Thoughts on Institutional Change

Material Opportunity for Jamaica by Damion Brown

 

The thin parliamentary majority of the current government may be interpreted as a risk to macroeconomic stability by some due to perceived inability to push through tough measures.  However, I consider it to provide a wonderful opportunity to push through fundamental institutional changes that will improve confidence, the quality of governance and transparency.

  • An independent investigative body focused on politicians and public sector, with ability to prosecute so as to reduce major instances of corruption. There is a perception that significant state resources are regularly wasted by giving contracts/deals to the politically connected, which significantly misdirects government expenditure from where it would be most productive and reduces the impact of actual spend. The likelihood of being actually sent to prison for such actions would result in much lower waste and greater productivity from government expenditure (even if contracts are still given to politically connected they would at least be required to provide reasonable value/performance)
    1. To my mind more important that the actual money lost to corruption is the dynamic it creates where instead of focusing on efficiency and productivity, businesses focus on maintaining patronage and keeping their party in power even if the policies are questionable and performance poor. We blame poor people for being mindlessly loyal to parties (“willing to vote for a dog dressed in the party’s colours”), but it may be that business owners are even more biased due to the even greater benefits they get (large contracts are much harder to walk away from than the rum and curry goat meat meal that the grass roots supporters get). Changing this dynamic will lead to a much better dynamic where focus is placed of the efficacy of policies and actual execution, rather than simply defending one’s party due to the great financial benefit of maintaining them in power.
    2. There are significant efficiency gains beyond just more effective government expenditure, to the extent some of the “powerful” in our society have become so not from true entrepreneurial talent or the ability to create value but from behind the scenes patronage. The result is that their voices are the ones that drive society/private sector views and not necessarily those of the truly intelligent/capable. Actions of civil society/private sector will be influenced/stymied by their objectives as they can only truly desire conditional change (ie. corruption and political access remains for them, while change is limited to removing impact of criminals and populist elements), which prevents us from effectively addressing the underlying governance problems and corrupt system.
  • Greater inclusion and partnership with the private sector and civil society. The uncommitted vote is larger than the committed vote for any party, the problem is that the uncommitted vote mainly reflects apathy and therefore does not respond to the party that displays better governance and policies. This reduces the incentive for any party to pursue good governance and policies and increases there need to pander to populist views and the needs of their committed political base.   If the perception that the PNP has greater “committed/ die hard” support than the JLP is true, then the JLP does stand to benefit substantially by engaging the politically uncommitted, increasing transparency, and pursuing sound policies that have been endorsed by civil society.    It is for us within civil society to strongly agitate for sound policies and endorse /criticize the current government based on policies and create political pressure for performance.
    1. This has been the missing dynamic in Jamaica, however the “success” of the “IMF programme” and broad consensus that macroeconomic stability is necessary and the thin majority in parliament, means that the impact of civil society is potentially even greater than it has ever been before.
    2. Both the previous administration and current administration have pursued broadly responsible and politically difficult policies. Even with the “questionable” election promises for income tax, the current administration has actually executed in a responsible manner that does not threaten stability (whether it actually achieved its election promise is a different conversation)
  • While both parties have consistently spoken to “private sector led” growth, there are serious questions as to whether they were committed to this or were simply forced by circumstances to follow prudent policies under an IMF programme (current administration failed the earlier programme and the current opposition also did not execute on some of the most politically challenging reform aspects, such as public sector size and efficiency and pension reform). This is a significant opportunity for society to align on the role of government in support of the private sector, broadly what form that will take and what the priorities are in the medium term (touch decisions will still have to be made given our debt burden) in the context of the Vision 2030 framework that is still considered a very good overall blueprint for development.   Private sector led growth will also have to be redefined as it can not be limited to those who currently hold capital and power, but mechanisms (capital market development and financial inclusion) must be introduced to ensure that resources and opportunities flow to those with the “best and brightest minds”, not to old money that are “most connected and lightest skin tones”.
    1. The sense of social exclusion and perception/reality that economic opportunities are mostly limited to those with connections and inherited wealth must be addressed. We cannot achieve true efficiency and dynamic growth if competition is largely limited to established wealth.
      1. In North America, the most dynamic companies (especially in the digital economy) do not reflect inherited money but more so capabilities, if not luck (yes the system is still biased to white males, but everything is relative). In Jamaica we speak about families as if they are genetically imbued with business ability, however if we actually browse the stories of Jamaicans who do incredibly well outside of Jamaica we hardly ever see the last names of those families…. maybe they are so patriotic that the only limit their awesomeness to Jamaica, or maybe as in other developing countries the concentration of capital, lack of strong financial infrastructure, and corruption /absence of rule of law results in a few having significant advantages within the country, relative to others.
    2. If we can get strong alignment across civil society, business and politicians then continued macroeconomic stability will eventually stimulate the local private sector to greater levels of investments or at least facilitate foreign investment. I am not a fan of the “diaspora will invest and transform the economy” argument, but we have successful entrepreneurs and technical people living abroad. This would really be an opportunity for them to utilize their skills/technology/ business networks and raise the capital to execute within Jamaica.
  • Reorienting the public sector is necessary but politically difficult given potential job losses, however a program to have any savings placed into specific capital programs could offset this. To ensure the capital programs are material some sort of public/private partnership structure would be required, possibly with government providing defined risk sharing.  Additional fiscal space could be earmarked for this transition,  with credibility in the overall programme maintained despite the resulting deviation by ensuring the capital projects are endorsed by private sector/ civil society supported by multilateral technical assessments that the projects provide high value added and will support long term growth.

