Crunching numbers on PAYE proposal
This paper represents both a quantitative and qualitative analysis of the personal income tax (PIT) reform proposal outlined in the recently published 10-Point Plan and an evaluation of their appropriateness and sufficiency. At present, the first J$592,800 of a person's annual income is tax-free. Any income in excess of this tax-free threshold is taxed at 25%.
The Jamaica Labour Party's (JLP) PIT reform proposal has three components:
I. Full exemption from income tax for persons earning income up to J$1.5m per annum.
II. Persons earning income above J$1.5m and less than J$5m per annum will continue to be taxed at 25% on their income in excess of the current tax-free threshold of J$592,800.
III. Persons earning income in excess of J$5m per annum will be taxed at the rate of 25% on their entire income (i.e., the tax-free threshold of J$592,800 from which they currently benefit will be withdrawn).
A. Do the proposed measures represent good tax policy?
It is widely accepted that good tax policy ought to reflect certain key characteristics. Two of these are equity and certainty. In terms of equity, tax ought to be imposed in a manner that is consistent with taxpayers' ability to pay, and similar taxpayers ought to be treated similarly.
The proposal as presented does not meet this first critical test. This is best illustrated by way of example.
Employees A and B work in a clothing store. Employee A earns J$1.5m per annum and Employee B earns J$1.6m per annum. The following table highlights their current and proposed after-tax incomes (ignoring other statutory deductions):
Under the current tax regime, A's and B's income tax liability is consistent with their relative levels of income. In contrast, the proposal under review results in A earning a significantly greater after-tax income than B, despite their having a higher gross salary. This is because (relative to A) B is being required to bear an additional tax liability of J$251,800 just because they earn J$100,000 more than A.
This represents a marginal rate of income tax of 252% on B's additional J$100,000 income.
The proposal in its current format is, therefore, inequitable and distortionary and would disincentivise persons earning marginally below J$1.5m from seeking additional income (whether through overtime, increased salary, bonus or promotion) as they would become worse off until their income rose sufficiently to offset the additional tax. The proposal as structured will create challenges for employers in rewarding and motivating staff and will adversely impact productivity.
By way of illustration, an employer paying a person a gross salary of, say, J$1.5m per annum, would need to pay them an increase in gross salary of over J$300,000 per annum in order increase their after-tax income by a mere J$1 per annum under the new proposal. Perversely, employees earning between J$1.5m and J$1.8m would be better off negotiating lower salaries in order to increase their after-tax take-home pay. These issues also arise for persons earning incomes below J$5m (who will enjoy the threshold) and those who earn incomes marginally above J$5m.
To address these significant inequities, a marginal relief mechanism would need to be introduced for incomes marginally above J$1.5m and J$5m, respectively. This will, however, further increase both the cost and complexity of the proposal.
B. How easily will tax authorities and employers be able to implement and manage the reformed system?
A second feature of good tax policy is certainty - the tax which each individual is required to pay is clear and certain, both in terms of amount and timing of payment. Given the challenges outlined above, the proposal is likely to create significant headaches for payroll administrators, as they will have to contend with dramatically shifting tax obligations as individual employee pay crosses the J$1.5m and J$5m levels (whether because of overtime, salary increases, bonuses, promotion, etc.); and this will all have to be apportioned, allocated and computed on a weekly/monthly basis depending on the wage payment cycle. In its current format, the proposal would create an administrative nightmare for employers and this will be further compounded where marginal relief mechanisms are incorporated to deal with the inequities noted above.
C. What is the revenue impact of the reform proposals?
Based on a 2014 dataset of PAYE taxpayers and the PAYE paid, the estimated annual cost of each component of the proposal is as follows:
The above estimated revenue loss is, however, based upon a proposed reform that would be totally impractical to implement for reasons outlined in sections I and II above (i.e., inequitable outcomes as demonstrated in Table I, as well as the dramatic shift in tax liability with which employers would need to contend). Some form of marginal relief mechanism would, therefore, be required to address the clear inequities of the proposal under review.
The effect of any such marginal relief mechanism would be to substantially increase the negative revenue impact of the proposal beyond the estimate in the table above. A marginal relief mechanism is designed to protect employees from the shock of significant inequitable additional taxation as their income crosses over the J$1.5m level (and to a lesser degree over the J$5m mark). It does this by initially capping the tax liability by reference to a formula so that the effective tax rate for increased income climbs at a steadier pace without unjustifiable leaps in tax.
It has alternatively been suggested, in order to address the inequities described in sections I and II, that the income tax threshold should simply be increased from J$592,800 to J$1,500,000 per annum.
