Core
Business World, 21 August 2012
The administration of Benigno Aquino III has finally accepted the reality that new taxes are needed in order to finance its costly expenditure program. That’s a significant move forward.
But it is important to manage the reforms properly, since designing appropriate changes in the tax system is hard to do and shepherding them through Congress is tricky (oftentimes, expensive) while ensuring new taxes are passed with as few departures as possible from the executive’s original proposal.
So far, the level of discourse on two reform measures — sin tax and rationalization of fiscal incentives — has not gone beyond how much incremental revenues the new taxes will raise.
For sure, the tax yield is important. But the projected additional taxes that will be generated by the reform have to be realistic, based on estimated elasticities of demand (response of consumers to changes in prices) and experiences in the past in other countries which raised similar tax rates recently.
On the rationalization (meaning reduction and simplification) of fiscal incentives, there should be no illusion that new revenues can be generated overnight. It will simply reduce revenue loss but not immediately. Government commitments to favored firms will have to be honored.
In what follows below, I will focus the discussion of the proposed changes to the taxes on cigarettes and alcoholic beverages.
EMPIRICAL BASIS NEEDED
The level of tax discourse has to go beyond the motherhood statement that “bad” goods should be taxed heavily to reduce the negative externalities they impose on society.
Policy decisions have to be based on real effects which are based on hard facts. What is the negative external effect of smoking? On drinking? On petroleum consumption?
Shouldn’t the definition of “bad” goods be broadened to include soft drinks (sugar is bad for one’s health) and bottled water (water per se is not bad, but the plastic container is bad for the environment)?
This is relevant in designing a tax system with a broader base and thus lower tax rates, a much better tax system than one where the burden of taxation is too high for the few who pay taxes because the tax base is so narrow.
Is the negative external effect equal for all, or does one product (say smoking) have more of such effect than the other (say, drinking). Within each product, say smoking, does one type of cigarettes (say unfiltered, lowest class) have more externally damaging effect on smokers than another type (filtered, high blend)? Then, if the externality argument is carried to its logical conclusion, there should be a higher tax on the unfiltered, lowest class of cigarettes.
If on the other hand, the harm is invariant with respect to the quality of the cigarettes, then a uniform rate may be appropriate.
Again, decisions by policy makers should be based on hard facts. When rates are differentiated, it has to be based on some empirical grounds.
The level of discourse should recognize some of the “nice” properties of an ideal tax system: economically efficient (in the sense that the “deadweight” loss is minimized), equitable or least perceived to be equitable, high revenue yielding, and easy to administer.
Tax inefficiency is a difficult concept and is not easy to explain. As a result, the Department of Finance, which itself grapples with the idea, does not explain the idea of welfare loss (or deadweight loss) to policy makers. I doubt whether senators and congressmen are briefed at all on this important concept by the respective committees on ways and means in the Senate and the House of Representatives.
Deadweight loss (DWL) has something to do with the idea that whenever a tax is imposed, it evokes changes in the behavior of the individual or firm. For example, DWL can come from consumers buying a good, say wine, instead of beer, as a result of the tax.
Consider the following: If the price of a glass of beer is P25 and the price of a glass of wine is P25, a consumer would prefer to buy beer. If the government decides to impose a beer tax of P10 per glass of beer, the consumer might prefer to drink wine.
The deadweight loss (or excess burden of taxation) is the loss of utility to the consumer for drinking wine instead of beer.Similarly, it might be the loss of utility to the consumer for buying one brand of cigarette rather than another brand because the latter is taxed less than the former.
For some, tax changes might provide higher incentive to evade taxes. A higher tax, in an environment where tax administration is weak (more often, corrupt), will lead to tax evasion or smuggling (in the case of imported goods).
For others, tax changes might lead to tax avoidance. The taxpayer or firm may choose to hire the best accountants and lawyers money can buy in search of possible loopholes in the existing tax laws for the purpose of minimizing tax liabilities.
But DWL as a measure of economic inefficiency is an important concept. It increases exponentially. A doubling of the tax rates lead to a quadrupling of DWL, a tripling will lead to an eightfold increase in DWL, and so on.
But what’s the important lesson here?
First, increasing tax rates increases (exponentially) the DWL; such loss is minimized if tax rates are lower.
Second, for a given revenue target, the broader the tax rates, the lower the tax rate.
No wonder, most successful tax reforms focus on broadening the tax base.
And real tax reforms do not necessarily require raising tax rates; in some cases, they involve lowering tax rates.
MONUMENTAL MISTAKE
Sadly, as a result of the Ramos tax reform, the tax base for the value added tax (VAT) was narrowed.
This was followed by a series of populist tax exemption laws. One may argue that the tax base is narrower now than what it was during President Cory Aquino’s term.
I remember that after EDSA 1, President Aquino reformed the tax system within a few months of her term. Some of the tax changes involved reducing rather than raising some tax rates. Many indirect tax rates were reduced and replaced by a lower, uniform 10% VAT rate.
Tariff rates were cut, invoking the theoretical argument that higher tariff rates lead to rampant smuggling. Lo and behold, lower tariff rates resulted in higher revenues for the Bureau of Customs. Theory was supported by reality.
Part of the Aquino tax reform program was to shift the manner of taxation on sin products from specific to ad valorem taxation. The shift simplified the tax system, rendered unnecessary frequent discretionary changes in tax rates, and yielded significant revenues.
Future tax reforms should aim to recover what was lost in the area of “corrective” taxation. Taxes from goods with negative externalities — that is, cigarettes, liquor, and petroleum products — used to account for a large part (about a third) of total taxes.
In recent years, the relative importance of these taxes has been eroded. The ad valorem tax system on sin products was doing well until the dominant cigarette manufacturing firm resorted to transfer pricing.
In response, President Ramos, supported by the de Venecia-led House, changed the manner of taxation of sin products by reverting to specific taxation. What a monumental mistake! What followed were falling revenues from sin products, both in nominal and real terms, for a long, long time.
The first best solution was obvious but was missed. It was to define through legislation what constitute “transfer pricing” and impose heavy penalties (including imprisonment ) on offending parties.
The shift from ad valorem to specific taxation was like throwing out the baby with the bath water.
The income-unresponsive sin tax was further reformed in 2005. But the specific tax nature of the tax was kept; added was a weak provision for price indexation.
As a result, the tax on cigarettes continued to fall from 0.6% of gross national product (GDP) in 1998 to 0.4% of GDP in 2010. Similarly, the tax on alcoholic beverages was cut by half — from 0.4% of GDP in 1998 to 0.2% in 2010. Some P32.4-billion revenues from alcohol and tobacco was foregone in the years 2006-2010, according to the Department of Finance estimates.
As a general rule, valorem system of taxation is superior to specific taxation in an environment where getting new taxes and upward adjustment of existing taxes are difficult to legislate. A good tax reform strategy is to broaden the base of VAT which, by definition, is ad valorem in character. In the future, the VAT system should include practically all commodities, including cigarettes and liquor.
Recall that as a result of the Cory Aquino tax reform program, tax effort — that is, taxes as percent of GDP — progressively rose and peaked at 17% in 1987. At the moment, tax effort hovers around 12.5%, some great distance away from its historical peak.
