By Desmond A. Nartey
A notable economist once joked that the two certainties in life are death and taxes. Now how much more ominous can that get. But the concept of taxation plays a critical and necessary role in policy formulation and economic development. Throughout the history of human existence tax policy has been used both as a development tool as well as a vehicle to engineer social and economic change. Tax revenue has been used to build bridges, hospitals, schools etc, to improve social welfare, to influence the location of business enterprises and industry, to redistribute income from the more to the less endowed and also to improve consumption and mitigate social tension. Most important of all, taxation has always been a very compliant tool for underwriting war efforts and ensuring national security. Consequently, to try to run an economy without taxation would be analogous to trying to drive a car without fuel.
According to a 2009 Organization for Economic Cooperation and Development (OECD) life satisfaction (happiness) index, some of the world’s most taxed nations (based on total tax revenue as a percentage of GDP) are the happiest: Denmark with a ratio of 50.0% is the happiest nation on earth, Finland with a ratio of 43.6% is the second happiest and the Netherlands with a ratio of 39.5% is the third happiest. Austria (43.4%), Belgium (46.8%), Norway (43.6%) and Sweden (49.7%) follow, but not in any order. The index is computed based on parameters such as health, education, welfare, prosperity, governance, housing, strong family and social connections, among others.
The information contained in the happiness index hardly suggests any positive correlation between taxation and social or economic development. Otherwise countries such as Cuba and Zimbabwe with total tax revenue to GDP ratios as high as 44.8% and 49.3% respectively would not be such economic and, to some extent, social basket cases. When corporate and personal income taxes are, however, disaggregated from the data on tax to GDP ratios an interesting pattern emerges. This pattern provides some insights into why some of the most taxed nations on earth are the happiest. All the supposed seven happiest nations on earth share a common thread: they have significant positive tax spreads (the difference between personal income and corporate income tax rates) and high GDP per capita (see table).
The Laffer curve, named after the work of Arthur Laffer, refrains from espousing any such direct correlation between taxation and economic development. The Laffer curve is a theoretical representation of the response of government tax revenue to all possible tax rates. It is very useful in illustrating the concept of taxable income elasticity. That taxable income will change in response to changes in the rate of taxation. The Laffer curve hypothesis is that at the extreme ends of the tax rate continuum - 0% and 100% - government tax revenue will be zero. Of course at a tax rate of zero percent it is evident that no revenue will be raised. At 100% tax rate the assumption is that no rational tax payer would want to earn income when all that is earned will be taxed away. Somewhere along that tax rate continuum, according to the Laffer curve, is a rate that optimizes economic activity and tax revenue. While this optimal tax rate may vary from country to country, it is the tax structure that invariably determines the overall response rate, which raises the issue of the tax structure in Ghana.
Ghana’s tax code may be simple and the rates arguably low, but it is nevertheless profoundly pernicious. A few of the pernicious provisions of the code are enough to drive home the point. The withholding tax policy, the treatment of bad debt provisions, accrual rather than cash-based assessment, absence of loss carry forwards and the resuscitated national reconstruction levy (now national development levy) are inherently business unfriendly. Granted that some of these provisions are based on international practices, the difference, however, is that the jurisdictions from which these provisions have been borrowed have also incorporated into their tax codes comprehensive relief mechanisms intended to mitigate any unintended consequences. A great deal of Ghana’s tax provisions amount, effectively, to taxation of capital rather than profit.
Withholding Tax
The withholding tax provision mandates an employer to withhold a portion of payments made to an employee in respect of the employee’s tax obligation for a given tax year. The problem with this provision for businesses is that the tax is assessed on the total payment rather than the net margin, and where the applicable withholding tax exceeds the net margin then the difference effectively becomes a tax on capital. Given that withholding taxes are deducted and paid to the Internal Revenue Service immediately payments for goods and services are made, the effective tax rate becomes all the more punitive to business.
Carry Over of Losses
Until 2001, the tax law allowed losses to be carried forward for five successive years. What that meant was that a business was allowed to recover a loss in a particular year against the profits made in the five subsequent years. Until the loss was fully recovered the businesses was exempt from any income tax. The objective was simply to incentivize entrepreneurs by protecting their capital from the long arm of the tax law.
