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Maintaining the Level of Income Tax Collections Under Inflationary Conditions

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1970
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INFLATION affects the incidence, yield, and administration of an income tax in various ways. As money income expands with a rapid rise in the price level, the tax burden is intensified unless adjustments are made in personal exemptions and rates. Because of the increased pressures of rising living costs, taxpayers seek ways to evade higher taxes and delinquencies may increase sharply. From the government’s point of view, a serious lag in tax revenues may develop. If tax collections are not kept current with rapidly rising prices, and if tax payments are not synchronized with accrual of the tax liability, payment is made in devalued money and the treasury may have difficulties in meeting growing expenditure demands.

This paper explores techniques that have been adopted to maintain income tax collections under inflationary conditions. Section I discusses the nature of these problems and how they arise. Section II deals with measures to combat delinquency, and Section III examines schemes that better assure payment of taxes concurrently with the accrual of tax liabilities.

Emphasis is on the individual income tax throughout the discussions, but reference is made to corporation income tax where appropriate.

I. Nature of the Problem

Increased incidence owing to progressivity

Under inflationary situations tax liabilities increase at a faster rate than the increase in money income because of the progressivity of the tax schedule. The tax elasticity—a measure of the percentage change in tax payments for each 1 per cent change in money income—depends on the tax schedule, the average personal income, and the income distribution among individuals. With an assumption of a coefficient of 1.5, an average taxpayer with a 30 per cent increase in money income over that of the previous year owing to inflation has to pay a 45 per cent greater tax—11.5 per cent higher in real value than in the previous year.1

Inflation causes a proportionately larger tax increase for low-income groups than for high-income groups. To visualize this effect, let us take an example based on Japan’s personal income tax rates in 1949, when inflation plagued the nation’s economy. In 1949 Tokyo’s retail prices rose by about 60 per cent from those in 1948, and wages of all industrial workers increased by almost the same rate. If the income of wage earners in 1948 increased by 60 per cent in 1949 as shown in the first column of Table 1, the tax liability would have been as recorded in the fourth column. Coefficients in the fifth and sixth columns clearly show that progressivity in the tax schedule (with the same personal exemptions) produced a greater increase in tax liabilities than the rise in money income (1.6 times) and distributed this greater tax incidence among the taxpayers in such a way that a relatively heavier tax fell upon taxpayers within the lower income brackets.2

Table 1.Japan: Relative Changes in Income Tax Incidence, 1948 and 1949 1(Cols. 1–4 in yen)
Income in 1948Tax Due in 1948Income in 1949Tax Due in 1949Tax Increase, 1948 to 1949 (Col. 4 ÷ col. 2)Income Elasticity of the Tax (Col.511.61)Relative Real Disposable Income in 1949 (Col.3col.4Col.1col.2×11.6)
(1)(2)(3)(4)(5)(6)(7)
30,000048,0000
40,000064,0001,750
50,000080,0005,100
60,0001,10096,0008,7007.911.50.926
70,0002,975112,00012,3004.15.20.930
100,0009,600160,00026,1002.72.90.926
200,00042,100320,000100,2252.42.30.870
300,00089,350480,000194,6002.22.00.847
500,000206,600800,000401,3501.91.60.849
700,000333,9751,120,000628,7251.91.50.839
1,000,000541,3501,600,000988,7251.81.40.833
5,000,0003,686,1008,000,0006,235,4751.71.20.839

For uniformity in computation, (1) every taxpayer was assumed to have three dependents (including spouse), to receive his whole income from wages or salaries, and to earn 60 per cent more income in 1949 than in 1948. (2) In arriving at taxable income, two exemptions were allowed: first, ¥ 15,000 as a basic exemption; second, employment income exemptions that were 25 per cent of the total employment income, up to the ceiling of ¥ 37,500. (3) After having applied the graduated rates to his taxable income, a taxpayer was allowed to credit ¥ 1,800 for each dependent.

For uniformity in computation, (1) every taxpayer was assumed to have three dependents (including spouse), to receive his whole income from wages or salaries, and to earn 60 per cent more income in 1949 than in 1948. (2) In arriving at taxable income, two exemptions were allowed: first, ¥ 15,000 as a basic exemption; second, employment income exemptions that were 25 per cent of the total employment income, up to the ceiling of ¥ 37,500. (3) After having applied the graduated rates to his taxable income, a taxpayer was allowed to credit ¥ 1,800 for each dependent.

A similar table (Table 2) evidences the same effect for the Argentine income tax.3 Figures in the sixth column represent the income elasticity of the tax for individual taxpayers, which corresponds to that in the sixth column of Table 1 for Japan. It is evident that the taxes of the lower income groups increased more than those of the higher income groups as inflation progressed.

Table 2.Argentina: Relative Changes in Income Tax Incidence, 1955 and 1956 1(Cols. 1–4 in pesos)
Income in 1955Tax Due in 1955Income in 1956Tax Due in 1956Tax Increase, 1955 to 1956 (Col. 4 ÷ col. 2)Income Elasticity of the Tax (Col.511.221)Relative Real Disposable Income in 1956 (Col.3col.4Col.1col.2×11.22)
(1)(2)(3)(4)(5)(6)(7)
30,00036,600462
38,00051846,3601,2992.516.850.985
43,00094052,4602,1472.285.840.981
48,0001,51258,5603,2122.125.110.977
53,0002,23464,6604,4521.994.510.972
58,0003,10670,7605,7371.853.850.971
66,0004,73480,5207,9811.693.120.970
76,0006,94292,72011,0301.592.680.970
93,00011,100113,46016,3721.472.160.972
118,00017,598143,96025,0081.421.920.971
143,00024,720174,46034,5351.401.800.970
168,00032,468204,96044,7821.381.720.969
406,000115,644495,320147,7991.281.260.981
906,000305,6601,105,320385,3881.261.190.983

For uniformity in computation, every taxpayer is assumed to have three dependents (including spouse) and to earn employment income only. The following allowances were applicable: (1) M$N 7,200 as a basic exemption, (2) M$N 2,400 for having family dependents, (3) M$N 2,400 for the spouse, (4) M$N 1,800 for each of the other dependents, and (5) M$N 15,000 for earning employment income only. These allowances total M$N 30,600, which is deductible in order to arrive at taxable income.

The assumption is that taxpayers obtained 22 per cent more income in 1956 than in 1955. This was the average annual percentage change in cost of living in Argentina during the period 1950–58. See Raymond F. Mikesell, “Survey of the Alliance for Progress: Inflation in Latin America” (a study prepared at the request of the Subcommittee on American Republic Affairs of the Committee on Foreign Relations, U.S. Senate, 90th Congress, 1st Session, Washington, 1967), p. 3.

It is assumed that tax rates did not change in 1956. In fact, income brackets were rearranged and the tax rates modified in that year.

For uniformity in computation, every taxpayer is assumed to have three dependents (including spouse) and to earn employment income only. The following allowances were applicable: (1) M$N 7,200 as a basic exemption, (2) M$N 2,400 for having family dependents, (3) M$N 2,400 for the spouse, (4) M$N 1,800 for each of the other dependents, and (5) M$N 15,000 for earning employment income only. These allowances total M$N 30,600, which is deductible in order to arrive at taxable income.

The assumption is that taxpayers obtained 22 per cent more income in 1956 than in 1955. This was the average annual percentage change in cost of living in Argentina during the period 1950–58. See Raymond F. Mikesell, “Survey of the Alliance for Progress: Inflation in Latin America” (a study prepared at the request of the Subcommittee on American Republic Affairs of the Committee on Foreign Relations, U.S. Senate, 90th Congress, 1st Session, Washington, 1967), p. 3.

It is assumed that tax rates did not change in 1956. In fact, income brackets were rearranged and the tax rates modified in that year.

Whether the real disposable income of lower-income groups is reduced more than that of high-income groups depends on the particular features of the tax schedule. The calculations for Japan during the 1948–49 period show a greater reduction for high-income groups (column 7 of Table 1), whereas similar calculations for Argentina show little or no difference between income groups (column 7 of Table 2).4

Tax delinquency

It is often argued that the progressive rates of the personal income tax act as a powerful weapon against inflation by siphoning off excess purchasing power of consumers. Although correct in theory, the actual collection of the statutory tax liabilities dictated by the progressive tax schedule is frustrated by the inflationary situation itself. This situation is typically accompanied by an abrupt rise in tax delinquencies, which is illustrated by Japan’s experience over the period 1946–51.5

Tax delinquency started in the fiscal year 19466 and taxes in arrears as a percentage of taxes assessed rose sharply, reaching in the fiscal year 1949 an almost incredible figure of 84 per cent for self-assessed personal income tax and remaining at this level for a few years (Table 3).

Table 3.Japan: Tax Delinquency of Self-Assessed Personal Income Tax, 1948–51
Fiscal YearTaxes AssessedTaxes Unpaid on Due DateRatio of Unpaid Taxes (Col. 2) to Assessed Taxes (Col. 1)Taxes Unpaid Beyond Fiscal YearRatio of Unpaid Taxes (Col. 4) to Assessed Taxes (Col. 1)
(1)(2)(3)(4)(5)
Million yenPer centMillion yenPer cent
1948144,95998,14767.7
1949197,178165,55384.073,72337.4
195086,86971,97682.915,81618.2
195189,41970,33478.622,98225.7
Source: National Tax Administration Agency, Annual Report for Fiscal Years 1949, 1950, and 1951, October 1952, pp. 423–25 and 430 (in Japanese).
Source: National Tax Administration Agency, Annual Report for Fiscal Years 1949, 1950, and 1951, October 1952, pp. 423–25 and 430 (in Japanese).

All these delinquencies were not of long duration—some were paid within several months after the due date. But a large part remained unpaid beyond the fiscal year, as the fifth column of Table 3 shows.

The accumulation of tax arrears may be explained in several ways:

(1) The tax burden was simply too heavy for the taxpayers and could not be met without lowering living standards; in other words, the Government’s demands in fighting inflation were greater than the taxpayers could sustain. A fully employed, semiskilled industrial worker who earned an annual income of ¥ 105,000 in 1949, which was barely enough for basic subsistence, had to pay the income tax.

(2) The shortage of liquidity was another major factor. Although the money supply expanded from ¥ 30 billion in 1945 to ¥ 787 billion in 1949, businessmen were increasingly pressed for the necessary working capital to produce the same volume of goods, as prices rose by 10 per cent or more each month. In August 1950 a survey of the causes of tax delinquencies indicated that the liquidity problem was the most important factor.7

Causes of DelinquencyNumber of CasesPercentage Distribution
Shortage of liquidity4,24547.7
Dissatisfaction with government assessment2,65929.8
Negligence8609.7
Insolvency6287.1
Other reasons5095.7
Total8,901100.0

Because of the monetary stringency and high interest rates induced by the inflation, businessmen found it advantageous to finance their needs through the Treasury simply by postponing tax payments.8

(3) Lack of compliance by many small taxpayers contributed much to the tax delinquency. The sweeping income tax reform in 1947 incorporated a great number of new taxpayers who were inexperienced in income tax matters. The vast majority of the income tax returns filed by small and medium-sized businessmen were found to be inadequate, and the amount of reported net income was marked up by the officials—frequently by more than 100 per cent.9 Government reassessments were often made arbitrarily, without any current investigation on the taxpayer’s premises. This kind of approach evoked opposition among taxpayers, who organized demonstrations against authorities and hindered officials from enforcing seizure of property. There is no doubt that noncompliance by some taxpayers inspired resistance to the tax laws by others.

(4) Successful administration was handicapped by the lack of experienced personnel. The tax reform in 1947 involved a mass of new taxpayers and required an increase in the number of tax officials. The best efforts in recruiting failed to secure a sufficient number of qualified men, chiefly because of the less attractive salaries offered by the public sector. The youthfulness, inexperience, and low salaries of a majority of the tax officials weakened confidence in the tax administration.

Tax evasion

It is generally agreed that if a government maintains income tax rates or does not appreciably lower income tax rates during an inflationary period, the tax yield does not increase correspondingly because of the incentive given to tax evasion.10 Inflation alone does not generate tax evasion, but it stimulates evasion by moving more taxpayers into higher tax brackets, and it generally causes deterioration in compliance.

