Tax Reform 5: The nuts and bolts of its design

Introduction
Last week I claimed the value of taxes not paid in 2010 but which ought to have been paid under the tax code was roughly equivalent to that actually paid ($102 billion). Taxes paid therefore were only about one-half what was theoretically due. This week I consider some important nuts and bolts considerations essential to designing successful tax reform. These support my contention that only a National Commission on Tax Reform can fully address it in all its varied social, political, and cultural dimensions.

Tax expenditures
First, the estimate of the Guyana tax-gap, which I provided last week is conservative. It includes three components: 1)the indicators US authorities use (under-reporting, under-payment, and non-filing); 2) tax-evasion in the underground economy; and 3) serious tax-evasion in such sectors as gold mining, retailing, independent small farming, skilled artisans, and the self-employed. However, it specifically excluded tax giveaways (tax expenditures).

Readers should be aware that, from an economic standpoint, if the tax code offers an enterprise a tax holiday its economic effect is similar to one where the enterprise pays the tax and then the government returns it. In other words a tax expenditure has both revenue and expenditure effects. My solution to this conundrum is for each individual researcher to decide on whether to include tax expenditures when measuring the tax-gap, as long as he or she specifies the components covered.

Tax level, structure
Second, readers need to appreciate the difference between the tax level and tax structure. The tax level is captured in the tax revenue-to-GDP ratio, which as I indicated is 26 per cent for Guyana. This simple average was also compared to that for the group of OECD countries (where it ranged from about 19 per cent to 48 per cent). Recent worldwide estimates though, show a range from under 10 per cent (mostly in small, poor, open economies) to about 50 per cent (mainly in high income European countries). Data further show that, while the average tax/GDP ratio rises as income levels rise, this is a weak relation.

Economists broadly portray a country’s tax level as a function of its economic structure and preference function or political/social choices. The former depends on such considerations as size, degree of income poverty, level of dependence on natural resources, and degree of openness. Guyana is a small open economy with high levels of both income poverty and reliance on natural resource-based economic activities.

On the other hand, the tax structure refers to the share of various taxes in total tax revenue collection. Based on data I have already provided, the most noteworthy feature for Guyana is the difference in its tax structure when compared to developed economies, particularly 1) taxes on goods and services versus income and property; 2) taxes on personal incomes versus business income; and 3) the role of imported items in providing tax revenues through VAT and excise taxes.

Available data suggest a country’s tax structure is a function of its economic structure, historical evolution, conditions in the countries with which it principally deals, and preference function.

Tax buoyancy, elasticity
Third, last week I indicated Guyana’s rate of growth of tax revenue as compared to the rate of GDP growth reveals considerable tax buoyancy and a high income elasticity of tax revenue. However, readers should note while these two concepts are related, they do not have the same meaning. Tax elasticity is measured only in the absence of tax policy changes. Therefore, tax policy changes in Guyana (Tax Reform Action Plan (TRAP), VAT, etc) must be isolated to arrive at this measure. When tax policy changes are not isolated, it is more accurate to speak of tax buoyancy. My reference last week, therefore, to the high responsiveness or elasticity of tax-revenue in Guyana (because it grew by several multiples (5-6) of GDP growth since 2003), is better represented by the notion of tax revenue buoyancy rather than elasticity. Further, the overall elasticity of Guyana’s tax system can be interpreted as the average of the elasticity of individual taxes weighted by their individual shares of tax revenue collected.

Volatility
A related measure to tax elasticity and tax buoyancy is tax volatility. Tax revenue does not flow at a regular steady rate into the Treasury. There are seasonal variations to these flows. I do not want to unnecessarily complicate the discussion for the general reader, but this is the major reason why governments like Guyana’s, issue short-term Treasury bills ― to smooth out cash flow variations.

However, variation or volatility in tax     revenue flows is not only seasonal, but can also be cyclical and secular. It is cyclical, when these reflect short-to-medium term cycles in the level of economic activity. This is captured in the experiences of expansion (boom) and decline (recession) as in the current global economic crisis. Although a weak relation, when economic activity rises, generally tax revenues rise and when it declines vice versa.

Secular declines in tax revenue, however, reflect long-run declines in the sources of income from which revenue derives. This can be located in the decline of the whole economy (as in the case of a depression) or in particular sectors from which the tax revenue mainly derives.

Because of the above, tax reform should be aimed at reducing both tax revenue volatility and long-term secular decline. To avoid these, taxes must be diversified across the economy and made less reliant on volatile sources of income and employment generation.

Next week I shall conclude this aspect of my discussion by addressing three remaining nuts and bolts considerations, namely, tax stability; taxation and economic efficiency; and the economic costs of taxation, before proceeding to introduce what would be my targeted goals for tax reform in Guyana.

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