This may appear to be a very optimistic outlook but based on a presentation I attended recently, other countries have executed on similar initiatives and done very well. While we have seen improvements in policy making and political maturity over the last few years, if there is one thing I am convinced off is that simply waiting for “them” to fix the country is not the best solution. The question is are we going to sing the same old song that the “powers that be” are the problem or are we brave enough to push for the changes that are necessary to move our country forward?

 

 

 

A Primer on Tax Policy: Part 1 by Denvil Duncan*

Abstract

As Jamaica navigates the current economic climate, its leaders must pay careful attention to tax policy design and implementation. Tax policy can be difficult to design and its effective implementation can be even more challenging. However, there is over 200 years worth of knowledge regarding tax policy design and implementation that can be used to make this task a bit easier. This series of essays provides an introduction to tax systems through the lens of a public finance economist. The series begins with outline the main features of tax systems. This is followed by a detailed description of the characteristics of a ‘good’ tax, and a discussion of implementation strategies. The discussions will include numerous references to Jamaica’s current and proposed tax policies. The primary goal of the essays is to get Jamaican voters up to speed with some of the key concepts required to critically review current and future tax policy proposals.

*Contact Information: School of Public and Environmental Affairs, Indiana University. 1315 East 10th Street, Bloomington IN 47405. Email: duncande@indiana.edu; Phone 812-855-7493. Website: https://sites.google.com/site/denvild/Home

 

Features of a tax system

Every tax system has three core features. Below I describe each of the three features.

Tax Trigger.

The tax system must specify the set of actions that trigger tax liability. This component also includes a precise definition of the tax base and the tax rates. Consider the personal income tax, for example, actions that trigger tax liability include working or investing; the tax base is labor earnings or investment income less any deductions or exemptions. The tax rate schedule can either be linear or graduated.[1]  A linear rate schedule is one that has a single rate that applies to all taxable income. For example, Jamaica has a linear tax rate schedule; everyone pays a tax rate of 25% on their taxable income.[2] A graduated tax rate schedule is one that has multiple tax rates that each apply to different tax brackets (see Table 1 below).

