Business Taxation in a Low-Revenue Economy a study on Uganda in Comparison With Neighboring Countries

A. PURPOSE OF THE STUDY

B. METHOD OF DATA

An alternative measure of the impact of taxes is the average effective tax rate (AETR).¹⁰ As with the METR approach, the AETR is based on a cash flow calculation and can be used for comparisons among firms, industries, or jurisdictions. The main differences between the two measures are the following:

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  AETR is the total amount of taxes payable divided by the total value of the taxable input or output. It is an accounting concept that provides a measurement for overall tax burden but lacks the economic underpinning that marginal rather than average factors drive economic decisions by firms. The AETR is also sensitive to taxpayers’ performance and hence not very reliable for policy simulations.
  

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  METR is the incremental amount of taxes payable on the last unit of taxable input or output. It is an economic concept that provides a measurement for tax incidence on taxpayer behavior. It is sensitive to policy settings as well as certain economic indicators and hence a useful tool for policy simulations.
  

As mentioned earlier, when using the METR analysis in a low-income country where the tax administration tends to be weak, a key issue is how much the actual tax incidence differs from that of the formal tax structure. While the METR analyses can relatively easily be extended to the comparison of impact of the formal tax structure across industries or jurisdictions, obtaining adequate information about actual administrative practices as well as detailed industrial parameters is more difficult. The issue is not so much whether the METR model can handle the real world but how well we understand the real world and are able to quantify the differences between the formal tax structure and tax administration.

Although the METR application presented in this paper is based on Uganda's formal tax system, it uses actual firm level data for key non-tax parameters. For example, the debt-to-assets ratio is obtained from the 1998 firm survey, which collected quantitative information on five sectors.¹¹ The URA taxpayer database was used to obtain the capital structure by industry, while the 1992 input-output tables were used to estimate the cost structure by industry.¹² As mentioned above, the survey data are also used to assess whether administrative practices are likely to produce a METR, which is different from that based on the formal tax system. In addition, we compare firms’ perceptions of compliance by their competitors and performance of tax administration over time, using results from an earlier survey.¹³ We also use regression analysis to determine whether tax holidays and exemptions are correlated with higher private investment.

The rest of this report is organized in the following five sections. Section II presents an overview of tax provisions in Uganda. The overview covers the taxes and tax-related incentives that affect capital investment and other business inputs, particularly labor and fuel. Section III analyses the METR on capital and cost of production for domestic firms. The former will focus on the cross-asset, cross-industry, and cross-tax-code (regular, tax-holiday, and small firms) comparisons. The latter will emphasize the impact of taxes levied on inputs other than capital. A cross-border comparison of the METR on capital and cost of production for foreign investors in Kenya, Tanzania and Uganda is presented in Section IV. Section V provides survey evidence on the impact of compliance and tax administration on the METR results. Finally, Section VI concludes and discusses policy implications of the study.

In tax policy there are two broad approaches with respect to attracting private investment. One is to apply standard tax provisions to all business activities combined with low tax rates. The other is to tax various business activities differently to achieve economic policy goals, such as increases in private investment, exports or employment. The latter is typically implemented through fine-tuned incentives, including tax holidays. Depending on revenue needs, the second approach can result in a relatively high tax rate in some sectors and hence induce problems for compliance, and adversely affect the general investment climate. The Ugandan tax system is being gradually reformed away from highly selective incentives towards more standard across-the-board provisions.

The Government instituted a range of tax incentives in the early-1990s to compensate firms that undertook major investment projects for prevailing market distortions. The 1991 Investment Code included project-based licensing of large investments. A typical license entitled its holder to a full or partial income tax holiday and duty exemptions on imported inputs. As market distortions were subsequently reduced, the Government implemented an income tax reform in 1997 to streamline the system of tax incentives. The reform was preceded by the introduction of duty-free treatment of imported capital goods to all firms. The objective of the income tax reform was to broaden the tax base, improve efficiency, increase administrative simplicity, and encourage long-term investment and technology transfer. The major changes introduced in 1997 were:

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  Taxable income was broadened from domestic income to worldwide income;
  
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  An initial allowance for investment in machinery and plant was made available to all regular taxpaying firms;
  
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  Tax-holidays were abolished;
  
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  A 20-percent annual depreciation allowance was made available to farm works, most of which were subject to an annual depreciation rate of 4 percent under the previous system; and
  
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  Previously unregistered and hence non-taxable small firms are now required to register and subject to a presumptive tax of up to one percent on gross receipts, unless they opt to file an income tax return.
  

Table 1 summarizes key features of the pre- and post-1997 tax systems, including all key categories of business taxes, that is, capital taxes, indirect taxes applicable to business inputs, and payroll taxes.¹⁴