Attempts have been made to measure the effect of inflation on tax evasion, but no definite results have been obtained.11 In a study of Argentina’s experience in the period 1950–55, an income elasticity of income tax of 0.77 was estimated. This implies that the income tax failed to siphon off even a constant share from the higher national income. Two main factors distorting the elasticity of the tax were cited: a rising rate of tax evasion and time lags in collection.12

Collection lags

Whenever tax payments are not synchronized with the accrual of income tax liability, by means of withholding or current payment of taxes, the delays in the course of an income year may make it possible for a taxpayer to pay his tax liability in money of a lower purchasing power. This delay is usually prolonged by the length of time allowed after the end of the taxable year for a taxpayer to prepare his tax return or the time it takes the revenue officials to assess the income tax. Even then the tax liability may not be immediately payable in full but over an additional period. Finally, collection may be further delayed by failure of the taxpayer to meet his liabilities when they are due. Delays allowable by statute will be discussed first; tax delinquency, which was discussed on pages 281–83, will be dealt with further in a later section.13

Time lags between accrual of income and the closing day of an income year

Income tax is usually based on income arising over the period of a year. Therefore, even if the date for reporting income and paying the tax were fixed on the last day of the income year during which prices had risen, liability would be discharged in devalued money. The effect of this time lag on the tax incidence or tax revenue may be illustrated as follows:

For simplicity, consider an economy characterized by a monthly price rise of r per cent beginning in the second year. An individual who obtained an income of Y1=12y (where y denotes assumed monthly income) in the first year may earn the following income (Y2) in the second year:

Y2 may be rewritten as (l + ρ)Y1, where

Values of ρ that show the annual rate of increase in money income when r equals 1 per cent, 2 per cent, …, 5 per cent are given in the second column of Table 4. The corresponding percentage depreciation in the value of money at the end of the year is shown in column 3.

Table 4.Price Rise, Increase in Money Income, Depreciation of Money, and Corresponding Increase in Tax Rates Required to Maintain Real Value of Tax Collections(In per cent)
Monthly Price Rise, rAnnual Increase in Money Income, ρAnnual Depreciation of Money, R1Increase Required in Tax Rates (1+R1+ρ1)
(1)(2)(3)(4)
16.812.75.5
214.026.811.2
321.742.617.2
430.460.222.9
539.379.628.9

R=(1 + r)12–1.

R=(1 + r)12–1.

If the real value of tax collections is to be maintained, it would be necessary to raise the tax rate by the percentages shown in column 4 for a flat, proportionate tax (e.g., corporation income tax). A personal income tax with graduated rates, as has already been explained, has an income elasticity greater than unity. Therefore, if the time lag arising in an income year is considered, a graduated personal income tax may be said to have a self-adjusting device as long as the income elasticity has a value high enough to compensate for the depreciation in the value of money. But the built-in mechanism of the tax structure, as has been observed, enhances the tax revenue by increasing most the tax payable by middle-income and lower-income taxpayers. To mitigate this effect, tax cuts through adjustments of personal exemptions and tax rates may be necessary when inflation continues.14 If the required tax adjustments are made, however, other measures may be necessary to cover the deficiency caused by the time lag—namely, insofar as practicable, the synchronization of tax payments with the accrual of the tax liability, by a withholding tax system and a current payment of estimated tax.

Time lags between the closing day of a taxable year and payment of tax

Different practices are followed by different countries in the scheduling of tax payments. In Japan, the individual’s income is taxed on a calendar-year basis; a return must be filed not later than March 15 15 of the following year, at which time the tax is to be paid in full. Normally, about two thirds of the total amount of tax, calculated on the basis of the previous year’s income, will have been prepaid in two equal installments—not later than July 31 and November 30.

On the other hand, within two months after the end of its accounting period, a return of a corporation’s taxable income and the tax due must be filed and the tax paid. A majority of Japanese companies take six months as their accounting period, and thus file returns and pay taxes twice a year. Upon application, one half of the tax payment may be postponed for three months. This installment plan was introduced in the postinflationary period. Thus, Japan allows a relatively short period for preparing the return and settling the tax liability: two and a half months for an individual, and two months for companies.

In Brazil, there is a substantial lag in payment of income tax. For corporations, limited-liability companies, partnerships, etc., the deadline for filing returns (depending upon the termination date of the accounting period) ranges from the last working day in January to the last working day in May of the following calendar year. In the past, unless its liability was very small, the taxpayer was entitled to pay the tax in equal monthly installments over the remainder of the calendar year in which the return was filed, the first installment being payable within 20 days after filing; in the extreme case where a taxpayer closes his accounting year on January 31, the liquidation of the tax liability would be completed almost 22 months after the closing of the taxpayer’s accounts. By a recent decree, effective in 1969, income tax liabilities (except for small amounts) become payable in 12 monthly installments due on the twentieth of each month during the calendar year following the end of the accounting period. The early installments payable before the return is filed are based on the liability of the previous year, and installments are adjusted after the declaration is filed.

Returns of individuals are filed annually during the month of April and relate to income earned in the previous calendar year. The taxpayer pays his liability in equal monthly installments during the remainder of the year, the first being payable within 20 days after he receives official notice of the assessment (usually made immediately after filing), and the remainder in installments at intervals of 30 days thereafter. Taxpayers, either juridical persons or individuals, electing to pay in full at the time the declaration is filed are entitled to a discount ranging from 8 per cent to 2 per cent, depending on the month when payment is made.

The British system for filing and payment, which operates in a number of Commonwealth countries, is illustrated by Sierra Leone’s practice prior to April 1968, when new legislation was introduced. All businesses that kept accounts were liable to tax on the income earned in the accounting year ended on or before the last day of the year preceding the year of assessment.16 The Commissioner requested the returns at the beginning of each year of assessment, i.e., on April 1, and taxpayers were required to furnish the returns within 21 days. The Income Tax Department then made the assessment and notified the taxpayer. The tax was to be paid 21 days after receiving the notice, but if one half of the tax was paid within the prescribed period, the payment of the remaining half might be delayed until the following March 31. For example, a taxpayer with an accounting year ending June 30 would not fully discharge his tax liability until 21 months after the end of the accounting year.

Column 6 of Table 5 shows the extent to which, in a hypothetical situation, the U.K. payment pattern 17 would yield less real value of revenue in comparison with a scheme with a 3-month time lag: 0.93 with a 10 per cent yearly increase in prices, 0.87 with a 20 per cent increase, and 0.82 with a 30 per cent increase. The disparity under a system of current payment is, of course, somewhat greater. The difference may be measured by the indices listed in column 7 of Table 5, which show the real value of payments by taxpayers of a trade or profession.

Table 5.Depreciation in Value of Tax Payments with Payment Lag and Hypothetical Increase in Price Level
Annual Percentage Rate of Increase in Price LevelReal Value of Tax PaymentsDepreciation of Value of Tax Payments Under U.K. System
With 6-month lagWith 9-month lagWith 12-month lagWith 15-month lag(Col.2+col.42)(Col.3+col.52)
(1)(2)1(3)(4)(5)(6)2(7)3
100.950.930.910.890.930.91
200.910.870.830.800.870.83
300.880.820.770.720.820.77
400.850.780.710.660.780.72
500.820.740.670.600.740.67

Let r equal monthly rate of increase in price level. In an inflationary economy with a 10 per cent annual rate of price increase, (1+r)12 is equal to 1.10. From this equation the value of r can be obtained. Then, we get 1(1+r)6, the value of which is listed in column 2.

These figures show the real value of tax payments with a minimum delay under the U.K. pattern, taking tax payments under the system with a 3-month lag as a base (1.00).

These figures show the real value of tax payments by businessmen and professionals with a minimum delay under the U.K. pattern, taking current payments by withholding as a base (1.00).

Let r equal monthly rate of increase in price level. In an inflationary economy with a 10 per cent annual rate of price increase, (1+r)12 is equal to 1.10. From this equation the value of r can be obtained. Then, we get 1(1+r)6, the value of which is listed in column 2.

These figures show the real value of tax payments with a minimum delay under the U.K. pattern, taking tax payments under the system with a 3-month lag as a base (1.00).

These figures show the real value of tax payments by businessmen and professionals with a minimum delay under the U.K. pattern, taking current payments by withholding as a base (1.00).

Income tax payment systems thus show considerable variation. Schemes that provided for lagged tax payments may have been justifiable when they originated, and under normal economic conditions they do not weaken the government’s ability to maintain the real value of its tax revenue. In periods of inflation, however, they become a threat to sound fiscal policy, since the government’s revenue is geared to the country’s smaller economy of about a year or more previously. Wage and salary earners currently pay greater tax liabilities, which are increased by progressive rates and a rapid increase in their incomes, while the taxes of businessmen, farmers, and professionals are comparatively less because of the payment lag. The preferable solution to the problem would be to place all taxpayers on as current a basis as feasible. This explains the tendency in many countries to shorten the payment lag and also to make the transition to a current payment system.

II. Measures to Combat Delinquency

Experience has shown that it is extremely difficult to control tax delinquency under an inflationary situation. One solution is to take preventive measures that will assure payment of taxes concurrently with the accrual of tax liabilities. It is still necessary, however, to ensure prompt payment of taxes by an effective system of penalties or inducements that removes economic incentives to postpone payment. Intensified enforcement procedures are all the more necessary under inflationary situations. These techniques are described below.

Intensified enforcement (Japanese experience)

At the beginning of the 1949 fiscal year the Japanese tax authorities were under the heavy pressure of outstanding unpaid taxes of ¥ 82.3 billion (the number of overdue tax cases was as high as 5.6 million) carried over from the preceding fiscal year.18

In order to provide unified and competent guidance for compulsory collection at some 500 National Taxation Offices,19 a tax collection section was established in June 1949 in the new National Tax Administration Agency; and in October 1949 some 300 experienced officials were appointed as National Tax Collectors working with the National Tax Administration Bureau.20 They were assigned to give guidance for collection at the National Taxation Offices and to collect those delinquent taxes that were in large amounts. All tax collection officials undertook a campaign against delinquent taxpayers by the use of sanctions, such as distraint and public sale.21 Despite all-out efforts, taxes in arrears rose to ¥ 125.8 billion at the end of the fiscal year 1949 (of which ¥ 88.3 billion represented self-assessed income tax delinquencies). At the outset of the 1950 fiscal year, Tax Collection Divisions were set up in each National Tax Administration Bureau. In June 1950 the Minister of Finance issued a statement against delinquency, and the Commissioner of the National Tax Administration Agency designated three months (July to September) as a special period for intensified effort. Every collector was required to engage in field work at least 20 days a month, and well-trained senior collecting officials were sent to support the collection campaign of the National Taxation Offices. In October, the National Tax Administration Agency formed an Antidelinquency Drive Center and the Commissioner himself headed the campaign. The number of distraint cases mounted from 1.2 million in 1949 to 1.6 million in 1950, and taxes collected through distraint increased from ¥ 38 billion to almost ¥ 44 billion.

Government reassessment procedures and the strict collection enforcement program during the period 1946–50 proved successful in securing the estimated government revenue, although it failed in some fiscal years to collect in full the self-assessed income tax.22 Such methods, however, adversely affected public relations with taxpayers, and a change in collection policy was urgently called for.

With the coming of the 1951 fiscal year the tax authorities were convinced that the former policy should be replaced by a more liberal and reasonable one, and they adopted a so-called internal control system. This system relied more heavily on internal accounting procedures and personal contacts. First, it required orderly, up-to-date records, so that any taxpayer’s account would be available on a moment’s notice. Second, the system attached greater importance to human relationships; officials at the higher levels were required to make personal contact with delinquent taxpayers, and a senior official tried to ascertain why the taxpayer neglected his duty and to make a fair determination of capacity to pay. Most cases could be solved by an arrangement for payment of the overdue tax (plus interest) in installments. If it was confirmed that the taxpayer had neither assets to cover the tax nor any prospect of earning enough income to afford it, the Chief of the National Taxation Office could, at his discretion, suspend the case after accepting whatever the taxpayer could pay.23 Third, for those who intentionally broke the agreement to pay the tax in installments or for those who willfully shirked the tax payment, distraint and other direct enforcements were to be used.

To make the new system workable, there was a large-scale revision of the National Tax Collection Law. This revision left seizure of property to the tax agency’s option. It also created so-called postponement of tax payment, under which, upon the taxpayer’s request, the tax authority may postpone collection of the tax for not more than two years when the tax payment created an unusual hardship. This gave the authority a legal basis on which it could make an arrangement for installment payments. The scope of property on which attachment could be made was further restricted.

