This paper deals with both individual and corporate income taxation. To begin with, some typical traits of the income tax systems in centrally planned economies are presented.1 Since many centrally planned economies have already taken the first steps toward reform, the old system will be described in the past tense. Considerable elements of the old system are still in force in several of the countries referred to. The following section describes the necessary modifications to adapt the system to a market economy, and the final section will present the problems of getting from here to there.
Income Tax in Centrally Planned Economies
Individual Income Tax
Typically, in a centrally planned economy, individuals work either for the government, a government-owned enterprise (normally described as nationalized or owned by the people), or for some other collective organization, principally bound by directives issued from the central (party or government) authorities. Since wages and salaries under these circumstances are subject to central decisions, they may be presumed fair and equitable, and accordingly, not in need of any adjustment in the direction of social redistribution or taxation according to ability to pay. This simplifies the system a good deal; instead of individually taxing each wage and salary earner on the basis of his income, one can impose tax, as needed, on the total payroll, and make the employing enterprise or organization pay.
The issue is different when there is an element of private initiative in the formation of income. Circumstances have differed between centrally planned economy countries in this respect. Some did, for instance, accept some activities in the liberal professions; others did not. In a country where, for example, physicians are supposed to work full time for the public health service for a salary, normally no need is seen for an income tax on their earnings as private practitioners. At the same time, private demand quite often brings about a flourishing (black) market for their services, an unused potential source of tax revenue. Other such incomes may be those of authors, composers, and artists. In a strictly planned economy, however, these are funneled through public institutions, and special income tax arrangements may, accordingly, have been found unnecessary.
The crucial point where the market economy and the planned economy differ is that of private enterprise. If the economy is totally collectivized, there is no room for private enterprise at all. What may at all exist, does so illegally, and tax laws are redundant, since the entrepreneurs are liable to confiscation of whatever their earnings from the forbidden activity might have been. Often, however, countries have abstained from nationalization of small enterprises. Tolerated profit-making up to a point implies income formation beyond the direct control of the authorities. Here, therefore, a redistribution motive might come to the fore. Often, of course, this has been coupled with the wish to make life so sour for the entrepreneur that he gives up, opting instead for the nationalization of his business and his own employment in the public sector. An outflow of this attitude has typically been a schedular income tax system, with mildly progressive rates for the cultural workers, and with a stiff progression for the not yet nationalized private enterprises.
With respect to investment income, the picture has been similar. To the extent real property in private hands was still tolerated, a need was perceived for tax on the yield, again, typically, in the form of a schedular tax on rental income.2 Such a tax may also have included the incomes realized by those who sublet real property. Again, the choice has been one between taxing the activity and treating it as a crime. The schedular taxes were often confiscatory, with high rates on gross rents, and with no, or insufficient, deductions for maintenance, depreciation, and mortgage interest. The property owners had the choice between charging black market rents and using their capital to pay tax.
Interest income was normally not officially tolerated in other forms than interest on government bonds, or on accounts in government banks, or in other centrally steered credit institutions. Just as the incomes from employment in the government sector, the interest payments were centrally fixed, and any further adjustment through an income tax may have seemed redundant. In the same vein, capital gains taxes were virtually unheard of in centrally planned economies, again for the simple reason that such gains were not tolerated in the first place, even though they might well have occurred.
Some centrally planned economies have been confronted with the problem of residents or citizens deriving incomes from abroad. Inasmuch as such incomes were received by residents while staying in the country, they may have been adjusted to the domestic level already by way of converting them at an unfavorable artificial exchange rate. This treatment may, however, have been combined with a schedular tax. Some cases are also known of countries tolerating, or even encouraging their citizens taking employment abroad, but then in a collectively organized form, with the authorities seizing the difference between what the foreign employer pays for the labor and what the workers get to use of their wages and salaries for their own needs. With such arrangements, again, a special income tax may have been seen as superfluous.
Individual income taxation was normally imposed with some personal allowances, in the first place, a basic tax-exempt amount or zero bracket for the taxpayer himself, and more often than not also with some tax relief for dependents. This relief may be granted in the form of a deduction from tax, or possibly, even a refundable tax credit (the more usual form in this case is that of a direct subsidy to children), or in the form of a deduction from income. If the income tax system is schedular and wage and salary earners are exempt (the tax on wages and salaries being paid in the form of a payroll tax charged to the employers), the need may be perceived for measures of a different kind to take regard to family burdens. Cases are known, in particular, from Romania, of special taxes imposed on childless persons. The logic is that present or past parents will thus get a relative relief. The same relief has been offered to those not yet found old enough to have children. It is only fair to say that such an arrangement, penalizing childlessness, was more to be seen as a measure to promote a higher birth rate than as one to bring about equity between taxpayers with and without children.
Corporate Income Tax
There are several conceptual problems with respect to the corporate tax systems prevailing in centrally planned economies. First of all, payments from government-owned enterprises to government were not necessarily seen as taxes, but rather as simply a matter of cash management, government moving its money from one pocket to the other. Second, much of the taxes paid were turnover taxes, levied on the basis of the established profit margin between inputs at regulated prices, and outputs, again at regulated prices, as well as on planned production and sales volumes. These turnover taxes were normally adapted to a highly discriminatory price policy. If the authorities decided that a certain category of goods should be sold at a relatively high price, and the corresponding margin was paid in as turnover tax to the authorities, this should, in normal terms, be interpreted as a kind of excise taxation. Yet, this arrangement has often run parallel to another one, more akin to the idea of a profits tax, establishing the obligation of enterprises to pay to the Treasury a certain percentage of their gross profits, normally with a ceiling for the gross profit ratio allowed to be retained in the enterprise. This implies, in other words, a 100 percent top marginal profits tax ratio.
