct investment but contain predatory measures which may result in a shift of part of the tax base of another country.
Potentially harmful tax competition is typically found in banking, finance, insurance, location of regional headquarters, and distribution and other similar services. While these are legitimate commercial activities, when these are targeted at only foreign companies, lack transparency, and are not subject to international exchange of information, they could potentially create harmful tax practices. The OECD has been putting pressure on its member countries to address such practices, including attempting to persuade tax-heavens governed by its members to change their behaviour in this regard.
For the tax heaven countries and some financial centres, OECD’s effort have also centred on addressing the issue of money-laundering, and bank secrecy laws. Protection of the tax base of OECD countries is an important motivation, and the organization is not averse to levying sanctions on those tax jurisdictions which do not address these issues satisfactorily.
The OECD has had very limited success so far in moderating harmful tax practices. But there will be increasing pressure on both the tax-heaven and other countries engaging in such harmful practices to modify their behaviour. Some countries, such as Australia have controlled foreign corporation (CFC) legislation to guard against such behaviour. The OECD report (1998) also suggests other measures to deal with these issues.
Many East Asian countries, such as Singapore and Malaysia have made extensive use of preferential tax treatment and other implicit and explicit subsidies to attract MNEs to build their countries (Asher, 2001). The list of such incentives in Southeast Asia is growing and so are the agencies authorised to grant and administer them (Asher, 2001) Econometric investigation by Chen et al (1999) provides some empirical confirmation of the potential tax competition during the 1972-1980 period between certain East Asian countries (viz. Hong Kong, Malaysia, Singapore and Taiwan) for FDI from the major industrialized countries (viz. Germany, Japan, UK and US) between 1972 and 1980. In fact, Chia and Whalley (1995) suggest the existence of a sort of Stackelberg competition among Southeast Asian countries, with the rest of the countries emulating or responding to the tax incentives provided by Singapore.15
The prisoners’ dilemma situation thus prevails with respect to fiscal incentives in Southeast Asia. Given the variation in tax rules and regulations defining the tax base for businesses and individuals, complete tax harmonisation is neither desirable nor feasible in developing and developed countries, including those in Southeast Asia. Convergence of nominal tax rates should not be confused with convergence in effective tax rates. Greater example of information and corporation in tax administration at the regional level is however both feasible and desirable.
Free-market advocates and economists have criticized differential taxation between relatively immobile domestic investment and the FDI. However, legislation and international agreements are unlikely to be successful in this area. While there has been a trend towards transparency in tax structures, preferential treatment is often negotiated on a case- by- case basis and agreements are not made public. Hence, enforcement of any type of international rule becomes virtually impossible. Furthermore, if limits are placed on tax concessions, preferential treatment can easily move to expenditure concessions, which are generally considered an area entirely sovereign.16 It should be stressed that low corporate (or other) taxes applied across the abroad by non-tax heaven countries such as Hong Kong or Ireland, are usually not regarded as objectionable by OECD.
At the same time, the formal tax incentives form only a part of the overall picture. The negotiation of customised informal tax incentives with investment promotion officials is not uncommon in Southeast Asian countries. Thus, formal tax incentives represent only a broad basis for negotiations with the prospective investors. For instance, Singapore provides customized subsidies to investors that go well beyond traditional tax measures, involving training, expenditure, pricing of land and utilities, and even taking rather large equity stakes in selected ventures.
In addition, informal tax incentives, often as side contracts with particular tax officials are also not uncommon in some Southeast Asian countries. As with the formal incentives, the informal incentives are also likely to benefit large companies, both domestic and foreign, disproportionately. Transparency of the formal and informal fiscal incentives’ regimes has been rather low in Southeast Asia. Except in Singapore, there has also been a noticeable lack of post-incentive evaluation of performance of firms granted formal fiscal incentives.
The 1997 crisis has put additional pressure on the investment promotion authorities (Asher and Heij, 1999). Even Indonesia, which removed income tax-based incentives as a part of its 1983-tax reform, continued with provisions of non-income tax incentives. Indonesia reintroduced income tax-based incentives after the crisis(Jakarta Post, May 15, 1999). The power of foreign and domestic capital has meant that Indonesia has had difficulties in reversing existing incentives, even when it has had the support of the IMF. Thus, Indonesia has been unable to bring the activities on the Batam Island under the VAT net due to investor resistance (Asher, 2001). Thailand has recently expanded the scope of tax-based incentives, such as income tax holidays, tariff and VAT exemptions, and of non-tax incentives such as guaranties, and provision of specific services. (Asher,2001).
In addition, there seems to be a trend towards making the existing free trade zones (FTZs) more attractive as well as the establishment of new FTZs. Indonesia is presently considering extending the Batam free trade zone to the entire Barelang area (a total of 42 islands), while Vietnam recently introduced specific tax incentives for the Lao Bao Trade Zone in the central province of Quang Tri. Moreover, Malaysia has widened the range of services that companies in the FTZ, Labuan, can offer to Malaysian residents.17
The Southeast Asian countries have operated on the basis that, in a globalized world, those able to locate a particular activity or a plant in their jurisdiction will be in a better position to grow. Thus, it is the insecurities of globalization that have been driving formal tax incentives in these countries. It is for this reason that they have not been able to agree on the tax and non-tax rules for competing for investments. The current crisis has made these countries more insecure, and has enormously increased the complexity of their tax systems (e.g. in treatment of foreign exchange losses, asset revaluations, mergers and acquisitions and loss carry forward provisions). The crisis is also likely to lead to even sharper demarcation between fiscally strong countries such as Singapore and Malaysia on the one hand, and the remaining Southeast Asian countries, on the other. This suggests that prospects for cooperation concerning fiscal incentives have become even dimmer than before the crisis.