The loss carry over relief has since been removed from the tax law. Given this situation, if a business, for example, were to lose half of its capital in a particular year and were to borrow to make up for the capital shortfall, any profit in the subsequent year will be subject to tax at the corporate tax rate of 25%. This effectively amounts to taxation of capital and a clear disincentive for entrepreneurship and job creation.
Accrual versus Cash-based Accounting
Accountants like to recognize income as soon as a transaction is completed, but payment for that same transaction, or part of it, may be several periods away. Consequently, a business can be very asset rich and yet fail because it is cash poor. Cash, they say, is king. Because Ghana’s tax law is based on accrual accounting the tax liability of a business is based on its total sales (cash and credit) rather than its cash receipts. It is therefore conceivable that a business that does a lot of credit sales may be forced to dip into its reserves or borrow at considerable cost, from time to time, to settle its tax liabilities, putting pressure on its capital.
Charge for Doubtful Debt
Businesses, according to best accounting practices, are expected to age their receivables and charge the portions they consider to be uncollectible against their income for the period. This is supposed to lower an entity’s tax liability by cushioning the entity against paying taxes on income it is yet to collect. Ghana’s tax law would, however, like to have none of it. In computing the tax liability of a business, the taxman grosses up the provision for doubtful debt before applying the tax rate, thereby making the tax liability higher than it would otherwise have been if the tax liability were computed on cash received.
While the business could collect the doubtful or bad debt at a future date or may be allowed to write off the amount after providing evidence to substantiate an actual loss, this relief often comes long after the taxman has had his bite, essentially resulting in some form of taxation on capital, given the cash-flow effects of taxation based on accrual accounting.
These anti-business tax provisions listed above are not by any means an exhaustive list of the problems encountered by businesses. Neither is this piece an anti-tax crusade. After all the happiness index seems to shows that some of the happiest nations on earth are the most taxed. The issue then is how they did it and whether their approach is replicable.
The claim that high taxes may have something to do with happiness may sound counterintuitive. But the story of Denmark, Finland, the Netherlands and the rest of the seven happiest nations provide a reason to analyze the phenomenon. Naturally, people have a strong aversion to paying taxes, especially if it is thought to be unjust or unfair. What is different about the seven happiest nations on earth may be the structure of their tax systems and the return on compliance received by their taxpayers.
Capital, undoubtedly, has become fluid and would go where it is most welcomed. A high tax regime is obviously one of the major barriers to attracting capital. US Companies are said to be holding US$1.2 trillion outside the US because of its corporate tax rate, which is about 35%. Cisco Systems, Inc alone is said to be holding US40.0 billion outside the United Sates. But Zug, a small city in Switzerland, with a population of about 26,000, which provides a tax haven for American companies, has a corporate population of about 30,000 largely due to its 15% corporate tax rate, and may be the only place on earth where the corporate population is higher than the human population.
Not all capital, however, is easily mobile. While the rapid development in telecommunication has made it possible to move vast amounts of money at the click of a button, human capital still faces considerable constraints notwithstanding recent developments in international relations. A portfolio investor can liquidate his position and move to a more rewarding destination in a relatively short period of time, but an engineer who decides to relocate to greener pastures has to contend with a lot of considerations, not least foregoing his current social connections. This difference in mobility opportunities for the various types of capital may be at the heart of the success of the tax regimes in the seven happiest nations. The table below shows some tax and GDP data on the subject countries compared to a few selected countries.
Corporate and Personal Income Tax Rates for Selected Countries -2009/2010
Country Corporate Tax Rate (%) Personal Income Tax Rate (%) Tax Spread (%) GDP Per Capita US$* World GDP Ranking
Denmark 25.0 62.3 37.3 36,450.00 17
Sweden 28.0 56.6 28.6 38,031.00 14
Netherlands 25.0 52.0 27.0 40,765.00 9
Austria 25.0 50.0 25.0 39,634.00 11
Belgium 34.0 50.0 16.0 36,100.00 18
Norway 28.0 40.0 12.0 52,013.00 4
Finland 26.0 30.5 4.5 34,585.00 22
OECD Avg 26.6 37.2 10.6 23,833.00 -
Japan 39.5 50.0 10.5 33,805.00 24
USA 35.0 35.0 0 47,284.00 7
Singapore 17.0 20.0 3.0 56,522.00 3
Botswana 15** 25 10.0 15,489.00 53
Malaysia 25.0 26.0 1.0 14,670.00 57
Ghana 25.0 25.0 0.0 2,615.00 137
Nigeria 30.0 25.0 (5.0) 2,422.00 142
Note: Tax rates are stated at the upper cap prevailing in the country and tax spread
is defined as the difference between the personal income and the corporate income tax rates