The definition of profit for these purposes was not in all respects in accordance with the accounting concepts prevailing in market economies. The definition of costs was usually tainted by the absence of well-defined depreciation rules, or by restrictive rates of depreciation, assuming clearly unrealistic useful lives. Whereas the payments to government may have been defined, at least to some extent, as interest on government capital, there was no entry in the cost accounting for interest on such debt, and as is usual in centrally planned economies accounting, the time value of money was not a working concept. Whereas direct production costs were deductible, there was often insufficient regard taken to overhead costs. The result was that the total payments often exceeded the net profits in the market-economy sense of the word, and that enterprises would have been drained, and actually were so in many cases, if they were not provided with fresh capital from the government.
Another important deviation from the rules prevailing in market economies was the measurement of profitability as the taxable profit in percent of production and distribution expenses rather than of capital invested. Romania, for instance, imposed a 100 percent tax on all profits exceeding 10.5 percent of these expenses. Another peculiarity is the tax on depreciation of assets imposed in the U.S.S.R. and Czechoslovakia.
A system of this kind lends itself poorly to a traditional classification, separating profit distribution from taxes and direct taxes from indirect ones, or, using a more modern distinction, separating taxes on income and property from taxes on goods and services. The proper substitute may well be a combination of measures, including a non-tax element of dividend payments on the equity capital (initially in the hands of the government, but presumably ending up in other hands through privatization measures), an element of corporate income taxation, and an element of taxation on goods and services.
One might have different opinions on what effects the old system has had on the behavior of corporate management. It is, for instance, often pointed out that managers of government-owned enterprises are not threatened by bankruptcy, if they make consistent losses. They are, likewise, not confronted by shareholders craving for dividends, nor do they have to fear takeover bids that may occur in a market economy if confidence in the future performance of corporations slackens and the market rates of their shares fall below the value of their net assets.
Also, in systems of nationalized enterprises, the positive motivation of profit-related bonuses and fringe benefits seems to have been absent. If profits are taxed at 100 percent or more on the margin, even the stimulus involved in being able to undertake desired investments out of increasing profits is taken away. Incentives of a different kind may, however, have been offered: favorable publicity and bonuses granted for exceeding plan objectives, and often not more aboveboard, opportunities to derail production factors into profitable activities in the informal sector, or into fringe benefits such as company housing, stores, etc., available to management. It is likely that incentives of this kind have existed in many or all centrally planned economies. It is less likely that they have always been of a kind stimulating the most efficient economic behavior, measured in terms of market prices.
Income Taxation in a Market Economy
Personal Income Taxation
Income or Expenditure-Based Taxation?
After, or in connection with, the transformation of a centrally planned economy into a market economy, the problem arises, what kind of a tax system to substitute for the old system? Obviously, it is tempting to aim for optimal solutions, particularly in view of the fact that the prevailing system obviously has to be jettisoned, and that fundamental tax reform is clearly seen as needed, the only question being of what kind.
Some might find that the best answer is a system that includes no income tax at all. Those who feel that consumption is a better measure of ability to tax than income, be it objectively, be it for reasons of the disincentive effects on savings accompanying an income tax, will argue in favor of some type of consumption tax. If for reasons of equity or redistribution there is a preference for individualizing the consumption tax and making it progressive, this may be complicated but not impossible. In fact, patterns of progressive expenditure taxes or cash flow taxes have been discussed a long time already, in several countries.
Two practical experiments with a progressive expenditure tax actually undertaken, in India and Sri Lanka, were both given up as failures. Industrial countries seriously considering the same tax, have not come to a positive decision.
It is difficult to generalize about the reasons for this negative attitude. Equity considerations may have been part of them, although there are those who feel that income tax has been oversold as an equity measure. These critics feel that it is more equitable to tax people on how much they take out of the pool of resources (i.e., their consumption), than on what they put in there (measured by their income, if that represents the value of what they produced, or the yield on what they invested). International harmonization has possibly played a more important role as an argument against expenditure taxation. It is hard to see the equity in a system that allows people to make their incomes in a country where expenditure, not income, is taxed, and then spend the money in a country taxing income and not expenditure. The need, if not for harmonization, then at least for approximation of taxes, may be most strongly felt in common market areas, but is certainly a consideration even outside them. Such harmonization or approximation is rendered more difficult if drastic systemic changes are undertaken in some countries and not in others. The international outlook, in a sense, supports conservatism.
In the view of some experts, the very purpose of the expenditure tax, to promote savings, is possibly put in jeopardy in situations where taxpayers expect their consumption standard or the tax rates to be higher in the future. With those assumptions, a progressive expenditure tax should imply an incentive for timing consumption expenditures earlier rather than later. In this discussion, it will simply be assumed that centrally planned economies in transition to a market economy will not go for an experiment in the form of a cash-flow tax or an expenditure tax.
If that is so, then an income tax will be the natural instrument for imposing taxation in accordance with ability to pay. The introduction of the market economy will imply that the government no longer controls the distribution of income, in the sense that it did under central planning, and that therefore, to the extent there is an egalitarian trend in the policy chosen, taxation will be more needed than before as an instrument of redistribution.
