Business Taxation in a Low-Revenue Economy a study on Uganda in Comparison With Neighboring Countries
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D. THE IMPACT OF TAX ADMINISTRATION ON THE METRThe firm survey reveals three key differences between the formal tax system and actual practice which can affect the METR results presented in this paper. First, according to the Ugandan income tax law, firms that enjoy a tax holiday are subject to mandatory tax depreciation. In other words, they are required to write off their depreciable assets annually during the tax holiday period, and should not be able to claim tax depreciation on the full cost of capital invested in the beginning of or during the holiday period. Typically, the mandatory depreciation is incorporated into the METR model as it is part of the formal tax system. However, if the practice is that tax-holiday firms do not file their income tax returns at all and hence manage to claim for the full tax depreciation allowance after the tax holiday ends, then their real effective tax burden can be much lower than predicted by the standard model.34 Second, among the firms that were audited, at least every third had to pay additional taxes, while every fourth firm incurred additional costs, such as bribes. It is interesting to note that all firms whose tax assessment differed by 100 percent or more reported that they ‘always’ had to pay bribes to the URA officials, while on average all survey firms reported that they were required to pay bribes only ‘seldom’. Payment of bribes may affect the effective tax burden in two ways. On the one hand, despite being a cost, bribes can reduce the tax burden (measured by the METR) if they provide an opportunity to tax evasion. On the other hand, the extra costs may increase the tax burden when used, say, to avoid a lengthy appeal and settlement process (which in itself would increase the burden but is not captured by the METR based on the formal tax system). Third, as the VAT is a consumption tax and therefore should not have any impact on capital investment and taxable business activities, it is generally ignored in the METR model. However, if the input tax credit under the VAT system is not timely refunded, or not refunded at all, then VAT can cause an additional tax burden on the business sector.35 As the VAT was introduced to Uganda only in 1996, implementation problems can be expected to arise. In 1998 the main complaint from the business sector concerns refunding of the input VAT credit. As Table 17 shows, 81 percent of firms purchase inputs from VAT-registered suppliers but only 56 percent of these firms claim for input tax credits. It is somewhat unclear whether this results from the VAT credit and liability offset procedure.36 Another potential reason is that firms with excess input tax credits simply decline to claim for refunds, for example, due to higher compliance costs. This could be tempting for firms that can pass on the input VAT cost to consumers but less so for the firms that have to absorb the cost themselves. In the former case, it would result in the VAT cascading so as to increase tax revenue in a short term but at the cost of consumer welfare in the long run. In the latter case, firms may incur a profit loss that can, in turn, affect the CIT revenue. Fifty-two percent of the firms that claimed for an input tax refund received their expected amount in 1998. However, a significant portion (18 percent) of firms that claimed the input tax credit did not receive any refund at all, while the rest (40 percent) received a partial refund. Furthermore, the waiting period for even a partial refund of the input VAT credit can be lengthy. For example, among the firms that received at least a portion of refund, over a half waited for more than six weeks, while 10 percent waited for more than half a year. The lengthy process for input VAT refund is likely to curb compliance as well as increase the cost of doing business, tying a considerable portion of working capital that has a high opportunity cost, considering a current bank lending rate of over 20 percent. There are mainly two reasons for the delay in the VAT refunds: a lack of sufficient funds on the refund account, and a lack of sufficient human resources to perform a full audit on all claims within the stipulated one-month time limit. These problems are not uncommon in countries that do not have an established tax culture and that have introduced the VAT only recently. A functional VAT system, however, would require adequate funds for the refund process and limiting the full audit only to those claims with greatest revenue risk. Hence, in terms of compliance and tax administration, two types of factors emerge from the analysis of survey evidence that could alter the METR results. These factors operate in opposite directions. First, tax evasion in general and avoidance of the mandatory depreciation during the tax holiday in particular would reduce the actual METRs compared to the formal tax system. As compliance is firm-specific and tax administration also tends to treat firms differently, this impact is not the same across the industries or even within a particular sector. Second, delays in the VAT refunds and in some cases payment of bribes could have the opposite effect of increasing the tax burden compared to the formal tax system. The net effect is