Business Taxation in a Low-Revenue Economy a study on Uganda in Comparison With Neighboring Countries
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A. CONCEPT OF MARGINAL EFFECTIVE TAX RATEThe METR calculation is based on the assumption that profit-maximizing firms base their investment or business decisions on the foreseeable incremental net revenue at the present value. Taxes reduce the profits accruing to the firm, while tax allowances mitigate such a reduction. Due to the interaction between statutory tax provisions and actual economic and industrial conditions, the effective tax rate can vary by industry under the same tax regime. Furthermore, for a cross-jurisdiction comparison, the effect of taxation can be singled out by applying the same set of economic and industrial conditions to different tax regimes. For profit-maximizing firms, the gross rate of return on capital (net of economic depreciation) must be equal to the financing cost of capital, adjusted for taxes. The size of the adjustment for taxes on investment is the METR on capital. For example, if the gross-of-tax rate of return to capital is 15 percent and the net-of-tax rate of return is 12 percent, then the marginal effective tax rate on capital is 25 percent when the net-of-tax rate is used as denominator, or 20 percent when the gross rate is the denominator. In the case of the METR on cost of production, the gross rate of return on production must be equal to the total cost of all inputs. For example, if the gross-of-tax rate of return to production is 15 percent and the net-of-tax rate of return is 12 percent, then the marginal effective tax rate on cost of production is either 25 or 20 percent, depending on the choice of denominator. It should be noted that the METR analysis in this study deals with ‘profitable’ firms only. By ‘profitable’ we mean those firms that have taxable income, if not granted a tax holiday. This assumption is important because, according to the Ugandan tax law, operating losses can be carried forward indefinitely. However, those firms that obtained a tax holiday are not able to carry forward any losses incurred during and before the tax holiday. Therefore, a tax holiday is irrelevant to an unprofitable firm that does not have to pay taxes and can carry forward its losses indefinitely. B. METR ON CAPITALAs described above, the marginal effective tax rate on a given type of real capital investment is defined as the proportional difference between the gross-of-tax rate of return (rG) and the net-of-tax rate of return (rN) required by financial investors. rG is the marginal revenue product, or user cost of capital, net of economic depreciation. The net-of-tax rate of return is the weighted-average of the return to debt and equity securities held by the financial investor. Thus, the effective tax rate (t) is defined as:t = (rG - rN)/rG or t = (rG - rN)/rN (1) We use the latter definition in this study. Real Cost of FinancingFor domestic firms, the real cost of financing (rf) is defined by: rf = ßi(1 - U) + (1 - ß)r - p (2) with ß = debt-to-assets ratio, i = cost of debt, U = the statutory corporate income tax rate, r = cost of equity, and p = inflation rate. While interest costs are deductible for the income tax purpose, cost of equity is not. That is, the cost of financing for a domestic firm is the weighted-average cost of financing, net of inflation rate.For foreign firms, the real cost of financing (rf) is defined by: rf = [ ß’i’(1 - U’) + (1 - ß’)r’]*(1 -g)/(1-x) +g*[i(1-U) - p +p’] - p’ (2') with ß’ = debt-to-assets ratio in home country, i’ = cost of debt in home country, U’ = the statutory corporate income tax rate in home country, r’ = cost of equity in home country, g = the ratio of debt raised in host country to total investment fund, x = weighted average withholding tax rate in host country, i = cost of debt in host country, U = statutory corporate income tax rate in host country, p’ = inflation rate in home country, and p = inflation rate in host country. According to the above formula, the cost of financing to a foreign firm is the weighted average of cost of its investment funds taken from home country and debt raised in host country. The former is the weighted average of cost of financing at home net of withholding tax payable in host country, and the latter is the cost of debt in host country adjusted for income tax deductibility and the difference in inflation rates between home and host country. Net-of-Tax Rate of Return on CapitalFor domestic financial investors, the net-of-tax rate of return on capital is defined by the formula: rN = ßi + (1 - ß)r - p (3) This is the rate of return on capital required by the financial investor, or the supplier of investment funds.For foreign investors, the formula is: rN =[ ß’i’(1-U’) + (1 - ß’)r’ - p’](1-g) +g(i-p) (3') This is the net-of-tax rate of return on capital required by fund suppliers, including foreign financial investors in host country. Applying (3) and (3') to equation (1), respectively, yields us the effective corporate tax rate on capital for domestic and foreign firms.Gross-of-Tax Rate of Return on CapitalFor domestic firms, the formula is: rG = (1+tm)(rf +d)(1- k)[1 - A +t(1-U)/(a +rf+p)]/[(1-U)(1- tp -tg)] - d (4) with tm = tax on transfer of property, or transaction tax (e.g., import duty) on capital goods where is applicable, d = economic depreciation rate, k = investment tax credit rate, A = present tax value of the accumulated capital cost allowance, t = capital tax rate, a = tax depreciation rate, tp = property tax rate, and tg = gross receipts tax rate, or presumptive tax. For international firms, the formula is: rG’= (1+tm)(rf’+d)(1- k)[1 - A +t(1-U)/(a+rf’+p)]/[(1-U)(1- tp -tg)] - d (4') InventoryFor domestic firms, the formula is: rG = (1+tm)(rf +Upz)/[(1-U)(1-tg)] +t (5) with tm = sales tax on inventory where it is applicable, and z = 1 for FIFO accounting method and 0 for LIFO. For international firms, the formula is the same except that the financing cost should be the one relevant to the international firms, that is, rf should be replaced by rf’. LandFor domestic firms, the formula is:rG = rf (1+tm) [1 +t(1-U)/(rf + p)]/[(1-U)(1- tp -tg)] (6) For international firms, the formula is the same except that the financing cost should be the one relevant to the international investors, that is, rf should be replaced by rf’. AggregationThe effective tax rate for a given industry is the proportional difference between the weighted average of before-tax rate of return by asset type and the after-tax rate of return which is the same across asset type within the industry. That is, the marginal effective tax rate ti for industry i is calculated as: ti = (Sj rGijwij - rNi)/rNi (7) where j denotes asset type (i.e., investments in buildings, machinery, inventories, and land), wij denotes the weight of asset type j in industry i. The above are general formats of the formulas used in this study. Due to the variance among different sectors or jurisdictions, some variables can be zero for some sectors or jurisdictions. For example, in all three countries under this study, there are no taxes based on capital and hence t = 0 in equation (4) - (6). METR DispersionMETR dispersion, or the weighted standard deviation, is used to measure the tax distortion. There are three measures of dispersions: overall, inter-industry, and inter-assets dispersion. Only inter-industry dispersion is estimated in this study. Let wi, wj, and wij denote the capital weights for the ith industry and the jth type of asset, respectively. The inter-industry METR dispersion sI is calculated as the weighted standard deviation: sI = Sj wj {S wij(tij – tj )2}1/2 (8) The expression tj is the average effective tax rate for the asset j across industries, and tij is the effective tax rate for the jth asset type in the ith industry. |