Nevertheless, the Southeast Asian countries will need to ensure that their activist fiscal incentives’ stance are consistent with emerging international practices and norms that limit their use (also see fn 16). However, such formal or informal tax competition – commonly referred to as ‘tax poaching’, ‘tax piracy’ or more broadly ‘fiscal dumping’, may merely be replaced by non-tax forms such as countries ‘cutting corners’ by relaxing environmental and other standards in an effort to reduce non-tax costs for mobile factors (sometimes termed ‘race to the bottom’).18
In many DTAs, there is a tax-spading clause. Assuming a DTA exists, this clause permits firms from high-income country who have invested in the low-income treaty country to fully credit applicable income taxes even when because of tax holidays, no actual income tax is paid. There is evidence that such tax sparing agreements make repatriated profits less sensitive to taxes in home countries (Chen et al., 1997). While Canada, Japan and UK have made extensive use of such tax sparing agreements, the US has not. Most countries that provide fiscal incentives to attract FDI have actively encouraged or even required tax-sparing clauses to be added in tax treaties. Thus, for instance, Thailand has not signed a tax treaty with the US for this reason (Leechor and Mintz, 1991).
The tax-sparing clause is usually employed when the DTA is between low to middle income capital importing country and high-income capital exporting county. When a country such as Singapore which is a high-income country and both a capital importer and exporter, the net benefit calculations of the clause are more complex. Traditional capital exporting countries would be reluctant to grant such a clause to Singapore (and to a lesser extent to Malaysia) when the DTA is renewed; while capital-importing countries will expect such a clause in their DTAs with these countries.
With growing specialization in production of components in different locations across the globe, intra-firm transactions account for a growing share of world trade. For instance, in 1994, 36 percent of US exports and 43 percent of US imports were of the intra-firm nature (Clausing, 1998). There is evidence that the share of intra-firm trade of the trading partners of the US is significantly higher, at least with regard to their bilateral trade with the US (He, 1995). With the global dominance of MNEs in trade and related transactions, one of the major issues of tax policy is the allocation of the tax base for these firms between countries. Accounting manipulations allow for a transfer of tax bases (paper profits) even if physical capital (real activity) remains intact, as MNEs attempt to exploit differences in marginal statutory tax rates across countries, either actual or de facto (if there exist differing laxities with which tax administration is carried out). In most situations, this involves maintaining a judicious setting of the imputed values on the internal transfer of goods and services between operations in different countries. Such tax-shifting manipulations in which intra-firm sales are invoiced (i.e. ‘transfer pricing’) is often arbitrary, since no formal sales occur, and firms can play strategic games in an effort to lower their tax liabilities. The customary notion of “arms length transaction” is not always easy to apply in practice.19
It has been found that, for the period 1982 to 1994, the US has had a less favourable intra-firm trade balance with low tax countries (Clausing, 1998). This would be expected a priori, if we assume that US sales to affiliates based in low taxed countries are under priced, while those with high taxed ones are overpriced, and that the tax differential is not offset by import tariffs imposed by the low taxed countries. Similarly, evidence suggests that US MNEs reduce their tax burden by between 3 and 22 percent by shifting reported incomes from high- to low-tax countries (Harris, et al., 1993). The fact that transfer pricing is pervasive in the US, despite the fact that US tax authorities are among the most technically well-equipped in the world and thus most effective in imposing penalties on flagrant tax violations, suggests that its existence on a global scale is indeed widespread.
Those developing countries, such as India whose firms are setting up subsidiaries abroad, or those firms which are also listed abroad, particularly in the US, need to be aware of the tax reporting and other tax implications of their moves (Business India, December 11-24, 2000, pp 119 and 122). They also need to establish transfer-pricing guidelines which are internationally acceptable for IT- enables services, and other high priority sectors to provide comfort and security to investors, and to preserve the revenue base.
The above discussion suggests that the developing countries need to develop expertise in transfer pricing, DTA technicalities, and other tax areas, which have generally being the free-acceptation of the OECD countries. It is only through enhanced expertise in the tax matters that the developing countries can safeguard their interests.
As globalization process unfolds further, it may be increasingly difficult to sustain the current methods of taxing MNEs operating in different tax jurisdictions. Instead of taking each jurisdiction as a separate entity as is currently done, consideration may need to be given to the adoption of the unitary or world-wide tax base for the corporate income tax, with internationally agreed system of tax credits or allocation procedures to prevent double taxation and to maintain international competitiveness. As noted, in the United States, the tax base of the corporate income tax at the state level is already allocated on the basis of a formula. To adopt such an approach at an international level will however neither be easy nor quick.
As developing countries including Southeast Asia really much more on revenue from corporate taxes20and use fiscal incentives more widely, they have a vital stake in international rules and formulae adopted for taxing corporations.
5. Tax Competition and Human Capital
For individuals, particularly high net-worth individuals, the proportion of income earned or derived 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 global taxation principle – viz., that all income of the individual should be aggregated and taxed at the same rate (a la Simons, 1938) 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. Such ‘discriminatory’ or a scheduler approach to taxation is, in fact, increasingly common. For instance, Scandinavian countries have moved towards a ‘dual’ income tax, with lower taxation on income from capital than from labour earnings. The problem with this is that, if the tax differential is significant, it provides incentives for tax evasion and avoidance, with incomes from higher taxed sources being disclosed as having been derived from the lower taxed sources.21
For the developing countries, the migration of skilled labour has been a major issue (so-called ‘brain drain’). Consequently, ‘emigration rents’ has remained an important policy issue. The Philippines is one of the few countries to have, until recently, taxed its citizens abroad. This has, however, been scrapped under the currently applicable Philippines income tax law. Most other developing countries also do not tax their citizens working overseas, given the inevitable inability to administer such a tax effectively.