The new system gradually proved to be effective, producing rather better results than had been expected. A decline in the amount of overdue tax made it easier for a taxpayer to pay his current tax liability on the due date and resulted in a reduction in delinquencies. The tax collection ratio improved rapidly year after year.

Fiscal sanctions

This section deals with preventive measures to enforce prompt payment of tax—called broadly “fiscal sanctions” of a civil nature. The fiscal sanctions comprise a variety of forms referred to as interest charges, delay penalties, delinquency penalties, delinquency taxes, addition to the tax, and the like. Rebates may also be offered to taxpayers who are regular and punctual in discharging their tax liabilities.

Fiscal sanctions for failure to pay taxes when due are generally agreed to comprise interest charges and penalties. This duality seems to have originated in the idea that a delay in payment is tantamount to borrowing from the government and should be compensated for by an interest charge,24 but at the same time it may be a failure to abide by the tax law and therefore should be penalized by the equivalent of a fine. In this way that part of the delay penalty that corresponds to the prevailing market rate of interest is reckoned as an interest charge, and the remainder is considered a penalty. It may follow that interest charges are deductible as an expense, while delay penalties should not be deductible because they are in the nature of a fine. However, it will be seen that such a system does not always meet every situation well, particularly during inflation.

Practices in different countries

(1) Japan. Until 1962 Japan imposed both interest and penalties for late payment of tax. Since then, interest has been assessed only on those who are granted postponement of tax payment in accordance with the tax laws,25 and so-called delinquency taxes have been imposed on taxpayers who are in arrears. Delinquency tax runs at the rate of 4 sen per diem for 100 yen (equivalent to 14.6 per cent per annum) from the statutory due date to the actual payment; however, the rate is reduced to 2 sen per diem for 100 yen from the statutory due date to the eleventh day after the issuance of a notice of demand.26

When self-assessment was adopted for direct taxes in April 1947, “addition to tax” was collected at the rate of 4 sen per diem for 100 yen (14.6 per cent per annum) for the period from the statutory due date through the due date as fixed by the notice of assessment,27 while a delay penalty ran at the same rate for the period that taxes remained unpaid after the due date. In substance, it meant that for direct taxes a penalty ran at the rate of 4 sen per diem through the period of nonpayment. The rate was then raised in December 1947 to 5 sen per diem, i.e., 18.3 per cent (for delinquency of withheld tax, 10 sen per diem). In July 1948 the rate was increased to 10 sen per diem28 (36.5 per cent) for addition to tax, and 20 sen per diem (73 per cent) for delay penalty.

The delay penalty was thus adjusted to the soaring market rates of interest that accompanied the inflation. This high rate was severely criticized as being a probable cause for the piling up of delinquent taxes. The Shoup Mission recommended

that the present interest charges of approximately 31 percent and 71 percent a year on delinquent taxes be reduced, to the equivalent of 12 percent a year up to the time the tax office demands payment, and 24 percent a year thereafter. Interest rates as high as the present ones are self-defeating. They tend to make the taxpayer hopelessly delinquent within a short time. This is probably one reason for the large amount of delinquent tax now outstanding.29

Following this recommendation, Japan introduced in April 1950 a new system consisting of interest and delay penalties. Interest ran at the rate of 4 sen per diem (14.6 per cent a year) for the entire delinquency period from the statutory due date. In addition, if the taxpayer did not pay the tax within ten days after the notice of demand was issued, the delay penalty was imposed at the rate of 4 sen per diem for the period following the eleventh day after the issue of a notice of demand. However, the amount of delay penalty was limited to 5 per cent of the unpaid tax outstanding on the eleventh day, in order to ease the burden of payment. Finally, in 1962, both interest and delay penalty were incorporated into a single so-called delinquency tax, already described.

(2) Uruguay. The personal income tax was introduced in Uruguay in 1961. At that time, it was established that delinquency was to be penalized by a charge of 2 per cent a month, the rate already in effect for most other taxes. However, the Tax Department was authorized to grant extensions for payment up to 36 months to those taxpayers filing their returns and requesting the extension at least one month in advance of the due date. In these cases, interest was to be applied in lieu of the charges, at an annual rate of 12 per cent.

In 1963 the cost of living index increased by 20.5 per cent, almost doubling the increase of 1962; prices increased even more in the following years, rising by 43.0 per cent in 1964, 56.6 per cent in 1965, and 73.7 per cent in 1966.30 Under these conditions, the rates of interest and charges for late payments of tax liabilities became clearly inadequate, since they could no longer function effectively as a deterrent to delinquency. Therefore, an attempt was made in 1967 to correct this situation, and a new law introduced a new and more flexible system of penalties. According to the new provisions, charges are to be applied at a rate of up to 5 per cent a month, with the monthly rate effective for each calendar year to be determined by the Government, rendering account to Congress. The Government made immediate use of this power and raised the monthly rate from 2 per cent to 4 per cent. The 1967 law also changed the special rules applicable to taxpayers requesting extensions. Instead of the annual 12 per cent interest rate, it imposed a charge of 3 per cent a month and dropped the requirement that the request for a postponement should be made before the due date. Finally, in October 1968 an additional 10 per cent charge was introduced; it is applicable to all late payments regardless of the time involved.

It was recognized that the rates of interest and charges for delinquent payments were not enough to deal effectively with the problem. Moreover, several amnesty laws were passed allowing delinquent taxpayers to pay their liabilities without payment of charges and interest, and it was believed that something should be given to those taxpayers who were discharging their obligations punctually. Therefore, a law passed in 1963 granted a 5 per cent discount on payments of most taxes, including income tax, made by taxpayers within the periods stipulated by statute. This rate was increased to 10 per cent in 1965. Remittances of tax withheld at source do not qualify for a discount; taxpayers are required to return the amounts discounted when tax reassessments result in an increase of more than 20 per cent of the originally self-assessed tax.

(3) Brazil. The Brazilian system of penalties for delinquency in personal income tax payments has the following features: (a) For all delayed payments, there is a penalty of 5 per cent of the amount due if the delay is 30 days or less; for more than 30 days the rate is 10 per cent a semester or fraction of a semester, (b) In addition to this penalty, interest is applied at a monthly rate of 1 per cent, beginning one month after the payment is due. (c) Interest and penalties because of late payments cannot exceed 30 per cent of the amount of tax in arrears.

As in Uruguay, discounts are granted to taxpayers who discharge their liability in advance of the statutory payment date. Usually taxpayers file a return by the end of April stating the income earned during the previous fiscal year. Payments are then spread in monthly installments over the remainder of the year. However, if payments are made in full before the due date, taxpayers can benefit from discounts that decrease with time: 8 per cent in January, 6 per cent in February, 4 per cent in March, and 2 per cent in April.

(4) Mexico. In Mexico, delay penalties are in the form of sanctions and surcharges. If a taxpayer obtains from the Government an extension for payment, he becomes liable to a surcharge at a rate that shall be determined annually in the Federal Revenue Law according to the interest rate prevailing in the market,31 applicable on the delinquent amount for each month of the delay or fraction thereof. If a tax is paid late but voluntarily32 and no request for extension has been made, the rate for surcharges shall be doubled. In any case, surcharges cannot exceed the amount of tax due.33 Finally, if the tax payment is not considered voluntary, a penalty is imposed of 8 per cent a month of the amount of tax in arrears with a maximum of three times the tax due, in lieu of surcharges. The penalty depends on the seriousness of the violation.

OAS Model Tax Code

The problem of tax collections has been especially acute in Latin American countries that have experienced inflation. A Model Tax Code prepared for the Joint Tax Program of the Organization of American States and the Inter-American Development Bank34 proposes the following treatment of tax delinquencies: (1) If, upon request, delayed payment is authorized before the tax liability becomes due, the taxpayer shall pay interest at a rate equivalent to the bank rate for discount of commercial notes, as determined by the government in the previous calendar year. Interest is not considered a penalty but an adequate compensation for the use of tax funds. The variability of the rate attempts to deal with inflationary situations, where the taxpayer may be induced to postpone tax payments when the market rate of interest is higher than that applicable to tax liabilities. (2) If the payment is delayed without authorization of the tax administration, the taxpayer is considered to be in default and, in addition to the interest charge, shall pay a penalty of an equivalent amount. (3) If the failure to pay has been exposed by the tax administration before the actual payment is made, a penalty shall be imposed, ranging up to the amount of the tax when the cause is negligence and to two times such amount when it is intentional. In both cases, the penalty is in addition to the interest and penalty just described in (1) and (2).

Limitations of interest and penalty charges—taxpayer insolvency

As was observed above, interest and penalty charges tend to soar in countries that undergo inflation. In part, this is rather a natural consequence of the advantage taken by many taxpayers to finance their credit needs through the national treasury. Because of the general scarcity of credit and its high cost induced by the inflation, it is generally advantageous to pay the delay charges for the use of the tax funds otherwise payable, particularly if the charges are less than the market rates of interest. However, if the charges reach too high a level, they may worsen the delinquency, intensify business distress, and fail to accomplish their objective of stimulating tax payment.

Too high a penalty rate is apt to drive taxpayers into despair. A taxpayer may manage to pay at least a part of the overdue tax even when there is great difficulty in doing so, if there is hope that full settlement can be made some day. However, too high rates may lead to insolvency of taxpayers, which accounts for a considerable portion of the backlog of unpaid taxes in an inflationary period.

The accumulation of overdue taxes in inflationary situations can be attributed in part to the inefficiency of the tax administration. Taxpayers may not be deterred by the high penalties because they believe that the widespread seriousness of their situation will lead to a formal or de facto amnesty that reduces or cancels the penalty.

It is difficult to determine an appropriate rate of late payment charges in an inflationary situation. In principle, such charges should be higher than the interest rate prevailing in the money market.35 However, because of differences in credit risks that tend to spread more widely in a period of inflation, no single interest rate would be appropriate to all taxpayers. The rate selected will almost always be too high for taxpayers with prime credit ratings and too low for those with poor credit, some of whom cannot borrow at any price. A rate set high enough to discourage taxpayers with high credit ratings from trying to finance their needs through the treasury may serve to limit the scope of the problem without imposing unbearable penalties on less creditworthy businesses, thereby making more feasible the collection of charges from them.

However, this does not necessarily mean that high delay charges are always to be avoided. Otherwise, businesses are more likely to choose to expend their limited resources on the financing of inventories or employees’ salaries rather than to pay the tax. An upward adjustment of penalty charges with the progress of an inflation may be justified for the prevention of tax delinquency, but not beyond a certain limit of tolerance.

The efficacy of delay charges

Delay charges are in their very nature a supplementary measure in preventing or reducing taxes in arrears. Their primary purpose is to prevent taxes from falling in arrears, rather than to collect delinquency penalties. When the rates are too high, they may even result in an increase of unpaid taxes. There is a danger that the accumulation of delay charges will make taxpayers desperate, unless the total remains within reasonable limits.

Under normal economic conditions, delay charges may have considerable value in keeping tax delinquency within reasonable limits. They can be made to work efficiently under the conditions that (1) market rates of interest are within a normal range and the rates of delay charges are varied accordingly but within tolerable limits, (2) enforcement is carried out vigorously and efficiently, and (3) taxpayers are informed of the nature and size of the charges—a most important condition.

There are some who advocate complex delay penalties so as to encourage early settlement of taxes in arrears. However, if the system cannot be easily understood, the taxpayers will not respond in prompt payment of tax. Wide publicity and communication with the taxpayer are important prerequisites. In practice, the administration should send a notice of demand within a prescribed period after the due date, informing the taxpayer of his overdue liability together with the penalties for delay.

Finally, the efficacy of delay charges depends largely on the credibility of their enforcement. If taxpayers are well aware that the penalties will not be collected in full, or if they can expect an amnesty, penalties become of little value.

Technical aspects of delay charges

An important technical problem concerning delay charges is whether or not they should be deductible as an expense. In some schemes, interest charges are deductible as an expense,36 while delay penalties are not deductible. However, all fiscal sanctions against nonpayment or late payment serve the same purpose. First, they provide an incentive to the taxpayer to pay the tax on or before the due date or at the earliest time thereafter. Second, they maintain equity between taxpayers who have paid the tax in full on or before the due date and those who are in arrears. It is quite difficult to consider a certain portion of the delay charges as interest charges and the remaining as delay penalty. In its essence, the delay charge is more like a coercive fine. The delay penalties bear but a faint resemblance to interest in the ordinary sense. Therefore, no portion of delay charges should be deductible as an expense. This policy has two advantages: first, by not mitigating the penalty it helps to prevent total tax liabilities from piling up and, second, it prods alert taxpayers, such as big businessmen or corporations, to earlier settlement of their tax liabilities because they are highly sensitive to the real rate of delay charges.

