By Mukul G Asher
Professor, Public Policy Programme.
National University of Singapore.
March 21, 2001
A speech to be delivered on March 21, 2001 in Singapore as a part of the executive program on Infrastructure in a Market Economy, jointly organized by the John F. Kennedy School of Government, Harvard University, and The Public Policy Program, National University of Singapore, March 25-31, 2001, Merchant Court Hotel, Singapore.
Thank you Mr. Chairman. Good afternoon ladies and gentlemen. I am delighted to be given the opportunity to address such a distinguished audience.
The task before us this afternoon is to examine the impact of globalization on the fiscal systems, and how this in turn may affect financing of infrastructure.
At the outset, it is important to recognize that the term infrastructure is quite heterogeneous. It covers economic infrastructure such as roads, ports, water and sewage systems, electricity, telecommunications, and irrigation systems; as well as social infrastructure such as schools, community centers, health facilities, prisons, and police and fire stations. It is essential that the specific characteristics of different types of infrastructure are recognized, and temptation to over generalize resisted.
The construction phase of most of the infrastructure of a country has traditionally been financed from the budgetary receipts, including government borrowing. Tax and non-tax revenues are however often the largest source of budgetary receipts, and deserve special attention.
While the private sector or private-public partnership may assist in some areas of infrastructure, adequate and effective public expenditure on most areas of infrastructure remain essential for crowding-in other investments. Moreover, government’s role in regulation, ensuring appropriate property rights, and in dispute resolution remains essential particularly when the private sector is involved in infrastructure.
Globalization has significantly increased the importance of infrastructure in at least two ways. First, more infrastructure activities now fall into the tradable sector. Second, good quality infrastructure is no longer a luxury but essential to meaningfully engage in a globalized economy.
Costs of good quality infrastructure are high, both to build and to maintain. Failure to plan for the interrelationships between the capital and maintenance expenditure for infrastructure has often led to diminished effectiveness of infrastructure projects.
Given the fiscal stringency, financing methods therefore need to be more complex, requiring financial engineering and legal skills not normally found in government bureaucracies. Recent experience in such countries as Malaysia and Thailand suggest that it is also essential to take in to account total financing costs over the whole project cycle, including any contingent liabilities arising from government guarantees for infrastructure projects.
The financing of the operating phase has often been based on cost recovery, with varying degrees of subsidies provided for different types of infrastructure and for different users. The design and level of subsidies have often been influenced by such considerations as political power of the users and the election cycles. Predictably, such subsidies have often been neither efficient nor equitable. While cost recovery implies that an activity is worth subsidizing, the main issue being the level of subsidization; the term user charges implies that users should pay the full cost of the economic activity. For some types of infrastructure, it is the user charges rather than cost recovery which are more appropriate.
As the full impact of Globalization and associated technological changes on the nations and their governments begins to be better understood, the above traditional modes of financing infrastructure will require substantial modifications. The nature of such modifications will of course vary from country to country, and even within each country, according to the type of infrastructure. The nature and the type of risks associated with infrastructure financing, including political and regulatory risks have also become considerably more varied and complex, and so have the methods for addressing them. International power relationships are of course a relevant factor in the way these risks are shared among the stakeholders.
In the remaining time, I would like to elaborate on how globalization and associated changes are likely to impact the tax systems, often the largest source of budgetary receipts; and what will be the resultant implications for financing of infrastructure.
The term globalization does not have precise and uniform definition. For the present purposes the term may be used to describe two trends that are here to stay. The first is that the level, pace and scope of economic activities which are taking place across national boundaries have expanded considerably in recent years, and this is expected to continue, though not necessarily in the same manner as has been the case during the past decade. The second is the Increasing integration of financial and capital markets of different countries. The globalization process has thus centered on production and distribution networks, and on financial institutions, products, and transactions.
Globalization has been aided by the technological revolutions in communications, life sciences, including biotechnology, micro electromechanical systems (MEMS) and information processing and dissemination. These have already necessitated far-reaching changes in economic, social and even political systems, both within and between countries.