In this light, Jagdish Bhagwati had proposed a ‘brain drain tax’ for developing countries to benefit from the higher incomes earned by their migrants who work abroad (see for instance, collection of Bhagwati’s papers in Irwin, ed., 1991). Such a tax is particularly defensible, since most have benefited from highly subsidized higher education in their home country (India is a prime example in this regard). While a similar result could conceptually be attained by a residence tax, the problems involved in administering the tax also hamper the implementation of this proposal in the absence of tax cooperation. Further, even if effectively administered, if the home country tax rates are significantly higher than what the migrant pays in the host country, there is always the possibility of tax avoidance through a change in citizenship (assuming the alternative is feasible).
Consideration may be given to studying the feasibility of a global trust fund approach. Under this approach, net labour-receiving countries make a contribution to the fund based on an agreed formula, and these then can be channeled to agreed upon activities in the labour exporting countries. Proposed Global Tax Organisation (GTO), if it comes into existence, may be an appropriate forum for a such study.
Globalization has also resulted in increased cross-border movement of professional personnel for short periods, particularly in information technology sector. How to facilitate this and how to tax their activities, has become an important issue. The World Trade Organization (WTO) is addressing this issue under the Movement of Natural Persons, but regional and international co-operation is also needed.
6. Globalization and Indirect Taxation
For both Malaysia and Singapore, non-tax revenue to GDP ratio is exceptionally high. Thus, during the 1993-1997 period, this ratio averaged 20.04 percent for Singapore and 5.74 percent for Malaysia (Asher, 2001, Table 1). In the case of Singapore, this is due to investment income, and revenue from the lease of land. In Singapore, there is no constitutional or common law right to own land. The state owns around 85 percent of total land in Singapore, which it leases out for varying periods to different users. Several Southeast Asian countries, notably Singapore and Malaysia, have also made extensive use of regulatory taxes not only on goods (e.g. motor vehicles), but also on factors (e.g. monthly levy on foreign workers), and on asset transactions (e.g. leasing of land). For Vietnam, total revenue (excluding grants) to GDP ratio in 1997 was estimated to be 21.9 percent (The World Bank, 1998, Table 5.2B, pp.95-96). This ratio is in line with the other Southeast Asian countries.22
Greater ease of international trading, reductions in transactions costs and eight rounds of multilateral trade agreements, are making it difficult for countries to sustain large tariff differentials with others. Under the concluded Uruguay GATT agreement, tariffs on manufactured imports into industrial and developing countries were reduced by about 40 percent and 30 percent respectively, the reductions to be phased in over a five year period. Substantial progress was also made with regard to tariff bindings (i.e. commitment not to levy a duty exceeding a particular, ‘bound’ rate) by all countries (Martin and Winters, 1996).
The role of routine cross-border trade among adjacent areas of two countries is also increasing. Regional free trade agreements (FTA) may be expected to give impetus to this trend. Thus, for instance, the revenue reliance on import duties is significant for Malaysia, Philippines, and Thailand. During the 1993-97 period, import duties to GDP ratio averaged 4.74 percent for the Philippines, 3.27 percent for Malaysia, and 2.89 percent for Thailand (Asher, 2001, Table 1). As a result, shift towards minimum tariff barriers as required under the ASEAN FTA (AFTA) will put particular pressure on their revenue systems. This is also likely to be the case in Vietnam as trade taxes formed around a quarter of total tax revenue in 1997. (The World bank, 1998, Table 5.2B, pp. 95-96). Vietnam has made a commitment to implement provisions of AFTA by 2003. A shift from quotas to tariffs as required under the WTO commitments may however help mitigate the revenue loss to these countries.
Various distortions generated by such trade taxes, which drive a wedge between domestic and world prices, suggest that efficiency gains far outweigh the loss of such revenue sources. While it can be shown that a combination of taxes that do not discriminate between the tradable and non-tradables sectors will yield the same revenue at lower efficiency losses (Dixit, 1985), Rodrik (1992, p.312) has made the important observation that:
While trade taxes would not be on any theorist’s list of optimal tax instruments…practical and administrative considerations dictate that trade taxes will be an important source of revenue for developing country. The poorer the economy, the higher the reliance on trade taxes.
Globalization also has implications for sales and excise taxes, especially on products with high value but little weight or volume, such as perfumes, electronic goods and jewelry. The possibility and increasing popularity of cross-border shopping (including airports becoming huge shopping centers and major shopping outlets close to tax borders), the use of the Internet (see Section 7), mail or phone-order shopping, and the like, have placed a ceiling on sales and excise tax rates on such tradable.23Various negotiations under multilateral and regional trade and investment agreements are under way in the area of telecommunications and information technology, thus, further reducing the scope for levying taxes on these sectors through pricing policies of state monopolies. This in turn could lead to reduced state revenues.
The above will affect all Southeast Asian countries, but particularly those with capacity substantially above domestic demand such as Singapore. Singapore would also need to contend with increasing willingness of Malaysia and, to a lesser extent, Indonesia, to use fiscal and other measures to reduce the share of their international trade conducted through Singapore.
State enterprises in Southeast Asia, including monopolies in telecommunications sector are also likely to find it much more difficult to continue to enjoy high profit margins. The overall tax mix is likely to shift even more towards in-rem taxes which do not take into account individual taxpayers’ relevant circumstances, as compared to personal taxes that do. But the generation of revenue from newer taxes will not be automatic. State agencies will need to acquire the necessary expertise to implement and regular these activities. To the extent the Southeast Asian countries are able to generate revenue from newer sources such as more extensive use of auctions, permits, cost-recovery policies and user charges, the share of revenue from conventional taxes can be expected to decline.
Globalization, E-commerce and Taxation of the Internet
New technologies are resulting in a growing importance of sophisticated barter and electronic commerce (also known as ‘Net Commerce’ or more commonly, ‘E-commerce’). According to the OECD (1997, p.1):
E-commerce refers generally to commercial transactions, involving both organizations and individuals, that are based upon the processing and transmission of digitalized data, including text, sound and visual image and that are carried out over open networks (like the Internet) or closed networks…that have a gateway onto an open network.
