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

A. CAPITAL TAXES

Capital taxes include company income tax (and related tax allowances), personal income tax on investment income, presumptive tax on small businesses, municipal property tax, and import duties applicable to capital goods. The company income tax is 30 percent in Uganda. Ugandan firms are allowed to carry over their operating losses indefinitely, except for the firms that enjoy a tax-holiday. Two types of deductions from the company income tax are allowed under the 1997 Income Tax Act: the initial investment allowance and the annual depreciation allowance. Investment in machinery and plant is strongly encouraged through tax incentives; it is entitled to both the initial allowance, and the annual depreciation allowance available to all taxable firms.¹⁵ For industrial buildings, there is no initial allowance, and the annual depreciation rate is much smaller (5 percent) than that for machinery. However, expenditures on acquiring farm structures are entitled to a higher annual depreciation allowance (20 percent).¹⁶

There are two main accounting methods for writing off the cost of inventory for tax purposes. They are the first-in-first-out (FIFO) method and the last-in-first-out (LIFO) method. During a period of rising prices, the choice between these two methods can make a significant difference in taxable income. More specifically, when inflation is high and inventories are large, FIFO can penalize firms by taxing profits that are not genuine but derived from the low cost of inputs (i.e., the inventory sold is much more expensive to replace). Conversely, the LIFO approach would increase the tax burden if the value of inventory were falling rapidly. In principle, Uganda allows both inventory accounting methods but taxpayers are not allowed to change the method, which they initially chose. In practice, most firms use FIFO.

Prior to the tax reform, a holder of the certificate of incentives was exempted from company income tax, withholding tax and tax on dividends for a certain period, depending on the total value of investment.¹⁷ As mentioned above, new tax holidays were repealed in 1997, but firms with current tax holidays can choose to retain them until they expire. Interest and dividends are taxed at the same rate (15 percent).

A presumptive tax on small business was introduced in 1997. Previously, most small firms did not have any tax obligations. Instead of paying a regular income tax, a small firm with annual turnover below U Sh 50 million (equivalent to about US$37,000) is subject to a presumption tax up to one percent of its gross turnover, unless it opts to file the regular income tax return. This tax is final and no deductions for capital expenditure or any other business expenses are allowed.

Finally, municipalities impose a property tax on immovable property or buildings but not on vacant land. For this study, the Kampala property tax system is used.¹⁸ The tax rate is 10 percent on the ‘ratable value’ which is obtained by deducting maintenance cost from the ‘gross value’, or the rent one may expect to receive from the property. Hence, the tax base for the local property tax is the same as for rental income, which is determined through an assessment conducted by government valuers. This property tax is deductible for income tax purposes.

B. INDIRECT AND PAYROLL TAXES

There are two main transaction taxes levied on business inputs in Uganda: import duties, applicable mainly on raw materials and taxes on petroleum products. Imports of capital goods were zero-rated in 1995. The fuel tax has been a special revenue source in the 1990s. The ad valorem rate ranges from 100 percent to over 200 percent for paraffin, diesel and petroleum products. A weighted-average rate is estimated at 174 percent (see Appendix B for details). A high fuel tax is not uncommon in many developed economies, particularly for environmental reasons. As we will see below, what makes it problematic in the Ugandan context is that Kenya and Tanzania have much lower tax rates on fuel, resulting in substantial smuggling and a higher effective tax rate on the cost of production for the Ugandan firms that do not smuggle.

Payroll taxes include social security levies. Since 1985 the social security contribution by the employer has been 10 percent of the gross salary payments with no ceiling (excluding allowances which are commonly used in Uganda). The employee contribution is 5 percent but it is poorly enforced in practice.

As discussed above, the estimation of the METR is not only sensitive to tax policy but also to the choice of macroeconomic indicators and industry-specific parameters, such as inflation rate, interest rate, debt-to-assets ratio, economic depreciation rate, capital structure, and cost structure. While inflation and the interest rate are usually the same for all industries within an economy, the other parameters vary by sector. For example, depreciable assets used by different industries have a different useful life and replacement cost, which results in a different economic depreciation rate. Capital structures also vary by industry. For example, compared to tourism, the capital structure in manufacturing is more intensive in machinery and inventories and less intensive in buildings. To ensure that the choice of non-tax parameters does not drive the results, we provide sensitivity analyses for the base case assumptions (Table 2).