Tax amnesties and rescheduling of arrears

In some countries the problem of tax arrears has become so critical that the government—being unable to enforce regular collection procedures—has taken emergency measures to alleviate taxpayer distress in an endeavor to speed up the collection of urgently needed revenues. These measures, which take the form of tax amnesties and provisions for rescheduling tax payments, are frequently employed by Latin American countries faced with serious inflationary situations. Such amnesties evidence the practical limitations of delay charges in enforcing payment of tax delinquencies under inflationary conditions, and if used with discretion, they may be successful both in speeding up tax collections and in restoring business morale. There is a danger, however, that they may be counterproductive when employed regularly by the government.37 Experience with tax amnesties and rescheduling of payments in Uruguay and Brazil point up the limitations of government policy in this respect.

(1) Uruguay has used these devices. The first one applicable to the new income tax was introduced in April 1963. All taxpayers in arrears on January 31, 1963 who either wholly or partially paid these arrears between December 20, 1962 and May 15, 1963 were exempted from interest, surcharges, and fines corresponding to the amounts effectively paid during that period.

Apparently this measure was not effective; it was followed by another law passed in January 1964, when taxpayers were given a 90–day option of paying their arrears accumulated up to December 31, 1963 in one of the following three ways: (a) in full within 90 days, resulting in a total exemption from interest, surcharges, and any other late payment penalty that otherwise should have been imposed; (b) within 3 years, resulting in a 50 per cent exemption; and (c) within a period of more than 3 but less than 15 years, resulting in no exemption.

If the taxpayer opted for either (b) or (c), he had to agree to pay his liability (including the corresponding late payment penalties) in equal and consecutive installments that would include interest at 8 per cent per annum. For each installment, he was required to sign a document that served as indisputable evidence of his tax liability. If he defaulted, the Government could on the basis of this document recover the amount in arrears through a quick, summary court proceeding.

If the taxpayer opted for (c) above, the tax administration was entitled to request from him either a collateral or a personal guarantee covering the amount that he agreed to pay in installments. Delays in payment of more than three installments or a similar delay in payment of the tax liabilities accrued after December 31, 1963 were to have the effect of canceling the agreement and the exemptions granted by the law. As a further step, banks and other financial institutions were forbidden to extend or renew loans of more than a certain amount to any person who did not sign a sworn declaration stating either that he was not in arrears on December 31, 1963 or that he had agreed to pay, using some of the options provided by the law.

A third law, along the same lines, was passed in July 1967, but it was less generous than the one introduced in 1964. Arrears up to May 31, 1967 could be paid either in full or in consecutive installments of 12, 24, or 36 months. Exemption of late payment penalties was granted only to those paying the full amount of arrears within 60 days of the approval of the law. For the other options, the original liability was to be increased by surcharges at monthly rates of 1, 2, or 3 per cent, depending on the number of installments elected.

(2) The Brazilian Government has also resorted to these exemption measures several times. An analysis of recent amnesties related to the two main federal taxes shows how they operated.

(a) Income tax. A Decree Law passed in 1966 established that those taxpayers paying before January 31, 1967 their arrears for fiscal years previous to 1966 would be granted a 50 per cent reduction of fines, the arrears also being exempt from the monetary correction.38 Payment in monthly installments (up to a maximum of six) was to be allowed whenever the amount due exceeded Cr$5,000, but in such instances the first installment must be paid before January 1, 1967. This amnesty was broadened in 1967 with these main provisions: the grace period was extended by one month; the benefits granted earlier would apply to arrears for fiscal year 1966, if paid before March 15, 1967; those required to withhold tax at source were to be included in the amnesty; and the officers in charge of regional income tax offices were authorized, under special circumstances, to grant installments of up to 18 months.

(b) Tax on industrialized products. An amnesty declared by Brazil in 1967 granted a 50 per cent reduction of fines and allowed up to 36 months for monthly installment payments for arrears. Taxpayers were required to declare their tax arrears within 30 days, and the monetary correction was to be applied only from January 1, 1966. The number of installments was to be determined so that each installment should not be less than 20 per cent of the average monthly payments in 1966.

Benefits granted by this amnesty were to be canceled if the taxpayer became delinquent (after two installments) either on his arrears or on his current tax payments. If he became delinquent, the fines originally imposed were to be re-established and the monetary correction was to be applied fully, both being calculated on the balance of arrears. Instances of fraud and the like were excluded from the amnesty.

(c) Results. The main purpose of these provisions was to accelerate collection of an important amount of arrears by reducing the financial strain on the taxpayers; on the basis of available information, it does not appear that it has been accomplished.

A large proportion of taxpayers who agreed to pay under the protection of the recent amnesties was previously under investigation by the tax departments and would have been obliged to pay their arrears; however, the large percentage who filed voluntarily suggests that there were serious administrative deficiencies in delinquency control. Therefore, because of their negative effects on the taxpayer’s compliance, such amnesties seem to be generally self-defeating, even if revenue producing, and hardly justify recurrent adoption.

Revaluation of tax arrears (monetary correction)

As has been demonstrated (pp. 283–88), an inflationary situation makes it advantageous for the taxpayer to delay the payment of taxes, because late payment can be made in money with less purchasing power than when legally due. Delay charges are designed to encourage prompt payment by placing a penalty on delinquency, but unless the delay charges are very high they may not compensate for the decline in the purchasing power of money that has accompanied the inflationary situation in many countries.

For this reason some countries, especially in Latin America, have considered techniques for adjusting unpaid taxes to reflect changes in the purchasing power of money. Brazil adopted such a technique, known as “monetary correction,” at the time of its tax reform in 1964. Chile has introduced a similar provision, but it covers only the tax payments made on statutory dates. The Uruguayan Government proposed a monetary correction in 1967, but it was rejected by the Parliament. This technique is examined below with particular reference to Brazil’s experience.

Brazil

A law was introduced in 1964, providing that all tax and related liabilities not paid within the calendar quarter in which they became due would be subject to monetary correction according to the changes in the purchasing power of the national currency, as determined quarterly by the National Economic Council. The most relevant provisions of this law were as follows: (1) In the second month of each calendar quarter the National Economic Council would publish the table of coefficients effective for the next quarter. The monetary correction would be based on the coefficients in the table effective when arrears were paid; (2) the fines and interest incurred through delay (previously a percentage of the original tax liability) would be calculated on the “corrected” amount of tax; (3) the revaluation would cover the period up to July 17, 1964, unless the taxpayer liquidated the arrears originating within that period before certain dates specified in the law; and (4) in case of pending appeals, the taxpayer would be required to deposit the amount claimed by the administration; otherwise it would be subject to monetary correction when the appeal was settled.

In spite of these good intentions, the application became eroded through subsequent laws: (1) In 1964 the deadlines for payment without revaluation of taxes due before July 17, 1964 were postponed and the fines applicable reduced by 50 per cent. (2) In 1965 payment of the pre-July 1964 arrears without monetary correction was postponed until January 31, 1966. The 1965 legislation made two other important changes in the original law: (a) Liabilities incurred before July 17, 1964 were exempted from the monetary correction for the period up to that date. (This provision was the final outcome of a long controversy on the possibility of making retroactive the system of revaluation of arrears.) (b) From November 30, 1965, late payment penalties would no longer be subject to monetary correction and were not to exceed, in total, 30 per cent of the initial tax liability. However, in 1967 a decree law reversed this and made late payment penalties again subject to the correction.

Apart from modifications made by law, the principle of revaluation of tax debts was further weakened by a profusion of ministerial decrees (portarias), in which grace periods for pre-July 1964 arrears were extended again and delays in tax payments were allowed. Tax amnesties have also dulled the effectiveness of the instrument of correction.

Taking into account the rate of inflation that has occurred in Brazil in recent years, as reflected in the coefficients for monetary correction effective in the third quarter of 1967 (Table 6), the principle of revaluation of tax arrears may appear to be attractive. It is hazardous to measure its effectiveness by reference to actual collections. The improvement of revenue in real terms in 1965 and 1966 could have resulted from the expansion of the economy as well as from other factors (e.g., increases in tax rates and administrative improvements), and it is impossible to isolate the effect of the revaluation of arrears on the taxpayer’s attitude toward payment by the due date. Nevertheless, it is likely that taxpayers were induced by the system to keep their payments on a more current basis, at least in the beginning.

Table 6.Brazil: Monetary Correction Coefficients Effective from 1964 to Third Quarter of 1967
Period When Tax Liability Should Have Been PaidIndices Prepared by the National Economic Council
1964
Up to 3rd quarter2.290
4th quarter1.965
1965
1st quarter1.731
2nd quarter1.636
3rd quarter1.551
4th quarter1.475
1966
1st quarter1.310
2nd quarter1.212
3rd quarter1.127
4th quarter1.063
1967
1st quarter1.000
2nd quarter1.000
Sources: Diario Oficial, various issues.
Sources: Diario Oficial, various issues.

The amount collected as monetary correction per se was negligible in relation to the total tax yield, particularly for the tax on industrialized products. If the system had been applied stricly, the percentages would have been much larger, since the existence of large arrears was undeniable. The explanation of the low yield may lie in the several tax amnesties that the Government has passed in recent years rather than in any inherent weakness of the monetary correction as such. In the long run, and taking into account the recurrent exemption measures, the taxpayer will be encouraged to postpone payments until the next amnesty.

Experience in other countries

In 1965 Chile introduced a system of monetary correction. It covers only the payments of income tax liabilities made on statutory payment dates and may be interpreted as an attempt to compensate for the loss of revenue in real terms owing to the lag between the accrual of income and the payment of tax.

Most taxpayers file a return between January and March following the year when income is earned. The resulting liability can be paid either fully at the time of filing or in three equal installments—the first at the time of filing, the second in July, and the third in October.

A 1965 law established that the income tax liability was to be increased by 50 per cent of the percentage increase in the consumer price index for the year in which the income was earned. The adjustment would not apply when the taxpayer paid his entire tax liability at the time of filing; instead, he would be granted a 5 per cent discount.

The scheme was changed in 1966 and again in 1967. The first modification raised the adjustment coefficient to 80 per cent for taxpayers paying in installments, while those paying fully at the time of filing were subject to correction at 40 per cent of the percentage increase in the price index. Finally, in 1967, the coefficients were increased to 100 per cent and 50 per cent, respectively.

In 1967 the Uruguayan Government submitted a proposal to the Parliament for a system of revaluation of tax arrears. The Government would establish “coefficients of monetary revaluation” equivalent to the percentage changes in the general price index. Fines would also be revalued, and delay penalties would be based on the revalued original tax liability.

During the discussion in the Parliamentary Committee, the government representatives stressed that the scheme was not punitive and that it was intended mainly to discourage tax delinquency and evasion. Upon discovery, taxpayers who have failed to pay or who have evaded tax would have to make substantial payments. Moreover, the revaluation would also deter taxpayers from making unjustifiable use of litigation procedures for the sole purpose of delaying payments.

The proposal was strongly criticized by both legislators and representatives of the taxpayers, and it was finally rejected by the Parliament, mainly for these reasons. (1) Inefficient tax administration had helped to cause the accumulation of arrears, which led to the introduction of amnesties. (2) As the taxpayers were used to periodic amnesties, they would be even more reluctant to pay and would anticipate more amnesties. (3) Somewhat inequitably, the Government, as a debtor to the private sector, would be exempt both from the revaluation and from paying interest. (4) The revaluation would be disastrous, as the country lacked sufficient liquidity. (5) Its approval, by implying a long or even unsuccessful fight against inflation, would endanger the Government’s anti-inflationary program.

III. Current Payment

A current withholding system is no doubt one of the most efficient techniques that is employed for preventing tax delinquency and evasion. Delinquency is encouraged by a system that postpones collection of tax on the current year’s income until the following year. Problems of tax evasion tend to be intensified by filing practices of taxpayers, and, with present assessment procedures, the tax administration can hardly attain 100 per cent correction to the statutory tax liability.

