An important choice of a non-tax parameter is that of the expected inflation rate. Inflation mainly affects the METR on capital through its impact on the nominal interest rate. That is, for a given real interest rate, the higher the inflation rate, the higher the nominal interest rate will be. The nominal interest rate interacts with taxes mainly in the following manner. First, as interest costs are deductible for income tax purposes in nominal terms, the higher the nominal interest rate in relation to a given real interest rate, the lower the real after-tax financing cost. This effect will benefit the sectors with a high share of debt financing and contribute to a lower METR. Second, a higher inflation rate may, through a higher nominal interest rate, lower the accumulated present value of a given tax depreciation allowance. This effect will raise the METR on certain depreciable assets. Third, during periods of high inflation, using the FIFO inventory accounting method may cause inflated taxable income, and hence a higher METR on inventory capital. Therefore, a high inflation rate can affect the METR on different asset in different directions, depending on the financing structure. The net impact on the aggregate METR on capital in a given industry depends on how these effects offset each other through its industry-specific capital structure. The debt-to-assets ratio measures the financing structure. For a given inflation rate and real interest rate, the higher the debt-to-assets ratio, the more a taxpayer can benefit from the tax deductibility of interest expenses. That is, the higher the debt-to-assets ratio, the lower the METR. To prevent tax-driven borrowing, or ‘thin capitalization,’ many jurisdictions implement restrictions on the debt-to-assets ratio for tax purposes. In the case of depreciable assets, the economic depreciation rate interacts with the tax depreciation allowance, affecting the METR. The higher the economic depreciation rate relative to the tax depreciation allowance, the higher the METR. For example, given the mobility of capital and technology, one can assume that a given type of machinery is depreciated at the same economic rate everywhere. Therefore, a jurisdiction that grants a faster tax depreciation allowance for this type of machinery will have a lower METR. Non-tax parameters for Uganda used in this study are summarized in Table 2. B. METR ON CAPITAL Capital investment generally involves two categories of capital, that is, depreciable and non-depreciable assets. These two categories can be further divided into buildings and machinery (depreciable), and inventory and land (non-depreciable). As mentioned earlier, capital investment by asset type varies by industry. Consequently, even if a certain type of asset incurs the same METR, the different capital structure by industry will result in a different aggregate METR on capital across industries. Similarly, the cost structure by input varies by industry. Hence, the larger the share of an asset, or an input with a high METR, the higher is the METR on capital or cost of production in that industry. Asset Type Our base case is the 1997 regular taxable firm. We define the METR on capital as the percentage of the difference between gross- and net-of-tax revenue from an incremental unit of investment, using net revenue as denominator. As Table 3 shows, machinery is the lowest taxed asset in Uganda. This is mainly because of the very generous initial allowance (50 percent), along with the annual depreciation allowance, starting from the first year. In fact, the METR on machinery is found to be negative in a number of industries which indicates a tax subsidy.19 The transportation sector, however, incurs a relatively high METR on machinery (17 percent). This is mainly because vehicles are not eligible for the initial allowance. Inventories are the highest taxed asset (a METR of 45 percent). This is mainly due to the FIFO accounting method combined with a positive inflation rate. Buildings, except those used by commercial agriculture, are taxed the second highest (a METR of over 40 percent), mainly because of the local property tax on buildings, combined with less generous tax depreciation allowances. Due to a more generous depreciation allowance for farm works, buildings used in commercial agriculture bear a low tax burden (a METR of 12 percent). Structures used by the construction industry incurred a higher METR than other sectors, mainly because of a higher economic depreciation rate. Finally, non-farm land is also subject to the local property tax, resulting in a relatively high METR (42 percent), while farmland incurs a significantly lower METR (28 percent). As shown in Table 3, while non-depreciable assets, such as inventories and land, are taxed at the same level across industries (except land for commercial agriculture), depreciable assets, such as buildings and machinery, are taxed unevenly. The main reason is that depreciable assets used by different industries have different useful lives and different tax depreciation allowances. For a given depreciable asset, the wider the gap between the economic and tax depreciation rate, the higher the METR on this asset. Industries
The aggregate METR for each industry is simply a proportional difference between the weighted average of the before-tax and after-tax rate of return by asset, based on the industry-specific capital structure. Obviously, the larger the share of the assets that are highly taxed, the higher is the industry’s aggregate METR. As shown in Table 3, tourism incurs the highest METR (39 percent) in the base case. This is mainly a result of its very high capital weight in buildings (71 percent), which is the second highest taxed asset. Manufacturing incurs the second highest METR (33 percent), mainly because the sector invests about two thirds of its total capital in the two highest taxed assets, inventories and buildings. In contrast, transportation enjoys the lowest METR on capital of all sectors (21 percent). The primary reason is its heavy capital weight in machinery (84 percent), particularly vehicles which have a relatively high annual depreciation allowance (30 percent). For the same reason, agro-processing and construction (capital share of machinery is 48 percent) incur a relatively low METR (23 percent and 24 percent, respectively). The METR on capital for commercial agriculture and the communications industry are somewhere in-between (a METR of 26 percent and 31 percent, respectively). The primary contributor to the former is its rather high capital share in inventories (33 percent). The main factor for the latter is its high capital share in buildings (57 percent). Small Firms As described above, small firms do not pay regular income taxes, unless they opt to do so, but are instead levied a presumption tax up to one percent of their gross turnover. In this section small firms refer to those firms qualifying for and choosing to pay the presumptive tax. Since the presumptive tax is imposed on the gross-receipts without any adjustments, small firms are neither entitled to the generous initial allowance for investment in machinery nor subject to any restrictions regarding writing off business expenditure. As a result, the METR for small firms is found to be lower than that for large and medium-sized regular taxable firms on all other assets but machinery (Table 4). However, except for those engaged in commercial agriculture, small firms still pay municipal property taxes. Therefore, buildings and land are taxed higher than investment in machinery and inventory by small firms. As depreciable assets wear off at a different pace from industry to industry, buildings and machinery incur a different METR across industries even though they are subject to the same presumptive tax rate and have no differentiated sector-specific tax allowances. Compared to the base case (regular taxable firm) by industry, small firms are taxed significantly less as measured by the aggregate METR on capital. The gap ranges from 15 percentage points in agro-processing to over 24 percentage points in manufacturing. Furthermore, the inter-industry dispersion is smaller than in the base case of the regular taxable firm. |
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