Eastern Caribbean Currency Union: Selected Issues
Author: International Monetary Fund
Publication Date:
07 Mar 2008
eISBN:
9781451811728
Language:
English
Keywords:
ISCR; CR; ECCU; exchange rate; tax; CIT competition; CIT holiday; tax harmonization; accelerated depreciation; weighted average CIT; Corporate taxes; Tax harmonization; Tax holidays; Depreciation; Caribbean
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This paper assesses the evolution of Eastern Caribbean Currency Union (ECCU) real exchange rates over time, and examines whether the region has lost competitiveness. The main finding is that there is little evidence of overvaluation of the Eastern Caribbean (EC) dollar. The relationship summarized above permits the calculation of equilibrium current account balances or norms. The financing of ECCU current account imbalances appears stable. This paper also provides evidence on the distinctive impact that tourism plays in the determination of the real exchange rate in tourism-driven economies.

Abstract

This paper assesses the evolution of Eastern Caribbean Currency Union (ECCU) real exchange rates over time, and examines whether the region has lost competitiveness. The main finding is that there is little evidence of overvaluation of the Eastern Caribbean (EC) dollar. The relationship summarized above permits the calculation of equilibrium current account balances or norms. The financing of ECCU current account imbalances appears stable. This paper also provides evidence on the distinctive impact that tourism plays in the determination of the real exchange rate in tourism-driven economies.

VI. Corporate Income Tax Competition in the Caribbean40

A. Introduction

1. Corporate income tax (CIT) competition—commonly referred to as the lowering of a country’s tax burden relative to foreign jurisdictions in order to attract foreign direct investment (FDI)—is a common phenomenon in developed as well as developing countries. As elsewhere in the world, CIT competition has intensified in the Caribbean during the last two decades. In particular, statutory CIT rates have fallen by about 30 percent on average since the mid-1980s. The main wave of reforms occurred in the mid-1990s, but the pace has continued in recent years. These reforms seem consistent with the prediction of economic theory. It has been argued that competition to attract FDI will lead to a “race to the bottom”—a term used to characterize the demise of capital income taxation as a source of government revenue. This chapter calculates average effective tax rates (AETRs) to assess whether CIT competition has eroded the tax base in the Caribbean.

2. The traditional method of measuring the impact of the CIT on firms’ investment decisions in small open economies is through the cost of capital. At the margin, the cost of capital should equal the required post–tax real rate of return on an investment project. Thus, a firm will invest up to the point at which the marginal product of capital is at least equal to the cost of capital—so that, at the margin, the project just breaks even. Typically, firms are assumed to be mobile and able to raise capital on the world market. In this framework, taxes push up the cost of capital and, therefore, act as a disincentive to invest.

3. The average effective tax rate is appropriate for assessing the impact of CIT competition on revenue. Two measures widely used to analyze the impact of taxes on investment decisions are marginal effective tax rates (METRs) and AETRs. Although the METR is widely reported in the literature, it is only appropriate for analyzing whether the threshold for profitability has been shifted by the tax system—i.e., it relates to projects that just break even. The AETR, developed by Devereux and Griffith (2003) and summarized in Box VI.1, is a more relevant measure for assessing the impact of corporate tax reforms on revenue because it is defined for different levels of expected economic profit, allowing an impact analysis varying with the profitability of the investment.

The Model1

Equation(1)METR=phat−rphat, and
Equation(2)AETR=(phatp)METR+(1−phatp)T; where
Equation(3)phat=(1−A)(1−τ)(1+π){ρ+δ(1+π)−π}−δ,
Equation(4)A=τφ{1+(1−φ1+ρ)+(1−φ1+ρ)2+...}=τφ(1+ρρ+φ, and
Equation(5)T=1−γ(1−τ)(1+r)(1+π)1+ρ, whereγ=(1−mD)(1−c)(1−z), and ρ=(1−mD)i1−z.