Proportional or Progressive Income Tax?
To be sure, redistribution by way of progressive taxation is an objective that is not very fashionable these days. Repercussions on the incentive to work and to take risks, and the negative influence on the compliance with tax laws, are arguments for restraint in this regard. Conceivably, the practical experience of confiscatory taxes on remaining private enterprises and private landlords may be drawn on to convince governments that there are narrow limits to what can be done in a market economy to achieve equal distribution through taxation. Obviously, the message has to be that common happiness will be greater if a larger pie is shared in unequal parts, than if an equally shared pie is kept small as a result of excessive redistributive measures that hamper growth. The problem is to establish some consensus about when redistribution is significantly impeding growth.3
If it is intended to use the income tax for redistributive purposes, a global tax on all the taxpayer’s income from all sources is clearly the ideal. The same holds, if ambitions just include taxation according to ability to pay—a principle that in reasonable interpretations will also include a degree of progressivity. A progressive rate for each of a number of schedular taxes would unduly benefit taxpayers with incomes of different kinds at the cost of those whose incomes are derived from one source only. The brackets should be few; for all reasonable purposes, three to five brackets are sufficient.
Worldwide Income Tax or Territoriality?
Similarly, it is desirable, at least in principle, to establish the income tax base for individuals as the worldwide income, so as not to put a premium on investment or other activities abroad, and to establish as fair a measurement as possible of the taxpayer’s ability to pay. Moreover, there is a technical argument in favor of worldwide taxation, namely, that a taxpayer who is found to have a standard of living far beyond his declared means should not be offered an opportunity of explaining away this fact by pretending to have had incomes derived from abroad, notably of a kind not easily checked by the tax authority. If, for these reasons, a worldwide income tax seems desirable, there are, on the other hand, administrative difficulties connected with such a tax claim. The ideal may well be a system where, as a general rule, passive income received from foreign sources remains taxable, whereas active income, mainly wages and salaries, but possibly business income derived from permanent establishments abroad, remains exempt from domestic income tax. Also, it is obvious that very little is gained by any effort to extend this claim to tax on foreign-source income to nonresident citizens. With few exceptions (the big one being the United States), countries limit their claim to tax on worldwide income to residents.
Taxation of Income in Kind
Experience tells that if taxation is limited to money income, taxpayers and employers will find ways to escape taxation by giving compensation in kind. The taxation of fringe benefits is a complicated issue. If the tax authority insists on consistent taxation of all benefits in kind, it looks like nit-picking. If it leaves benefits untaxed, taxpayers will use the loophole. Valuation of benefits raises problems, particularly if one tries to tax benefits only at the value they have to the employee. The personal consumption content of housing, company cars, travel for mixed business and recreation purposes, or participation in business entertainment, is often difficult to identify.
Some countries avoid dealing with the taxpayer himself by establishing, instead, either a tax on the value of the fringe benefits charged on the employer, or a separate tax on fringe benefits, likewise paid by the employer. One problem is how to deal with nonprofit employers and with government as an employer.
No solution to the fringe benefit problem is satisfactory. The general trend, however, goes toward more consistent taxation, even at the price of what might look as excessive stinginess on the side of the tax administration. Keeping a strict line here can prevent a development toward a barter economy that in the long run will hurt everybody, taxpayers, employers, and the fiscal authority.
Capital Gains Taxation?
Capital gains are nowadays generally conceived of as being part of income. Are there weighty reasons for giving them preferential treatment? The answer to this will depend on several factors. One has to do with the income tax rate schedule: if the rate is high, the fundamental weakness of a capital gains tax that is limited to realized gains only, the “lock-in” effect, will be more pronounced than if the rate is more modest. No country has successfully applied a tax on unrealized capital gains. Accordingly, if the general rate is not kept reasonably low, a separate capital gains tax rate will be needed, and the Pandora’s box of tax shelter operations, turning current income into capital gains, will be opened.
Another issue is that of inflation. The higher the inflation rate, the more unfair will a system of capital gains taxation be, if no adjustment of the base is made for inflation. Again, in the absence of indexation, it is usually found necessary to include some general rule mitigating the tax rate, or reducing the part of the gain liable to tax. In view of the invitation to sheltering current income that this will offer, many countries have seen it as less cumbersome to apply a rule under which the cost base is lifted by a factor based on the movement of the consumer price index, unless inflation is very modest. The justification for indexation of the cost base also applies to the debt side, particularly if a deduction has been offered for nominal debt interest payments.
Indexation of Interest Income?
A similar argument applies to interest income and to the deductibility of interest in general. Without indexation, and with a sizable degree of inflation, the taxation of nominal interest receipts and the deductibility of nominal interest payments may well imply that the real rate of interest received or payable, net of tax, turns lower than zero, even if the nominal rate of interest exceeds the rate of inflation. Again, indexation may be seen as a necessary element in a tax system aimed at functioning well in an inflationary environment.
Individual or Household Income?