While the origin of withholding dates back to the nineteenth century, its large-scale adoption, particularly with respect to wages and salaries, was quite recent: Germany in 1920, Japan in 1940, the United States in 1943, and the United Kingdom in 1944.39 The system was instrumental in meeting the fiscal needs of financing World War II and in. checking the postwar inflation. The latter role is exemplified by the postwar experience of Japan, when the delinquency problem was most serious. In 1949–51, the worst period that the Japanese tax authorities have faced in tax collections, more than 90 per cent of income taxes assessed were collected through withholding (Table 7). In 1949 the grave danger of a fiscal deficit because of mass tax delinquencies in the self-assessed income taxes was barely averted by an increase in the income tax collections withheld in excess of estimates.

Table 7.Japan: Income Tax Collection Ratios, 1949–51 1
Income Taxes WithheldSelf-Assessed Income Taxes
Fiscal YearTaxes assessed

(1)
Taxes collected

(2)
Ratio (Col. 2÷col. 1)

(3)
Taxes assessed

(4)
Taxes collected

(5)
Ratio (Col. 5÷col. 4)

(6)
Million yenPer centMillion yenPer cent
1949150,778141,54793.9235,752137,20658.2
1950139,355127,51691.5146,64192,61963.2
1951162,923150,23092.2119,58475,44163.1
Source: National Tax Administration Agency, Annual Report for Fiscal Years 1949, 1950, and 1951, October 1952, pp. 423–25 (in Japanese).

The figures in this table differ from those in Table 3 because they include not only taxes assessed or collected for the current income year but also taxes that were assessed or collected during the current fiscal year for the incomes in past years.

Source: National Tax Administration Agency, Annual Report for Fiscal Years 1949, 1950, and 1951, October 1952, pp. 423–25 (in Japanese).

The figures in this table differ from those in Table 3 because they include not only taxes assessed or collected for the current income year but also taxes that were assessed or collected during the current fiscal year for the incomes in past years.

The present section analyzes the role of current withholding, the conditions for its effective operation, its benefits, and its costs, with special reference to inflationary situations. Current withholding from wages and salaries will be considered first, followed by current withholding from interest, dividends, rents, etc. A brief discussion of current payment of estimated tax follows. The current payment system introduced in Indonesia will then be discussed.

Current withholding from wages and salaries

Techniques

A rough measure of the significance of the withholding technique is the ratio of its collections to total income tax collections. Its share in total collections depends on its coverage of personal taxable income. Current withholding is commonly applied to two major categories: wages and salaries, and investment income. In some countries it is extended to income from professional services, such as compensation for actors, musicians, and other professionals, fees for speeches, writings, etc., and to the income of nonresident individuals and corporations. This broader application may be important from an enforcement point of view but has little fiscal implication.

Japan’s experience over a period of almost 20 years provides an interesting illustration of how the importance of withholding increases with the expansion of the economy. By 1965 withholding collections reached about 75 per cent40 of total income tax collections, against 23 per cent in 1947. Another remarkable trend is observed by the figures in the last column of Table 8, which show the increasing relative importance of tax withheld on investment income.

Table 8.Japan: Income Tax Withheld at Source, 1947–65
Assessed Income Taxes Subject to Withholding at Source
Wages and salariesInvestment and other incomeAssessed Taxes Subject to Withholding as a Percentage of Total Taxes AssessedRatio (BA+B)(Per cent)
Self-Assessed Income TaxesTaxpayers (Thousands)(Million yen) Taxes assessed

(A)
Taxes assessed1(Million yen)

(B)
YearTaxpayers (Thousands)Taxes (Million yen)
19478,33692,05526,71365522.92.4
19488,780161,13376,1291,34332.51.7
19499,454200,554142,9843,06242.12.1
19504,33585,4439,936124,3575,90760.44.5
19513,51086,3749,067149,3987,08464.44.5
19522,93281,5158,655163,30223,42569.612.5
19532,16769,0048,301180,81829,84575.314.2
19542,27463,4528,921196,54830,71378.213.5
19552,41160,1758,558189,20928,14978.313.0
19562,20869,4478,703204,71628,76577.112.3
19572,22361,6008,998159,60036,56976.118.6
19582,12053,0309,667154,86641,53578.721.1
1959
19602,15193,42611,733220,93677,67776.226.0
19612,085120,07713,067265,859100,69975.327.5
19622,312142,01114,855312,062119,96775.327.8
19632,582183,59216,500390,962112,66173.322.4
19642,845219,31317,184477,503124,23573.320.6
19652,920230,93716,942533,548197,33976.027.0
Sources: For 1947–58—Ministry of Finance, Zaiseikinyu-tokei-geppo (Monthly Report of Public Finance), Vol. 110 (1960), pp. 69–72; for 1960–65—Ministry of Finance, data from Tax Bureau.

Taxes on interest and dividends probably account for a substantial part of these. The rates of these taxes have been subject to changes; for instance, the 1959 reform made interest subject to withholding tax at 10 per cent (it had been exempt from tax since 1955). In 1963 the rate was reduced to 5 per cent, but in 1965 it was again raised to 10 per cent.

Sources: For 1947–58—Ministry of Finance, Zaiseikinyu-tokei-geppo (Monthly Report of Public Finance), Vol. 110 (1960), pp. 69–72; for 1960–65—Ministry of Finance, data from Tax Bureau.

Taxes on interest and dividends probably account for a substantial part of these. The rates of these taxes have been subject to changes; for instance, the 1959 reform made interest subject to withholding tax at 10 per cent (it had been exempt from tax since 1955). In 1963 the rate was reduced to 5 per cent, but in 1965 it was again raised to 10 per cent.

The technique of current withholding embodies two distinct principles: the first is the collection of tax at source, and the second is current payment of tax withheld.41 The former is concerned with assuring both the correctness of reporting and the full payment of tax before the income is received by the employee. The second principle assures that tax is paid in money of the same purchasing power as that at which it is earned. Current withholding is thus one of the most effective fiscal techniques against inflation.

The two major approaches to withholding income tax from wages and salaries are exemplified in the systems used by the United States and the United Kingdom. In the United States the technique is not designed to withhold the precise amount of annual tax liability due, whereas in the United Kingdom the opposite is usually true. In the United States the withholding tables originally used basic personal exemptions and allowances claimed by each employee and a flat rate of tax, but since May 1966 the rates have ranged from 14 per cent to 30 per cent. Each month the employer pays the Government the amount withheld, and at the end of the year he gives the employee a statement of his total wages or salary earned and the tax withheld. The employee attaches a copy of the statement to his tax return, which indicates whether he owes more tax, is entitled to a refund, or is even. When the tax has been overwithheld, a refund is made after the return is filed. In the United Kingdom at the beginning of the year each employee furnishes the tax administration information about his dependents, anticipated deductions, and other income. The administration assigns him a code number, which his employer uses to determine the amount of tax to withhold for each pay period, based on accumulated wages and tax paid to date in the taxable year.42

A system that withholds an amount precisely equal to the taxpayer’s ultimate tax liability, as does the U.K. system in theory, would seem ideal. The tax authority would then be spared the cost of processing final returns. In addition, the cost of collecting small amounts from many taxpayers, the necessity for refunds, and the losses from uncollectible accounts would be eliminated. Also, the taxpayer would have the convenience of not filing a final tax return. But such a “fine tuning” for all taxpayers can be achieved only by provisions that are difficult to administer and may place a considerable burden of compliance on employers. On the other hand, a withholding system with a flat rate is much easier to apply. The system may function satisfactorily if most wage earners have a steady income that is not above the lowest bracket to which the standard rate is applied. A further degree of complexity may be found in “the year-end adjustment” used with graduated rates, which can approximate within the tax year the income tax rate schedule. The employer adjusts the employee’s last payment of the year in order to meet the difference between the final tax liability and the cumulative tax withheld.

Merits of current withholding at source

Improved collection—prevention of delinquency. The experience of many countries testifies that the extension of the personal income tax to the lower-income groups can be implemented successfully only if the tax is withheld at the source.43 By this means a comparatively small group of tax collectors (employers) is introduced between a large number of wage and salary earners and the administration. The tremendous amount of work and cost that would be incurred in collecting tax from individual earners in the absence of the system is greatly reduced, and employers can be more readily identified and located and more easily required to collect and pay employees’ taxes.

The great majority of people are likely to rely on their future earnings to discharge their tax liabilities without setting aside funds to meet their taxes as they accrue. Compulsory payment of income taxes by a withholding tax removes a large element of the uncertainty that may arise from this practice. A discrepancy between the tax liability and liquidity that, as we observed earlier (pp. 281–82), tends to be enlarged in an inflationary period and becomes a major threat to tax collection can be greatly reduced if the withholding system operates successfully.

Prevention of evasion and underreporting. A withholding system has a direct effect upon the taxpayer’s compliance in reporting tax liabilities. Successful working of the system leaves little room for underreporting of wages and salaries. Taxpayers are less conscious of the magnitude of their tax burdens because the tax is paid as income is earned. Withholding also contributes to better taxpayer morale by the belief that others are also paying their fair share. Also, the employers have an interest in reporting them fully, since the payments made to employees are deductible as expenses in computing their own tax liabilities. Furthermore, a better check on compliance can be expected if a third party is introduced between taxpayers and the government.

Quick response to economic changes. The current payment principle embodied in withholding has a great value in making the income tax more responsive to changes in the economy. The income tax is widely accepted as a powerful fiscal weapon, and to be most effective it should be placed on a current payment basis. Current withholding that results in a proportionately greater increase (or decrease) in tax collections as income increases (or decreases) serves as a built-in stabilizer. When the government takes discretionary measures, such as tax cuts or tax boosts, withholding rates can be adjusted to obtain a more effective countercyclical response.

The current payment principle is even more important in times of sustained inflation than in short-term business cycles. A much greater response is necessary to siphon off purchasing power by collecting the tax in money of current value rather than in rapidly depreciating money. In such a situation, a withholding system with graduated rates is much more effective than one with a flat rate, since the former may capture proportionately greater taxes from rising salaries and wages.

Limitations of current withholding

The current withholding system has proved to be a successful method of collecting taxes on wages and salaries and is particularly expedient during inflation. However, the system may not be appropriate under all conditions. The benefits of current withholding should be weighed against its limitations and costs.

One of the major objections to current withholding of taxes on wages and salaries is its discrimination against one class of taxpayers. Other taxpayers, especially professional and other self-employed people, who are not subject to this discipline can continue to evade their income tax liability or to discharge their liabilities with devalued money.

There are also some problems involved with refunds when the tax is overwithheld. Employees may find themselves in an unfavorable position because they are forced to deposit with the government money that is refunded after its value has declined. Moreover, refund procedures may be burdensome. Prompt refunds may mitigate the situation, as in the United States, but the best solution is to tune the system to the amount of income tax liabilities finally due.44

It has been suggested that a current withholding system will not be successful unless the revenue from the income tax comes largely from the tax on wage and salary earners. Acceptance of the system by those earners is important for its success, and this can hardly be expected if a number of other taxpayers do not share the same treatment.

The average number of employees per employer is another factor that deserves careful attention in adopting a withholding system. If this number is too small, only a modest benefit can be obtained at a rather large expense, and the system may not be worthwhile.

The recent experience in Uruguay illustrates these considerations. In 1961, when legislation introducing the personal income tax was passed, a withholding system was made mandatory for unidentified income earners (bearer shareholders and the like) and for nonresidents. At the same time, the Administration was empowered to extend the withholding system to income of other categories of taxpayer. In 1966 withholding was extended to wages and salaries, rental income, etc., at a time when several years of inflation had eroded the extremely favorable tax treatment given to income from wages and salaries, and when many more wage and salary earners had become subject to tax. This created a strong political opposition that was based on the allegation that people earning modest wages and salaries were going to be fully subjected to the tax, while large-income earners, such as professionals, businessmen, and farmers, were escaping tax through the use of loopholes and outright evasion. At the beginning of the 1968 fiscal year when increases in family allowances and other deductions became effective and the number of wage and salary earners liable to income tax was greatly reduced, the Government took the opportunity to discontinue the application of the withholding system.

There is no full assurance that the amount of tax withheld by employers will be turned over to the government on a timely basis. It has been pointed out that in some Latin American countries there has been a tendency among employers, particularly during severe inflation, to use the money withheld to finance their own needs instead of paying it over to the treasury. The Argentine and Brazilian legislations, for example, have established heavy penalties against this violation.45

Transition problems

When collection at the source is introduced, special consideration must be given to the burden of superimposing one year’s tax upon another year’s tax. Technically, the most convenient time to initiate such a program is either when the personal income tax is first introduced or expanded considerably, or when a serious inflation seems imminent.