 

Now, let’s illustrate how these two types of tax schedules work. Suppose your taxable income is $50,000, then:

  • A linear tax schedule would tax the full $50,000 at the same tax rate. So, if the tax rate is 25%, then your tax liability is $12,500 (=50,000*0.25).
  • A graduated tax rate schedule would first divide your total taxable income into parts that match the tax brackets, and tax each part at the corresponding tax rate for that bracket. Let’s use the schedule in Table 1 to illustrate. Because there are three tax brackets, you would first divide your $50,000 into three matching brackets. The first $20,000 of income is taxed at 10%. The second $20,000 (the amount between $20,000 and $40,000) is taxed at 15%, and the remaining $10,000 (the amount between $40,000 and $50,000) is taxed at 25%. In this case, your total tax bill is $7,500 (=$20,000*0.1 + ($40,000-$20,000)*0.15 + ($50,000-$40,000)*0.25). Notice that this tax liability is lower than the one above because of the specific numbers used in the examples. It is very easy to chose values that would cause the graduated schedule to yield a higher tax liability than the linear schedule.

 

Table 1: Graduated Tax Schedule

Taxable Income Marginal Tax Rate
Less than 20,000 10%
20,001 –  40,000 15%
More than 40,000 25%

 

Tax Burden

The tax system must specify the allocation of statutory and remittance burden. Let’s take on these concepts in turn.

  • Statutory burden. The statutory burden of a tax refers to the person on whom the legal obligation to pay the tax falls. For example, the personal income tax liability falls on the income earner. The general consumption tax liability falls on consumer. Notice that the government can assign the statutory burden of the tax to the seller rather than the consumer. Similarly, the government can impose the statutory burden of the income tax on the employer rather than the employee.
  • Remittance Burden. Every tax system must also specify the person legally responsible for handing over the tax payments to the government. For example, the pay as you go (PAYE) component of the personal income tax is collected monthly by your employer, and your employer is then legally responsible for paying this revenue over to the government. In other words, the remittance burden of the PAYE falls on your employer.
  • Here is another example: consumers are legally required to pay general consumption tax. This implies that consumers face the statutory burden of the tax. However, the seller is legally responsible for collecting the tax from the consumer and remitting said tax revenue to the government. So, the statutory burden falls on the consumer, but remittance burden falls on the seller.
  • Economic Burden. We have long recognized that a tax does not stay where it is placed. For example, a tax on gasoline does not necessarily fall on those who buy gasoline. Because of this, it is important to identify what is called the economic incidence or economic burden of the tax. Let’s illustrate with a tax on gasoline. Suppose the government increases the gasoline tax. What do you expect will happen to the price of gasoline? Also, what do you expect will happen to the price of goods and services that are heavily reliant on gasoline? A reasonable response to these two questions is that prices will rise. The price of gasoline increases so that the economic burden falls on consumers of gasoline.[3] But, it doesn’t stop there; producers who rely heavily on gasoline as an input to their production process will respond by raising the price of their goods and services. Consider for example, a taxi driver. He has to buy gasoline, which is now more expensive because of the tax. He will respond by raising the taxi fare he charges. This then shifts the tax onto people who rides in his taxi.[4]
  • Now, the extent of the shifting depends on how responsive consumers and suppliers are to price changes. For example, the demand for gasoline is generally unresponsive to price changes because there aren’t many alternatives; people have to move between places and doing so requires energy, which is almost exclusively gasoline. Because of this, sellers can increase the price of gasoline without much impact on quantity demand and hence profit. As a result, we would expect to see gasoline prices increase by approximately the full amount of the tax. It might not increase by the full amount if there is robust competition among gasoline sellers. The amount of the increase in taxi fare is less clear. It is less likely to increase by the full amount of the tax because there are more options for consumers; e.g., you can take a bus instead of a taxi. So, not only do you have competition among taxis, but taxis have to compete with other modes of transportation. What this means though is that price will rise, but not necessarily by the full amount of the tax. The degree of the price increase will depend on the responsiveness of demand and supply.
  • To summarize, while the statutory burden falls on gasoline consumers and the remittance burden falls on gasoline sellers, the economic burden is borne by
    • gasoline consumers,
    • people who consume goods/service that rely heavily on gasoline,
    • gasoline sellers, and
    • people who produce goods/services with a high gasoline content.
  • The important thing to know about the economic burden of a tax is that it cannot be legislated. The government can specify the statutory and remittance burdens, but it cannot specify the economic burden; only the market can do that via changes in prices.

