Tax Reforms in Developing and Transition Economies

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					Policy Aspects of Tax Reforms
           Michael J. McIntyre
              Professor of Law
     Wayne State University Law School
       Visiting at Utrecht University
    Challenges Facing Developing and Transition Countries

▪ Broken Promises on Agricultural Subsidies
▪ Pressure to Liberalize Capital Flows
▪ Reduction in Revenues from Import Duties
▪ Tax Competition
▪ Int’l Rules Limiting Source Taxation
▪ Tax Haven Abuses
  ▸ Capital Flight by Wealthy Individuals
  ▸ Evasion/Avoidance by Companies
      Changes in the Economic and Political Landscape

▪ Production of many goods is relatively easy.
▪ Redistribution of income and wealth is hard.
▪ Transportation, communication, financial
  transactions, and energy are relatively cheap.
▪ “Trade secrets,” etc. available for sale.
▪ Absolute comparative advantage is unimportant.
▪ High-tech workers are mobile, but not
▪ Tax fraud is easy and cheap.
     Tax Reform is Local, and Tax Advice is Custom Work

▪ Best tax system for any country depends on many
  factors, including its:
      ▸ economic structure,
      ▸ capacity to administer taxes
      ▸ public service needs
      ▸ political organization (national or federal)
      ▸ income inequalities (individual and regional) and
        political willingness to address them.

▪ Still, some tax goals and methods of achieving them are
       “Middle-level” Developing & Transition Countries

▪ Raise enough revenue to pay the bills — mobilizing
  resources for development.
      ▸ Good taxes are better than bad taxes, but most
        bad taxes are better than no taxes (inflation).

▪ Redistribution of Wealth and Income.
     ▸Income (corporate and personal) promote regional
       and individual equality.
     ▸VAT can be progressive in some countries.

▪ Economic growth. Avoid high rates and use taxes that
  can be administered.
      Conditions that Make Taxation a Practical Possibility

▪ Although taxes are compulsory, taxpayers have a lot of
  leeway in avoiding tax. A country needs some hook to
  make its tax effective (and not shifted).

▪ Access to market. A country with a good domestic
  market has a capacity to tax because foreign taxpayers
  who do not pay can be denied access to that market.

▪ High profit opportunities. A country has power to tax if
  taxpayers can make good money there.
            Corporate Tax As Tool for Development

▪ The story from many economists since the 1980s has
  been to avoid taxes on capital, including a corporate tax.
  Claim is that avoiding taxes on capital promotes growth.

▪ In a developing or transition economy, the corporate tax
  serves three important functions even if growth is only
  ▸ Taxes monopoly rents earned by MNEs.
  ▸ It is less bad than any likely alternative tax.
  ▸ It protects the personal income tax.
             Growth is Just One Important Goal

▪ Revenue — Most Developing and Transition Countries
  Have Impoverished Public Sector.

▪ Captures gains in modern sector — benefit taxation, in
  that much government revenue spent for the modern

▪ Regional Redistribution — Socially Acceptable Method
  for Taxing Prosperous Regions.

▪ Regulation of Business — Some Check on Private
  Corruption and Protection of Shareholders
       Methods for Removing Income of MNEs from Tax

▪ Excessive deductions for interest and royalties.
     ▸ Countries should preserve right to tax in treaties,
       especially for royalties.
     ▸ Thin Capitalization Rules Needed.

▪ Currency manipulation and other use of derivatives with
  related entities. Countries should not allow deductions
  for hedging, etc. with related persons.

▪ No exemption or special treatment of capital gains.
              Treaties and Domestic Law Rules

▪ The first requirement is that a country have sensible
  domestic laws governing international income.
     ▸ Goal is to tax income arising in the country.
     ▸ That goal is best achieved by taxing worldwide
        income with a credit system. Exemption system
        provides more tax avoidance opportunities.

▪ The second requirement is administrative capacity.
            UN Model Favored Over OECD Model

▪ OECD Model limits source taxation on both business
  and investment income. UN Model also limits source
  taxation improperly, but less so than OECD Model.

▪ PE Rule. OECD Model creates too high a threshold for
  taxation. Better rule is to allow taxation if business
  activity is substantial (.e.g., above € 200,000).
  ▸ OECD limits taxation of e-commence to residence
                     Transfer Pricing

▪ OECD has read its 1995 Guidelines into the Article 9
  (Associated Enterprises). In fact, only method that works
  for most developing countries is the Transactional Net
  Margin Method (TNMM), called Comparable Profit
  Method (CPM) by US.

▪ New Guidance from OECD on allocation of profits to a
  PE. Favors arm’s length method for banks and
  insurance companies.
          Huge Problem for Many Developing Countries

▪ Capital flight problems are increased as a result of
  greater freedom to move capital. Developing and
  transition countries should be cautious in liberalizing
  capital movement rules.

▪ For Africa, outflow of capital appears to exceed the
  inflow. But the problem is nearly universal.

▪ EU saving directive, which goes into effect today, tries to
  deal with capital fight out of EU but will not be helpful in
  limiting capital flight from developing countries into EU.
                      Taking a Stand

▪ Developing and transition countries both promote tax
  avoidance/evasion and are the victims of it. They need
  to decide which side they favor.

▪ Private investment, although important for development,
  needs to come on terms beneficial to the host country.

▪ Cooperation among developing and transition countries
  is critically important — the developed countries have
  their own agenda.