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

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C. IMPACT OF TAX REFORM

Regular Taxable Firms

As shown in Table 3, the tax burden incurred by large and medium-sized regular taxable firms was significantly reduced following the 1997 income tax reform. The difference in the aggregate METR between the two systems ranges from 5 to 15 percentage points. The most striking change is the difference in the METR on machinery, ranging from 9 percentage points for transportation to 34 percentage points for the communications sector. This is mainly because of the generous initial allowance for investment in machinery and equipment (except vehicles) available to all tax-paying firms under the new system. The other contributor is the zero-rated import duty for imported machinery.

Following the reform, the METR on buildings declined about 3 percentage points. This is mainly due to the slightly higher annual depreciation allowance (increased from 4 to 5 percent). The wider gap (about 19 percentage points) for commercial agriculture reflects the effect of a higher annual allowance for farm works. There was no change in the METR for inventory and land.

Regular Taxable vs. Tax-Holiday Firm

Corporate tax holidays were abolished in 1997 and replaced mainly by an initial investment allowance for machinery. As a result, the METR on machinery was significantly reduced (around 25 percentage points lower across industries, except for the transport sector). This indicates that, given the generous allowances, profitable firms that invest heavily in machinery can benefit from opting out from the tax holiday status.^²⁰

For all other assets, however, the METR was lower under the tax-holiday regime. First, as the annual depreciation allowance for buildings is relatively low, there is still a large balance left (76 percent of the total cost) to take advantage of the tax depreciation allowance even when the tax holiday has expired. Obviously, the longer the tax holiday, the less is the unclaimed balance worth in the present value terms. Second, the significantly lower METR on inventories is due to the fact that tax-holiday firms are able to avoid the tax penalty caused by inflation when using the FIFO accounting method. Third, by investing in land, the only tax benefit a tax-holiday firm may lose is the interest deduction. When the debt-to-assets ratio is low (25 percent or less in Uganda), this loss is insignificant compared to the benefit gained from the tax holiday.

As can be seen from Table 3, inter-industry tax distortion actually increased following the tax reform.^²¹ A further analysis shows that the main contributor is the difference in the METR between commercial agriculture and all other sectors. As farm works are entitled to a fast write-off, and properties used for commercial agriculture are exempted from municipal property tax, buildings and land are taxed much less than in the other sectors.

To summarize, industries investing heavily in machinery gained most from the tax reform, reflecting the policy-makers’ desire to provide incentives for acquisition of new technologies. The most evident example is the transportation industry where the advantage measured by the METR for regular taxable firms is 6 percentage points compared to their tax-holiday counterpart. However, the METR for the regular taxable firms in the tourism sector is significantly higher (13 percentage points) than their tax-holiday counterpart, due to the high capital share in structures. Similarly, commercial agriculture and manufacturing incur a higher METR under the new system (11 percentage points) as these industries invest more in non-depreciable assets, particularly inventories for which the tax holiday regime was more advantageous. Despite a relatively high capital share in machinery, the construction industry also lost slightly (3 percentage points) because of the opposite effect from large inventories.

D. SENSITIVITY ANALYSIS

This section provides three different policy simulations and sensitivity analyses for non-tax parameters. As before, our base case is the regular taxable firm under the 1997 tax system. First, we assess the importance of the choice of the accounting method, followed by an assessment of the impact of an initial allowance for buildings and that of municipal property tax on small firms. Second, we examine the extent to which the choice of inflation rate, debt-to-assets ratio, and economic depreciation rate changes the results.

Inventory Accounting Method

Table 5 provides a simulation to illustrate how the choice of the LIFO (last-in-first-out) accounting method could alter the base case results, other things being equal. While the Ugandan tax law allows firms to use either FIFO (first-in-first-out) or LIFO for writing off inventories, firms are not, however, allowed to change the method after their initial choice. In practice, most firms use FIFO.