A is net present value of allowances per unit of investment; δ is the economic rate of depreciation; τ is the statutory CIT rate; T is the statutory CIT tax rate adjusted for personal taxes; r is the real interest rate; γ is a discrimination factor between distributed and retained earnings; ρ is shareholder’s discount rate; ф is the rate at which capital expenditure can be offset against tax; mD is the personal income tax rate; z is the capital gains tax; c is the investment tax credit; α is the inflation rate; and i is the nominal interest rate. In addition, p is defined as the pre-tax rate of return on a project, over and above the rate of depreciation; and phat is the minimum acceptable value of p that makes an investment break even.

The two elements of equation (2) reflect the two extremes of the distribution of acceptable investment projects. For a marginal investment, p = phat: hence AETR = METR. At the other extreme, for a very profitable investment, as p →∞,AETR.→ T. T differs from the actual statutory tax rate only because of personal taxes. In the absence of personal taxes, 1 + ρ + 1 +i = (1 + r)(1 + α) and γ = 1, implying that T = τ The intuition is that for very profitable investment projects, allowances become insignificant and the only relevant factor is the rate at which income is taxed.

1/See Nassar (2008) for additional details.

4. This chapter analyzes trends in AETRs for 15 countries in the region over the last 20 years. The objective is to answer the following questions: (i) what is the impact of CIT competition on the ability to tax corporate income in the region?; (ii) what impact will recent tax policy proposals (i.e., accelerated depreciation, loss carry forward provisions, and tax harmonization) have on tax revenue?; and (iii) how can the tax base be broadened? The chapter finds evidence suggesting that the use of CIT holidays has eroded the tax base and that they must be removed for recent tax policy initiatives to be effective. These findings suggest that the authorities should either avoid granting CIT holidays or rely more on consumption taxes in order to broaden the tax base.

B. Background and Motivation

5. Tax concessions are a common feature of tax regimes in the Caribbean. Since the early 1980s, governments in the Caribbean have faced the challenge of promoting economic diversification from agriculture (bananas and sugar) to tourism. As a result, many of the countries have run fiscal deficits to provide the supporting infrastructure, contributing to a large debt overhang. However, the use of tax incentives (including the widespread use of tax holidays) continues to limit the ability of governments to raise revenue.41 For example, the corporate tax structure of countries in the region is characterized by base erosion resulting from many special allowances and high standard deductions (allowed for different amounts of investment), and by the failure to tax large enterprises which would have been profitable even without tax incentives. In addition, there is anecdotal evidence suggesting that tax holidays doled out to large domestic and foreign investors led to pressures from small investors for similar treatment. As a result, the corporate tax system has become complex, and its ability to raise revenue in an equitable and a less distorting manner impaired, which further perpetuates tax avoidance and tax evasion.

C. Related Literature

6. The public finance literature is replete with arguments for and against tax competition. According to one school of thought dating back to the classic analysis of Tiebout (1956), tax competition among jurisdictions leads to an efficient provision of public goods and different equilibrium tax rates. A second school of thought that dates back to Oates (1972) touts a contrary view. According to this school, tax competition for mobile capital could lead governments to adopt inefficiently low corporate income taxes and, as a result, provide a sub-optimal level of public goods. Yet others argue that international competition affects investors differently, and that this creates the opportunity for governments to design tax systems that tax relatively immobile capital more than mobile ones.

7. The Caribbean region offers a “natural experiment” for testing the arguments just outlined. First, the 15 countries studied are mainly small islands that promote tourism as a development strategy. Second, with few exceptions, they are all endowed with sand, sea, and sun—i.e., they are close substitutes. Third, they all vie to lure brand products in the hotel industries in North America and Europe—thus, capital is relatively mobile. It is, therefore, highly likely that the empirical findings in the Caribbean would be stronger than elsewhere.

8. The literature on CIT competition in the Caribbean is relatively new but growing. Bain (1995) analyzes the revenue implications of tax concessions in the ECCU, concluding that considerable revenue is foregone. Chai and Goyal (2006) estimate forgone revenues at about 9 percent of GDP per annum in the ECCU. Alcock (2003) finds that the impact of tax harmonization in CARICOM states is mixed.42 Nallari (1998) and Sosa (2006) adopt the METR approach to the case of Belize and the ECCU, respectively. Sosa shows that with tax holidays the tax burden on investment either disappears or becomes negative.