The globalization of the income tax would facilitate any measure to take regard to the taxpayer’s family situation. A choice would have to be made, to begin with, of which unit to use for taxation: the individual, the married couple, or the whole household? The general tendency, worldwide, is nowadays in favor of separate taxation of husbands and wives. One administrative reason for this is that separate taxation facilitates final withholding taxation of wages and salaries. Two policy problems will also be solved by separate taxation. One is that under a progressive system the joint taxation of married couples discriminates against them in comparison with other forms of cohabitation. The other policy problem, also taken care of through separate taxation, is that with joint taxation, the spouse last deciding to join the labor force will be inhibited from doing so, since she or he will face the marginal rate applicable on top of the other spouse’s income, Obviously, the price to be paid for separate taxation is that taxation of different households with the same income might differ depending on whether one or two individuals contribute to the household income. A splitting of the total income into two between the spouses solves the last problem, and may be carried as far as to eliminate discrimination of married couples, but leaves unsolved the third policy issue, the discouragement of entering the labor force.
Family Allowances
With respect to children and other dependents, industrial countries sometimes choose to offer the relief in the form of a subsidy independent of the tax system, offering the same amount per child, regardless of parental income. An intermediate position is that of a refundable tax credit, an arrangement that likewise assures the same amount to each child. If only tax relief is aimed at, it is usually found that a tax credit is more equitable than a deduction from income, although many countries still stick to the deduction from income. Finally, some countries, following an originally French pattern, apply the progressive rate schedule under a family quotient system, splitting the income, for instance, into two for childless couples, into three for couples with two children, and so on. This family quotient system offers substantially more relief for each dependent, the higher the household income. The preferred solution from the technical point of view is to subsidize children outside the tax system and disregard them for purposes of defining the tax burden. If any tax relief is considered, a tax credit should be the preferred method.
Indexation of Rate Schedules and Allowances?
Again, in this context, the inflation problem has to be taken into consideration. For threshold amounts and family allowances, as well as bracket limits in the progressive tax schedule, the erosion of nominal amounts following inflation, if not compensated for by discretionary measures, implies that the effective tax rate goes up with inflation, that a relatively greater number of income earners get caught in the tax net, and that the reliefs for dependents diminish in value.
Many countries have avoided this situation by indexation of the amounts involved. Obviously, strong equity arguments speak in favor of such indexation. It is inconceivable that standards of fairness and equity underlying the original tax system would change with inflation to such a degree as to make a system affected by “bracket creep” and inflationary erosion of exemptions and allowances still remain acceptable under fairness and equity standards prevailing after inflation.
On the other hand, the argument can be made that an inflation adjustment ex post, taking regard of an inflationary movement in the previous year, may have a damaging effect on revenue in the next year, during which there will possibly be much less inflation. Also, a government may well feel that it can make more political hay by allowing inflation to increase taxes without Parliamentary decisions, while at the same time allowing itself to mitigate this invisible inflationary tax increase by way of a highly visible tax reduction decision. And finally, any inflation adjustment on the statute book may be seen as a sign of government tolerating inflation and counting upon it as a normal element.
As a final remark on indexation, it should be emphasized that total indexation of tax systems is usually not practiced in other countries than those with hyperinflation. In other countries, partial indexation may be applied, most often in the field of personal allowances and bracket limits, but also with respect to the capital gains tax base, to depreciation allowances, and to interest payments. Moreover, inflation-hit countries have particular reasons to watch over it that taxes are paid currently, since delays in paying tax implies that the money the tax is paid in is worth less than the money in which the tax base was computed. Measures to compensate for this effect may include strict rules on current payment of tax and high interest rates for late payment.
If countries hesitate with respect to complete or partial indexation, they may go for alternative solutions to the same problem. A case in point is depreciation, where generous depreciation rules and last-in-first-out valuation of inventories are often seen as substitutes for indexation. Also, frequent discretionary changes of allowances and rate bracket limits may be seen as such a substitute, as will the exemption of interest from tax and the nondeductibility of interest paid.
Corporate Income Taxation
Turnover Versus Income Tax
First of all, there must be established a clear distinction between turnover taxes and other taxes on goods and services, on the one hand, and income taxes, on the other. The former will, as mentioned elsewhere in this book, ideally take the form of a value-added tax. Among other reasons, the fact that a VAT in international practice follows the destination principle would make it a mistake to regard the VAT as an alternative to, or part of, the corporate income tax.
Liable Enterprise Forms
Second, there must be a firm basis for deciding what kinds of enterprises are liable to corporate income tax. There is no point in establishing that an individual is liable to personal income tax on his business income as long as he has no more than five employees (a rule sometimes applicable in centrally planned economies), once the market economy principles apply and allow him to hire more labor. On the other hand, there is a tendency among some industrial countries to establish income tax on enterprise units, regardless of legal form, establishing a “tax fence” between the firm as such and its owner. With such a rule, the enterprise income tax can be made uniform between corporations, partnerships, and proprietary firms, and the physical owners, be they shareholders, partners, or proprietaries, will be taxed only on profits they take out of the enterprise in the form of dividend, profit share, or salary.
It is not necessarily the best idea to take this route. The existence of alternative legal forms for businesses gives flexibility, and traditional tax systems have adapted to this by allowing intermediate forms of enterprises to grow. A proprietary owner who wants the corporate form for his business might normally be able to do so by forming what is formally, or at least in reality, a one-man corporation; if the tax law allows him to take out a salary with no, or generous limits, he may be able to achieve the same purpose as the “fence” rule provides for. The use of the partnership form, allowing a separate legal personality for the enterprise while at the same time providing the partners an opportunity of deducting current losses from their current income, may have been abused in many cases for pure tax shelter investments. Yet, there are ways of stopping the abuses while still keeping the advantage of the partnership form for promoting new business ventures, if that is seen as an objective.