ambiguous. Finally, the impact of frequent tax audits and assessments on the METR is also ambiguous, depending on whether they simply contribute to enforcement of the formal rules, or cause an extra cost to firms over and above the METR. VI. CONCLUSIONS The marginal effective tax rate (METR), as calculated in this paper, provides important findings on the tax burden that the formal tax system places on firms in Uganda. As this study demonstrates, it is indeed possible that, even when the country’s level of public revenue is low at the macroeconomic level, rapidly increasing taxation may pose a constraint to private investment at the microeconomic level. There are two reasons for this. First, the formal enterprise sector in these economies typically represent a small share of output but a high proportion of the effective tax base. Second, access to credit is limited and interest rates are often high, particularly for smaller firms, and hence most private investment is financed by profits and personal savings. As a result, taxation is linked to private investment in two ways: it reduces both the expected revenue from a given investment project and the availability of finance. Even if there were an adequate number of profitable investment projects available, high business taxation is likely to have a negative impact on the level of private investment by constraining liquidity. From the perspective of foreign investors, Uganda appears to be a more highly taxed environment compared with its neighboring countries, particularly Kenya. Raising tax rates is therefore no longer a feasible policy option for Uganda. Interestingly, at the microeconomic level the Kenyan tax system appears to place the lowest burden on firms investing in manufacturing and tourism, while at the macroeconomic level Kenya's share of tax revenue in GDP is the highest of the three countries (22.7 percent in 1997/98 compared to 11.2 percent in Tanzania and 10.7 in Uganda). Uganda's tax disadvantage results mainly from its property tax on buildings, which does not exist in Kenya and Tanzania, and its significantly higher fuel taxation. There is a strong case for harmonization of fuel taxes within the region. The findings also point to a difference in treatment of investment in non-agricultural buildings between the three countries. Kenya grants a generous initial allowance for investment in structures, while Uganda and Tanzania do not. To level the playing field, discretionary corporate tax holidays were abolished in 1997 in Uganda and replaced by an initial investment allowance for machinery for all firms. As a result, the METR on machinery was significantly reduced. The analysis indicates that profitable firms that invest heavily in machinery clearly benefited from this policy change. However, for all other assets the METR was lower under the tax-holiday regime. The inter-industry tax distortion was also slightly increased in 1997 due to the introduction of a generous depreciation allowance exclusively for farm works Future changes in tax policy should ensure that the inter-industry dispersion will be reduced. Inventories and buildings are the highest taxed assets in Uganda. Hence, industries investing heavily in them, particularly tourism, manufacturing and communications incur a higher METR than the other sectors. Small firms that are subject to a presumptive tax are taxed much less than large and medium-sized firms. The heavy fuel taxes increases the tax burden in some industries, particularly in agro-processing, transportation and manufacturing. The METR estimates presented in this paper tell mostly a story of the formal tax structure. Tax administration, if not fair and efficient, can distort the best intentions of policy-makers and produce a very different outcome in terms of the actual tax burden faced by firms. Using recent firm survey evidence, we identified several factors that can alter the METR results. First, there are factors that are likely to reduce the METRs, including wide-spread tax evasion in a number of sectors reported by firms, evasion of mandatory depreciation during the tax holiday period, and firm-specific exemptions which, despite efforts to curb them in recent years, show up strongly in the 1997 data. Second, delays in the VAT refunds and in some cases payment of bribes are likely to have the opposite effect of increasing the METR compared to the formal tax system. The net effect is ambiguous. Like in many other low-income countries, tax administration is a key area to be tackled in the Ugandan tax policy. In particular, efforts to combat corruption, including the tax authority, and mechanisms to resolve grievances between the business sector and the tax authority would be important. These efforts require regular dialogue with the private sector in order to build trust, and tax education and training for both taxpayers and administration staff. APPENDIX A: Marginal effective tax rate The marginal effective tax rate (METR) on capital calculated in this study is the effective corporate tax rate on capital, while the marginal effective tax rate on cost of production is an integration of the METRs on all inputs, using the augmented Cobb-Douglas production function. The METR is estimated for both domestic and foreign firms. Unless otherwise specified, all estimates are based on the 1997 tax regime and the latest economic indicators available. |