D. Developments in Statutory Corporate Income Tax Rates and Bases

Corporate income tax rates

9. The data show that CIT competition is indeed a worldwide phenomenon. The sources of the data are Bain (1995), PriceWaterHouse&Coopers (various years), and Worldwide Corporate Tax Guide by Ernst and Young International (various years). Figure VI.1 shows the CIT rates for each country, along with the average for the region, as well as the average for the OECD and Asian countries. Between 1985 and 2005, statutory CIT rates fell in all countries in the Caribbean, except for The Bahamas, which kept its rate unchanged at zero. In 2005, CITs in the Caribbean ranged from a minimum of zero percent in The Bahamas to a maximum of 45 percent in Guyana. The average CIT rate for the region was only marginally higher than the average for the OECD and Asian countries, indicating that there was indeed downward pressure on CIT rates worldwide.

Figure VI.1.
Figure VI.1.

Caribbean: Statutory Corporate Income Tax

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

10. In the Caribbean, larger countries are much more aggressive at cutting CIT rates than smaller ones. The time series of the average and the weighted average CIT (weighted by GDP, measured in U.S. dollars) for all countries in the Caribbean show a steady decline in average CIT rates during the period 1985–2005 (Figure VI.2). The weighted average follows a similar pattern, though with a slightly steeper fall during the late 1980s and early 1990s, indicating that the larger countries cut their tax rates by more than the smaller ones. In addition, the dispersion of CIT, measured by the standard deviation, has narrowed since 1994, implying that CIT rates have begun to converge.

Figure VI.2.
Figure VI.2.

Average Statutory Corporate Tax Rates

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

Note: The shaded band around the average rate represents ±1 standard deviation.

The tax base

11. The definition of the corporate tax base in the Caribbean is complex. In line with the empirical literature, this section focuses on depreciation allowances for capital expenditure in analyzing the tax base. The allowed depreciation rate depends on the type of asset; for example it varies between 4 and 10 percent for buildings. In addition, in some cases there are initial allowances ranging from 10 percent to 40 percent, which are not deducted from the initial investment (Table VI.1). Figure VI.3 shows the present discounted values (PDV) of such allowances for investment in buildings, expressed as a percentage of the initial cost of the asset. The PDV would be zero if there were no allowances at all, but would be 100 percent if the total cost of an asset could be deducted from taxable profits in the year in which it is incurred.

Table VI.1.

Caribbean: Depreciation Allowances for Buildings

(In percent)

article image
Sources: Bain (1995); and Worldwide Corporate Tax Guide (various years).
Figure VI.3.
Figure VI.3.

PDV of Depreciation Allow ances

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

Source: Author’s calculations.

12. Surprisingly, most countries have left their tax base unchanged for over 20 years. The PDV of allowances for each country in 1985 and 2005 is based on a single nominal discount rate for all countries and for all years (13½ percent, reflecting 3½ percent inflation, and 10 percent real discount rate). A fixed discount rate for all countries allows one to abstract from changes in the inflation rate and the real interest rate and to focus on changes in the rates of allowance set by governments. While eight countries have left their tax base unchanged, seven have increased their depreciation allowances for investment in buildings—that is, they have narrowed their tax base—notably, Barbados and St. Lucia. This finding is in line with Keen and Simone (2004), who find that industrialized countries have reduced their CIT rates and broadened their tax base, while developing countries reduced their CIT rate but narrowed or left their tax base unchanged.

13. There is no evidence that inflation expectations have played a role in determining the tax base. To examine whether governments have adjusted their depreciation allowances in response to observed or expected changes in inflation (which has generally fallen over the period analyzed),43 we present the time series of the mean PDV of allowances assuming constant and actual inflation (Figure VI.4). Surprisingly, the spread between the two PDVs has remained relatively stable, with both measures rising slightly over time. Lower inflation accounts for the tighter spread observed during the periods 1986–87 and 1997–2002.