The form of a cooperative, either a producer cooperative or a consumer cooperative, is well known, at least as a concept, in many centrally planned economies as well as in many nonsocialist countries. Tax laws around the world contain many provisions giving special relief to cooperatives, either for pure political reasons or for the reason that the cooperative is seen as an extension of the original producers or of consumers, and therefore should not be seen as necessarily subject to the same tax as those doing business for profit.
In reality, the name of cooperatives is very often used as a cover for what is regular profit-making business. There is obviously no point in trying to make a distinction between producing business firms or agricultural enterprises, on the one hand, and producer cooperatives they own, on the other. The issue is somewhat more delicate with respect to consumer cooperatives. The distribution function performed by them might be seen as an extension of the chores otherwise resting on the households. In theory, there is a very fine line between a number of households organizing joint purchases to get lower prices for the higher quantities they buy, and the same households setting up a cooperative retail store to carry on basically the same activity. In all these cases, the guiding principle should, however, be to keep fair competition in the market place. If cooperatives are given special treatment, they may out-compete more efficient, noncooperative enterprises, and they may be abused for purposes of private businesses carried on in the cooperative guise.
For the same reason, it is not recommended to make a difference in the corporate tax rate between different types of corporations. Also, the corporation tax rate should be proportional, not progressive. There is no reason to believe that large investors invest in large companies, small shareholders in small ones, rather the opposite. Technically, the use of progressive rates leads to considerable complication if abuse by splitting up businesses is to be avoided. Usually, the corporate tax rate is chosen at a level not exceeding the top income tax rate (this would induce an escape into partnerships), but not very much below it, either (to prevent abuse of companies to accumulate personal income).
Taxation of Corporations and Shareholders
There is no reason to expect that former centrally planned economies will dispense with the traditional corporate form of business. The problem is how to tax corporations and shareholders. In this regard, the issue facing countries in transition is, to an extent, somewhat easier to deal with, compared with the corresponding problems in countries where privately owned corporations are already in existence and a tax system applied to them has been in force for a long time already. The reason why the situation is simpler in the former centrally planned economies is that whatever new tax system is chosen, there is no windfall gain or loss for shareholders, who have acquired their shares at a rate in which the negative or positive value of the formerly prevailing tax regime has been discounted.
To begin with, a decision should be made about the system to be chosen for the taxation of corporations and shareholders. The “classical” system provides for taxation of corporations on their whole profits, with the income from dividend distributions again being taxed in the hands of the shareholders. This is called economic double taxation of distributed corporate income. The system is often criticized as unjustly discriminating against the corporate form, although those defending the classical system traditionally argue that the use of the corporate form is a privilege that should be paid for. What they have in mind is, in particular, the fact that a shareholder is not personally responsible for a corporation’s debt. Critics of the classical system may respond with a reference to economic realities: private owners of closely held corporations very often have to sign personal guarantees for the corporate debt, thus forgoing the privilege assumed to motivate the double taxation.
Even in countries with a classical system, steps may be taken to mitigate the effect of double taxation. As already indicated, there may be a smooth transition from a system of simple taxation to the double one, if closely held corporations are allowed to pay salaries to managing shareholders without limits, or with limits generous enough to make the salary absorb the profit. This implies that double taxation hits only nonbusiness corporations and corporations with shareholders not at the same time working for them. Similarly, countries may redefine what is, for tax purposes, a normal corporation subject to double taxation, by opening the opportunity of partnership treatment (i.e., the taxation of each shareholder on his share of the corporate profit, with no regard to whether it has been distributed or not), for instance to corporations with a limited number of shareholders, all of them taxable individuals. (In the United States, the “subchapter S corporation” is a case in point.)
The same idea can, in principle, be extended to all corporations. It is, however, not realistic to apply the partnership treatment to corporations with a great number of shareholders. The principle of establishing the profit on the basis of the corporate accounts and to tax each shareholder on his share of the profit (or give him a deduction for his share of the loss) is clear enough in theory, but bogs down in a morass of complication, if applied to thousands of shareholders buying and selling their shares throughout the year. Moreover, if the tax authority finds reason to contest the corporation’s tax return, the assessments of all these shareholders may have to be kept open, possibly for a long time, until the assessment of the corporation’s profits has been settled. One might, however, apply a modified partnership method by combining two rules: one, a rule that gives the corporation a deduction for dividends distributed, and two, a rule that gives corporations and shareholders the right to opt for a dividend to be deemed as distributed, although the corporation has kept the money. Such a rule was recommended by the famous Carter Commission in Canada, but never brought to the statute books.
If the partnership method is generally seen as an impractical way to solve the double taxation problem, two other rules are more close to reality. One is the split rate method, under which distributed profits are taxed at a lower corporate tax rate than profits retained, in the extreme case at a zero rate (i.e., deductible as costs). The other is the imputation method, under which shareholders may take a credit against the income tax on dividends received for all or some of the corporate income tax paid by the corporation with respect to the profit out of which the dividend was paid.