The challenges of decentralization in Indonesia and Malaysia for example, are to a considerable degree due to the above forces. These developments have also altered the economic boundaries of the state, enhancing the role of the private sector, including in infrastructure. Blending of financial resources from several sources such as multilateral institutions, banks, insurance companies, and debt markets to finance infrastructure is now widespread. There is now also a private insurance market, with a coverage of up to 12 years for insuring infrastructure investment risks.
Let us now turn to globalization’s impact on the tax systems.
Present tax systems evolved when each country formulated its own tax policy and focused on the requirements of its domestic economy. Where tax treaties, agreements and conventions among nations were negotiated, they were within the framework of national sovereignty in tax policy.
The main challenge, therefore, is to make the current 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.
There is an extensive literature on the impact of globalization and associated technological developments on the tax system. Most, but not all, experts lean towards the view that both the level and the structure of the tax systems will be altered significantly. They argue that just because there has not been major impact until now (for e.g. total tax revenue to GDP ratios in the OECD countries have not shown any tendency to decline), this does not necessarily imply that profound changes in the tax systems will not arise in the future. Indeed, Tanzi uses the term “Fiscal Termites” to depict how globalization and technological changes will impact on the national tax system in a slow and subtle rather than in a discontinuous manner.
Globalization has greatly increased mobility of both capital and certain types of labor, thus implying higher factor supply elasticity for any given jurisdiction. The inverse elasticity rule (so called Ramsey rule) suggests that the marginal tax rates on factors with high supply elasticity should be quite low. The dilemma is that while such low rates are consistent with economic efficiency, they may not be consistent with the notions of equity and fairness. This is because those unable to participate in globalization are likely to be lower income groups, and since they have low supply elasticity, they will be taxed relatively heavily. The role of personal taxes, i.e. those taxes which can take into account individual’s tax paying circumstances such as income, family size. Etc., is expected to decline, while the role of in-rem taxes, such as the VAT, which cannot do this, is expected to increase.
The larger danger is that broad political support for globalization could be significantly eroded unless the equity issues and the feeling of pervasive insecurity with perceived loss of control are addressed reasonably satisfactorily.
3. High volumes along with volatility of capital flows, particularly of the short-term variety, could have serious negative impact on the macro-economic variables and on the exchange rate. Regulatory measures, and taxes, such as the Tobin Tax on currency transactions, have been suggested to lessen the volatility of capital flows. But as yet, there has been no consensus on this issue.
A Tobin tax is essentially a permanent, uniform, ad-valorem tax on international foreign exchange transaction flows. This tax is regarded as inversely proportional to the length of the holding period, thus discouraging short-term flows.
But the Tobin tax will not be easy to devise and implement, as it requires all major financial centers to agree on the necessity of levying such a tax, and on the method for distributing the resulting revenues. The synthetic nature of many financial products such as derivates has also complicated the implementation of the Tobin tax conceived for challenges of an earlier era.
4. Globalization implies higher supply elasticity for businesses and factors located within any single tax jurisdiction, be it a city in a given country, or a country itself. That this vulnerability also exists in the high-income countries is indicated by the stunned reaction of the officials in Seattle and in Washington State to the announcement by their most important corporation, Boeing, that it will be shifting its headquarters from Seattle to another city yet to be decided. The need for efficient and equitable treatment of firms and individuals operating in multiple tax jurisdictions has consequently become more urgent.
For individuals, avoiding double taxation, particularly in the areas of fringe benefits, stock-options, and pension arrangements has become much more difficult given the vastly enhanced scope and frequency of movements of high-level professional staffs and managers. Even in the European Union, which is a common market with free factor mobility, harmonization of tax burdens and pension benefits is a complex and so far unaccomplished task.