Figure VI.4.
Figure VI.4.

Average PDV of Depreciation Allowances

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

E. Evolution of Effective Tax Rates

Marginal effective tax rates

14. The METRs show that tax reforms have contributed to an investor-friendly environment in the Caribbean. The base case for the effective tax rates is assumed to be an investment in buildings, financed by new equity. Figures VI.5 and VI.7 show the development of METRs over time. Holding annual inflation constant at 3.5 percent and assuming no personal taxes, Figure VI.5 shows that the METR has declined for all countries, except The Bahamas, suggesting that the threshold for investment projects to be profitable has been shifted downward. Furthermore, the effective tax rates remain lower than the CIT rates (Table VI.2), indicating that the tax base favors investment.

Figure VI. 5.
Figure VI. 5.

Caribbean: Marginal Effective Tax Rates

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

Table VI.2.

Caribbean: Comparison of CITs, METRs, and AETRs

(Excluding personal and capital gains taxes)

article image
Sources: Country authorities; and Fund staff estimates.

Average effective tax rates

15. The emerging trend is that CIT reforms favor investments that break even more than profitable ones (Figures VI.6 and VI.7). In each case, following Devereux et al. (2003; and 2004), the investment project is assumed to have an expected real rate of economic profit of 30 percent (i.e., p-phat = 0.30).44 Figure VI.6 shows that, holding inflation constant, AETRs have declined in all countries, reflecting the pattern observed in the statutory tax rates. The evolution of both the AETRs and METRs in the Caribbean indicate that the latter have declined by more than the former (Figure VI.7), suggesting that the tax burden on less profitable investments has fallen by more than that on profitable investments.

Figure VI.6.
Figure VI.6.

Caribbean: Average Effective Tax Rates

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

Figure VI.7.
Figure VI.7.

Effective Tax Rates for Buildings

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

Sources: Country authorities; and Fund staff estimates.

CIT holidays

16. Results show that tax holidays have eroded the tax base. As mentioned earlier, governments in the Caribbean have also resorted to widespread use of CIT holidays, which have been granted, in many cases, for periods exceeding 20 years. To assess the impact of tax holidays, we set the statutory CIT rate (τ) equal to zero.45 This implies that the net present value of allowances, A (Box VI.1 equation (4)). It can be shown that the minimum acceptable pre-tax rate of return on a project (phat) equals the real interest rate (r) (equation (3)); therefore, METR = 0 (equation (1)). Similarly, the adjusted statutory tax rate 0 = T (equation (5)), because we assume no personal taxes (i.e., the discrimination factor between distributed and retained earnings γ = 1); therefore, AETR = 0 (equation (2)). Figure VI.8 confirms this outcome. In other words, tax holidays have eroded the tax base, which suggests that the “race may have already reached the bottom” in the Caribbean.

Figure VI.8.
Figure VI.8.

Caribbean: Average Effective Tax Rate on Investment, 2005

(In percent)

Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A006

17. Recognizing that tax holidays are a permanent feature of CIT regimes in the Caribbean, we now analyze recent tax policy proposals in the region (i.e., accelerated depreciation, loss carry forward provisions, and tax harmonization). First, we consider accelerated depreciation. We do so by imposing a higher rate at which capital expenditure can be offset against tax ф, say ф = 0.10, 46 which allows companies to capture the tax savings on their investment earlier rather than later. The immediate impact of this measure is to increase A (equation (4)); but A = 0, due to CIT holidays. This implies that accelerated depreciation will have no impact on the framework. Second, we consider loss carry forward provisions, which amount to allowing firms to write off their before-tax profits against past losses within a specific period of time. Recall that tax holidays are granted for periods exceeding 20 years, while the economic life of the asset (buildings) is 25 years. This essentially means that companies will pay no taxes during the life of their investment. In other words, CIT holidays must be removed for loss carry forward provisions to have a discernible impact on revenue.