Enforcement

Finally, the tax system must specify an enforcement strategy. How many tax returns will be audited? How will the audit selection process work; i.e., how do we determine which tax returns to audit? Is audit selection random or does it depend on the characteristics of the taxpayer? What is the penalty for evaders?

 

The enforcement strategy is an exceptionally important piece of every tax system because most people would rather not pay any taxes. This is especially true in developing countries where corruption is rife and the connection between taxes paid and goods/services received is unclear. Additionally, countries that are heavily reliant on cash transactions and have a large informal economies are prone to tax evasion. The government has to implement an effective enforcement strategy in order to improve tax compliance. This starts with designing taxes that are simple and that provide very little incentive to cheat.

[1] It is not uncommon to hear people refer to the tax rate as being progressive. This is not accurate. The tax rate is either linear or graduated, and either of these can give rise to a progressive or regressive tax system. So the correct description is as follows: the tax rate schedule is linear or graduated while the tax system is progressive, regressive or proportional.

[2] This will change with the proposed tax policy that was tabled in the recent budget presentation by the Minister of Finance.

[3] For example, suppose gasoline is currently sold at $2.00/gallon and the government adds a tax of $1.00/gallon. If the price of gasoline increases to $3.00/gallon after the tax, then it means that the full amount of the tax has been shifted to consumers of gasoline. Suppose instead that the price of gasoline only increases to $2.50. In this case, only half of the tax is shifted to gasoline consumers; the remaining half is borne by the seller of gasoline. So while the statutory incidence on consumers is $1.00, the economic incidence is only $0.50.

[4] So if a $1.00 tax is placed on gasoline and this causes the price of gas to increase by $1.00, which then causes tax divers to increase their taxi fare by $1.00, then the tax has been shifted to the taxi riders.

Transfer Pricing Regulations – Opportunities or Threats!

Transfer Pricing Regulations – Opportunities or Threats!

by Andrea Scarlett-Lozer

Transfer Pricing Regulations introduced late last year (via the Income Tax (Transfer Pricing Documentation) Regulations, 2015 and Income Tax (Advance Pricing Agreements) Regulations, 2015) seem to be getting a lot of negative press and some amount of resistance from the businesses that will likely be affected. Justifiably, there is a lot of focus on the increased administrative burdens and resources that will be required to satisfy the new requirements for Advance Pricing Studies, the negotiation and preparation of Advance Pricing Agreements, as well as, the need to complete annual declarations regarding Related Party Transactions. The increased cost of compliance could no doubt be considered a threat to business success. However, I believe that there may be a silver lining in this cloud.

The process of creating an Advance Pricing Study and deliberate decision making in relation to Related Party Transactions will likely lead to increased efficiencies in the allocation of asset valuations and costing throughout the business of a group of companies. Traditionally, the allocation of asset valuations and costing in relation to Intellectual Property and other intangibles used in the business; and management, technical, administrative and other business support services are usually “gray” areas and in many instances are not supported by objective information.

The Transfer Pricing Regulations present an opportunity for businesses to establish a valuation for their Intellectual Property assets. This can prove very valuable in the sale of a business or a part of it, or in the sale or licensing of the Intellectual Property (for example, in establishing a franchise), or in using the Intellectual Property as security for a loan, or in claiming a capital allowance for Intellectual Property under the Income Tax Act. In order for Intellectual Property to be recognized as an asset and be included in the financial statements, the process of establishing its value must meet certain criteria. Having arms-length commercial agreements, including related party agreements, which isolate dealings related to Intellectual Property will provide evidence of the value of the asset and will also provide a basis for the asset to be re-valued at appropriate times. To maximize the benefits of this opportunity, it is important to have appropriate Intellectual Property Licensing Agreements which reflect the usual arms-length provisions, are enforceable in a court of law, and in some cases containing rights which are transferable to third parties. It is also important to ensure that Intellectual Property rights are properly registered, documented and protected.

