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Tax Reforms in Developing and Transition Economies
Utrecht University, July 1, 2005
Policy Aspects of Tax Reforms
Michael J. McIntyre
Professor of Law
Wayne State University Law School
Visiting at Utrecht University
Economic Context For Tax Reform
Challenges Facing Developing and Transition Countries
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Broken Promises on Agricultural Subsidies
Pressure to Liberalize Capital Flows
Reduction in Revenues from Import Duties
Tax Competition
▪ Int’l Rules Limiting Source Taxation
▪ Tax Haven Abuses
▸ Capital Flight by Wealthy Individuals
▸ Evasion/Avoidance by Companies
“New” Features of the Global Economy
Changes in the Economic and Political Landscape
▪ Production of many goods is relatively easy.
▪ Redistribution of income and wealth is hard.
▪ Transportation, communication, financial
transactions, and energy are relatively cheap.
▪ “Trade secrets,” etc. available for sale.
▪ Absolute comparative advantage is unimportant.
▪ High-tech workers are mobile, but not
absolutely.
▪ Tax fraud is easy and cheap.
Nature and Limitations of Tax Advice
Tax Reform is Local, and Tax Advice is Custom Work
▪ Best tax system for any country depends on many
factors, including its:
▸ economic structure,
▸ capacity to administer taxes
▸ public service needs
▸ political organization (national or federal)
▸ income inequalities (individual and regional) and
political willingness to address them.
▪ Still, some tax goals and methods of achieving them are
common.
Common Tax Goals
“Middle-level” Developing & Transition Countries
▪ Raise enough revenue to pay the bills — mobilizing
resources for development.
▸ Good taxes are better than bad taxes, but most
bad taxes are better than no taxes (inflation).
▪ Redistribution of Wealth and Income.
▸Income (corporate and personal) promote regional
and individual equality.
▸VAT can be progressive in some countries.
▪ Economic growth. Avoid high rates and use taxes that
can be administered.
Leverage to Tax
Conditions that Make Taxation a Practical Possibility
▪ Although taxes are compulsory, taxpayers have a lot of
leeway in avoiding tax. A country needs some hook to
make its tax effective (and not shifted).
▪ Access to market. A country with a good domestic
market has a capacity to tax because foreign taxpayers
who do not pay can be denied access to that market.
▪ High profit opportunities. A country has power to tax if
taxpayers can make good money there.
Taxing Multinational Corporations
Corporate Tax As Tool for Development
▪ The story from many economists since the 1980s has
been to avoid taxes on capital, including a corporate tax.
Claim is that avoiding taxes on capital promotes growth.
BAD ADVICE.
▪ In a developing or transition economy, the corporate tax
serves three important functions even if growth is only
goal:
▸ Taxes monopoly rents earned by MNEs.
▸ It is less bad than any likely alternative tax.
▸ It protects the personal income tax.
Other Advantages of Corporate Tax
Growth is Just One Important Goal
▪ Revenue — Most Developing and Transition Countries
Have Impoverished Public Sector.
▪ Captures gains in modern sector — benefit taxation, in
that much government revenue spent for the modern
sector.
▪ Regional Redistribution — Socially Acceptable Method
for Taxing Prosperous Regions.
▪ Regulation of Business — Some Check on Private
Corruption and Protection of Shareholders
Earnings Stripping
Methods for Removing Income of MNEs from Tax
▪ Excessive deductions for interest and royalties.
▸ Countries should preserve right to tax in treaties,
especially for royalties.
▸ Thin Capitalization Rules Needed.
▪ Currency manipulation and other use of derivatives with
related entities. Countries should not allow deductions
for hedging, etc. with related persons.
▪ No exemption or special treatment of capital gains.
International Aspects of Reform
Treaties and Domestic Law Rules
▪ The first requirement is that a country have sensible
domestic laws governing international income.
▸ Goal is to tax income arising in the country.
▸ That goal is best achieved by taxing worldwide
income with a credit system. Exemption system
provides more tax avoidance opportunities.
▪ The second requirement is administrative capacity.
Some Tax Treaty Issues
UN Model Favored Over OECD Model
▪ OECD Model limits source taxation on both business
and investment income. UN Model also limits source
taxation improperly, but less so than OECD Model.
▪ PE Rule. OECD Model creates too high a threshold for
taxation. Better rule is to allow taxation if business
activity is substantial (.e.g., above € 200,000).
▸ OECD limits taxation of e-commence to residence
country.
More Treaty Issues
Transfer Pricing
▪ OECD has read its 1995 Guidelines into the Article 9
(Associated Enterprises). In fact, only method that works
for most developing countries is the Transactional Net
Margin Method (TNMM), called Comparable Profit
Method (CPM) by US.
▪ New Guidance from OECD on allocation of profits to a
PE. Favors arm’s length method for banks and
insurance companies.
Capital Flight
Huge Problem for Many Developing Countries
▪ Capital flight problems are increased as a result of
greater freedom to move capital. Developing and
transition countries should be cautious in liberalizing
capital movement rules.
▪ For Africa, outflow of capital appears to exceed the
inflow. But the problem is nearly universal.
▪ EU saving directive, which goes into effect today, tries to
deal with capital fight out of EU but will not be helpful in
limiting capital flight from developing countries into EU.
Concluding Notes
Taking a Stand
▪ Developing and transition countries both promote tax
avoidance/evasion and are the victims of it. They need
to decide which side they favor.
▪ Private investment, although important for development,
needs to come on terms beneficial to the host country.
▪ Cooperation among developing and transition countries
is critically important — the developed countries have
their own agenda.