0.21 Taxation and development  (Page 2/4)

Consumption based taxes do not burden savings. Savings are beyond the scope of such taxes. Thus, a switch from income-based to consumption-based taxes enhances incentives to save, as well as taxpayers’ capacity to save. The exclusion from tax, by expanding private savings allows but does not guarantee higher economic growth.

Also, consumption taxes, relative to income-based taxes involve fewer economic distortions in the allocation of capital across different sectors of the economy. Under typical income tax regimes income originating in the corporate sector is taxed twice, once under the corporate tax and then again in the hands of dividend recipients. This distorts the allocation of capital within the corporate sector. Why? Income tax regimes allow deduction of ¨interest costs in determining taxable corporate incomes. But dividends are not deductible. This provides corporations with an artificial incentive to use debt finance, rather than equity finance. This bias in favor of debt finance (issuance of bonds) and against equity finance, encourages overuse of “leverage” – debt in the capital structure of firms. This renders firms more vulnerable to fluctuations of the business cycle. Dividends are paid only when a firm makes a profit. But interest is a contractual obligation. It must be paid to bondholders even if the firm makes zero profit. If interest obligations cannot be met, then the firm goes into bankruptcy. Thus, the structure of corporate income taxes exposes firms to a higher risk of bankruptcy.

These considerations help account for the recent ascendancy of consumption-based taxation such as the VAT in Europe, Canada, Africa and Latin America. See Malcolm Gillis, (2001), “Tax Policy and Capital Formation: African Experience with the Value-Added Tax”, Policy Sciences , 34(2): 195-215. Even in the United States, widespread perceptions of inherent problems of the income tax led to the emergence, in the nineties, of many influential pressure groups seeking a fundamental shift toward reliance consumption as the tax base at the national level. This will likely never happen in the U.S., for reasons we will soon discuss.

The VAT works best when it utilizes a simple, single rate tax, a flat -rate tax, as in Denmark, Indonesia, and Peru. A single rate makes tax work more smoothly, with less evasion, with less severe economic effects some countries employ multiple rates of VAT, with especially high rates on so-called luxuries. This vastly complicates VAT operations.

In Africa, up until the seventies, only Cote d'Ivoire, Senegal, and Madagascar (former French colonies all) utilized any form of VAT. The early form of VAT used in these nations was crude relative to the present European-style VAT. Now the VAT has spread over much of Africa, improved versions of the tax now operate .

The producer goods issue provides another example for the attractiveness of the VAT. Examples of producer goods include capital equipment. (More on producer goods later).

Alone among broad-based indirect taxes, only the VAT can be structured to fully relieve producer goods, as well as exports from tax. This feature of the VAT has often proved to be decisive when tax reform has been under consideration. Even so, there are – unaccountably – several countries that do not permit full and immediate deductions of VAT on capital goods. S. Cnossen, (1998), “Global Trends and Issues in Value Added Taxation”, International Tax and Public Finance , 5: 399-428. As early as 1969, Sweden switched from a single stage retail tax to a VAT precisely to encourage capital formation and exports, Malcolm Gillis (1986), “Worldwide Experience in Sales Taxation”, Policy Sciences, 19: 125-142. because of the greater ease with which producer goods and exports can be treated relieved of tax under the VAT. How? When a firm pays any taxes or capital goods it purchases, it can under the VAT, but not other sales taxes deduct these taxes from taxes due on sales.