The Transfer Pricing Regulations also present an opportunity for local businesses to scrutinize their corporate structure and consider whether it is simple, efficient and continue to meet their needs. The regulatory framework for doing business is clearly changing. One theme that is consistent among modern regulations affecting various aspects of the business environment is increased transparency. I believe this means that simplicity is better for business in many instances. How many local group companies are taking advantage of the recently implemented 0% tax on dividends received by one local company from another? The 2013 amendment to the Income Tax Act introduced a nil rate of tax on dividends received by a company resident in Jamaica from another company resident in the island in which the receiving company holds at least 25% voting rights in the paying company. This tax break benefits group and affiliate companies, where the local parent company or investing company receives dividends from its local subsidiary or affiliate, respectively. Up to recently, the most tax efficient corporate structures would usually include an international business company in a CARICOM jurisdiction with an election to pay 1% tax on income in that jurisdiction. There are now obvious tax benefits of establishing a local group structure which is simpler, probably more transparent, cheaper in terms of maintenance cost, and may even lead to less scrutiny by the tax authorities to see whether there are transfer pricing violations.

As group companies are incentivized or compelled (depending on your perspective) to deliberately consider the costs associated with shared management, administrative, technical and business support services, etc. it is inevitable that some businesses will learn more about themselves than they knew before. Armed with new information, management will likely innovate, improve and operate more efficiently.

At MF&G, our cadre of commercial attorneys is equipped to, among other things: assist with negotiating, drafting and reviewing Related Party Agreements, providing services that will assist in building and maintaining an Intellectual Property portfolio, advising on the implications of existing and new corporate structures, and handling documentation for transactions (such as re-organisation of operations) that may arise from management decisions.

Andrea Scarlett-Lozer is a Partner at Myers, Fletcher & Gordon, Attorneys-at-law. She specializes in Commercial Transactions and Advisory, as well as, Intellectual Property law. Andrea is the Head of the firm’s Intellectual Property Department.  She may be contacted via andrea.scarlett@mfg.com.jm or www.myersfletcher.com.

 

Revisiting the Jamaica Labour Party(JLP’s) Tax Proposal

 

By: Theodore Mitchell

The Jamaica Labour Party (JLP) pulled off a surprising win in the recently concluded general elections in Jamaica on February 25, 2016. The JLP won by the slimmest of margins after tallying 32 seats to the People’s National Party’s (PNP) 31 seats.

The JLP made a number of election promises, but one resonated well with the voting populace more so than any other and that is to effectively allow persons earning under $1.5 million to pay no income tax. The proposed income tax schedule is summarized in Table 1.

Slide1
Table 1:Proposed Income Tax Schedule

Notably, this promise is being made as Jamaica enters the fourth and final year of a four-year Extended Fund Facility (EFF) with the International Monetary Fund (IMF). The Fund program calls for, among other things:

  1. The country running a primary balance surplus equivalent to 7.25% of GDP (revised downwards from 7.5% of GDP as at the 10th country review by the IMF);
  2. Reduction of wages and salaries to GDP from 10.2% at end-March 2015 to 9.0% by end-March 2017 (previously end-March 2016); and
  3. Reduction in the debt to GDP ratio to 96% by end-March 2020.

It is estimated that Jamaica’s debt to GDP will fall to 126% at end-March 2016 while real GDP growth is expected to accelerate to 2.5% by 2020, based on the IMF’s forecasts.

Notwithstanding improvements in the country’s macro-fiscal profile, real economic growth remains lethargic and is estimated at 0.8% in 2015, which is relatively in line with the 20-year historical average of 0.7%. This brings into sharp focus whether or not it is possible for the government to implement the promised income tax policy and achieve the remaining quantitative targets embedded in the EFF.

Quantitative Analysis of the Reduction in Income Tax

It is estimated that around 340,000 persons out of a labor force of 1.4 million pay personal income tax (PIT). As at January 1 2015, the income tax threshold was increased to $592,800.  This means that every additional dollar of income above the threshold is taxed at a rate of 25%.  The JLP’s tax proposal, in a nut shell, is to increase the threshold to $1.5 million, but the caveat is that only persons earning this amount or less will benefit from paying no tax.  Persons earning between $1.5 million and $5 million, will maintain the existing threshold of $592,800 and therefore their income after tax will remain the same.  However, persons earning above $5 million will have not benefit from any threshold and therefore will be liable to pay an additional $148,200 in PIT per annum.