Of these two methods, the split rate method, although seemingly the simpler one, is the one that raises most problems. First of all, it gives relief even where no relief is needed, the recipients of dividends being tax-exempt (charities, pension funds, even foreign shareholders, provided there is not a high enough withholding tax on the dividends). Second, it may be deemed necessary to apply a rather high withholding tax on dividends to prevent distribution and reinvestment from emerging as a better alternative to the retention of profits. Without such a withholding tax, foreign-owned corporations may be in a better position than corporations with domestic shareholders, but the withholding tax may well be seen by the foreign shareholders and their governments as a means of discriminating against them.
The imputation system is more popular and has been adopted by the majority of the EC countries, as well as in a good number of countries outside the Community. It is, however, not without problems. These are of several kinds: incidence, incentive effects, equity, and international discrimination.
The incidence issue refers to the fact that a corporate income tax that is presumed shifted to the purchasers of corporate products or back to the production factors used by corporations cannot at the same time be seen as a prepaid levy on the shareholders’ dividend income. Therefore, one has to assume that the corporation tax is basically not shifted, to make it rational to integrate the corporate income tax with the taxation of the shareholders’ income. The matter is particularly sensitive in relation to integration schemes that eliminate personal income tax on shareholders with respect to their dividend income. The elimination, through imputation of personal income tax on dividends, may seem to be a misplaced tax subsidy in the eyes of those who feel that corporations shift their taxes onto consumers or production factors. The matter is seen in the same unfavorable light by those who, whatever shifting they assume, feel that corporations should be held separate from their shareholders.
Another issue has to do with the incentive to distribute income rather than to retain it. A theoretical approach is to assume that an imputation system does not stimulate distribution of dividends; the argument is that if the money can grow more quickly by being retained in the corporation than invested by the shareholders, the latter should prefer to let it stay in the corporation. The intuitive approach is more straightforward: if there is a tax relief offered against the double taxation of distributed profits, and no such relief is available for undistributed profits, then those shareholders who want distributions may feel they have an argument against those who want to retain the profits.
If there is economic double taxation of distributed profits, retained profits will be seen as a cheap source of capital, since the economic double taxation reduces the opportunity cost of using such profits to finance new corporate investments. The prevailing theory concerning the cost of capital for corporate investments stresses the need for some degree of neutrality between different sources of financing. In this respect, financing with new equity capital is relatively the most expensive form of financing in a classical system, whereas financing with retained profits is the cheapest form. With an integrated system the relative cost of new equity-capital will be lower, and that of retained profits will be higher. With loan interest deductible from taxable profits, borrowed capital will be relatively cheap as a source of financing. It can be argued that complete neutrality presupposes identical treatment of loan capital and equity capital.
The point is often made with respect to countries poor on capital that they should use the classical system as a means of stimulating the retention of capital, in particular if the alternative is distribution to shareholders outside the country, who might not reinvest there. On the other hand, it is generally felt that it would be rational to harmonize the cost of capital for different types of financing, so as to make the cut-off point for new investment basically the same for all investors, regardless of their financing opportunities. It is, of course, doubtful, to say the least, that the ideal of neutrality will ever be even approximately achieved.
The equity aspect leads both ways. The classical system with its economic double taxation can be said to penalize shareholders in corporations distributing all or part of their profits. Imputation implies that all a taxpayer’s income, be it earned by himself or by a corporation where he has stock, carries the same tax. The problem is that it does not look like that, since some of the tax is paid in advance by the corporation. Experience has taught that it may be risky for politicians to be shareholders in a full imputation system. Angry voters finding that their shareholding politicians are enjoying “tax-free” dividends while they themselves toil for a wage compensation fully taxed, have on occasion reacted with a backlash.
The international aspect is also complicated. The EC has not been able to harmonize the different approaches to company/stockholder problems. Imputation is more often than not offered to domestic shareholders only, and this, in turn, is often seen as discriminatory against foreign shareholders. Moreover, there is usually a requirement that domestic tax be paid corresponding to the tax credited to the shareholders. If foreign source income is taxed abroad, with a tax credit or exemption applied in the country where the corporation is domiciled, the law in that country may well make it a condition for imputation that a corresponding tax (précompte, A(dvance) C(ompany) T(ax)) be paid before a dividend can be made on which shareholders can collect an imputation credit. This, in turn, may well be a disincentive to foreign activities for companies affected. Accordingly, the imputation system may work in favor not only of domestic shareholders but domestic investment, as well. In some countries, it is felt that this has not been regarded as a disadvantage, rather the opposite.
How Does One Come From Here to There?
Administration Issues
The most important factor in deciding how to reform a tax system is the availability of administrative resources. Laws on the statute book have no beneficial effect, if not implemented. Implementation does not come by itself but must be dealt with by the tax administration. It is dangerous to issue tax laws when compliance cannot be effectively monitored. It is particularly detrimental in countries, such as the former centrally planned economies, where many citizens are used to distrusting the authorities, and where it must be feared that voluntary compliance is rare.
The large part of budgetary revenue emanating from the major government enterprises has traditionally been under the control of the government bank system and of the government audit agencies. Inasmuch as tax authorities have functioned, their tasks have been more limited, dealing primarily with smaller entities, individual income earners, owners of vehicles, etc.
It would be futile to ask this rudimentary tax administration to shoulder the task of introducing and supervising an entirely new system of individual and corporate income taxes, including individual tax returns from all income earners, perhaps over half the population, and information returns in an even higher number. The new system will have to be introduced in a form that safeguards the revenue while at the same time minimizing the administrative burden. Several policy decisions must be based on this basic consideration.