Inflationary pressures require that disposable income of taxpayers be reduced and that tax payments be based upon the higher current incomes rather than on the lower incomes of the preceding year. In such situations paradoxical effects on income tax liabilities can be observed: (1) increased incidence owing to progressivity, in which the degree of increase depends upon the tax schedule and the income bracket to which a particular taxpayer belongs;46 and (2) reduced incidence owing to the time lag (in the absence of current withholding), in which the degree of reduction depends chiefly upon the degree of the inflation and the length of the payments lag.47 For the purpose of mitigating the harsh results (heavier incidence on lower-income earners) caused by the first effect, a tax cut may be needed. At the same time a current withholding system should be introduced to offset the lower value of tax collections in real terms owing to the time lag. Thus, tax liabilities in the current year would be better geared to the proper amounts, and the payment would be made currently.

The one-time payment of the tax for the preceding year (which might be regarded as a double payment of tax) would siphon off the excess purchasing power of the taxpayers and serve as an efficient weapon against inflation but would possibly go too far. Under the conditions stipulated, a certain variation of this approach—double payment to some degree by a limited number of taxpayers—would be an effective solution to the transition problems. Other approaches could be planned to meet other conditions.

One alternative is for the government to forgive the tax due for the preceding year. Since this procedure would unduly benefit those with lower incomes or no taxable income in the current year, the government could forgive the income tax due in either the current year or the prior year, whichever is the lower. Another alternative is to provide for a transitional period of several years so as to temper the suddenness of the increased burden without losing revenue.48

Requirements for implementation

A country that meets the conditions set forth in a preceding section (pp. 310–11) would find it advantageous to institute a current withholding scheme for income tax on wages and salaries. If it is prepared well and introduced at the right time, a current withholding system is the best fiscal remedy to combat the erosion of income tax under inflation, since it attacks the three serious problems arising from inflation—delinquency, evasion, and the time lag. For better implementation of withholding—focusing special attention on inflationary situations—the following proposals are extremely relevant.

Tax rate cuts may be necessary. In view of the tendency for income taxes to increase at a faster rate than incomes during inflation, cuts in tax rates may be required to keep the tax burden on employees within reasonable limits. In the absence of a withholding technique, such a measure may be rejected on the grounds that the time lag has a countervailing effect on the real value of tax collections. On the other hand, current withholding would eliminate partially or wholly the countervailing effect and leave an unduly heavy tax burden.

Adoption of prepayment of estimated tax. One of the serious objections to a withholding scheme on wages and salaries, as observed above, is the discrimination between this group of taxpayers and other taxpayers. It is almost impossible to eliminate the discrimination completely, because no single technique that may be employed for the other taxpayers can match withholding in the prevention of delinquency, evasion, and time-lag effects. A suitable approach to be employed for the other taxpayers is a combination of current payment of estimated tax and reinforced administration to combat tax delinquency and evasion. The current payment of estimated tax would alleviate to some extent the time-lag discrimination.

Withholding taxes from interest, dividends, royalties, rents, etc.

The withholding of taxes on interest, dividends, royalties, rents, etc., has operated in many countries much longer than it has on wages and salaries. Withholding from investment income has the same advantages as withholding from employment income—prevention of tax delinquency and evasion and correction of time-lag effects—but withholding from the former normally provides no benefits to taxpayers, while withholding from the latter often enables taxpayers to be free from the troublesome work of filing a declaration. The withholding system for investment income usually takes the form of a single flat tax rate, and it can be implemented in a relatively easy way. There are varying degrees of ease, cost, and benefits, according to each particular kind of investment income. Withholding from interest, dividends, and royalties normally causes few problems,49 while withholding from rental income may pose special difficulties because there is usually a large number of tenants and many of them are unsuitable as withholding agents.

Current payment of estimated tax

Purposes served

Current payment of estimated tax by self-employed persons whose incomes are not subject to withholding serves the following purposes: (1) It partly removes the discrimination against wage and salary earners subject to current withholding; (2) it assures a steadier flow of revenue into the treasury without the problem of time lags; (3) it aids taxpayers in discharging their liabilities through regular installment payments and better protects the government against defaults and loss of revenue; (4) it makes government revenue more responsive to changes in income and economic activity, both as a countercyclical and as a counterinflationary measure.

In most developing countries the income tax initially constitutes a relatively small share of government revenue, and current payment may not play an important role from the fiscal point of view, Accordingly, the second and fourth purposes are of less practical importance in developing countries than in developed countries.50 However, current payment of estimated tax is important in a changing economy because it redresses the inequity involved when withholding is applied to wages and salaries.

Inflationary conditions seem to require that current payments should be based on estimated tax for the current year rather than on the previous year’s tax liability. But making an accurate estimate of income that depends on uncertain conditions in the future presents a serious problem. Moreover, if a taxpayer’s estimate in his declaration is far less than expected by the authority, a heavy burden is placed on the administration to scrutinize the declaration. In Japan, however, the requirement that taxpayers’ declarations should reflect accurate estimates of future income ended in failure,51 and the law was revised to provide that the advanced payment be based on the income of the preceding year. In view of wide fluctuations in economic activity the Ministry of Finance was authorized to prescribe blanket percentage increases over the prior year’s income. But this clause was repealed before it was put into effect.

Transition problems—alternative approaches

As in the introduction of current withholding from wages and salaries, the transition to a current payment system presents a serious problem because of double tax payments—those due for the previous year and those due for the current year. One method of mitigating this problem is to forgive part or all of one year’s tax liabilities.52 A second method is to require taxpayers to continue to pay last year’s taxes but to postpone payments over a period of several years. A third technique is to provide for a gradual shortening of the payments lag over a period of years until the transition is completed.

If one year’s tax is to be forgiven, it is undesirable that the tax forgiven be on income earned during the current year, since current collection of income taxes should be geared as much as possible to the current year’s income, particularly in an inflationary period. Moreover, taxpayers whose incomes have increased should be expected to pay more taxes than those whose incomes have declined. Perhaps most desirable of all would be to forgive either the tax on the current year’s income or the tax on the previous year’s income, whichever is lower.

With respect to the implementation of a current payment system, in 1943 the U.S. Treasury consistently opposed full cancellation of one year’s tax on the following grounds: “… (1) the unfortunate effect of full forgiveness on the distribution of the tax burden, (2) the excessive relief it would offer to taxpayers in a year of record national income [1942], and (3) the addition of forgiven taxes to inflationary pressures.” 53 While opposing full cancellation, the Treasury recognized that some cancellation, especially in the lower brackets, would be necessary to avoid undue hardship.54

Some of the countries (e.g., Pakistan, Trinidad and Tobago, and Sierra Leone) that had been following the U.K. tax pattern have moved recently to a current-year basis of collection of taxes on income that is not from wages and salaries. After examining the Canadian tax system, Trinidad and Tobago in 1963 introduced current payment for business profits and the like by canceling the tax due on either 1962 or 1963 profits, whichever were less. The major difference from the Canadian system is that the current year’s income is deemed to be the same as that of the previous year, instead of basing installment payments on estimated income for the current year.

In the year of assessment 1967/68 Sierra Leone moved its largest taxpayers to a current payment system by means of the second technique referred to above. Their two tax payments traditionally lagged the accounting year by 12 months and 21 months, respectively. For example, one company paid the tax on the profits for the accounting year ended June 1965 in two equal installments, in June 1966 and March 1967. Under the new current payment system the company was required to pay the tax on the income for the accounting year ended in June 1968 in four equal installments—in September 1967, December 1967, March 1968, and June 1968, with a final adjustment in November 1968. As to the business profits for the accounting years 1965/66 and 1966/67, it was stipulated that the Commissioner might choose either of the two years for which the tax became payable in four equal annual installments, falling due in July of the years 1967 through 1970. As a result, in the year of assessment 1967/68 an inflow of revenue was expected to be at the same level as that prior to 1967/68, and in the three succeeding years payments would be increased by one fourth of the tax liability attributable to 1965/66 or 1966/67.

Other countries (e.g., Viet-Nam and the United States) have followed the technique of advancing the payment of corporation income taxes gradually until they are on a current basis. Viet-Nam’s transition to a current payment system for corporations was introduced during wartime inflation. Income taxes on corporations were assessed at 24 per cent and collected with a lag of more than 12 months after the end of the income year. In 1967 the Government instituted payment on a current basis, the transition to which would be completed over a four-year period. The principle of the system is to advance payments by one quarter each year until by 1970 payments would be made currently in April, June, October, and December; final settlement of the balance due is to be made upon filing a return in April of the following year. The effect of the transition is to increase yearly tax payments by 25 per cent, thereby increasing the effective rate from 24 per cent to 30 per cent.

In the United States, the acceleration of corporation tax payments was undertaken in three different stages, beginning in 1951. Prior to the 1951 revision, corporations that keep their accounts on a calendar-year basis paid the tax in four installments: on March 15, June 15, September 15, December 15, following the year in which income was earned. By 1968 corporations had completed the transition to a current payment basis for income tax liabilities in excess of $100,000, with four quarterly payments made in April, June, September, and December.55

The Indonesian system

In 1967 Indonesia initiated a unique withholding technique applicable to business profits earned by incorporated and unincorporated businesses. The difficulty in assessing and collecting income taxes from small independent businessmen, traders, farmers, etc., during an inflationary period led to the invention of a technique whereby provisional amounts of tax are withheld from payments for purchases of goods and services. Tax is withheld by a tax collector appointed by the head of the local tax office.56

The tax collector computes, deducts, and deposits on behalf of the taxpayer the tax covering payments that occurred within a certain period, usually the calendar month. The base for the tax withheld is the gross proceeds of the transaction, either a purchase or a sale, the compensation for services rendered, or any other amount determined by the Director-General of Taxes. The rate at which tax has to be deducted is determined by the Director-General, but it shall in no case exceed 20 per cent.57

The taxes withheld for each period are to be paid to the Treasury within seven days after the expiration of the period. Late payment penalty is 1 per cent a day. The tax withheld is credited against the taxpayer’s final liability for the year.

The scheme requires considerable paperwork on the part of the tax collector. He has to provide the taxpayer with a tax certificate for every amount that he withholds, make a deposit slip when payment is made to the Treasury, and file a return with the tax office within 20 days after the expiration of the period. Copies of the tax certificates and the deposit slips have to be filed together with the return.

The tax office, after checking the return with the accompanying deposit slip and the tax certificates, files copies of the tax certificates, which are checked against the final return filed by the taxpayer.

Such a system is likely to place a large burden on the tax administration, especially if many refunds are to be made after assessing the final liability. Gross income bears no uniform relationship to the amount of net income, and family allowances are an important factor in determining final liability for personal income tax. It would appear, therefore, that in such a system the withholding rates should be kept reasonably low. This has been the approach of the Indonesian authorities. Another step toward minimizing the problem of refunding was the appointment as tax collector of only the bigger businesses that carry on most of their business with other large firms. This reduces the chance of withholding taxes from many persons who are not liable for income tax and thereby diminishes the number of refunds to be made.

To the extent that the rate schedule results in withholding taxes in amounts that are more or less in line with the magnitude of the final assessed tax liabilities, the system has the advantage of enabling the Government to collect on a current basis substantial amounts of tax, regardless of the existing level of compliance among taxpayers. However, if substantial overwithholding results and the administration does not process claims for refunds, the scheme takes on the features of an indirect tax. In 1968 taxes withheld amounted to 32 per cent of total corporation tax collections and to 17 per cent of total income tax collections.

A second innovation was also introduced in Indonesia in 1967, i.e., the technique of self-assessment for income tax and corporation tax. This technique involved payments in advance of the final tax liabilities but by the taxpayers themselves without the intervention of tax collectors.

The tax is computed and paid by those persons who have received a letter of confirmation from the head of the local tax office. The tax base is the gross receipts. The value of a transaction, a substitution value, or any other value is determined by the Director-General of Taxes, who is also empowered to determine the applicable rate, which shall not exceed 20 per cent.58

The rate is applied to the proceeds for a specified period, generally the calendar month, within the taxable year 59 and is credited against the final liability arising at the end of the period. Payments to the Treasury are to be made within 15 days after the expiration of each period. There is a late payment penalty of 12 per cent a month. Within 20 days after the expiration of the period, a report on the liability and payment must be filed with the local tax office.

