Mon | Jan 22, 2018

Damien King | Jamaica on the way to fairer tax system

Published:Friday | May 20, 2016 | 12:00 AM
Dr Damien King
Budget document.

Minister of Finance Audley Shaw, in his Budget presentation last week, promulgated a shift of the tax burden from income taxes to taxes on consumption, primarily on petrol and international travel.

This signals a more efficient and possibly even fairer tax system. Here's why.

The highest long-run priority in a country like Jamaica (poor and unequal) is to be able to fiscally sustain - meaning finding the revenue to pay for - government's expenditure on infrastructure, public goods and services, and social protection.

Indeed, a typical failure of poor countries is their inability to extract revenue from their economies. Typical revenue/ GDP ratio in rich countries is 25-27 per cent. In poor countries it is 18-20 per cent.

Taxing a country in which two-thirds of the population is quite poor, and so many work informally, is not easy. Forget about collecting taxes from only the one-third better-off and the formal. The burden becomes too high on that small group and you end up on the wrong side of the 'Laffer Curve', where higher tax rates actually yield less revenue.

Income tax may be an effective tax where the overwhelming majority of economic activity resides in the formal sector and, for collection, you have the capacity of an entity like the Internal Revenue Service at your disposal. However, where half of economic activity occurs in the informal sector and tax administration is vastly under-resourced, income tax is collected unevenly and arbitrarily. In Jamaica, more income tax is evaded than is paid.

Incentive to hide income

The problem is that income is just too easy to hide and, at a tax rate of 25 per cent, the incentive to do so is great. Further, there are as many points of collection as there are income earners, so the cost of monitoring and collecting is high.

The difficulty of collecting makes income tax inefficient. But it is also unfair; it is worse than regressive. Comparing the effective tax rate at different income levels is to examine 'vertical equity'.

But even worse than vertical inequity is horizontal inequity, which characterises our income tax. People with the same level of income pay vastly different tax rates - some pay 25 per cent; some pay zero. And the ones paying zero, or very little, are not only the poor. The evaders are equally distributed along the income spectrum. Income tax in Jamaica is the most unfair tax.

So when we examine the equitableness of any other tax, it should be compared to the terrible income tax.

Consumption taxes, in contrast, are much harder for consumers to evade. You do have conspiratorial cash transactions - 'if you pay cash, I won't charge GCT' - that do evade it, but that doesn't work for most kinds of purchases.

Merchants, of course, try to avoid GCT, too, but the rate, and so the incentive, is lower. Plus, there are fewer business units than workers, so auditing and collection is easier.

Sceptics are concerned, however, that consumption taxes may be regressive - such that the wealthy pay a smaller share of their income in taxes than the poor. This is not a trivial issue in a deeply unequal society in which we rely on government to mitigate historical inequities and the arbitrary distributional outcomes of a market economy.

First, consumption taxes are only mildly regressive since everyone is actually paying the same rate as a percentage of their income. Second, any regressivity in consumption taxes, that is, the extent to which they are inequitable vertically, still makes them superior to the horizontally inequitable income tax.

Third, a tax on petrol, and on energy in general, is actually likely to be more progressive than your garden-variety consumption tax, such as GCT. Petrol consumption tends to rise more than proportionally with income. The bus passenger uses a tiny amount of petrol; the 'pop down' car owner uses more, but the SUV-driving, upper St Andrew resident uses a lot. The incidence of a petrol tax on each varies accordingly.

Finally, and this may be the most important argument, welfare objectives are poorly met on the revenue side of the budget.

Targeting is difficult on the revenue side. A low consumption tax is a low consumption tax for everybody - rich and poor alike. Alternatively, welfare objectives should be pursued through the expenditure side where they can be precisely targeted, as is the case with the PATH programme and the public health delivery system. Any obligation to be progressive rests upon the entire fiscal budget, not just the revenue half.

Funding fiscal obligations is so important to a country's development that efficiency of collection should be the primary consideration.

Fairness counts, too, but the income tax fails badly on that score anyway. And, with the additional revenue from a more efficient tax, welfare objectives can be better met through targeted expenditure.

Damien King is Head of the Department of Economics at the University of the West Indies and co-executive Director of the Caribbean Policy Research Institute.