The number of Internet hosts worldwide were 16 million as of January 1997 (Owens, 1997). While estimates of the global use of the Internet worldwide fluctuate wildly (from anywhere between 30 and 60 million), of relevance is the fact that even the lower end of this figure represent a sharp increase from only a few thousand in the early 1990s. This figure is expected to reach some 140-150 million over the next several years on the basis of current growth trajectories. The varieties of transactions conducted on the Internet, includes the provision of on-line information, payments and settlement of accounts, advertising, gambling and other entertainment (music, games, etc.), sale-lease of goods, banking, insurance and brokerage services, legal services, real estate services, travel services, and increasingly, health-care, education and government services, share trading, reservations and ticketing (OECD, 1997 and Owens, 1997).
Two types of commodities are particularly amenable to trade on the cyber way. First, the products delivered electronically on the Internet. Second, physical items ordered on the Internet and shipped across borders. The value of E-commerce of all types, including transactions among businesses in particular (which has accounted for about 70 percent of E-commerce transactions), but also between business and consumers, is expected to grow very rapidly. Thus, while business-to-business E-commerce transactions in 1997 were valued at US$5 billion, the US Commerce Department forecasts that by the year 2002 this trade will reach US$327 billion, equal to 2.3 per cent of GDP and increasing to about 6.0 per cent of GDP by the year 2005 (Rath, 1998). However, the usual caveat regarding hazards of such projections is particularly relevant in this case.
E-commerce will require major adjustments in the transitional means of allocating revenue among jurisdictions and in the current systems of tax administration. Thus, it would be difficult to apply the permanent establishment and source-based taxation methods to businesses involved in E-commerce (Au, 1998). E-commerce transactions could result in the disappearance of traditional audit trails (through creation of electronic books), in greater accessibility of tax havens and offshore banking facilities – indeed, E-commerce uses its own payments system, referred to as ‘cyberpayments’ – and in the weakening or elimination of convenient points of taxation in the production–distribution process due to disintermediation (OECD, 1997 and Owens, 1997). Business-to-business E-commerce transactions could facilitate the use of transfer pricing by MNEs and makes them increasingly difficult for governments to detect. As noted by Owens (1997, p.1849):
(t)he communications revolution presents no new problems, no fundamentally or categorically different dimensions, for transfer pricing. It just presents all the old problems more quickly.
The inability to tax Internet-based transactions, on the one hand, and non-zero tariffs on physical cross-border trade, on the other, may hasten the pace of substitution of the mode of transactions to virtual commerce as it gets technically feasible to do so. This in turn will further erode the tax base on tradable goods. Global agreements and standards will be needed before E-commerce can be taxed effectively. Member countries of the World Trade Organisation (WTO) have agreed to keep E-commerce tax-free until 1999, and the US and the European Union (EU) have reportedly jointly stated that the Internet should be a ‘tariff-free environment’ (Frost, 1998). Nevertheless, the future of taxation of E-commerce and the Internet remains far from certain. For instance, recently, the German Finance Ministry has reportedly made a controversial proposal, that a world wide agreement be reached on the way to police software sales over the Internet and automatically transfer sales and other applicable taxes to the concerned governments (Au, 1998, pp. 6-7) (also see foot note 3).
The communications revolution, which has led to the rapid growth of the Internet, could also offer some benefits to tax administration. These include, possibilities of more accurate and efficient record-keeping, faster and easier compliance with tax requirements, including through electronic filing of returns and automated deductions of certain taxes such as payroll and social security taxes and provision of information to tax-payers. The communications revolution could also assist in improved exchange of information among the tax administrators of different countries.
However, the advantages of the communications revolution for tax administrators, particularly those in developing countries, will definitely not be automatic. Tax administration systems would need to be revamped, requiring substantial investments in information technology hardware, development of specialized software, intensive high quality training for existing tax officials and modifications in personnel policies to secure requisite manpower comfortable with new technologies. The governments would need transparent, consistent, and realistic policies for taxing E-commerce. While countries such as Singapore are well-positioned to harness the benefits of these new technologies (Das-Gupta and Mookherjee, 1998, chapter 11), the new technologies will pose severe short- and medium-term challenges to most developing countries, particularly in terms of making it increasingly difficult for them to collect even the existing taxes. Absent effective policy coordination and collective action on at least a regional if global basis, the Internet and accompanying new communication technologies will pose grave challenges to governments in maintaining fiscal sustainability (an issue taken up in Section 8).
The OECD (1997, p.9) has succinctly summarized the key issues of E-commerce and the Internet for tax authorities as follows: a) to review existing taxation arrangements, including concepts of sources, residency, permanent establishment and place of supply, and to modify the existing arrangements or develop fair alternatives, if required; b) to ensure that E-commerce technologies, including electronic payment systems, are not used to undermine the ability of tax authorities to properly administer tax law; c) to provide a clear and equitable taxation environment for businesses engaged in both physical and E-commerce; and d) to examine how these new technologies can be exploited to provide a better service to taxpayers. Developing countries must take the lead of the OECD in undertaking analyses of how E-commerce will impact the tax base and tax regulations, administration and compliance for specific taxes such as the VAT and plan for a coordinated approach to tackle the challenges posed by the Internet.
In the November 1997 meeting of Asia Pacific Economic Cooperation (APEC) Economic Leaders, E-commerce was at the top of the agenda and a task force and work-program to deal with E-commerce was established (Felton-Taylor, 1998). There are however differences between Europe and the United Sates on how the internet transactions should be taxed, particularly as these concern the VAT, with the former in favour of taxing them like any other transactions, and United States in favour of not taxing (or at least having an extended moratorium on current taxes) on such transactions.
