Tax reform: Forget the sizzle; mind the steak

Claude Clarke, Contributor

The moment society recognised the benefit of public goods and services to the quality of people's lives, the taxes needed to finance them became as inevitable as death itself. But the value of taxation has progressed well beyond this benefit. Tax policy has become one of the principal tools for organising a society to realise its full economic and social potential.

Apart from paying for the goods and services that we all use in common, the intensity of global competition has led governments around the world to adopt taxation policies to sharpen their countries' competitiveness and promote their development.

In both respects, Jamaica's tax system has been in need of reform since the second decade of our Independence. Since the 1970s, we have been losing the battle for economic success to our global counterparts, and our economy and the quality of our people's lives have been on a downward path. Much of the decline has been caused by the failure of government to properly define its role and design a framework of taxation that provides an economic environment in which the creation of real economic value is fostered.

The most important predicate for constructing an economically effective tax system is a clear definition of the public goods and services that are better provided by the government than through private initiative. This not only restricts the size of government but it allows us to establish the realistic and reasonable cost of the things that government must do.

Increasing tax revenues without the benefit of such an assessment puts the cart before the horse and is ultimately counterproductive. Blindly extracting more taxes from a society to feed a wasteful and inefficient government is economically suicidal, particularly in a country in as deep an economic hole as Jamaica is.

In this respect, the tax-reform proposals recently presented by the Private Sector Working Group (PSWG) has missed the mark. Its proposals provide a construct within which Government will raise approximately $7 billion of additional revenue.

While one must acknowledge the critical need to raise revenues to repay the enormous debt accumulated by Government to finance its past profligacy, Government taking more from the economy only weakens the country's future ability to repay that debt. It is, therefore, very difficult to see any value in proposing that Government further contract our stagnating economy to increase the already disproportionately large share of the county's output it now captures.

Inequity a major shortcoming

The PSWG has correctly identified inequity as a major shortcoming in the present tax system. However, while equity is important, in the circumstances of our severely challenged economy, what is most needed is a system that creates the conditions for economic expansion and sustainable improvement in our standard of living. But the PSWG's proposals do not adequately lay the groundwork on which either equity or economic expansion is likely to be built.

Reducing the corporate tax rate from 33 1/3 to 15 per cent, even in combination with a token 10 per cent tax on dividends, in the expectation that increased investments in the economy will result ignores both history and empiricism. The investment outcomes of reduced dividend taxes in Jamaica, and the 1990s tax cuts by the Bush administration in the United States, provide ample testimony to the fallacy of that view. How can we tell where the tax benefit will be invested or spent? It could just as easily be invested overseas or spent on consumption of expensive goods and services abroad.

The corporate tax-cut advocates in both the US and Jamaica might benefit from reacquainting themselves with the simple capitalist principle that the profit motive, not the availability of funds, is the principal motivation for investment decisions. If the Government wants to motivate capital to invest in the Jamaican economy, it cannot rely on corporate altruism or patriotism but on the greater likelihood that owners of capital will follow their financial interests to make such investments. Government must go further and use the appeal of tax credits to induce capital to invest in what Jamaica needs most: production, foreign exchange gain and job creation.

Will tax-cut benefits go to investment?

Tax-cut crusaders in Jamaica and the US must understand that corporations and rich individuals cannot be depended on to use the windfalls realised from tax cuts in ways that advance their country's interest rather than to promote their own narrowly defined individual objectives.

That is why, in my article 'Tax reform: opportunity for development' in The Sunday Gleaner of October 2 last year, I proposed that a progressive tax system be applied to all personal and corporate incomes, including income from dividends. In an economy with so high an income disparity and that so desperately needs investments in production, it is the ultimate absurdity that we have promoted and maintained a flat income tax regime.

The 15 per cent income tax rate proposed by the PSWG could be an appropriate base rate for both personal and corporate tax. This would allow usually capital-deficient small businesses to benefit from significant tax relief to help grow their businesses. Above that, there should be a 25 per cent rate to reflect a smaller tax reduction to businesses in the medium-size bracket. The corporate and personal tax rates should be capped at 33 1/3 per cent. However, the effective tax rate for corporations and  individuals alike could be brought down to the 15 per cent base by providing tax credits on taxes applicable above that level, for investments in the real economy.

A tax regime such as this would achieve the dual objective of greater equity and a more attractive environment for businesses and individuals to invest in the development of the economy.

Equity would also be enhanced by significantly increasing the tax-free threshold to around $900,000, approximating the levels in Trinidad and Barbados.

Common 10% GCT rate

Although in some ways there is justice in taxing people's consumption decisions rather than the income earned from their productive effort, the wider the disparity in income within a society, the less equitable and more regressive taxes on consumption becomes. The poor spend nearly all their income on consumption within the country, exposing most of it to taxation. They also direct more of their consumption to domestic production.

A correspondingly smaller percentage of the income of the rich is used for consumption within the economy and on locally produced goods and services. Less of their income is, therefore, exposed to local consumption tax. That is why everything should be done to bring the GCT rate to the lowest level possible.

In my earlier article, I proposed a common 10 per cent rate with no exemptions. I also suggested that if the tax-free threshold on incomes were correspondingly lifted and a direct subsidy provided to those with incomes below the taxable level, any disadvantage suffered by the poor would be made good. The increased revenue that would come from the widened range of taxable items, and the greater degree of compliance that would be likely at the lower rate, would also ensure that Government's revenue was not compromised. The Government should be bold and go for it.

I am happy that the PSWG has amplified the position I advanced in my above-referenced article, that this would be a far more cost-effective way of assisting the intended beneficiaries than a system that, according to their analysis, squanders nine out of every 10 taxpayer dollars spent to exempt the poor from GCT on basic items.

The elimination of waste and possible corruption built into the present tax regime must be a central feature of the reform effort. Outrageously high taxes to which exemptions and waivers must be provided for the normal conduct of business institutionalises waste and corruption. The objective of tax reform must be to eliminate the case for waivers by bringing the tax rates involved to levels that render waivers unnecessary.

There can be no doubt that the present dysfunctional tax regime has been a significant cause of our economic stagnation and its overhaul is urgently needed. The regime has moved capital to areas where it is least productive and undermined the best utilisation of our valuable human capital.

Since 1990, employment in manufacturing, the sector that, based on the data, provides workers with the best opportunity to be productive, has declined by 50 per cent. Employment in the productive sectors, taken together, has also seen a dramatic decline. It is these sectors, as well as export services sectors like tourism, that are the foundation of the wealth of the economy, and it is they that are exposed to foreign competition. It must, therefore, be the principal objective of tax policy to preserve and promote their health and development.

The taxation arrangements needed to rescue the economy and put it on a development path can never be all things to all persons. It will not spark spontaneous Kumbaya among all sectors. The present economic framework, in which business activities that contribute less to our economic well-being benefit more, and those that are most valuable to our economic health are retarded, will have to be radically changed.

Strong opposition from special interests can be expected. But we can be sure that our dream of economic development will only be realised if the tax regime that emerges from the present effort at reform creates a changed environment that gives new life to our value-creating economic sectors and engages more of our people in rewarding production.

My advice to the Government is this: In evaluating the tax-reform proposals put before you, focus on the steak and not the mouth-watering sound of the sizzle.

Claude Clarke is a businessman and former minister of trade. Email feedback to columns@gleanerjm.com.