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Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 11

Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 11. Topics to be covered: Incidence of Corporate Income Tax Closed Economy Open Economy, Traded Sector Taxed Open Economy, Non-traded Sector Taxed Open Economy: Two traded and Two non-traded sectors Inflation as a Tax

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Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 11

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  1. Updated: 8 Feb 2012ECON 635: PUBLIC FINANCELecture 11 Topics to be covered: • Incidence of Corporate Income Tax • Closed Economy • Open Economy, Traded Sector Taxed • Open Economy, Non-traded Sector Taxed • Open Economy: Two traded and Two non-traded sectors • Inflation as a Tax • Impacts on Indirect Tax • Indirect Tax on a Unit Tax Basis • Impact on Personal Income Tax • Effects on Deductions • Taxation of Interest Income • Income on Corporate Income Tax • Depreciation • Cost of Goods Sold • Interest Deductibility • Collection Lags and Tanzi Effect 0

  2. Incidence of Corporate Income Tax • The corporate tax burden will be ultimately borne by labor and capital in the economy. To analyze the burden shared by these two sectors, some specific cases of closed and open economies are considered in this section. • Closed economy. Capital not mobile, goods not traded. • Open economy. Capital mobile, goods traded. • When the economy is open, the return to capital or price of capital will not change because capital can move out. Similarly, for traded goods, the price is determined in international markets and cannot be changed by domestic policies. 1

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  12. Taxing Mobile Capital at Labour’s Peril

  13. Introduction • This study is concerned with the impact of the WTO regulations that require the removal of the exemption from corporation income relief that some countries give to firms operating in export processing zones. • These regulations are part of the WTO’s Agreement on Subsidies and Countervailing Measures and it directly affects the operation of Export Processing Zones (EPZ). 12

  14. Introduction (cont.) • According to WTO rules, if there is a corporation income tax exemption of firms operating in EPZs or FTZs, it constitutes an export subsidy. • In the Dominican Republic, the firms operating in its FTZs are exempted from the corporation income tax, and therefore, consistent with the WTO they are recipients of an export subsidy. • In the case of the Dominican Republic, about 85 percent of the country’s total exports are produced in the FTZs World Trade Organization (1994), “Agreement on Subsidies and Countervailing Measures”. 13

  15. Model • The WTO insists on the imposition of the corporate tax on firms operating in the FTZs in order to create a non-discriminatory tax environment with respect to exports. • We begin our analysis by taking the existing pattern of taxes as given, and now apply the same corporation income tax system incrementally to firms operating in the free trade zones that were previously exempted from the corporation income tax 14

  16. Model (cont.) • The key assumptions of this analysis are as follows: • Capital is set to be perfectly mobile and its net of tax return is fixed by the international capital markets. • The prices of traded goods are set by the international market and cannot be changed by any single country. • The prices of non-traded goods are determined by their demands and supplies in the domestic market. • Labour supply is limited and not mobile across countries. 15

  17. We can classify the industries in the DR into these broad categories. The three sectors are defined as follows: • Traded Taxed: all companies operating in the FTZs (Type Z firms) that will now have the corporation income tax levied on their profits under the new WTO rules. • Traded Non-taxed: all those companies that are operating outside the FTZs, but whose workers have similar skills to those working in the FTZs and where production is traded internationally. • In the case of the Dominican Republic this sector consists mainly of the tourism (Type H firms) and • import substitution activities (Type I firms). • Non-traded Non-taxed: employs similar types of labour skills as the FTZs, but its output is not traded internationally. • includes domestic services, transportation, bars and restaurants, and • the manufacturing of non-traded domestic goods (Type NT firms).

  18. Under these assumptions, when a corporate tax is imposed on the FTZ corporations, there can not be a change in the net of tax return to capital. • The prices of the tradable goods these firms produce will not adjust to accommodate the higher cost of capital because these prices are set in the international market • (The items produced in the FTZs of the Dominican Republic are mainly garments and electronic goods). • Hence, capital (firms) will simply move out of the FTZs in the DR to seek investments elsewhere that will yield its “normal” return. • If labour is not internationally mobile, the reduction in its demand will result in a decrease in the wage rates for these types of labour skills across the entire labour market of the DR

  19. In this situation the net of tax rate of return on capital will again be restored to its “normal” international competitive level when the full burden of the corporation income tax imposed on the FTZ firms will be borne by the labour employed by the same FTZ firms. • This relationship can be expressed as, • TKZ KZ = ∆ PL LZ → ∆ PL = TKZ KZ / LZ (1) • Where KZ and LZ are the amount of capital and labour employed in the FTZs. • TKZ is the rate of corporation income tax paid per unit of capital in the zones, and • ∆PL is the change in the wage rate paid to the types of labour employed in the zones.