It should be recognised that the information technologies giving rise to e-commerce also provide opportunities for the tax authorities. Thus, direct deposits could replace checks as standard method for issuing payments; electronic availability of tax forms and filling could reduce transaction and hassle costs, automatic deductions of income and other taxes, including provident fund contributions could become possible; customs procedures can be streamlined, and exchange of information between different government agencies in the same country, and between different countries could become more feasible.
Some of the Southeast Asian countries have made progress in using the new tax technologies for tax administration. However, none of them have made much progress in developing special principles or measures to subject e-commerce to income and sale taxes. Singapore has recently enacted Electronic Transactions Act which provides that electronic transactions are deemed to be dispatched from the originator’s place of business, and are deemed to- be received at the place where the addressee has its place of business. The Southeast Asian countries also need to address the possible impact of E-commerce on their sales tax revenue.
7. Financial Globalization and the Tobin Tax
Financial globalization has not been an unmitigated blessing, as this period has simultaneously witnessed several episodes of severe financial turbulence in global currency markets. Indeed, since 1992, crises in global financial markets have been the norm rather than the exception. Specifically, in 1992-93, Europe was faced with the very real possibility of a collapse of the European Exchange Rate Mechanism (ERM), which, in fact, began outside the ERM area (in Sweden and Finland). The Italian lira and British pound were withdrawn from the ERM, three other currencies (viz. the Spanish peseta, Irish pound and Danish krona) were devalued, and there was a substantial widening of the bands within which the currencies could fluctuate. In 1994-95, there was the Mexican currency and financial crisis, which saw the steep devaluation of the peso, pushing Mexico to the brink of default. There were also some spill over effects to Argentina and Brazil (the so-called ‘Tequila effect’). And, since July 1997, the world has been experiencing the effects of the East Asian crises, which started somewhat innocuously with a run on the Thai baht, but spread swiftly to a number of other regional currencies, most notably the Indonesian rupiah, Malaysian ringgit, Philippine peso and Korean won (the so-called ‘Tom-Yam effect’). August 1998 brought about the devaluation of the Russian ruble with negative repercussions on the Turkish currency and those of several other emerging economies. And, most recently, in January 1999, the Brazilian real was devalued, losing over 40 percent of its value relative to the US$ within two months.
With the ever-escalating frequency and intensity of financial crises, they can no longer be dismissed as mere aberrations in an otherwise well-functioning global capital market. While emphasizing the need for measures to enhance the soundness of banking and financial systems (particularly prudential supervision), the ferocity of the East Asian crises have belatedly but surely awakened policy-makers to consider the need to impose some friction on the sand of the wheels of international finance. The theoretical rationale outlined for the possible imposition of some form of restraints on international capital flows may be summarized as follows (Rajan, 1999). The first best rationale for such levies (on a permanent basis) are based on the existence of capital market distortions, which include the prevalence of multiple equilibriums in foreign exchange markets and the herd behaviour of financial market participants. Second best rationale (for temporary controls) include the possible ‘over borrowing’ syndrome due to incomplete or inappropriately sequenced financial sector reforms (including inadequate prudential regulations).
A tax on international foreign exchange activities was originally proposed by James Tobin (1978). The so-called Tobin tax is essentially a permanent, uniform, ad-valorem transactions tax on international forex flows. It is claimed to be inversely proportional to the length of the transaction, i.e., the shorter the holding period, the heavier the burden of tax. For instance, a Tobin tax of 0.25 percent implies that a twice daily round trip carries an annualized rate of 365 percent; while in contrast, a round trip made twice a year, carries a rate of 1 percent. Accordingly, and considering that 80 percent of forex turnover in 1995 involves round trips of a week or less, it has been argued that the Tobin tax ought to help reduce exchange rate volatility and consequently curtail the intensity of ‘boom-bust’ cycles due to international capital flows.
What does Available Research Tell us about the Tobin Tax?
Based on available research on the topic, the following policy conclusions may be drawn (Bird and Rajan, 1999 and Haq et al., eds., 1996).
The Tobin tax cannot be applied unilaterally, as this will merely lead to a migration of forex transactions to untaxed countries (i.e., avoidance via migration). If the Tobin tax is limited to spot transactions (as per Tobin’s original suggestion), this will lead to a tax-saving reallocation of financial transactions from traditional spot transactions to derivative instruments. As such, to prevent tax avoidance via asset substitution, it ought to be applied on all derivative products such as forwards, futures, options and swaps. There is broad consensus that the tax must be levied at a rate designed to minimizes the incentive to undertake synthetic transactions in order to evade the tax (i.e., geographical or asset substitution) or to alter the forex market structure from a decentralized, dealer-driven market to one that is centralized and customer-driven. Suggestions of the ‘most appropriate’ rate of taxation have generally ranged between 0.1 and 0.25 percent. A Tobin tax will probably be far more successful in (and ought to be aimed at) moderating (short-term) capital inflows (especially debt financing), rather than outflows. In other words, the aim should be to prevent excessive ‘booms’ from occurring in the first instance, rather than attempting to mitigate the effects of (let alone, eliminate) the ‘busts’ that invariably follow. Given the above (preventive) objective of a Tobin tax, it needs to be imposed in a counter-cyclical manner, i.e., raise the tax rate during a boom period and lower it (even eliminate altogether) at other times. This is consistent with the Chilean experience with and management of its interest-free deposit requirement as well as the empirical literature on capital restraints, which seems to indicate that capital controls have been more effective at preventing ‘excessive’ capital build-up than at stemming capital flight.
Estimating the revenue from currency taxation is a complicated methodological exercise since much depends on the rate and coverage of the tax; the level of transactions costs; the elasticity of capital movements with respect to the effective increase in transaction costs associated with the tax; as well as the extent to which it is avoided. Based on tax rates of between 0.1 to 0.25 percent, estimates of tax revenue range from a low of US$140 billion to a high of US$290. While all such estimates must be viewed with some scepticism (given the complex calculations of tax rates and elasticities), what is certainly true is that a Tobin tax may be expected to raise a lot of money. Nonetheless, the political economy of currency taxation suggests that it will receive greater support if it can be shown to make a significant contribution to offsetting the perceived inefficiencies of private international capital markets (Bird and Rajan, 1999).