Personal Income Tax
First of all, the number of taxpayer files has to be kept to a minimum. This can be done by applying the tax on wage and salary earners as a final withholding tax, adjusted only in cases of multiple employment. The income tax on these categories would then basically be levied from the employers. Checking the withholding tax payments would be easier, the more standardized the tax rules. If the family situation of an employee could be ignored (separate taxation of husbands and wives, child subsidies rather than dependency allowances), and the tax based on monthly income, the control could be extremely simple.
Other incomes could be dealt with separately. For interest and dividend income, another final withholding tax would be the most practical. For business income, on the other hand, it would seem indispensable to use a system of personal assessment, preferably of the self-assessment kind. An integration with the system of tax on wages and salaries would be required, to prevent a taxpayer from drawing twice on the basic exemption, once from his salary and again from his business income. On the other hand, it would not be in accordance with the principle of extreme simplification to allow wage and salary earners to enjoy a refund of with-holding tax on these incomes as a result of declaring a loss from business activities.
With respect to agricultural income, major units should be treated like businesses, whereas small agricultural units should be subject to a simple scheme of presumptive taxation based on area, general quality, and location. In countries with a functioning system of purchasing agencies, it is, in theory, possible to impose a withholding tax on payments to agricultural producers, a tax that could be final for those of them not willing and able to produce proper accounts as a basis for a correct assessment of income. It is likely, however, that in many former centrally planned economies, much of the agricultural income will be realized by direct sales to consumers from producers in local market places. There is no sufficient reason to give these market sales a clear advantage over sales to wholesalers, millers, dairies, and abattoirs. On the other hand, an individual tax on presumed agricultural income, based on precise estimates of each individual crop, or number of animals could easily require as much of an administrative effort as an income tax based on real profits. It is therefore not recommended as a transition measure. The tax in the transition period should be simple.
Capital gains taxation would not be a practical proposal for the transition period. The establishment of a proper acquisition cost for those who receive property in the procedure of restitution of formerly seized property would be utterly complicated. For those who acquire property in the course of privatization, it might be easy enough to establish a basis, where their acquisition is for money. The technique being developed in several former centrally planned economies, however, is based on some voucher system, under which citizens are entitled to a certain amount in vouchers (that may or may not be defined in currency), and will use these to acquire securities. Applying a zero base to these acquisitions would to an extent act counter to the intention behind privatization, whereas little may be known about the actual market value of the vouchers at the time of acquisition.
It would seem easier to establish taxation of private capital gains at a later stage, when market values have been established. One could then use a D-day provision setting the date at which the base value is fixed for the future capital gains tax. In that context, the base value could be applied generally for all investors, regardless of how they acquired their property.
Definitions of capital gains vary between countries. It would seem rational, given the difficulty of introducing a system of private capital gains immediately, to adopt a system under which all business profits are taxed as such, with the capital gains concept restricted to private investments only. For businesses, an opening balance sheet has to be established for business profits tax purposes, as well as for purposes of accounting and control. Under that assumption, all profits referring to business assets could be regarded as business profits, and corresponding losses as business losses. This is the German rule, a country in which private capital gains are taxable as income only if the holding period is very short or the gains occur on the sale of shares representing a major holding. Obviously, the assumption that all gains on business assets constitute current income presupposes consistent treatment as realization for business purposes of all separations of business assets from the business, say, as a dividend in kind or for the private use of the owner of the business.
Corporate Income Tax
The important part in government financing previously taken by turnover tax, profits tax, and profit remittances from government enterprises will, to a large extent, have to be substituted for by a sales tax, preferably a VAT. To some extent, however, it will be indispensable to use corporate profits as a tax base. For this purpose, it will be important to build an organization for the assessment and collection of business taxes, possibly manned by staff earlier engaged in financial control, and rendered redundant in the course of privatization. The effort should be directed toward the more important enterprises first, and imply a financial reconstruction in which realistic opening balance sheets are established, on the basis of which genuine future business results can be computed.
It is important that valuation of assets in these opening balances is made in a business-oriented fashion. In other words, historic prices should not be relevant, and bad debts should be eliminated. The tendency has been for depreciation periods to be too long. This is accentuated even more when regard is taken to technical obsolescence, and disclosed when protected enterprises of a centrally planned economy are exposed to the international market.
It is not possible to generalize about the setting up of new opening balance sheets for government-owned enterprises in centrally planned economies. Arguments can be made for continuity, allowing excessive asset values to be depreciated over some time, while at the same time keeping the enterprises responsible for the debt they may have incurred to government banks, and other enterprises. If such a solution is realistic, it mitigates the problems occurring with respect to treasury accounts, as well as those of other creditors. Sometimes, however, the state of affairs in the enterprises is so bad as to necessitate a complete reconstruction, with a drastic write-down of assets, and with elimination of debt that cannot possibly be honored in the future and has to be eliminated for the balance to show a sufficient equity base. This type of reconstruction will obviously have repercussions on creditors, who, in turn, may also need the same treatment. Obviously, the whole problem area is one that includes not only tax legislation, but the commercial code as well.
It is important to go about this procedure speedily, to give the enterprises a realistic financial base and make it possible for them to establish a new accountability to creditors and to the fiscal authority. The procedure is particularly urgent for the major enterprises, and should be pushed forward vigorously, without time consuming perfectionism. For the purpose of assuring that all enterprises have orderly accounts to begin with, opening balances could be established provisionally, with the possibility of revision within a period of six months or possibly a year.