However, it is estimated that such a proposal would cost approximately J$31.247 billion per annum, a level of revenue loss that is simply unaffordable in the context of the current economic reform programme endorsed by the IMF.
Given that the JLP proposal in its current form is unworkable, and given the unaffordability of extending a $1.5 million threshold to all taxpayers, the only practical solution, if we wish to retain the exemption of taxpayers earning up to $1.5 million, is to implement a system of marginal relief and contend with the additional cost of that relief over and above the $8.347 billion revenue loss shown in Table II. In order to model the additional revenue impact of such marginal relief, the relief mechanism for persons earning over J$1.5 million is assumed to operate as follows:
For persons earning between $1.5 million and $5 million, their income-tax liability would be calculated at the lower of:
(i) Standard tax rate (25%) X (Total income - $592,800); or
(ii) Marginal relief rate X (Total income - J$1,500,000) (this acts as a cap)
For persons earning over $5 million, tax liability would be calculated at the lower of:
(i) Standard tax rate (25%) X Total Income; or
(ii) Marginal relief rate X (Total income - J$592,800)
The table below reflects the additional cost (above the $8.347 billion reflected in Table II), and the total cost of the proposal, including marginal relief tax rates at various levels between 25% and 50%:
The chart accompanying this article shows effective tax rates by income band for each of the corresponding marginal relief tax rates used in Table III above:
As demonstrated in the chart, the higher the marginal relief rate, the steeper is the effective tax rate curve plotted against taxpayer income, and demonstrates that any marginal relief rate above 35% produces a very steep increase in effective tax rates above annual income of $1.5 million. Even at a marginal relief rate of 35%, the cost of the JLP proposal with marginal relief would be approximately $19 billion (see Table III).
Caution should be exercised at any notion that all, or a substantial part of such revenue loss, could be recouped through imposition of higher indirect taxes such as the GCT. Such a measure would result in a more regressive tax system overall because the burden of any increase in indirect taxation, and GCT in particular, would itself be disproportionately borne by taxpayers in the lower income bands, and most significantly, by the poorest members of our society.
It is also important to note that if the reform proposal is implemented in a manner which exempts emoluments of J$1.5m or below, this would also result in associated statutory deductions being foregone. Employees' and employers' statutory deductions from taxpayers earning emoluments of J$1.5m and below are estimated at J$28.444 billion in total (J$10.123 billion and J$18.320 billion, respectively).
D. In the current environment, is this proposal the best way to reform Jamaica's PIT system?
It is submitted that Jamaica's regime requires a more thoughtful and comprehensive reform:
1. The current employed labour force in Jamaica is estimated by the Planning Institute of Jamaica to be in excess of 1,100,000 persons. Based on 2014 PAYE data, fewer than 327,000 of these workers were registered for PAYE; and of those persons registered for PAYE, fewer than 214,000 are reported as earning income above the threshold and, therefore, paying any PAYE at all. This means that less than 19% of Jamaica's employed workforce pays PAYE income tax. The compliance rate for self-employed persons is undoubtedly worse.
Any PIT reform proposal should, therefore, have as its central focus the incorporation of clear measures to enhance compliance and broaden the tax base.
While it is impatient of debate that a reduction of taxes imposed on persons within the lower income bands would improve the overall equity of the tax system, if this is done without addressing the underlying compliance issues, it will result in an even smaller subset of the workforce being required to meet an undue and excessive tax burden.
If Jamaica is to be in a position to reduce taxes/tax rates, the tax base must be broadened to include more individual taxpayers who bear their fair share of the tax burden.
2. Any PIT reform needs to involve a broader reform of payroll taxes, which include education tax, NIS, NHT and HEART contributions, including:
• A review of each statutory deduction to assess whether it should be retained in its current format or whether it should be modified (e.g., whether is it appropriate to require persons below certain income levels to contribute to NHT if they cannot realistically hope to qualify for, or avail themselves of NHT loan benefits; whether education tax should be reduced and/or consolidated with income tax, whether the NIS salary cap should be lifted, etc.)
• The harmonisation of the income base of each statutory deduction retained would allow for a consolidation of same, and further reduce the administrative burden placed on payroll administrators.
The submission by the Private Sector Working Group (PSWG) to Parliament in 2012 outlined multiple policy and administrative reforms pertaining to personal income tax and statutory deductions. These recommendations (which were made in the context of an overall revenue-positive reform) should be revisited and a review undertaken to determine what more comprehensive PIT reform can be implemented within available fiscal space.