Three months after the expiration of the taxable year, taxpayers must make a final computation of their tax liability and submit a return to the tax office. If the tax liability exceeds the sum of the advance payments plus the tax withheld by third parties, the taxpayer must pay the remainder before he submits the return. If, on the other hand, the balance is in favor of the taxpayer, the tax office informs him by written notice within three months after it has received the return. The excess is refunded or offset against other taxes payable.

The system has the same advantages and shortcomings as the withholding tax system. Moreover, the coordination of payments under the two schemes may present problems. For this reason, the Indonesian authorities have instructed the field offices that, whenever it is proved to their satisfaction that advance payments and tax withheld duplicate one another, the taxpayer may deduct from the advance payments the taxes withheld relating to the same commodities. This procedure makes administration of the scheme even more cumbersome to operate. In 1968 payments in advance amounted to 38 per cent of total corporation tax collections and to 14 per cent of total income tax collections.

IV. Conclusions

The personal income tax is widely regarded as one of the best forms of taxation. In general, because of the progressivity of its tax schedule, it also has a higher built-in income elasticity than any other tax. In an inflationary period a personal income tax siphons off excess purchasing power from the private sector and yields a fiscal dividend that can be an additional resource for the government’s anti-inflationary policy, provided that the tax is effectively enforced.

The administration of a personal income tax is geared basically to the normal operations of the economy and is vulnerable to a rapid change in the price level. If inflation moves too fast, the time lag in payment of the tax and increasing tax delinquencies and evasion may result in an erosion of tax collections, which may more than offset the increase in income tax liabilities owing to their elasticity. This is partly because the depreciation in the value of money makes it advantageous to postpone payment and partly because of a liquidity problem, which makes it expedient to remain in debt to the treasury.

Under a severe inflation the government may attempt to increase income tax rates in order to maintain revenues. However, a tax increase at this stage may be self-defeating and only invite further tax delinquencies and evasion. Thus, it is vital for the administration to adopt techniques that will enforce current collection of income tax during an inflationary period. Unquestionably the most effective scheme is to put tax payments on a current basis and to require withholding of taxes from income, insofar as it is practicable. Current withholding at the source facilitates a quicker response to economic changes by reducing time lags and minimizes tax delinquencies and evasion. But it has a serious shortcoming in that it cannot be applied to the income of self-employed businessmen and professional persons. Nevertheless, where the bulk of personal income tax payments comes from wage and salary earners, withholding is immensely valuable. Current payment of income tax by others, based on estimated tax liability for the year, is also important but requires taxpayer compliance and consistent enforcement for its successful operation.

In shifting tax payments to a current basis, consideration must be given to the problem of the doubling of tax payments. Several approaches—forgiveness of the previous year’s tax liabilities, postponement of payment, or gradual shortening of the payment lag over a period of years—have been used to avoid financial hardship for the taxpayer.

Fiscal sanctions, such as interest and penalties, serve to keep tax delinquencies within limits, provided that the charges and penalties are geared to changes in interest rates. They may be effective under normal conditions but become increasingly less effective as inflation advances. Revaluation of tax liabilities according to price indices, i.e., monetary correction, has been used to adjust tax arrears to reflect changes in the purchasing power of money. Although, theoretically, a monetary correction would appear to deter delinquency and to be a means of protecting government revenue, experience shows that it is no substitute for efficient enforcement of collections. The Indonesian system (under which taxes withheld and self-declarations are based on sales and other gross income) involves many problems, and its feasibility cannot be determined until Indonesia has had greater experience with its operation. Current payment of estimated tax may better assure prompt tax collections under Indonesia’s conditions than other schemes analyzed, but the payments are not well correlated with income tax liabilities, and substantial refunds and additional assessments are necessary.

There is no single prescription for collecting the proper tax liabilities from businessmen and other self-employed persons during periods of rapid inflation. It takes patient efforts to strengthen administration, such as maintaining the proper number of well-trained personnel, improved public relations for better taxpayer compliance, proper audit and reassessments by the government, and, most important, intensified enforcement of collections.

Tax amnesties and rescheduling of arrears aimed at alleviating taxpayer distress may be necessary in countries where tax arrears pile up. However, these measures can be self-defeating by encouraging taxpayers to postpone payment of their taxes in the expectation of future amnesties and can lead to further tax delinquencies.

Finally, income tax rates may have to be reduced during an inflationary period in order to mitigate the onerous statutory tax liabilities on various taxpayers that are inherent in a progressive personal income tax rate schedule. If the increase in statutory tax liabilities is allowed to go beyond tolerable limits, taxpayers may regard this as justification for their failure to settle their tax liabilities when due.

APPENDIX

Impact of Income Tax on Real Disposable Income During Inflation

Drawing attention to the after-tax income, or disposable income (D), one may say that the marginal rate of increase (dDdY) in disposable income with respect to before-tax income (Y) is smaller for high-income groups than for low-income groups. Since dDdY=1dTdY (where T is income tax) and the marginal tax rate (dTdY) is higher for upper brackets, the statement above is a logical consequence of the fact that the personal income tax has a progressive tax rate schedule. A similar argument may be advanced regarding the effect on real disposable income during an inflationary period. The ratio (DY), which represents how much is left after the tax, becomes D+dDY+dY in the following year; and the ratio D+dDY+dY/DY could be considered to be an indicator of the change in real disposable income over a year. Assuming a g that is not too great, this ratio (ξ) can be rewritten as follows:

where g denotes the rate of increase in income (dYY), t the average effective tax rate for each taxpayer in the first year (TY), and є the tax elasticity (dTTdYY). Given the rate of inflation, we may take the coefficient (g1+g) as a constant.

(1) If we could assume that the tax elasticity (є) is equal to unity, i.e., the tax is assumed to have a single flat rate, then the ratio (ξ) would take a constant value (unity). In other words, real disposable income will not be affected by inflation whether the taxpayer belongs to upper income groups or lower ones.

(2) If we assume that the tax elasticity (є) takes the same value (other than unity) for every taxpayer, the ratio (ξ) will have a variety of values depending on the average effective tax rate for each taxpayer—the smaller (ξ) for high-income groups and the higher (ξ) for low-income groups.

(3) Under any actual tax schedule, the tax elasticity, as we observed above, is greater for low-income groups and smaller for high-income ones. This characteristic feature of the progressive tax schedule lends force to hold the ratio (ξ) down for the low-income groups. Thus, whether the value of the ratio (ξ) is favorable for low-income groups or for high-income groups depends solely on which of the two factors [the average effective tax rate for each taxpayer factor (t1t), and the tax elasticity factor (є–1)] outweighs the other. For Japan the former factor prevails over the latter, and the ratio (ξ) is on a slight downward trend as incomes move upward, while for Argentina the factors nearly match and the ratio (ξ) remains almost unchanged, fluctuating to a very small degree.

Maintien du niveau de recouvrement des impôts sur le revenu en période inflationniste

Résumé

L’inflation affecte de différentes manières l’impôt sur le revenu, son rendement et son administration. Premièrement, la progressivité du barème des taux accentue le poids de l’impôt. Deuxièmement, le nombre des cas d’impôts impayés peut augmenter très fortement par suite de la réduction relative des disponibilités monétaires et de la hausse des taux d’intérêt. Troisièmement, l’évasion fiscale peut être encouragée par la pression croissante exercée par l’augmentation du coût de la vie. Enfin un manque important de ressources budgétaires peut apparaître par suite des délais légaux de paiement de l’impôt. La première section analyse la nature et les causes de ces problèmes.

Dans la deuxième section, plusieurs moyens de combattre le défaut de paiement des impôts sont passés en revue. L’un d’eux consiste à appliquer avec davantage de rigueur les dispositions fiscales. L’expérience du Japon pendant l’inflation de l’après-guerre, qui s’est heurtée à de nombreux obstacles en raison des tensions sociales qu’elle a fait naître, est décrite dans cette étude. Les sanctions financières — paiement d’intérêts et d’amendes — permettent de maintenir les cas de non-paiement des impôts à un niveau normal, mais elles perdent de leur efficacité en période d’inflation. La réévaluation des impositions en fonction des variations des indices de prix (correction monétaire) a été utilisée au Brésil et au Chili pour que les changements de la valeur de la monnaie soient incorporés dans les impositions qui n’ont pas été payées.

La retenue à la source au fur et à mesure de la réalisation des revenus qui est étudiée dans la troisième section est sans aucun doute la technique la plus efficace pour résoudre le problème du recouvrement de l’impôt en période d’inflation. Elle permet non seulement de réduire dans le temps les délais de recouvrement mais encore de diminuer les risques d’arriérés fiscaux et d’évasion. Diverses méthodes de retenue à la source sur les revenus courants sont analysées; leurs mérites et leurs faiblesses sont examinés.

Cependant, la retenue à la source ne peut être appliquée aux particuliers établis à leur compte et un système de paiement reposant sur une évaluation du revenu réalisé pendant l’année en cours doit être utilisé. Les auteurs décrivent les problèmes de transition d’un régime d’imposition des revenus réalisés l’année précédente à un régime d’imposition des revenus au fur et à mesure de leur réalisation. Enfin, ils examinent le régime particulier utilisé en Indonésie en matière de retenue à la source sur les revenus courants.

El mantenimiento del nivel de recaudaciones del impuesto sobre la renta habiendo una situación inflacionaria

Resumen

La inflación afecta de diversas formas el impuesto sobre la renta, así como la incidencia, el rendimiento, y la administración del mismo. Primeramente, se intensifica la carga del impuesto sobre la renta, debido a su progresividad. Segundo, puede aumentar notablemente la morosidad en el pago del impuesto a causa de la reducción relativa de las disponibilidades monetarias y de la elevación de los tipos de interés. Tercero, puede que resulte estimulada la evasión por la mayor presión que ejerce el creciente costo de vida. Finalmente, puede ocurrir que los plazos legales para el pago diferido del impuesto creen serias deficiencias presupuestarias. En la Sección I se analiza la naturaleza de esos problemas y su planteamiento.

En la Sección II se examinan varias medidas utilizadas para combatir la morosidad fiscal. Una de ellas es la intensificación del esfuerzo administrativo. En este trabajo se describe la experiencia del Japón durante la inflación posbélica, cuando se tropezó con serias limitaciones a causa de las tensiones sociales a que dieron lugar estos esfuerzos. Las sanciones fiscales, tales como el cobro de intereses y otras penalidades, en circunstancias normales sirven para reducir la morosidad, pero son menos eficaces cuando hay condiciones inflacionarias. En Brasil y Chile se ha recurrido a la revaluación de las sumas debidas al Fisco, con arreglo a un índice de precios (corrección monetaria), con objeto de hacer que los pagos tributarios reflejen las variaciones sufridas en el valor del dinero.

El método de retención del gravamen en la fuente, según se explica en la Sección III, es sin duda ninguna el más eficaz para resolver el problema de recaudación del impuesto sobre la renta en una situación inflacionaria. No solamente reduce los plazos para el pago, sino que sirve también para minimizar los pagos morosos y la evasión. Se analizan distintos sistemas de retención del impuesto en la fuente, y se evalúan sus ventajas e inconvenientes. Sin embargo, la retención en la fuente no puede aplicarse a la persona que trabaja por cuenta propia, y hay que utilizar entonces un sistema de pagos corrientes basados en estimaciones. Se describen también los problemas de transición que se plantean al colocar al contribuyente en un sistema de pagos corrientes. Por último, se examina el peculiar sistema que existe en Indonesia para la retención en la fuente.

Mr. Hirao, economist in the Fiscal Affairs Department, is a graduate of the Kyoto University. He was formerly a member of the staff of the Tax Bureau in the Japanese Ministry of Finance.

Mr. Aguirre, Tax Administration Analyst in the Fiscal Affairs Department, is a graduate of the University of the Republic of Uruguay. He was formerly a member of the staff of the Income Tax Agency in the Uruguayan Ministry of Finance.

A taxpayer will pay, on average, an increased tax liability—45 per cent more than that in the previous year—in money that has 30 per cent less purchasing power; that is, he has to pay a tax that is higher by 11.5 per cent, in real value (1.451.30=1.115), for the current year.

Teruo Hirao, “Factors Affecting Elasticity of Personal Income Tax—A Case Study of Japan” (unpublished paper, June 1968), pp. 6, 7, 26, and 27.

Oscar Oszlak, “Inflation and Income Tax in Argentina” (unpublished paper submitted in April 1965 to the Seminar of the International Program in Taxation, Harvard University Law School), pp. 39—42. Table 2 of this paper shows a slight modification of Oszlak’s example.

