Tax system change: The 4 arrows

MANILA, Philippines – “Change is coming” has become a popular mantra with the landslide election victory of Davao Mayor Rodrigo Duterte as the nation’s next president. It is a “vote for systemic change” said Calixto Chikiamco, noted economist and president of the Foundation for Economic Freedom (FEF), while Greek philosopher Heraditus said, “The only thing constant in this world is change.” So change we must.

The incoming administration appropriately listed tax reform among its top economic agenda. But what form will this change be? In response to widespread clamor from both legislators and taxpayers, proposals in the main will reduce the tax bite by tweaking corporate income tax rates lower and raising taxable income threshold of individual taxpayers to compensate for inflation. These measures will lighten the tax burden and remove a source of grievance, but they will not amount to systemic change or be sufficient to address the infirmities in the tax system.

Bold yet prudent

Reform must bring about long-term sustainable improvement to the fiscal position of the government by addressing the root causes of low taxpayer compliance. Reform must conform to local realities and respond to the high expectation for change. Consistent with the reformist character of the new administration, reform must be bold and innovative, not bound by the conventional or the orthodox, while being prudent and measured to prevent fiscal shock. To achieve this requires a proper understanding of the tax system and its inherent problems, and the formulation of appropriate corrective measures.  

Four reform arrows

For long-term sustainability, tax reform must achieve the following objectives: enhance equity, expand the tax base while spreading the tax burden, spur investment, lower administration and compliance cost, encourage voluntary compliance and, ultimately, raise higher tax revenues. 

Change must come with a complete package consisting of four components or the four arrows of reform, thus:

1.) Replace the income tax with a tax on gross revenue or GRT with certain exceptions

2.) Repeal the value added tax and revert to the simple sales tax

3.) Tax amnesty

4.) Repeal the bank deposits law for both domestic and foreign currencies.

All the four tax reform arrows must be implemented with income tax and VAT system change as preconditions for tax amnesty. Lifting bank secrecy will be the last of the package, but a necessary and inevitable step to bring the Philippines, being one of only two with such secrecy, into the mainstream of universal banking practices. Repealing bank secrecy without tax amnesty will require more prisons to be built to accommodate the hundreds of thousands of taxpayers that will be found afoul of tax laws.

Unresponsive tax system

The 1997 amendment of the tax code was billed “comprehensive tax reform.” There is no question the tax code is the product of the collective and brilliant minds in both the legislative and executive departments spanning many administrations. Yet it is a fact that the system with its mind boggling gamut of taxes and complexity does not yield sufficient tax revenues to cover expenditures or provide resiliency to compensate for exigencies.

Chronic fiscal deficits and complicated tax system

Chronic fiscal deficit was and continues to be the norm, with the deficits covered by borrowings. Consequently, the national government debt has tripled from P2.06 trillion in 2000 to P5.955 trillion at the end of 2015.

Tax revenue measured as a percentage of gross domestic product (GDP), or tax effort, dropped from 15.4 percent in 1997 to a low 11.8 percent in 2004, prompting a group of economists of the University of the Philippines to warn the country was on the “cusp of a fiscal crisis.” In 2006, tax as a percentage of GDP rose to 13.7 percent before making another drop to 12.1 percent in 2010 then rising from there to 13.7 percent in 2015.  The two turnarounds from the 2004 and 2010 bottoms were due to new tax revenues from the implementation of the expanded value added tax (E-VAT) in 2005 and sin tax reform on tobacco and alcohol products in 2012.

On the other hand, the decline from the high in 1997 were due to drastic tariff reform that decimated customs revenues, the economic recession that was an offshoot of the 1997 Asian financial crisis, and changed economic structure with a large tax exempt sector and inherent infirmities in the tax system. 

For instance, taxpayers are expected to voluntarily pay taxes, yet the system is structured such that it is difficult to comply compared to ASEAN peers and is one of self-assessment designed to fail.  Taxpayers are expected to voluntarily declare their income and pay taxes under a system characterized by complexity, onerous tax rates, inequitable structure, opportunities for discretion, narrow tax base carrying the burden, high administrative and compliance cost, and all of these infirmities against a backdrop of wastefulness in government expenditures.  Large enterprises have higher administrative capability and capacity to bear the cost of compliance, yet 96.6 percent of registered companies are classified as micro, small and medium enterprises.  These companies, who are subject to the same tax laws and regulations, do not have the capability and capacity to navigate and comply with the complex Tax Code and numerous Revenue Regulations.

The current tax on net income is a complicated multi-step calculation to arrive at the bottom line or the net income subject to tax. The bottom line is influenced by three factors – sales or revenue, cost of sales and operating expenses, all of which are subject to discretion on both sides - taxpayer and administrator that presents opportunities for corruption.

As a result, the BIR plays cops and robbers with taxpayers to the discomfiture of the latter.  Further, the Philippines ranks a very low 136 compared to 5 for Singapore, 31 for Malaysia and 70 for Thailand in terms of tax compliance.  It is easiest to pay taxes in Singapore, which is ranked number 2, followed by Malaysia with a 5 ranking and Thailand ranked 10 compared to the Philippines with a ranking of 20 in the 2015 Ease of Doing Business survey of the World Bank. 

GRT: The first arrow

The concept of a tax on gross revenue is not new. It is currently employed by the national government, albeit in a limited way, as a non-transferable direct tax on the income recipient. Some examples are the final percentage transaction tax on sale of listed shares of stocks, capital real property, corporate cash dividends and interest income. The GRT is employed at the local level and is a principal source of tax revenue.  In addition to the simplicity of the GRT, it may be devised to provide a monthly tax revenue stream to meet expenditures unlike the income tax, which is due quarterly as interim payments or annually with a final return. GRT rates, necessarily, must be progressive in accordance with ability to pay as mandated by the Constitution. A single or flat rate for all will not work. 