Globalization, Financial Flows and Perverse Fiscal Incentives
The expected inaction of the international community with regard to implementation of the Tobin tax, or, more generally, measures to deal with global capital market failures, makes it all the more imperative for small and open developing economies in Southeast Asia and elsewhere, to take appropriate measures to strengthen their domestic financial sectors. This is a must if they are to enjoy the benefits of globalization while being able to withstand future such crises. Domestic financial reforms include the removal of policy-induced tax and other distortions. For instance, certain tax measures may have contributed to the severity of the boom bust capital flow cycles in Southeast Asia (Nellor, 1999). This is so, as some Southeast Asian countries (Thailand and the Philippines in particular) have provided quite favorable tax treatment (e.g. lower corporate income tax rates, partial or full exemption from stamp duties and other business taxes) for foreign currency deposits held domestically. These deposits are then lent to domestic entities, thus exposing the banks and domestic financial system to huge foreign exchange risks, particularly as hedging and other risk-managing devices do not receive favorable tax treatment in these countries.24 As noted by Nellor (1999, p.2):(t)he complexity and volume of financial transactions, associated with the opening of emerging markets, have made tax administration a more challenging task. Just as strengthening financial systems must be a precursor to capital account liberalization, tax administrations clearly also require strengthening in such an environment.
8. Concluding Observations and Future Directions
Globalization and the consequent reduction of economic distances between nations pose severe challenges to tax structures around the world. Nations will experience far-reaching changes in the level of tax revenue, tax mix and systems of tax administration and compliance.
Globalization is making it more difficult to tax the full range of economic activities, hence making it increasingly difficult to attain ‘fiscal sustainability’. The notion of ‘fiscal sustainability’ loosely refers to trends and levels in budgetary revenue and expenditure that are consistent with the macroeconomic objectives of high employment, low inflation and the appropriate real exchange rate. Some have argued that one of the benefits of tax competition is exactly that it ought to lead to a reduction in tax bases and in public spending, which is ‘invariably’ unproductive and wasteful. Consequently, tax competition is argued to be net welfare-enhancing. However, political economy compulsions will almost inevitably mean that the burden of such adjustments are, by default, invariably fall on the social sector and on public infrastructure expenditure at the time when the need for both is quite great.
The economic crises in Southeast Asia has emphasized the need for social safety nets if social cohesion is to be maintained in times of adversity. More generally, Rodrik’s (1996) empirical study, which reveals a positive correlation between openness and government consumption, is interpreted by him as suggesting that government consumption plays a cushioning role in more open countries (which are) subject to external shocks.25 Grunberg (1998) has christened this increasing difficulty in mobilizing revenues (due to a shrinking tax base) and the growing need for fiscal expenditure concurrently, as the ‘fiscal squeeze’ model due to globalization. Moreover, as discussed in the previous sections, globalization has led to tax structures becoming less progressive, as the burden of taxation will increasingly fall on the immobile factors, while those on the mobile factors are driven down on the one hand, and there may be tendency to move to greater dependence on indirect taxes such as those on consumption, which are generally less progressive than taxes on income, profits, and assets.
The Southeast countries are, however, likely to find the task of pursuing sustainable fiscal policy much more difficult than in the past. The crisis and its aftermath are likely to reduce the revenue levels considerably, while there are both cyclical and structural pressures for increasing government expenditure. The need for greater efficiency in the delivery of public services, in project planning and implementation and a significant reduction in the leakages in public expenditure has thus acquired much greater urgency. On the revenue side, the government in Southeast Asia need to become more adept at raising resources through auctions, permits and various types of cost-recovery and user charges. They also need to equip their tax administrations to deal with much greater complexity of the tax systems.
As has happened with international trade, countries will need to come to terms with reduced autonomy in tax policy. As noted, there have been a number of tax proposals to deal with specific aspects of globalization. Examples include Bhagwati’s proposal for international cooperation in enabling source-countries to tax emigrating professional manpower; Tobin’s proposal to levy a small tax on forex transactions to deal with financial volatility; and the OECD’s efforts to develop investment codes, including rules for international tax competition and tax revenue implications of E-commerce. All these proposals are specific attempts to determine how and the appropriate manner in which to tax footloose factors at an international or regional level, so as to try and preserve the goals of fiscal sustainability, revenue adequacy, and equity (by easing the tax burden on the immobile factor).
Efforts at comprehensive and rigorous analysis of the changes, particularly in institutional design, needed to cope with globalization, are at an early stage. Tax and more broadly, fiscal policy, is at the heart of any country’s political economy. Therefore, rapid or smooth progress in such public finance reforms is far too much to be expected. Vito Tanzi, the former Director of the IMF’s Fiscal Affairs Department and an authority on international tax policy, has argued that a ‘Global Tax Organization’ (GTO), along the lines of the (World Tax Organization (WTO) may be necessary to enable systematic thinking on the need for international cooperation (Tanzi, 1999).26
As envisaged by Tanzi (1999, pp.184-85), activities under the umbrella of the GTO could include identification of main tax trends and problems and compilation and/or generation of relevant statistics and tax information, leading to the publication of an annual Tax Developments Report; provision of technical assistance to countries; the development of international norms in tax policy and administration; and acting as an arbiter and provider of surveillance over individual country, regional and global developments.