  20. The non-traded non taxed sector will also employ some of the same types of labour whose wages have been depressed. • In this case, the fall in the wage rates will lower their cost of production, hence inducing an increase in the supply of non-traded goods. • This increase will lead to a fall in the price of non-traded goods (PNT), and the quantity consumed of these items will rise. • If the firms in the non-traded sector are competitive, we can assume that the industry is characterized by constant marginal costs, hence, the change in the price of non-traded goods and services times the quantity supplied (QNT) , must be equal to the fall in the wage bill for that sector. • This relationship can be expressed as: • ∆ PL LNT = ∆ PNT Q NT (2)

  21. Tradable goods sector operating outside of the zone, can be broken into three components: • agriculture, tourist hotels, and import substitution manufacturing. • As the agricultural sector in the Dominican Republic obtains much of its labour from temporary workers from Haiti, the assumption is made that this labour is not substitutable for the types of labour used by the FTZs and hence the sector is not affected by the changes in the wage rates of the zone employees. • Workers in the tourism industry have basically the same skill mix that one finds employed in the FTZs, therefore, it is expected that as the wages are reduced in the FTZ they will also fall in the tourism sector (H). • This sector in the Dominican Republic has not only labour and capital in its production function but also land (B) that is particularly suited for the production of such services, i.e. beach front properties. This type of land is in limited supply.

  22. Price of land is PB and • the amount of beach front land employed by the tourism sector is BH , • then the relationship between the change in the price of labour ∆ PL and the change in the price of land, ∆ PB can be expressed as, • ∆ PL LH = ∆ PB BH (3) • Import substitution firms (I) operate almost entirely outside of the FTZs. • labour costs for these firms would fall by ∆PL LI , • where LI is the quantity of labour employed in the domestic production of importable goods. • The reduction in labour costs is assumed to accrue infra marginally to the owners of these production facilities.

  23. Over the entire economy the loss to labour can be expressed as, • Labour Loss = ∆ PL (LZ + L NT + LH + LI ) (4) • Increment corporate income tax (1) is equal to • Tax revenues = TZ KZ (5) • Labour’s share of burden= ∆ PL (LZ + L NT + LH + LI )/ TZ KZ • As ∆ PL L Z = TZ KZ • labour’s share of burden can be expressed as, • Labour’s share of burden= 1+ ( L NT + LH + LI )/ L Z(6) • It is clear from (6) that through the reduction in wage rates, labour must bear more than 100% of the burden of the corporation tax revenues collected from the firms operating in the FTZs.

  24. Empirical Analysis • The rate of income tax for taxable corporations in manufacturing, utilities and selective services in the DR is 25%. • An exemption is given to the firms operating inside the FTZs. We want now to examine the effect of this tax measure on labour income and the prices of other goods and services produced in the country if it were removed. • Until the present time, no records have been kept of the corporate profits generated by the firms operating in the FTZs. 23

  25. Estimation of The Potential Taxable Income of Corporation Operating in the FTZs. • Value added of Capital (VAK) for firms in FTZs = Exports of Firms – Imports – Purchase of Domestic Inputs – Cost of Labour – Overheads –Depreciation Allowances • Taxable Income for FTZ firms = VAK – Interest Expense 24

  26. Labour’s share of the Burden of Corporation Tax on FTZs 26

  27. Consequences of FTZ Corporate Income Tax on Industries outside of Zones 27

  28. the effect of changes in the price of labour on the price of the output of an industry can be expressed as, • Savings SiL,. Hence, the real income of labour of type j is expressed as,

  29. From Table 10 we find that while the labour whose wages are affected suffer 3434a net loss in real income of $ 392 million, those who obtain their income from capital, land and from non-affected occupations will gain a total of $ 327 million, either as recipients of factor income or as consumers. • The amount of tax revenue gained from this policy is a modest $65 million. • As shown above, labour’s burden is 6 times the additional revenue collected from the corporations while the owners of capital of domestic firms, owners of beach front land, and the categories of labour whose wages are not affected, gain an amount equal to approximately 5 times what the government gains in additional revenues.

  30. IMPACTS OF INFLATIONInflation as a Tax • Inflation is a tax in itself as it reduced the purchasing power of money. • Suppose gpe is the expected growth in prices in one year, that is, it is the rate of inflation. • Year 0 1 • Purchasing power of one dollar $1 $1/(1+gpe) • Thus, the reduction in the purchasing power of money due to inflation in one year, is: • 1 - 1/(1+gpe) = gpe/(1+gpe) • This reduction in the purchasing power gpe/(1+gpe) is the inflation tax. 35

  31. Impacts on Indirect Tax • The impact of inflation on indirect taxes is dependent on whether the tax is levied on an ad valorem or a per unit basis. • Indirect tax on an ad valorem basis. • When an indirect tax is levied on ad valorem basis, the inflation does not reduce the tax liability. This can be illustrated by the following example. • Suppose R0 and R1 are tax revenue in years 0 and 1 and t is the ad valorem tax rate. P0 is the price level in year 0 and Q0 the quantity transacted both in years 0 and 1. Then • In case of an ad valorem tax, the real tax does not change with inflation over the years. 36