Our simulation shows that, with an inflation rate of 5 percent, the METR on inventory capital can be significantly reduced under LIFO. This would obviously benefit those industries that require large inventories for their business activities. For example, the METR on capital for commercial agriculture, agro-processing, manufacturing, and construction could be reduced by about 5 percentage points. As can be expected, there is no significant difference in the METR on capital between the two accounting methods for transportation, communication and tourism as these sectors do not require significant inventories.

Initial Allowance for Buildings

While investment in machinery has a high initial depreciation allowance (50 percent), investment in buildings has no such allowance. As a result, industries investing heavily in buildings tend incur a much higher METR than other sectors. For example, in tourism, with 71 percent of its investment in buildings, the METR on capital is the highest (39 percent). Such a large difference in the initial allowance also contributes to a rather high inter-industry dispersion in the METR.

Table 6 presents three simulations for an initial allowance for buildings (10, 15, 20 percent, respectively). A comparison with the base case shows that a 10-percent initial allowance for buildings would reduce the METR on tourism and the communications industry by four percentage points. Other industries, except commercial agriculture, would also experience a reduction in their METR on capital from one to two percentage points, and the inter-industry dispersion would decline. Table 6 also shows that each additional 5-percentage point increase in the initial allowance for buildings would translate into a reduction of another two percentage point in the METR of industries with heavy capital share in buildings (tourism and communication). As other (non-agricultural) industries would also benefit, the dispersion between industries would decline when the initial allowance for buildings increases.

Municipal Property Tax and Small Firms

This simulation for small firms attempts to disentangle the relative importance of the presumptive tax and the municipal property tax for their METR on capital (Table 7). In the absence of the property tax, the METR incurred by small firms would be considerably lower. Further, the inter-industry tax distortion among small firms would be close to zero. In other words, it is the property tax rather than the presumptive tax that is mostly responsible for both the tax burden and the inter-industry tax distortion among small firms.

Inflation

Annual average inflation in Uganda has varied between 6.5 percent to 7.8 percent in 1994-98. Our base case assumes an expected inflation rate of 4.9 percent. In order to determine the extent to which our inflation assumption affects the results, Table 8 provides a simulation with zero inflation. We find that all types of capital assets, except inventories, would be taxed higher than with a positive inflation. The main reason is that the tax deductibility for the nominal interest expenses provides a shelter for the inflated cost of debt financing. In other words, Government actually subsidizes debt financing above the real interest cost. The higher the inflation rate, the more investors benefit from the tax deductibility of interest expenses. A lower METR on inventories tells a more complex story. When FIFO is used, inventories are taxed lower under zero inflation compared to a positive inflation rate. The opposite holds if LIFO is used.

Debt-to-Assets Ratio

Table 9 provides a simulation for debt-to-assets ratios that are either higher (40 percent) or lower (10 percent) than in the 1998 firm survey estimate for large and medium-sized firms (25 percent). A comparison between Table 9 and the first panel in Table 3 shows that, with a higher debt-to-assets ratio, the METR on all types of assets would be significantly lower, and vice versa. This is because for a given inflation rate and real interest rate, the higher the debt-to-assets ratio the more taxpayers benefit from the tax deductibility of interest expenses. Obviously, this tax benefit can be gained only when debt financing is available.

Economic Depreciation Rate

Table 10 provides two simulations for different economic depreciation rates. Compared to the base case, the first simulation has much higher economic depreciation rates (6 percent for structures and 25 percent for machinery), while the second simulation assumes lower rates (3.5 percent and 12 percent, respectively). As Table 10 shows, higher economic depreciation rates result in a higher METR on these assets, which in turn produce a higher aggregate METR on capital by industry. Obviously, the difference in the aggregate METR depends on the difference between the tax and economic depreciation rates as well as the capital weight on depreciable assets. The wider the gap between the tax and economic depreciation rate and the higher the capital weight in depreciable assets, the higher the aggregate METR on capital by industry.

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