The revenue implication of the tax proposal advanced by the JLP is summarized in Table 2.

Slide1
Table 2:Income tax yield from change in PIT structure

 

 

 Additionally, the following points should be noted:

  • Under this new tax structure approximately 238,000 persons (17% of the labour force) would benefit from increase in average annual (monthly) salary of $51,000 ($4,130); around 870,000 (72% of the labour force) would not benefit as their income already fall below the existing income tax threshold; and roughly 17,000 (1.2% of the labour force) would pay additional PIT of $148,200 per year or $12,350 per month.
  • The proposal as is could yield even lower revenues (than presented in Table 2) as persons with borderline income may opt for lower salaries to avoid paying higher taxes. For example, persons earning between $1.5 million and $1.65 million would take home more after tax pay if their salary is reduced to $1.49 million.
  • Given that the economy is growing at a slow pace and inflation and depreciation of the domestic currency have moderated, natural growth in tax revenue is stymied. The government would therefore have to find, at a minimum, equivalent new taxes to meet the primary balance target of 7.25% of GDP if there is no cut in expenditure.
  • The most likely sources for additional tax intake are the General Consumption Tax (GCT) and Special Consumption Tax (SCT). While both taxes are efficient to collect, they are regressive in nature as persons with lower income pay a disproportionately higher amount of their income in these taxes relative to higher income individuals.
  • Based on our estimate, PIT revenues would fall by approximately $10.0 billion (0.6% of GDP).

The central tenets of a good tax system are simplicity, ease of administration, equity (vertical and horizontal) and fairness. The proposed tax measure violates all these principles.  Thus, it should not be imposed.

There is a heightened political risk with imposing higher GCT/SCT tax rate on the public and therefore the administration may consider tinkering with the corporate income tax (CIT). However, increase in CIT could lead to reduction in investments and further impede the real GDP growth trajectory, which would see the country missing the debt target in 2020 by wide margin.

 

REPLY TO DEATH OF KING SUGAR

By Damion Brown:

The emphasis on modernizing the sugar industry and redirecting it to areas where it can generate the most value added (cogeneration of fuel, ethanol, etc) has significant merits.  Greater benefit can be extracted from the expenditure in the industry, leading to greater employment, savings on foreign exchange used in importation and the spill over benefits from increased use of technology.  Other countries have shown that transformation can take place to make sugar a profitable industry, with other beneficial spin off industries.

We however miss the broader question by going straight to the restructuring of the sugar sector,…as the saying goes “ask the wrong question and I will gladly give you the wrong answer”.  The right question is….is sugar one of the best industries to invest in, given Jamaica’s current situation?. Given the high unemployment, especially of the youth, the high import content of any industry that uses lots of equipment/infrastructure (such as hotels),  the emphasis should be on industries that can still be efficient with high labour utilization, significant skills training, a relatively short time to re-skill labour (no more than 4 years) and that can earn foreign currency.  “Knowledge” industries play this role, and money should instead be spent training data analysts, computer programmers, and specialized business analysts and business process operators.  A subsidy (many different ways such as building the infrastructure, or putting DBJ money as risk investment) could be put in place to entice investors to take the cost/risk of being significant first movers in these areas, and government could have special approval gateways and investor engagement to entice investors from abroad or locally.   These industries are also capital light, so that the ability to scale their size is significant and only truly limited by the size of the trained labour force, maintaining wage competitiveness internationally,

Lets be frank, looking 10 years down the line would the countries best be spent on getting more cane cutters, tractor drivers or even lab technicians for the sugar factory? or would young people with technological skills and industries to utilize these skills create far greater benefits and be better able to adapt to the inevitable changes in the global economy?

We must be bold enough to take a fresh looks as to where tomorrows opportunities and be decisive enough to break with tradition, even at great cost (financially and emotionally). Improved investment in sugar would turn out to be “sweet”, but using those resources in other industries would be far “sweeter”.

 

Kemmehi Lozer Death of King  is featured article: