Matalon
The following are excerpts of an address by Joseph M. Matalon, chairman of the Tax Policy Review Committee, presented at the Jamaica Conference Board forum on tax reform held on March 21. The full Tax Committee Report is online at www.jamaica-gleaner.com/feature/taxreport.
IN MY own view, one of the most important functions of the committee's report is as a foundation of rigorous analysis that can provide a sound platform for public debate of the choices we face in the arena of fiscal policy and public finance, given our current economic circumstances, the international development trends that most affect us, and our prospects for economic growth and social improvement.
I would like to firstly talk about two principles of taxation policy, which while not exclusively guiding the committee's deliberations, I believe most influenced our conclusions. They are the issues of equity on the one hand and economic efficiency on the other. I would then like to return to a discussion of some of the controversial recommendations, but with reference now to the particular issues of equity and economic efficiency that gave rise to them.
I would also like to give some so-called "air time" to some of the more important recommendations that appear to have been overlooked.
ECONOMIC EFFICIENCY
What do we mean when we talk of the economic efficiency characteristics of a particular tax measure or of the tax system as a whole? It is fairly easily understood that the imposition of any tax will naturally affect the price of goods and services on which they are imposed. The variations in relative prices that are brought about by a particular tax imposition may therefore be expected to prompt changes in, or distortions of, the behaviour of producers and consumers.
This is a natural and expected outcome and some will even argue that the tax system may legitimately be used to correct some real failure of market forces. In the absence of, and I would argue even in the face of, such market failure, however, these
distortions may also give rise to unintended and suboptimal allocations of economic resources with the result that output and consumption levels are reduced and the economy is thereby rendered less efficient overall.
Let us examine a concrete example of this phenomenon by which the committee was much impressed in the course of its work. Comparative data on total tax collections for a sample of 57 countries across various broad categories of taxation clearly demonstrates that the Jamaican tax system relies heavily, (at approximately 42 per cent of total revenues), and to a far greater extent than the average of the sample, on taxes on income and payroll taxes. At the same time, we also observed that the combined marginal effective rate of income and payroll taxes above the income tax threshold is approximately 40 per cent.
PRICE OF LABOUR
Following the framework of our earlier general analysis of economic efficiency, we could reasonably conclude that the relative price of labour in Jamaica is significantly distorted upwards through the operation of the tax system and that the relative price differentials so created have likely produced a bias away from labour and in favour of capital.
In other words, the system as structured will encourage the substitution of capital inputs in place of labour, which I cannot imagine could be the intended result in a country with a 15 per cent rate of unemployment, significant trade imbalances which in part reflect our almost total dependence on imported capital goods, and a Government that holds poverty alleviation as one of the main planks of its economic and social policy platform. And yet if we look further afield at our existing incentives regime, we find that its main focus seems to be to confer economic advantage on the employment of capital with almost no emphasis on encouraging the employment of labour. This seems doubly strange when one considers that most economists would suggest that our brightest economic prospects lie in the growth of service industries (such as tourism and information technology), the competitiveness of whose cost structures, all other things being equal, will be most directly determined by effective costs of labour.
There is another closely related way of looking at economic efficiency within a tax regime, and that is by estimating for each dollar of revenue raised by government, the total cost to the economy in terms of lost output and total consumer welfare commonly referred to as the 'Average Cost of Funds' or 'ACF'. The committee attempted to do this with the help of a specially constructed economic model of the Jamaican economy designed particularly to discern the probable effects of taxation on a range of economic variables, including ACF. Various experiments were conducted in the model to estimate ACF in circumstances where additional revenues equivalent to one per cent of GDP (or approximately J$5 billion) are raised through alternative tax measures.
I will quote the results of one of these experiments, which involved the collection of the required additional revenues from the GCT as currently structured, compared to an alternative model where the same level of revenue is generated from a far broader-based GCT with uniform rates and no exemptions. The results were quite striking: in the first case, the model measures ACF at $3.20, i.e. raising $5 billion in additional revenues is estimated to cost some $16 billion in terms of lost output under the GCT regime as currently structured.
GENERATING REVENUE
In the latter case, ACF is estimated at the much lower value of $1.40, implying that the cost to the economy of generating the same level of revenue will be approximately $7 billion, or less than half the cost implied under the GCT as currently structured.
These are the essential underlying findings that prompted what is arguably the central thrust of the proposed package of reforms: the shift away from the current heavy reliance on taxes on income and towards a greater emphasis on broader-based taxes on consumption.
We move now to examine the other major criterion of good tax policy, that of equity. What is equity and how do we define equity in relation to taxation? Generally, equity is the quality of being equal in the sense of being fair or even-handed. Tax policy practitioners further define equity in two ways:
Vertical equity is defined by reference to the effective rates of tax on total income paid by individuals at different levels of income. If by design effective tax rates rise as incomes rise, the system is generally described as "progressive," while if the reverse is true, the system is generally described as "regressive." Jamaica's current system of individual income taxation may be described as progressive because effective tax rates increase gradually from 0 per cent, for those individuals whose incomes fall below the income tax threshold, to rates approaching the statutory rate of 25 per cent at the highest income levels.
Horizontal equity on the other hand is defined as the extent to which equally situated individuals (that is to say, individuals of broadly similar total incomes) pay approximately the same amount of tax. The system of non-taxable allowances (including gratuities in the tourism industry) under the individual income tax, is an example of one of the existing features of the tax system which gives rise to horizontal inequity. This is so because individuals earning identical levels of wage income can suffer significantly different rates of tax, depending upon their ability to negotiate such allowances with their employers, or depending upon the particular industry in which they happen to work.
INDIRECT TAXES
Indirect taxes on consumption are generally thought of as regressive. This is so because such taxes are only incurred when income is consumed, and since lower income earners typically consume a greater proportion of their total disposable income than higher income earners, they will pay more of such tax as a percentage of their total income. The structure of Jamaica's particular indirect tax system is made less regressive than it might otherwise be by the exemption from tax of certain so-called "basic items" which are thought to make up a significant share of consumption by lower income earners.
At the same time, higher rates of GCT and SCT are imposed on certain categories of consumption (for example, motor vehicles), which by and large tend to be consumed proportionately more by higher income earners. The net result is a system that is mildly progressive; that is, effective tax rates, while not varying markedly across income classes, tend to be marginally higher as incomes rise.
How then do the committee's reform proposals stack up in terms of equity as defined? Clearly progressivity, and therefore the vertical equity of the system is improved through the substantial increase in the threshold and the elimination of a number of payroll taxes. Horizontal inequities are also reduced through the elimination of all allowances and industry specific tax-free gratuity schemes.
These improvements will cost in excess of $12 billion and must be paid for. In keeping with the committee's main thrust that taxes be shifted away from income and towards consumption, we have recommended a number of changes to the rate structure and tax base of the indirect tax system that will provide the necessary compensating revenues, while at the same time improving the economic efficiency of the tax system as a whole.