At the unskilled and semi-skilled level, significant outflow of temporary labor from some countries, e.g. the Philippines, Nepal, Myanmar, Sri Lanka is raising the issue of protecting their remuneration from excessive taxation by the host countries, and protecting their pension rights (when they exist) at home.
As far as corporate income tax is concerned, it may be increasingly difficult to treat the operations of MNCs in each taxing jurisdiction as a separate entity. It is likely that at some stage, serious consideration may be given to the adoption of a unitary or worldwide tax base for the corporate income tax, with internationally agreed system of tax credits or allocation procedures to prevent double taxation and to maintain competitiveness.
As developing countries rely much more heavily on revenue from corporate income taxes, and use fiscal incentives more extensively, they have a vital stake in international rules and formulas adopted for taxing corporations.
Firms from the developing countries such as India and China which are setting up subsidiaries abroad, or those firms listed abroad, particularly in the US will also need to be aware of the tax implications.
Such rules and formula could still provide incentives for corporations to shift income from high to low tax jurisdictions, assuming each country retains the right to decide on their own corporate income tax rates. To get maximum benefits in terms of enhanced compliance and reduction in administrative costs from the allocation methods, implicit or explicit understanding on the corporate income tax base, which would include the treatment of fiscal incentives, will be needed. Formula allocation methods however will further limit autonomy and flexibility of national governments, as well as of sub-national governments. It is possible that as a result, use of business levies and charges may increase.
But the current system, with extensive possibilities of transfer pricing (defined as intra-firm or intra-group pricing which is not done on an arms-length basis with a view to minimizing overall tax liability of a firm or a business group) and prone to “race to the bottom” due to tax competition, serves the MNCs well. Transfer pricing has become an important issue due to the rise of intra-firm transactions. Thus, in 1994, 36 percent of US exports and 43 percent of US imports were of the intra-firm nature, and these shares must have increased since then. Evidence suggest that the US MNEs reduced their tax burden by between 3 and 22 percent from transfer pricing. Thus, moving to a unitary or world – wide tax base will not be an easy task.
5. Greater ease of international trading, and reductions in transactions costs are making it difficult for countries to sustain large tax differential with others. This is especially true for products with high value but little weight or volumes, such as cameras. Tax-free shopping by international travelers could also undermine the tax base of some highly revenue productive commodities for some countries.
6. New technologies are resulting in growing importance of sophisticated barter and electronic commerce or E-commerce.
E-commerce involves two types of commodities:
i. Products delivered electronically on the Internet.
ii. Physical items ordered on the Internet and shipped across borders.
Each of the above in turn can be a business-to-business transaction or business-to-consumer transaction. The former currently predominates, but the latter is also expected to increase rapidly.
E-commerce will require major adjustments in the traditional means of allocating revenue among jurisdictions and in the current system of tax administration. Thus, it would be difficult to apply the permanent establishment and source-based taxation methods to businesses involved in E-commerce. This is turn would impact on double taxation treaties among countries which are based on the above concepts.
E-commerce could also result in greater accessibility of tax heavens (though OECD countries are trying to reform tax heavens), and offshore banking facilities, and in weakening or elimination of convenient points of taxation in the production-distribution process. Global agreements and standards will be needed before E-commerce can be taxed effectively. Indeed, the fear is that e-commerce will enormously complicate the task of administering the existing taxes and detecting tax avoidance and evasion. It could also adversely impact on revenue from such traditional sources as gambling duties which some countries, such as Singapore and the Philippines rely to finance a portion of their social expenditure.
The current U.S. practice of not levying sales taxes on online retailing has the potential to erode the revenue base, requiring higher sales tax rate on the remaining transactions. This is inefficient as well as inequitable because on the average, online shoppers have higher incomes. Thus, the poor in the U.S. are being asked to carry the burden of promoting the net.
International agreements, though the WTO, on making the Internet tax-free similarly have the potential to burden the developing countries. Some analysts believe that developing countries made a mistake in agreeing to such tax provisions in the WTO.