For a further discussion on this effect, see the Appendix.

The Tokyo retail price index, converted to a 1950 base year, was as follows:

19467.91950100.0
194721.31951129.4
194862.61952125.7
1949101.8
Source: Bank of Japan, Economic Statistics Monthly, October 1966, p. 3.
Source: Bank of Japan, Economic Statistics Monthly, October 1966, p. 3.

The fiscal year in Japan runs from April 1 to March 31.

National Tax Administration Agency, Annual Report for Fiscal Years 1949, 1950, and 1951, October 1952, p. 431.

A similar observation was made by Professor Hinrichs on the Argentine tax collections. “During the past 6 years the fall in the ratio of money supply to GNP from 37 percent to 18 percent has aggravated the public finance dilemma. The other determinants already mentioned were serious problems already but the diminution in the means of tax payment undercut much of the tax collection system. Evasion has always been a serious problem in Argentina as elsewhere throughout Latin America. But the shortage of finance contributed to nearly half the deficit in 1964 being due to unpaid but acknowledged back taxes.” See Harley H. Hinrichs, “Lessons of the Argentine Revenue Sharing Experience,” in Revenue Sharing and Its Alternatives: What Future for Fiscal Federalism? (prepared for the Subcommittee on Fiscal Policy of the Joint Economic Committee of the U.S. Congress, 90th Congress, 1st Session, Washington, July 1967), pp. 571–72.

Report on Japanese Taxation by the Shoup Mission (General Headquarters, Supreme Commander for the Allied Powers, Tokyo, 1949), Vol. II, p. 217; hereafter cited as the Shoup Mission Report.

E.J. Mishan and L.A. Dicks-Mireaux, “Progressive Taxation in an Inflationary Economy,” The American Economic Review, Vol. XLVIII (September 1958), p. 591.

For example, see Oszlak, op, cit.

Oszlak, op. cit., pp. 31–35.

See pp. 289–304.

See Hirao, op. cit., p. 27. Tax cuts can be made by widening income brackets according to the price indices.

In the period of inflation (1947–50) it was fixed on January 31.

“Year of assessment” represents the Income Tax Department’s accounting year and covers a period of 12 months from April 1 to March 31.

In the United Kingdom itself, tax charged on any individual engaged in a trade or profession is payable in two equal installments, the first on January 1 in the year of assessment (which runs from April 6 of one year through April 5 of the following year), and the second on the following July 1. The tax is assessed on the income earned in the taxpayer’s accounting year ending in the preceding year of assessment. Thus the first payment is delayed between 9 and 20 months and the second between 15 and 26 months, from the closing day of an accounting year.

According to the Shoup Mission Report (Vol. IV, pp. D41 and D42), “The present income tax picture is marked by a very high delinquency rate as respects tax payments. As of 31 May 1949, the tax collections with respect to individual self-assessed income taxpayers for the taxable year 1948 were about ¥ 107,700,000,000 with a delinquency of approximately ¥ 35,183,000,000. In addition ¥ 6,570,000,000 was delinquent as respect 1947 taxes. The number of delinquent accounts was about 3½ million.

“Such a delinquency situation is very serious. Proper tax administration cannot tolerate such a heavy load of unpaid taxes. Stern efforts are necessary to reduce these delinquencies immediately. It is estimated that a considerable percentage of the delinquent taxpayers could pay if proper and effective measures to enforce payment were taken. In other cases the delinquent taxes will be found to have been improperly reassessed. Tax Office personnel should be made immediately available to work on this matter and a persistent drive made to collect the unpaid taxes and to reduce the delinquencies to a reasonable level.”

National Taxation Offices carry out, except in special instances, all the field services, such as assessment and collection of national tax.

The whole territory is divided into ten districts, each of which has a National Tax Administration Bureau. It exercises, under the superintendence of the National Tax Administration Agency, the direct guidance and control over the National Taxation Offices situated in the district. Besides, the Bureau handles directly the assessment and collection of taxes for certain taxpayers.

When a taxpayer fails to pay tax in full by the due date, the Chief of the National Taxation Office sends a notice of demand after the time limit. If the taxpayer has not paid the tax due within ten days after the notice of demand, the tax authority initiates a distraint.

The estimate of tax yield of the self-assessed income tax for the 1949 fiscal year was ¥ 170 billion and the tax actually collected was ¥137 billion; for the 1950 fiscal year, ¥ 117 billion was estimated and ¥ 93 billion collected.

When three years had elapsed with no significant changes in the taxpayer’s condition after the enforcement had been suspended, the tax liability was canceled.

Interest is sometimes charged on the period covering a statutory extension of payment, but this is not properly considered a sanction against tax delinquency.

Interest runs for the period of postponement at the rate of 2 sen per diem for 100 yen (7.3 per cent per annum) under normal circumstances. In times of tight money, the rate may be raised according to a formula linking it with the prime rate. Interest is deductible as a necessary expense in computing taxable income.

The tax authority may, at his discretion, exempt a part or all of this late payment penalty for the period of extension of payment in unusual circumstances, e.g., the taxpayer is allowed to postpone the tax payment if he suffered disaster from earthquake, flood, or fire and cannot make prompt payment.

A notice of assessment is issued when the taxpayer either fails to file a return or underreports tax.

Tokyo retail price indices rose by 169 per cent in 1947, 193 per cent in 1948, and 63 per cent in 1949.

Shoup Mission Report, Vol. II, p. 222.

International Monetary Fund, International Financial Statistics, November 1969.

It was 12 per cent a year in 1969.

Tax payment is considered voluntary if it is made before any collection proceedings have been initiated or within 10 days after the tax becomes due, even if such proceedings have been started.

By statutory interpretation, such surcharges are in the nature of an indemnification of the Treasury rather than delay penalties (Income Tax Law, Art. 22).

The Model Tax Code was prepared by three Latin American tax experts at the request of the Joint Tax Program. It was drafted after extensive consultation with other Latin American tax experts and published in 1967. Reforma Tributaria para América Latina, Vol. III, “Modelo de Código Tributario” (Programa Conjunto de Tributación OEA/BID, Unión Panamericana, Washington, 1967).

As discussed later (pp. 297–98), late payment charges should not be deducted as an expense. Therefore, comparison with the current market rate should be made in terms of their effective rates.

This interest charge refers to the charge that is a part of fiscal sanctions against taxpayers in arrears. The interest running for the period of statutory extension of tax payment should be deductible as an expense, because it is not a delay penalty but interest in the ordinary sense.

For Argentina, Professor Hinrichs observed, “During and following the period of recession, political turmoil, and uncertainty in 1962–63, much of the energy of the tax administration was shifted to arranging financial payment plans for tardy taxpayers (some payments were scheduled up to 1970) rather than in a rigorous collection of tax revenues. There has been little recourse to prosecution of tax nonpayment or outright evasion. Companies and individuals have been given financing, discounts, and/or concessions in hope of future payment rather than meaningful penalties; bankruptcy and prosecution have not been used as instruments of enforcement.” (Hinrichs, op. cit., p. 571.)

See the following subsection.

Alan Page Murray, British and American Systems of Income Tax Withholding (unpublished doctoral dissertation, Columbia University, 1961), p. 1.

The corresponding figures are approximately 73 per cent in 1968 for the United States and about 87 per cent in 1966–67 for the United Kingdom.

The term “current withholding system” is more appropriate than “withholding system” because the latter does not include the principle of current payment; in Singapore, for example, the employer is required to withhold tax in discharge of employees’ tax liabilities calculated on income of the preceding year.

The term “pay-as-you-earn (PAYE)” is not used in this paper because its meaning became vague as the system was adopted in different countries.

Murray, op. cit., pp. 51–85.

George E. Lent, “Collection of the Personal Income Tax at the Source,” The Journal of Political Economy, Vol. L (1942), p. 725. See also United Nations Department of Economic and Social Affairs, Manual of Income Tax Administration (Discussion Draft, New York, 1967).

In some countries discrimination against taxpayers subject to withholding is even more serious because the tax withheld becomes the final liability and the system is not designed with any cumulative feature. Where it provides for progressive rates, it is heavily weighed against taxpayers that have fluctuating income and/or seasonal employment.

In Argentina imprisonment from one month to six years may be imposed upon those who incur such a violation, combined with a fine ranging between one and ten times the tax withheld. The Brazilian tax law explicitly defines this violation as equivalent to the crime of misappropriation, which is also sanctioned with imprisonment according to the Penal Code.

See pp. 277–80.

See pp. 283–88.

However, experience has shown that a sharp increase in tax delinquency and an expansion of taxes in arrears almost always follow a severe inflation. There are grave doubts that the government would be capable of collecting in full the taxes for the preceding year, regardless of the collection method used.

However, if withholding covers small savers, the need to speed up refunds will pose an administrative problem.

This would not be true if income taxes from corporations were considered fully, particularly in countries where the corporate sector plays a dominant role.

Before the introduction of its present prepayment system, Japan adopted a declaration-of-estimated-tax system that lasted for only three years. Taxpayers were required to file a declaration of estimated tax for the current year and at the same time to file a return determining the final liability of the preceding year. Two thirds of the estimated tax was to be paid within the current year. The result was described as follows: “In practice, however, taxpayers in their declarations generally estimate their income far below the actual amount. As a consequence, tax collections during the year fall well below these one-third and two-third levels. Collections then rise sharply at the beginning of the next year, under the pressure of reassessments. The pay-as-you-go system is thus defeated and tax collections are completely unbalanced.” (Shoup Mission Report, Vol. IV, p. D7.)

Also, Oszlak notes: “Nevertheless, advanced payments are often delayed or simply omitted, since in most cases no penalties are applied once the final return is submitted.” (Oszlak, op. cit., p. 25.)

This will probably take the form of forgiving the previous year’s tax. Another solution would be to forgive all or part of the taxes for the year in which the tax is the lower.

Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year Ended June 30, 1943 (Washington, 1944), p. 107.

Ibid., p. 111. “… the act canceled 100 percent of the lower of the tax liabilities for the years 1942 and 1943 where that liability was $50 or less, a percentage somewhat lower than 100 percent but greater than 75 percent, where the liability for the lower year was between $50 and $66.67, and 75 percent where the liability for the lower year exceeded $66.67. In certain cases where the taxpayer had a surtax net income for both 1942 and 1943 exceeding by more than $20,000 his surtax net income for the highest of the base years selected by him, 1937 to 1940, inclusive, a smaller percentage of the lower year’s liability was canceled. … the act provided that the uncanceled 25 percent could be paid one-half March 15, 1944, and one-half March 15, 1945.”

Beginning in 1951 corporations were to speed up payments gradually over a five-year period until they were on a two-installment basis with payments on March 15 and June 15 of the following year. The transition was to be accomplished by reducing the tax paid in the third and fourth quarters by 5 per cent of the total tax liability each year, and increasing correspondingly the tax paid in the first and second quarters.

In 1955 a start was made in moving toward payments in the current taxable year by requiring corporations with income in excess of $ 100,000 to estimate their taxable income for the year and to make advance payments in September and December. During a transition period of five years each of these advance payments was to be made at 5 per cent of the current tax due for the entire year beginning in 1955 and rising by 5 per cent a year to 25 per cent in 1959 and later years.

Further acceleration of current payment started in 1964 and continued over a five-year transition period. During this period about 10 per cent of the tax was paid in addition to the normal level of tax payments.

The tax collectors are to be appointed from the following: (1) buyers, for purchases of agricultural, forestry, mining, and fishery products and handicrafts for export and interinsular commerce from producers, produce merchants, and wholesalers; (2) sellers, for sales of industrial products, handicrafts, agricultural products from interinsular trade, and estate products meant for domestic consumption to wholesalers, retailers, and consumers; (3) persons who provide services, for services rendered; (4) the Foreign Exchange Bank, for importers and exporters; and (5) government agencies, if the other party is not such an agency.

The prevailing rate scale is as follows:

CategoryPercentage or Rate
General rate2
Special rates
Sale of cigarettes by manufacturers to wholesalers0.5
Hire of films3
ExportsRp 5 per US$1
Kerosene and diesel fuel0.4
Motor oil1.0

The prevailing rate scale includes two general rates—1 per cent for goods and 10 per cent for services—and a variety of special rates according to type of business, ranging from 0.2 per cent for gasoline stations to 5 per cent for banks in the main cities.

This is the calendar year for the income tax and the accounting year for the corporation tax.

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