In some sense, the Tanzi suggestion comes at the appropriate time, there being a number of other calls for the establishment of new institutions to tackle various other issues of globalization.27 For instance, the United Nations-Economic and Social Commission for Asia and the Pacific (UN-ESCAP) has suggested the need for a World Financial Organization (WFO) to deal with banking and financial sector issues, including transparency and data availability and dissemination. The financial gurus, Henry Kaufman and George Soros have suggested the creation of an international supervisory structure or international credit insurance corporation; while others have suggested expanding the mandate of the Bank of International Settlements (BIS). Many trade economists have suggested the creation of a General Agreement of Trade in Services (GATS). Esty (1995) has suggested the creation of an international environmental agency. Others have suggested a new labor organization or giving the existing International Labor Organization (ILO) more teeth for dealing with international labor issues (such as labor standards, including child labor).
It is, however, unlikely that a global tax organization as envisaged by Tanzi will be a high priority on the world’s agenda for some time to come, given the noted reluctance by governments to relinquish whatever existing national sovereignty (actual or perceived) they have on tax policy-making. As in the case of international trade and investment, a more feasible course would seem to be for regional organizations such as the APEC, the Association of Southeast Asian Nations (ASEAN) and the South Asian Association for Regional Cooperation (SAARC), to pay much greater attention to tax and fiscal policy issues, both in their internal workings and in their interactions with each other. Valuable lessons could be learnt from the progress made by the OECD in this area. Such cooperation in tax policies at a regional level could be an intermediate step towards a future multilateral accord. This is consistent with the notion in international trade of creating a number of ‘clubs’ of like-minded and willing countries to engage in deeper integration in areas not covered by international institutions like the WTO.
Harmonization versus Coordination
Even at the regional level, there is the issue of whether Slemrod’s (1990) suggestion of a formal harmonization or equalization of statutory rates, particularly relating to corporate (or company) income tax, is appropriate. There are a number of problems with this proposal for complete uniformity. For instance, policymakers have many ways other than nominal rates to provide subsidies (or incentives depending on one’s viewpoint) to businesses and others, and legitimate reasons to define the tax base to which these rates are applied. So a harmonization of nominal rates would not provide the implied level playing field. There is also the issue of at what levels harmonization should occur. Efficiency implications would be different depending on the level chosen. Referring to the question of whether the introduction of Euro would require harmonization of certain taxes in Europe, Antonio Martino, former foreign minister of Italy, has argued that a major fallacy in arguments for harmonization of taxes is that they assume “that there is such a thing as ‘right’ tax policy, independent from the distinctive characteristics of the country”. As he further notes, “(w)hy should the same tax policy apply to countries that have very different endowments of productive factors?” (Asian Wall Street Journal, August 3, 1998). More broadly, this takes us to the heart of the harmonization of standards (be they labor, environment or even in terms of socio-political systems), on the one hand, and globalization of economic activities (trade, investment, migration and related policies), on the other.
Regional coordination or ‘peaceful coexistence’ would seem to be a more preferable and viable option. Coordination allows for the maintenance of some degree of policy autonomy, but at the same time minimizes the potential for harmful or beggar-thy-neighbor competitive practices. Information-sharing and standardization of data may also be facilitated by such coordination, which ought to include a discussion of how tax revenues and burdens from internationally mobile factors, environmental protection and E-commerce transactions are to be divided and shared (Owen, 1993).
In the final analysis, from an individual country perspective, the process of tax reform in an era of globalization must constantly strike a balance between the ideal tax system and practical needs. Far too often the need for clarity and simplicity of tax laws and integrity and professionalism in administration, is lost in the search for higher ideals. Tax structures of the 21st century will only meet the needs of society if they can first gain acceptance from the public, the business community and the government officials who are relied upon for implementation and day-to-day operation of this and other economic policies.
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Individual and Company Income Tax Rates in Southeast Asia
(Applicable December 2000)
Individual Income Tax
Company Income Tax
|5-35 percent(5 brackets)||10-15-30percent(3 brackets)|
|10-60 percent(6 brackets)(Foreigners residing in Vietnam are taxed 10-50 percent)||10-50 percent(Standard rate of 32, with numerous exceptions and room for interpretation)Special rates for foreign investment(Standard rate of 25 percent)|
Sources: Adapted from Asher 2001; country sources
a Malaysia’s 1999 Budget proposed that corporate and individual income tax for 1999 be waived. This is to bring tax payments to a current year basis from the year 2000 onwards. Since before this change, there was a one-year lag in the payment of income tax (e.g. Income tax payable in 1999 is based on the income earned in 1998), this change did not affect 1999 tax revenue flows materially.
1The Southeast Asian region is usually defined to include ten countries, Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam.
2Tanzi (2000) identifies eight fiscal termites: electronic commerce and transactions; use of electronic money; intra-company trade; off-shore financial centres and tax heavens; derivatives and hedge funds; inability to tax financial capital; growing foreign activities; and foreign shopping.
3As an example, France has recently levied royalties tax on blank CDs, DCDs, and mini-disks. It is considering imposing such tax on anything that can be used to record an original work, such as computers, DVD players, and Video recorders, with the aim of compensating artists whose works may be copied (Business Times, Singapore, January 18, 2001).
4ADB (1997) and Heller (1997) discuss the general fiscal policy implications of ageing in East Asia; while Heller and Symanski (1997) explore the savings implications of these demographic trends. As a consequence of these rapidly ageing populations, an important priority in Southeast Asia is reforming existing social security systems with a view to enhancing their sustainability, adequacy, and equity (Asher, 1998).
5The assumption in this section is that the residence principle of taxation is not applied. This is elaborated upon in the next section.
6While this is true in general, to the extent that tax rates on property may increase (given its immobility), the extent of regressivity may be somewhat mitigated. However, one would expect the direct effect to outweigh the indirect one, thus leading to the conclusion that the impact of globalization on tax structures will probably be regressive on balance. In federal countries, mobility of real estate investments within the country is high. Since these taxes are usually assigned to lower levels of government, this mobility imposes an additional constraint on increasing property taxes.