7. Taxation of international trade transactions is being increasingly circumscribed by the regional and multilateral trade arrangements, such as through the World Trade Organization (WTO). This is also the case at the regional level, such as in ASEAN and SAARC. But many of these countries rely on import duties as an important source of revenue. How to adjust the tax-mix and yet retain the tax levels has thus become an important tax policy issue for these countries.
To ease adjustments, countries could consider:
i. Moving from quantitative (and other non-tariff) restrictions to tariffs. This would convert private monopoly rents to government revenue.
ii. Take measures to convert existing illegal border trade into legal trade with realistic tariff levels. This requires political will, high priority given to economic development objectives, and commitment to good governance. These attributes are not always evident in Asia or elsewhere.
iii. Rely more on cost recovery, user charges, auctions etc, in areas relating to international trade while simultaneously taking steps to reduce transaction costs.
8. While environmental problems are increasingly regional and global, tax and other instruments that are used to address them remain largely national. International cooperation is needed to address environment issues, but is difficult to achieve.
Many infrastructure projects (e.g. dams, power plants, and irrigation canals) often have significant environmental implications, and these need to be accounted for in any credible cost-benefit analysis. It is important to recognize that the quality of the environment is even more vital to the poor as their very livelihood may depend on it.
9. Finally, demands for fiscal transparency and for reducing the scope of implicit taxes and irregular and arbitrary levies are likely to become more persistent, particularly by the multilateral institutions such as the ADB, the IMF, and the World Bank.
The above discussion thus suggests that as a result of globalization and associated technological changes, countries are finding it increasingly difficult to make intensive use of existing tax bases; while their willingness and ability to levy taxes on newer areas such as the Internet is quite circumscribed. As a result, without innovative resource mobilization policies (and expenditure minimization per unit of government service benefit), attaining fiscal sustainability will pose a major challenge.
We now turn to the impact of globalization and associated changes on financing infrastructure. The foregoing discussion suggests that the traditional methods of relying on conventional taxes to finance infrastructure will no longer be adequate.
Globalization is also reducing the pricing power of the existing domestic monopolies in telecommunications and other infrastructure areas such as ports and roads. This reduces the extent to which domestic monopolies can be relied upon to generate revenues for the state.
This trend has been exacerbated by the 1997 Asian economic crises and by the excess capacity in some types of infrastructure such as airport and seaports in the region. As an example, the new Hong Kong airport is offering substantial discounts to airlines which start new routes to and from Hong Kong. It appears that the combined capacity of Kuala Lumpur International Airport (KLIA) and Changi Airport in Singapore is so large that the pricing power of each has been reduced considerably. It is also probable that if aggressive pricing (or fiscal incentives) strategies are adopted, neither airport will be able to generate sufficient economic returns. Under these circumstances, countries with strong fiscal positions have an advantage as they could more easily engage in “fiscal-dumping”, i.e. using fiscal concessions, including price discrimination for public infrastructure services, to retain or induce a given economic activity to a particular tax jurisdiction from its competitors. In large federal countries, such “fiscal-dumping” could occur among the states and provinces, with adverse effects on economic efficiency and on fiscal sustainability. It is essential to achieve coordination in granting of fiscal concessions, particularly in federal countries. The states in India for example have agreed not to use sales tax concession to attract industry and thereby protect their revenue base. Whether the Prisoner’s dilemma is thereby resolved among the States however remains to be seen.
Internationally, the decision by the Federal Communications Commission of the U.S. to unilaterally cut the rates U.S phone companies pay to phone companies abroad is bound to have serious revenue implications for the domestic telephone companies of the developing countries. High international call rates have been an important revenue source for the developing countries in building their telecommunications networks and as a way to tax consumption by the high-income groups. Technology is undermining the pricing power in this area as well, at least for some types of services.
Those developing countries with fairly high price and income elasticity for telecommunications services, and those which have technical and institutional capacity to introduce new products and services are likely to be able to adjust, though at same cost. Those without the above attributes are likely to be especially hard-hit. (Source: Business Week (Asian edition), October 11,1999, pp.86-87).