*Per Capita GDP is as computed by the IMF in 2010
**The rate refers to manufacturing sector, another 10% may apply.
Given the information in the table above, it is tempting to infer a link between positive tax spread and national wealth and happiness. While there may not be an empirical basis for assuming the relationship, nevertheless, this relationship appears to be a consequence of deliberate policy, informed perhaps by a classical economic phenomenon, rather than serendipity. The best cure for human aversion towards taxation is the institution of equity, transparency and value for money in the application of public funds. Combine that with the stickiness nature of human capital mobility and you have a winning formula for national development and happiness.
GDP per capita is an inaccurate reflection of economic welfare. In the seven happiest nations in the world, however, the reflection is more accurate than elsewhere because in these jurisdictions income distribution is more normal. This has allowed better social cohesion which has enabled government to impose very high personal income tax in order to provide the basic human amenities and public goods that engender economic and social wealth: affordable quality education and healthcare, reliable security, social welfare, strong family and social connections, sufficient leisure time and above all secure retirement.
When people go to bed knowing that their taxes will be used prudently to their benefit they have no reason to withhold their fair contribution towards national development. But this is also only possible when people have employment. Because investment capital lacks the sometimes altruistic motives of human capital it may be better to subsidize corporate tax rate with a higher personal income tax so that entrepreneurs could be enticed to create businesses and jobs for people to work and pay taxes.
While Ghana’s corporate tax rate is not the highest in the world, given the current fluid nature of capital, it may be too high to attract significant patient investment to boost its economic development. If there is anything to learn from the experiences of the seven happiest nations, it is doubtlessly the fact that they have figured out faster than any other nation on earth the economic and social rewards of hiking personal income tax to subsidize corporate tax.
E-Mail: danartey@hotmail.com
A notable economist once joked that the two certainties in life are death and taxes. Now how much more ominous can that get. But the concept of taxation plays a critical and necessary role in policy formulation and economic development. Throughout the history of human existence tax policy has been used both as a development tool as well as a vehicle to engineer social and economic change. Tax revenue has been used to build bridges, hospitals, schools etc, to improve social welfare, to influence the location of business enterprises and industry, to redistribute income from the more to the less endowed and also to improve consumption and mitigate social tension. Most important of all, taxation has always been a very compliant tool for underwriting war efforts and ensuring national security. Consequently, to try to run an economy without taxation would be analogous to trying to drive a car without fuel.
According to a 2009 Organization for Economic Cooperation and Development (OECD) life satisfaction (happiness) index, some of the world’s most taxed nations (based on total tax revenue as a percentage of GDP) are the happiest: Denmark with a ratio of 50.0% is the happiest nation on earth, Finland with a ratio of 43.6% is the second happiest and the Netherlands with a ratio of 39.5% is the third happiest. Austria (43.4%), Belgium (46.8%), Norway (43.6%) and Sweden (49.7%) follow, but not in any order. The index is computed based on parameters such as health, education, welfare, prosperity, governance, housing, strong family and social connections, among others.
The information contained in the happiness index hardly suggests any positive correlation between taxation and social or economic development. Otherwise countries such as Cuba and Zimbabwe with total tax revenue to GDP ratios as high as 44.8% and 49.3% respectively would not be such economic and, to some extent, social basket cases. When corporate and personal income taxes are, however, disaggregated from the data on tax to GDP ratios an interesting pattern emerges. This pattern provides some insights into why some of the most taxed nations on earth are the happiest. All the supposed seven happiest nations on earth share a common thread: they have significant positive tax spreads (the difference between personal income and corporate income tax rates) and high GDP per capita (see table).