Even if the new balance sheets are produced with the utmost speed, the operation will nevertheless be time-consuming, and there will be need for provisional tax to be levied in the meantime. It is obvious that the usual basis for provisional tax payments (i.e., the latest declared or assessed business profit, usually the one referring to the previous year) will not be available. Given the new principles of taxation, it is also inconceivable to use the traditional base for enterprise taxes or profit sharing. Therefore, as long as there is no opening balance to form the basis for a provisional estimate of expected profit, some other base has to be found for the current year payments of corporation tax. The possible alternatives are two: one, a percentage of gross receipts, and the other a percentage of gross profits. In practical terms, the former is somewhat easier to apply than the latter. The gross profits should, however, normally have a somewhat closer relationship to the net profit than the gross receipts have. For that reason, it is suggested that provisional payments of corporate tax be based on gross profits, obviously at a much lower percentage rate than the final tax on actual profits. As soon as a proper computation of net profits is possible, in other words, as soon as an opening balance has been established, and a net profit can be estimated, it should be permitted to switch over to the estimated net profit as a basis for provisional tax payments. For the final payments of corporate tax, it should be mandatory to use the net profit, but, as indicated above, it would possibly be necessary to keep a certain time period during which adjustments to the established opening balance would be permitted.
Final Comments
In the foregoing, no references have been made to the existence of special rules for foreign investments and joint ventures, these being treated in another chapter. Obviously, all reform measures discussed above have to be considered in the context of concessions already granted. Possibly, if the system is drastically changed, the climate might invite renegotiation, but caution must be exercised to avoid the impression that the country reneges on its legal obligations.
The word perfectionism has been used in the text. It might be worth pointing out that the warning against perfectionism is not a recommendation of laxitude. What is aimed at is realism. Rome was not built in one day, nor is a full-fledged modern tax system to be set up within a year or two. Therefore, it is important to have the proper priorities. These should be, first of all, to take care of the big revenue-raisers first, i.e., the general sales tax (turnover tax or VAT), major excises (tobacco, alcoholic beverages, petroleum products, and automobiles) and the tax on wages and salaries (including social security contributions), as well as taxes on major businesses and corporations. Experience tells that these taxes together represent almost all tax revenue. Other taxes such as estate or inheritance duties, capital gains tax, stamp duties, or license fees, may have significance in other respects but cannot compete as revenue-raisers. Revenue-raising is the number one problem that must be dealt with first.
Likewise, the administrative resources have to be concentrated, at least initially, on the largest taxpayers. In most centrally planned economies, the existing tax administration is oriented toward smaller taxpayers, the larger enterprises being submitted to audit in another context. It is essential to build a new tax administration with its main resources concentrated on the most important taxpayers. Again, priorities have to be set in a realistic fashion.
Once it was thought that the tax instrument would easily lend itself to all kinds of policy measures. Tax incentives were offered to influence individuals and enterprises in the direction of a number of different behavior patterns. In present times, the optimism surrounding this kind of interventionist fiscal policy has faded. There is a widespread understanding that subsidies worth giving in the first place might be better given directly over the budget, rather than in a hidden form as “tax expenditures.” There is also a tendency to dismiss fiscal interventionism as over-ambitious, and to revive the old requirement that the tax should be neutral, not influencing the behavior dictated by the market place. While extreme positions of both kinds are counterproductive, it is only realistic to accept that in today’s world, fiscal interventionism has few promoters, and that the general tendency is for countries to offer, and investors to demand, broad-based, simple systems with correspondingly low rates.
Vito Tanzi, in “Tax Reform in Economies in Transition: A Brief Introduction to the Main Issues,” IMF working Paper 91/23 (Washington: International Monetary Fund, 1991), offers a general picture of many of the issues dealt with here. Although in parts going into more detail, this chapter will not contain a description of each of the centrally planned economy’s tax system studied. All of them show substantial similarities, and the deviations from the common pattern in one country or the other are nor of much interest when it comes to analyzing the situation in general. It is onlywhen some particular feature stands out as, in a sense, exceptional, that reference will be made to the country or countries applying it.
There is a different twist to this story in some of those countries where all private ownership of land has been abolished. If governments have issued “rights of occupancy,” sometimes for a very low compensation, to individuals and firms found worthy of the privilege, these occupiers of land have not been subject to taxes intended to hit landowners, since, as a matter of right, they have not been owners. Lacking other taxes, they have been better off with their rights of occupancy than they would have been with full ownership. Obviously, this situation requires either the recognition of the holder of the right of occupancy as a beneficial owner, liable to all the taxes normally levied on landowners, or, alternatively, the introduction of a realistic periodic land rent, to be paid by the occupant to the Government as the beneficial owner, and fixed at a high enough level to equalize the occupant’s rights with those of a tenant.
The reason why there are many theories and not just one adhered to by all, is that the tax rate may have both a substitution effect and an income effect, the former, effective on the margin, discouraging the taxpayers’ efforts to earn more income, the latter, representing the total income-reducing effect of the tax, normally expected to encourage these efforts. A lump sum tax is optimal in the sense that it has no marginal (i.e., substitution) effect, but just an income effect. The problem is that a lump sum tax is basically unfair if not differentiated according to ability to pay. Yet, any factor used to differentiate the tax will automatically be burdened by the marginal effect that the lump sum tax was conceived to escape.