As a result, the countries will need to be much more skillful at raising resources through auctions, permits, licensing fees, charges, and the like. They will also need to ensure that the cost recovery and user charges are designed and implemented in a manner more consistent with economic efficiency and equity than has traditionally been the case.
Public enterprises will also need to utilize their existing assets more efficiently, and explicitly take into consideration the hidden costs borne by their organizations and by their economies. As an example, railways would need to consider how to turn their currently unused land and air space rights in to a recurrent source of revenue to finance their future plans. Increasingly, the traditional reliance on government budgetary support, fares, and market borrowings will be insufficient to finance their operations.
To reap benefits from the new methods of financing (and managing) infrastructure, well defined and enforced property rights and regulatory laws, policies, and procedures, as well as skills not usually attributed to the civil servants, will be needed. A clear demarcation between the public and the private sectors, Including in the financial sector, will also be necessary.
It should be stressed that the role of government will remain critical, though its nature will be different when new methods are used. Its main role will be to ensure credibility and professionalism to the contract awarding and negotiations process; and to ensure that the regulatory policies and infrastructures strike an appropriate balance between the interests of the consumers, producers, and the overall public interest.
The above suggests that the role of market supporting institutions will matter much more than has been recognized so far. While we have some ideas about the appropriate institutions, how to develop them is an area where considerable humility is needed on the part of multilateral institutions, policy analysts, and governments. It is vital that any steps towards marketization or privatization are consistent with the state of development of market supporting institutions. Premature or too rapid a privatization needs to be avoided as Malaysia’s case so amply demonstrates.
In many other countries in the region as well, such transition from traditional to new methods of financing infrastructure has not been smooth. Indeed, in countries such as Indonesia, political economy prevailing at the time various privatization contracts were signed has put the country in a no-win situation. If Indonesia honors these contracts, it will be saddled with high cost infrastructure and potentially debilitating contingent liabilities. If it insists on renegotiating (and this is not only costly but also requires highly skilled scarce human resources), the investment climate could be adversely affected, an out come it can ill afford given the substantial dependence on foreign sources of funding.
In India, the teething problems of new regulatory structures have been used by operators of some types of infrastructure, e.g. Telecom operators, to obtain greater concessions from the government. Such attempts at regulatory capture, if successful, could erode public support for the much-needed transition in India. The Enron’s Dabhol power plant case also reflects the importance of contract specification and negotiating skills, and the need for transparency in infrastructure privatization. The contract specification required the State and the Central governments to assume rather large contingent liabilities, which have now become actual liabilities, with sharply adverse impact on the fiscal balance.
The need for continued vigilance by the regulatory authorities even in high-income economies is indicated by the recent reports that six local mobile-network telecom operators in Hong Kong have allegedly engaged in anti-competitive behavior by simultaneously increasing the monthly fees by an identical amount. The increase was subsequently withdrawn, but without any penalties by the regulators. Many developing countries are unlikely to have regulatory agencies with as much resources and sophistication as Hong Kong.
The debate over the methods and results of utility deregulation in California indicate the necessity for careful planning, transparency, and balancing of interests of different stakeholders.
The above discussion thus leads to the conclusion that there is no blueprint applicable to all countries or to all types of infrastructure. As in other areas of public policy, professional skills, attention to details of design, planning, implementation, and regulation, and quality of market-supporting institutions remain critical ingredients for success. The importance of understanding and then taking actions to mitigate political and regulatory risks in the infrastructure sector, addressing principal-agent and moral hazard problems, ensuring effective competition, and taking into account demand side considerations should not be underestimated. Finally, the impact on privatization on the fiscal system should take into account both the income statement and balance sheet effects, as well as should explicitly address the issues of contingent liabilities of the State. Make haste slowly therefore may not be a bad maxim in infrastructure reforms, provided momentum towards sustainable reforms is maintained.