  32. Indirect Tax on a Unit Tax Basis • With a unit tax, the tax revenue (in real terms) gets reduced with inflation. • The above example is re-examined for a unit tax T. 37

  33. Impact on Personal Income Tax • Inflation affects personal income tax primarily in two ways. • First, the taxable income of an individual goes up in nominal terms because of inflation. • As a result, the person moves into higher tax brackets even though there is no change in the real income. This is called bracket creep. • Second, deductions/ exemptions remain fixed in nominal terms, thereby increasing the tax liability. Bracket Creep • As the nominal wages go up due to inflation, a person in low tax brackets will move into higher income brackets. • This increases the tax liability, although the income remains unchanged in real terms. • Thus, there is a need for adjusting the tax brackets. 38

  34. Impact on Personal Income Tax (Cont’d) • To illustrate, take the following tax structure: 10% tax on income 0-10,000, 20% on income over 10,000. • If there is 50% inflation between 2000 and 2001. • The average tax rate has increased from 10% in 1980 to 11.67% in 2001 due to bracket creep, although in real terms the purchasing power of the individual is the same. • Also, tax liability in real terms has increased by $133. • Therefore, it is necessary to index the brackets in order to avoid the effect of "bracket creep". • Following the same tax structure, if the brackets are adjusted, the first bracket would be up to $15,000 with a 10% tax. • The tax liability in 2001 would be $1,200. Now both the average tax rate and the tax liability in real terms are the same as in 2000. 39

  35. Effects on Deductions • The real value of exemptions and deductions is reduced with inflation. • This introduces regressivity in the system because it has a greater impact on low income groups than on higher income groups. • Consider, for example, the following tax structure: 10% tax on income up to 10,000, 20% tax on income over 10,000. Deduction of 1,000 allowed. • The individual's tax liability in 2000 and 2001, with a 50% rate of inflation is, 40

  36. To eliminate the effect of bracket creep, suppose the brackets are indexed. Now the tax liability would be as follows: • Therefore, in the presence of inflation, the un-indexed deduction leads to an increase in real tax liability and an increase in the average tax rate, even though the tax brackets are indexed. 41

  37. Now, consider the case in which both the deductions and the tax brackets are indexed. • The indexed deduction becomes $1,500 in 1990. Then, the tax liability would be, • Therefore, if both the brackets and deductions are indexed with inflation, the tax liability and average tax rates will remain unchanged for the same levels of income. But if the tax brackets and/or deductions are not indexed, the tax liability in real terms as well as the average tax rates would increase over the years for the same levels of income in real terms. 42

  38. The results of the above example are summarized below. 43

  39. Taxation of Interest Income • If one lends $1 today, and • r = real interest rate (say 5%) • i = nominal interest rate • gpe = expected growth in prices (inflation rate, say 10%) • Then, one dollar today would become equal to 1 + i after one year and, in real terms, it should be equal to 1 + r. This implies the following relationship: 44

  40. Taxation of Interest Income (Cont’d) • If "t" is the tax rate, then the nominal tax on interest earnings would be: • Tax liability, in real terms, on real interest r should have been only (r) (t). 45

  41. Taxation of Interest Income (Cont’d) • Thus the real taxes paid with inflation exceed the real tax liability without inflation by gpe*t/(1+gpe). • Therefore, if there is inflation and the interest income is taxed, the tax liability is more (in real terms) than if there were no inflation. • This is due to the fact that "gpe", which is the compensation for the fall in value of the principal of $1, and not the interest income, is also taxed. • The remedy in this case would be to eliminate the inflation the interest income and then to tax only the real income: • Nominal Interest income = r (1+gpe) + gp • Real interest income = (r(1+gpe) + gpe - gpA) • Where gpA is the actual rate of inflation for that period • When, gpA = gpe • Then, the real interest income expressed in year one is: r (1 + ge) • the real taxes collected if a tax rate of t is levied : • tr (1 + ge)/1+ge = tr 46

  42. Impact on Corporate Income Tax • Inflation affects the tax liability of a corporation in a variety of ways such as increasing interest income as well as interest deductions, changing cost of goods sold, increasing capital gains etc. • These impacts are analyzed in this section. 47

  43. Depreciation • Depreciation allowance is based on the historical cost of the asset. • As depreciation deductions are not adjusted with inflation, the tax liability increases with inflation. • Consider the following example where the tax rate is 40%, annual sales is $200, the historical cost of an asset is $300 and it has a life of three years. 48

  44. Depreciation(Cont’d) • Thus, with inflation, Present Value of tax liability increases, other factors remaining constant. 49

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