7A subtle, but conceptually useful distinction to make is that between tax evasion and avoidance. The latter is a situation in which the taxpayer makes use of all available loopholes and ambiguities in the statutes, including leaving the country altogether (if there is no control on capital flows). Tax avoidance is entirely legal (if not always ‘moral’), and is therefore also referred to as tax planning. Tax evasion is illegal and carries with it the possible imposition of penalties if caught. Thus, if there existed capital controls (on outflows) and capital flight were done through the parallel market that would be tax evasion. greater complexity provisions due to globalization and higher cross-border activities have enhanced the opportunities for tax avoidance and tax planning.
8Section 6 discusses the broader issue of commodity taxation in Southeast Asia.
9Of course, conventional (neoclassical) trade theory tells us that – as long as factor proportions do not vary ‘too much’ – product flows are substitutes for factor flows, in that both lead to factor price equalization. However, the presence of various market imperfections or differing technologies between countries may prevent trade from equalizing such factor returns, thus making international free capital flows and labour necessary for factor price convergence.
10The residence principle may be seen as the open economy version of the aggregate efficiency theorem in optimal tax theory a la Diamond and Mirrlees (1971).
11Bachetta and Espinosa (1995) have developed a game-theoretic model in which information transmission may be used as a strategic device by inter-jurisdictional authorities acting in a non-cooperative manner. In particular, the motivation for such cross-border information sharing is that it allows both governments to set higher tax rates. This is so, as the capital-importing country will have information on the exact amount of investment, while the capital-exporting country is able to ensure tax evasion/avoidance is minimized. On the other hand, the cost of such information sharing by the capital-importing country is that it is less able to attract foreign investment attempting to minimize global tax burdens. These two effects may lead to partial sharing of information between countries.
12According to Tanzi and Zee (1998), this is unlike the EU, in which inter-union informational flows are far more limited, hence making the residence-based tax far less workable. According to the authors, the coefficient of variation of personal income taxes in 1994 in the EU was about one third that in the US, suggesting that there is greater tax competition among EU member countries. Part of the reason for restrained tax competition among US states may also be due to the limited role state taxes play relative to the federal tax system, which collects over two thirds of total taxes.
13Most countries allow for deferment of active incomes, while requiring that passive income (such as dividends) be taxed on an accrual basis.
14Apart from the more formal empirical studies, one of the most revealing anecdotal instances of this is the intense competition between Thailand and the Philippines to attract a new General Motors automotive plant in the mid 1990s. The Philippines lobbied particularly aggressively, reportedly offering incentives such as the Subic Bay site and other fiscal inducements (Business Week, June 3, 1996, p.56). The project was eventually located in Thailand.
15A similar pattern seems to prevail in Central Europe, with Hungary taking the lead and being most aggressive in providing investment incentives, Poland and the Czech Republic responding in kind (Easson, 1998).
16However, Indonesia and Thailand’s fiscal programs are effectively under the control of the IMF. While Malaysia, the Philippines, and Vietnam are not formally under the IMF programs, they are currently in an extremely weak position to pursue fiscal policies, including those relating to incentives not favoured by the IMF. So the IMF’s influence may be an important countervailing factor.
17There is a preferential tax regime for Labuan, regulated by the Labuan Offshore Business Activity Tax Act (1990).
18However, empirical studies (both econometric and surveys) have failed to discern any relation between low environmental standards and the amount of investment inflows (Levinson, 1996). In OECD countries for ‘race to bottom’ is also not strong; but the revenue to GDP ratios have stopped growing (Messere, 2000; Tanzi , 2000).
19There exist four different methods determining arms-length transactions-i.e. Prices that would be objectively charged if the parties were not related- as described in the OECD (1979)
20For the 1993-97period, corporate income tax revenue to GDP ratio in Southeast Asia averaged 4.44 percent of GDP annually, while the corresponding ratio for the selected industrial countries was 2.62 percent (Asher, 2001, Table 1)
21This also comes into conflict with the trend towards harmonization of income tax on skilled labor and capital, thus suggesting that the burden may fall disproportionately on low-skilled (low wage) labor.
22 However, it needs to be emphasized that in this socialist-economy attempting to enhance the role of the market, the role of the state is significantly larger than in some of the other countries. Although Vietnam has made significant improvements in moving away from the dependence on state owned enterprises (SOEs), the Vietnamese government still depends for around 40 percent of its total revenue on income from SOEs. The revenue from SOEs is expected to drop significantly, as it appears that some of them are financially fragile, and are mainly surviving due to significant direct and indirect government assistance.
23For instance, the significant revenue-losses on beer and spirits as a number of Britons made their purchases in France to avoid the excise duties levied in their home country, led to the British government setting a cap on the excise duty on these products. Similarly, Canada’s attempts at a steep tax hike on cigarettes to discourage smoking had to be revoked in 1994, because of their de facto ineffectiveness due to smuggling from the US (The Economist, May 31, 1997, p.21). Japan is considering reducing the differential in prices of branded goods between Japan and other Asian countries to stimulate domestic activity, and generate government revenue.
24See Rajan (1999) for a formalization of the role of banks in the financial intermediation process in Southeast Asia.
25Alseina and Wacziarg (1998) have argued that Rodrik’s result may be capturing a spurious relation, as smaller countries have a larger share of government consumption in GDP and more open trade. They, however, confirm that Rodrik’s result (and thus insight) holds if government expenditures are limited to transfer payments.
26A minor, but not totally useless point to keep in mind is the following. Tanzi has used the term ‘World’ Tax Organization’. We however prefer the term Global rather than World Tax Organization. This is so, as in case such an organization does eventually come into existence, the acronym GTO would cause no problem, as opposed to WTO (World Trade, Tourism or Tax Organization?).
27There are of course, others who would argue for completely doing away with multilateral agencies such as the IMF, or at least severely curbing their powers and mandate, and ensuring that they become more participatory, transparent, and accountable.