The Laffer curve, named after the work of Arthur Laffer, refrains from espousing any such direct correlation between taxation and economic development. The Laffer curve is a theoretical representation of the response of government tax revenue to all possible tax rates. It is very useful in illustrating the concept of taxable income elasticity. That taxable income will change in response to changes in the rate of taxation. The Laffer curve hypothesis is that at the extreme ends of the tax rate continuum - 0% and 100% - government tax revenue will be zero. Of course at a tax rate of zero percent it is evident that no revenue will be raised. At 100% tax rate the assumption is that no rational tax payer would want to earn income when all that is earned will be taxed away. Somewhere along that tax rate continuum, according to the Laffer curve, is a rate that optimizes economic activity and tax revenue. While this optimal tax rate may vary from country to country, it is the tax structure that invariably determines the overall response rate, which raises the issue of the tax structure in Ghana.
Ghana’s tax code may be simple and the rates arguably low, but it is nevertheless profoundly pernicious. A few of the pernicious provisions of the code are enough to drive home the point. The withholding tax policy, the treatment of bad debt provisions, accrual rather than cash-based assessment, absence of loss carry forwards and the resuscitated national reconstruction levy (now national development levy) are inherently business unfriendly. Granted that some of these provisions are based on international practices, the difference, however, is that the jurisdictions from which these provisions have been borrowed have also incorporated into their tax codes comprehensive relief mechanisms intended to mitigate any unintended consequences. A great deal of Ghana’s tax provisions amount, effectively, to taxation of capital rather than profit.
Withholding Tax
The withholding tax provision mandates an employer to withhold a portion of payments made to an employee in respect of the employee’s tax obligation for a given tax year. The problem with this provision for businesses is that the tax is assessed on the total payment rather than the net margin, and where the applicable withholding tax exceeds the net margin then the difference effectively becomes a tax on capital. Given that withholding taxes are deducted and paid to the Internal Revenue Service immediately payments for goods and services are made, the effective tax rate becomes all the more punitive to business.
Carry Over of Losses
Until 2001, the tax law allowed losses to be carried forward for five successive years. What that meant was that a business was allowed to recover a loss in a particular year against the profits made in the five subsequent years. Until the loss was fully recovered the businesses was exempt from any income tax. The objective was simply to incentivize entrepreneurs by protecting their capital from the long arm of the tax law.
The loss carry over relief has since been removed from the tax law. Given this situation, if a business, for example, were to lose half of its capital in a particular year and were to borrow to make up for the capital shortfall, any profit in the subsequent year will be subject to tax at the corporate tax rate of 25%. This effectively amounts to taxation of capital and a clear disincentive for entrepreneurship and job creation.
Accrual versus Cash-based Accounting
Accountants like to recognize income as soon as a transaction is completed, but payment for that same transaction, or part of it, may be several periods away. Consequently, a business can be very asset rich and yet fail because it is cash poor. Cash, they say, is king. Because Ghana’s tax law is based on accrual accounting the tax liability of a business is based on its total sales (cash and credit) rather than its cash receipts. It is therefore conceivable that a business that does a lot of credit sales may be forced to dip into its reserves or borrow at considerable cost, from time to time, to settle its tax liabilities, putting pressure on its capital.
Charge for Doubtful Debt
Businesses, according to best accounting practices, are expected to age their receivables and charge the portions they consider to be uncollectible against their income for the period. This is supposed to lower an entity’s tax liability by cushioning the entity against paying taxes on income it is yet to collect. Ghana’s tax law would, however, like to have none of it. In computing the tax liability of a business, the taxman grosses up the provision for doubtful debt before applying the tax rate, thereby making the tax liability higher than it would otherwise have been if the tax liability were computed on cash received.
While the business could collect the doubtful or bad debt at a future date or may be allowed to write off the amount after providing evidence to substantiate an actual loss, this relief often comes long after the taxman has had his bite, essentially resulting in some form of taxation on capital, given the cash-flow effects of taxation based on accrual accounting.
These anti-business tax provisions listed above are not by any means an exhaustive list of the problems encountered by businesses. Neither is this piece an anti-tax crusade. After all the happiness index seems to shows that some of the happiest nations on earth are the most taxed. The issue then is how they did it and whether their approach is replicable.
The claim that high taxes may have something to do with happiness may sound counterintuitive. But the story of Denmark, Finland, the Netherlands and the rest of the seven happiest nations provide a reason to analyze the phenomenon. Naturally, people have a strong aversion to paying taxes, especially if it is thought to be unjust or unfair. What is different about the seven happiest nations on earth may be the structure of their tax systems and the return on compliance received by their taxpayers.