In lieu of the income tax, a gross receipt tax or tax on gross income will reduce this 3-step computation to just one – revenue or the top line. Cost of goods sold, at best a tricky calculation, will become irrelevant. The same is true for operating cost and expenses. The singular focus will be on revenue under the GRT as explained in my articles “Simplifying the tax system: The way to go” in Aug. 16, 2010 and “Simplifying the tax system redux” in Aug. 18, 2014.

Safeguards with calibrated application

Prudence dictates that measures must be taken to prevent fiscal shock from revenue slippage when any new tax system is introduced. Industry or sectoral benchmarking, which had guided the setting of withholding taxes, and historical data will help ensure GRT rates will be closer to the mark. Prior to implementation, GRT rates may be back tested against prior year’s data to validate them. An added safeguard is to impose the GRT rate or the prior two year’s average effective income tax rate, whichever is higher. 

Phased implementation

Again, for prudence sake implementation may be in three phases. Initially, or the first phase, may cover all micro and small enterprises or those with annual revenues below P120 million. This is the sector least capable of complying the income tax. The second phase may cover all medium enterprises with annual revenue of, say, P500 million and below, and, after an intervening period for evaluation and fine tuning, all other enterprises. Necessarily, exceptions or a choose and stay option with no switching allowed within a prescribed period of, say, three fiscal years, may be granted to new businesses or startups and loss-making businesses. Multinationals and listed corporations, by necessity, shall continue with the income tax with income statement reports pursuant to tax treaties, reportorial requirements of the Securities and Exchange Commission and for transparency to their shareholders. 

Consumption tax reform: 2nd arrow

The tax on consumption is the second largest source of domestic tax revenues next only to the income tax. It takes the form of a universally used system - value added tax with a flat rate levied on consumption of goods and services at all stages of the supply chain, from importers, manufacturers to wholesalers and retailers. Similar to the income tax, the VAT is complicated and tedious. It requires a transaction-by-transaction computation to account for the tax credit or input VAT that lessens the tax liability, has a high cost of compliance that handicaps small and medium enterprises in addition to being susceptible to manipulation. The sales tax is more suitable to local conditions as a replacement to the VAT. Similar to the tax on gross revenue, the sales tax is a one-step method that is simple to implement and comply. Cross-checking mechanism, which is purportedly the strong suit of the VAT, is similarly available as under existing Quarterly Summary List of Sales and Purchases (SLSP) regulation of the Bureau of Internal Revenue, sales and purchases beyond a threshold must be reported. Tax cascade, which is inflationary, may be avoided with lower rates down the supply chain.  The sales tax may be repugnant to those bound by dogma. In which case, the VAT may be continued, but simplified for MSMEs by allowing a scheduler presumptive input VAT credit that may range from 50 to 90 percent.     

Tax amnesty: Third arrow

What? Again? Yes, again, but this time it must be done as the third arrow and only after income and consumption taxes have been revamped and simplified with lower rates. The objective of the amnesty must be to enlarge the tax base by bringing untaxed wealth to the surface for investment to expand the economy. Previous tax amnesties did not achieve this objective as the tax system remained untouched with its onerous rates and complexity that nurtured the old ways. Pragmatism must prevail. Foreign direct investment has proven elusive and an unreliable source, while hot portfolio money flow in and out in a flash. The domestic banking system, on the other hand, is awash with liquidity. With tax amnesty, a large part of this domestic liquidity will be unleashed for investment.  To encourage compliance, amnesty must be simple to comply with the amnesty tax rate kept nominal as the objective is not to raise one-shot revenue, but recurring tax revenue from an expanded tax base, higher sustainable economic growth and with it, new jobs.

Lift bank deposits secrecy: Fourth arrow

The Philippines is reportedly the only one of two countries still maintaining secrecy of bank deposits. As the fourth reform arrow, R.A. 1405 and 6426 must be repealed to lift secrecy of both domestic and foreign currency deposits, but this must be done with prospective application after the first, second and third reform arrows consisting of tax on gross revenue, sales tax and tax amnesty, have been instituted. Unless the preconditions are met, the government will have to build more prisons to accommodate the legions that may be found afoul of tax laws.    

Other measures

The reform tide must touch other parts of the tax code. For instance, there is the tax rule that makes a distinction of real property, classifying one class as capital asset subject to a final 6 percent capital gains tax regardless whether a gain or loss is realized upon disposition. The other is the ordinary asset classification the sale of which is subject to the 12 percent VAT and a withholding tax of 5 percent with a final annual return requited for the net gain subject to the income tax that may vary, presently, from 30 percent for corporations and 32 percent for individuals. Distinction such as this with such a great disparity in tax treatment provides opportunities for evasion and corruption, aside from being a disincentive to sell. Another is the estate and donor’s tax, which are honored more in their breach due to its high 20 percent tax. The great differential of this death” tax with the 6 percent capital gains tax gives rise to transfer in contemplation of eventual death as part of estate planning. The pragmatic solution is to unify the tax on all these assets subject to the same 6 percent final tax.  This reform will eliminate corruption and likely raise revenue collection.

The choice is clear. We have tried the complex with little success if it can even be called that. Why not give taxpayers a chance for a clean start with tax system change? Now is the opportune time to do it.

(The author is a member of the Board of Governors of the Management Association of the Philippines (M.A.P.), member of its National Issues Committee and chairman of the National Affairs Committee of the Financial Executive Institute of the Philippines (FINEX), a C.P.A. and property developer. Feedback at [email protected].)