18. Finally, we consider whether convergence in CIT rates (tax harmonization) could prevent a race to the bottom. While the model presented in Box VI.1 suggests that the rate at which corporate income is taxed is relevant for location decisions for very profitable investment projects, Chai and Goyal (2006) show that, even with tax holidays, the Caribbean’s share of worldwide foreign direct investment (FDI) has declined over the last two decades. This suggests that even if tax incentives are effective in attracting investment to individual countries within the region, they are ineffective in attracting investment to the region as a whole, since this may be determined more by nontax characteristics. In this case, total FDI may be considered CIT inelastic, which implies that tax harmonization could lead to higher taxation of corporate income. However, there are several reasons why tax harmonization may not be achieved in the Caribbean. The main drawback is the widespread use of tax holidays. Second, as Klemm (2004) demonstrates, tax harmonization, to be effective, requires convergence in both the CIT rate and the tax base. The sheer administrative burden that this entails makes such an outcome uncertain.

19. The loss of revenue from corporate income tax raises the question of how to broaden the tax base. The foregoing arguments suggest that a policy choice is to avoid granting CIT holidays and broaden the tax base to offset the downward pressure on statutory CIT rates. A second option is to recover the foregone revenue from alternative sources, such as taxes on domestic consumption—i.e., the value-added tax (VAT)—given that many countries in the Caribbean have begun to implement a modern VAT regime.47 In this case, it would be important that the integrity of the VAT be preserved through limited exemptions and a single VAT rate, to ensure that the tourism sector does not use highly-taxed inputs to produce lightly-taxed outputs.

F. Concluding Remarks

20. This chapter uses the AETR approach to analyze corporate income taxation in 15 countries in the Caribbean over the period 1985–2005. It finds evidence suggesting that METRs have declined by more than AETRs, suggesting that the tax burden on less profitable investments has fallen by more than that on profitable investments. Although this outcome has made the tax systems as generous as those in industrialized countries, countries in the Caribbean have also resorted to the widespread use of tax holidays, which have eroded the tax base.

21. The chapter also analyzes the impact of recent tax policy proposals for countries in the Caribbean—i.e., accelerated depreciation, loss carry forward provisions, and tax harmonization. It finds that CIT holidays need to be removed for these policy measures to have discernible revenue gains. The authorities are faced with the choice of not granting tax holidays, or relying more on consumption taxes in order to broaden the tax base. Thus, in the presence of CIT holidays, it is important that the integrity of the VAT be preserved through a single rate with limited exemptions.

References

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  • Bain, L., 1995, “Tax Concessions and Their Impact on the Revenue Base of the ECCB Territories,” mimeo, Eastern Caribbean Central Bank.

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40

Prepared by Koffie Nassar.

41

Available data show that average corporate tax revenues as a share of GDP for the region have remained stable since 1990. See, for example, Chai and Goyal (2006) for an overview of tax concessions in ECCU.

42

CARICOM states include Antigua and Barbuda, The Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname and Trinidad and Tobago.

43

Note that allowances are based on the nominal cost of an asset. As a result, they are worth less during periods of high inflation.

44

The same assumption is made in the literature for countries in Europe. See Nassar (2008) for additional details.

45

Note that this assumption is consistent with the anecdotal evidence suggesting that small, domestic and lessprofitable investors clamor for similar treatment to large, foreign, and more-profitable investors.

46

Note, however, that The Bahamas has the lowest depreciation rate, which is zero.

47

In the ECCU, VATs have recently been introduced in Dominica, Antigua and Barbuda, and St. Vincent and the Grenadines.

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Cover IMF Staff Country Reports
Eastern Caribbean Currency Union: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2008: Issue 096
Publisher:
International Monetary Fund
ISBN:
9781451811728
ISSN:
1934-7685
Pages:
102
DOI:
https://doi.org/10.5089/9781451811728.002

Caribbean: Statutory Corporate Income Tax

Average Statutory Corporate Tax Rates

PDV of Depreciation Allow ances

Average PDV of Depreciation Allowances

Caribbean: Marginal Effective Tax Rates

Caribbean: Average Effective Tax Rates

Effective Tax Rates for Buildings

Caribbean: Average Effective Tax Rate on Investment, 2005

(In percent)