Capital, undoubtedly, has become fluid and would go where it is most welcomed. A high tax regime is obviously one of the major barriers to attracting capital. US Companies are said to be holding US$1.2 trillion outside the US because of its corporate tax rate, which is about 35%. Cisco Systems, Inc alone is said to be holding US40.0 billion outside the United Sates. But Zug, a small city in Switzerland, with a population of about 26,000, which provides a tax haven for American companies, has a corporate population of about 30,000 largely due to its 15% corporate tax rate, and may be the only place on earth where the corporate population is higher than the human population.
Not all capital, however, is easily mobile. While the rapid development in telecommunication has made it possible to move vast amounts of money at the click of a button, human capital still faces considerable constraints notwithstanding recent developments in international relations. A portfolio investor can liquidate his position and move to a more rewarding destination in a relatively short period of time, but an engineer who decides to relocate to greener pastures has to contend with a lot of considerations, not least foregoing his current social connections. This difference in mobility opportunities for the various types of capital may be at the heart of the success of the tax regimes in the seven happiest nations. The table below shows some tax and GDP data on the subject countries compared to a few selected countries.
Corporate and Personal Income Tax Rates for Selected Countries -2009/2010
Country Corporate Tax Rate (%) Personal Income Tax Rate (%) Tax Spread (%) GDP Per Capita US$* World GDP Ranking
Denmark 25.0 62.3 37.3 36,450.00 17
Sweden 28.0 56.6 28.6 38,031.00 14
Netherlands 25.0 52.0 27.0 40,765.00 9
Austria 25.0 50.0 25.0 39,634.00 11
Belgium 34.0 50.0 16.0 36,100.00 18
Norway 28.0 40.0 12.0 52,013.00 4
Finland 26.0 30.5 4.5 34,585.00 22
OECD Avg 26.6 37.2 10.6 23,833.00 -
Japan 39.5 50.0 10.5 33,805.00 24
USA 35.0 35.0 0 47,284.00 7
Singapore 17.0 20.0 3.0 56,522.00 3
Botswana 15** 25 10.0 15,489.00 53
Malaysia 25.0 26.0 1.0 14,670.00 57
Ghana 25.0 25.0 0.0 2,615.00 137
Nigeria 30.0 25.0 (5.0) 2,422.00 142
Note: Tax rates are stated at the upper cap prevailing in the country and tax spread
is defined as the difference between the personal income and the corporate income tax rates
*Per Capita GDP is as computed by the IMF in 2010
**The rate refers to manufacturing sector, another 10% may apply.
Given the information in the table above, it is tempting to infer a link between positive tax spread and national wealth and happiness. While there may not be an empirical basis for assuming the relationship, nevertheless, this relationship appears to be a consequence of deliberate policy, informed perhaps by a classical economic phenomenon, rather than serendipity. The best cure for human aversion towards taxation is the institution of equity, transparency and value for money in the application of public funds. Combine that with the stickiness nature of human capital mobility and you have a winning formula for national development and happiness.
GDP per capita is an inaccurate reflection of economic welfare. In the seven happiest nations in the world, however, the reflection is more accurate than elsewhere because in these jurisdictions income distribution is more normal. This has allowed better social cohesion which has enabled government to impose very high personal income tax in order to provide the basic human amenities and public goods that engender economic and social wealth: affordable quality education and healthcare, reliable security, social welfare, strong family and social connections, sufficient leisure time and above all secure retirement.
When people go to bed knowing that their taxes will be used prudently to their benefit they have no reason to withhold their fair contribution towards national development. But this is also only possible when people have employment. Because investment capital lacks the sometimes altruistic motives of human capital it may be better to subsidize corporate tax rate with a higher personal income tax so that entrepreneurs could be enticed to create businesses and jobs for people to work and pay taxes.
While Ghana’s corporate tax rate is not the highest in the world, given the current fluid nature of capital, it may be too high to attract significant patient investment to boost its economic development. If there is anything to learn from the experiences of the seven happiest nations, it is doubtlessly the fact that they have figured out faster than any other nation on earth the economic and social rewards of hiking personal income tax to subsidize corporate tax.
E-Mail: danartey@hotmail.com
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