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

E. METR ON COST PRODUCTION

The METR on cost of production is used to evaluate the impact of all business taxes, including capital, payroll and indirect taxes on overall business activities. It is estimated as an integration of the METR on various inputs, using the augmented Cobb-Douglas production function (Appendix A). Given that the fuel tax is an important revenue source in Uganda, motor fuel along with capital and labor is included as an input for production. As shown in Table 11, the cost structure varies across industries. Capital accounts for the largest share which probably reflects the very low labor costs in Uganda. Furthermore, as agro-processing requires a higher share of transportation services than commercial agriculture, the share of fuel in its total cost is nine percent, while it is only one percent in commercial agriculture.

Table 11 summarizes the METR on each of the three inputs as well as on the overall cost of production by industry. For the METR on capital we use the base case (regular taxable firm under the 1997 tax system), while the METR on labor is simply the statutory payroll tax rate of 10 percent, and the METR on fuel is estimated at 174 percent (see Appendix B).²² As the METR on fuel is significantly higher than that on capital, industries with a higher share of fuel may incur a higher METR on production cost than on capital. Agro-processing and transportation which have the lowest METR on capital fall in that category. In other words, the high fuel tax may actually negate some of the benefits of the tax reform which strongly encourages investment in machinery and equipment in agro-processing and the transportation sector as the two sectors are the most fuel-intensive in terms of their cost structure. In contrast, all other industries incur a METR on cost that is lower than their METR on capital, mainly due to the low METR on labor and their small share of fuel in the total cost. On cost of production, tourism and manufacturing are still the highest taxed industries in Uganda, while construction becomes now the lowest taxed industry instead of transportation.

This section compares the impact of taxation on foreign direct investment in Kenya, Tanzania and Uganda. It attempts to answer the following question: Which of the three countries is in the best position to attract foreign investors, if tax cost were the only factor in their investment decisions? We focus on manufacturing and tourism, as they are key areas for foreign direct investment in Eastern Africa. For simplicity, tax provisions and economic parameters for foreign firms are based on the United Kingdom’s tax system, as it accounts for the largest share (about 25 percent) of the total actual foreign investment in Uganda.²³ To eliminate the effect of factors other than taxation, Uganda’s non-tax parameters are used for all three countries. A simulation using country-specific parameters is also carried out.

A. TAX PROVISIONS IN KENYA AND TANZANIA

In Kenya the corporation income tax rate is 32.5 percent, which is slightly higher than in Uganda (Table 12). A weighted-average annual depreciation rate for machinery (based on Uganda’s capital component weights) is 14 percent for manufacturing and 22 percent for the tourism sector.²⁴ An initial investment allowance of 60 percent is available for investment in both structures and new machinery used in manufacturing and in the hotel industry. Both FIFO and LIFO are allowed for inventory accounting in Kenya. Most firms choose FIFO, despite the relatively high inflation rate in 1990s. As in Uganda, operating losses can be carried forward indefinitely.

A withholding tax of 7.5 percent is imposed on dividends received by individuals. There is also a land tax imposed on the rental value by local authorities at a rate varying by location. The highest rate (8 percent) is in Nairobi. However, there is no property tax on buildings in Kenya. Import duty for most capital goods is 5 percent, and that for most of raw materials is 15 percent. The average fuel tax is 62 percent.²⁵ The payroll tax in Kenya is a contribution made by employers to the national provident fund. The rate is 5 percent on the base, with an extremely low annual ceiling (K Sh 80, or about US$1.30).²⁶ As a result, the effective payroll tax rate is less than 0.1 percent.

In Tanzania, the corporation income tax rate is the same as in Uganda (Table 12). The weighted-average annual depreciation rate for machinery (based on Uganda’s capital component weights) is 14 percent for manufacturers and 20 percent for tourism.²⁷ Unlike in Kenya and Uganda, Tanzania has no initial allowances for capital investment. For inventory accounting, obsolete stocks are allowed to be written off. There seems to be no clear specification on inventory accounting methods in Tanzania.²⁸

The import duty in Tanzania is between 0 and 5 percent for capital goods, and between 10 and 20 percent for raw materials. Ad hoc exemptions, particularly for large investors, seem to be more common than in Uganda. However, detailed data on exemptions are not available. The uneven practice of granting exemptions may render the METR comparison somewhat less reliable across countries. The fuel tax in Tanzania is estimated at 26 percent.²⁹ Finally, the payroll tax payable by the employer is a contribution to the national social security fund. The rate is 4 percent on the total payroll without a ceiling.