From: Business World Online (Philippines)
Benjamin E. Diokno
AN IDEAL tax system for any country — developed, underdeveloped, or in transition — is one that is broad-based. A tax system with fewer exemptions would allow the possibility of lower tax rates, which would minimize deadweight loss (DWL), and reduce the incentive to evade or put differently, increase compliance.
These are basic tenets of taxation. Philippine authorities need not be reminded about them by the IMF managing director.
Yet, policy makers choose to ignore these basic tenets. Congress, and with the concurrence of the President, continues to grant tax exemptions, thereby enlarging the huge hole in the tax base. Another case where politics triumph over economics.
Many existing tax incentives are redundant. They are costly too, valued conservatively at 1% of GDP or ₱50 billion. That’s much higher than the incremental revenue yield of the proposed “sin” taxes.
Yet, Malacañang refuses to push vigorously the rationalization of fiscal incentives. Such proposal has been stuck in the congressional labyrinth for more than two decades. Worse, instead of rationalizing fiscal incentives, new ones are born every Congress.
Aside from generating large revenue losses, the proliferation of tax incentives also supports the perception that the playing field in Philippine business is uneven. The favored few are getting away with murder, while the majority of private firms suffer in silence.
If only fiscal incentives were rationalized, perhaps the corporate income tax rates, one of the highest in Asia, could be reduced to more competitive levels.
“Broaden the tax base, keep the tax rates reasonable,” should be the mantra of legislators and tax policy designers.
The proposal to raise taxes on locally produced cigarettes by more than 700%, now pending in the secretive Third Chamber of Congress, departs from this tax rule.
Do our legislators and Executive officials know the implication of such a move? I have not seen such a quantum jump in tax rates in my lifetime — here and abroad. What would be the smokers’ reaction? How would it impact on farmers, workers and capitalists in the industry? Would it lead to illicit trade and how would the government manage to control it? Is the government ready and capable to address illicit trade, and at what costs?
Forecasting changes in the behavior of individuals in response to changes in some economic events is an inexact science. The recent, and still ongoing Great Recession, is a grim reminder of that.
Economic theory suggests that reducing interest rates would lead to higher investment. But when governments all over the world reduce interest rates to zero or near zero level, investments didn’t expand as predicted.
As lower interest rates released new funds into the system, the additional funds ended up refinancing old debt. A huge chunk left the host country and went to transitional economies where the return on funds were higher. Domestic investments remain tepid.
I wonder how the new and an exponentially high tax on cigarettes would affect smokers. Assuming a demand elasticity of 0.6, then theoretically consumption would decline by 40%. Some 40% of smokers will quit. Admittedly, a heroic assumption.
The question is where would the 60% who will continue to smoke get their cigarettes? Local or foreign? Formal market or black market? It is reasonable to assume that most will shift to less expensive cigarettes. Some will shift to smuggled, more affordable, ones. The revenue forecasts appear to be too optimistic.
Yes, Angelina, an illicit trade market for smuggled cigarettes will inevitably emerge. I disagree with the dismissive statement than no such illicit market would develop. “Smuggling could be solved by better tax administration,” said Philippine Finance authorities. Baloney! That’s begging the issue.
What’s the reality? Right now, smuggling is taking place in a big way in this country. And what’s being smuggled? Luxury cars, oil products, steel, rice, among others. These are goods that are bulkier and harder to hide than cartons of cigarettes.
Smuggling is taking place because the Philippines is a country with more than 7,000 islands and a coastline so enormous. Bringing in illicit goods can be done practically anywhere — North, South, East and West. The irony is that a great deal of smuggling is taking place in official ports of entry.
It is true that smuggling has been significantly minimized in some first world countries — the United States, Japan, Singapore and others, as some government authorities argue. But the difference between these first-world countries and the Philippines is that they have excellent track record on the rule of law. In the first-world countries, smugglers or illicit traders get caught, prosecuted, and jailed. By contrast, the Philippines’s rating on the rule of law is, to put it mildly, embarrassing.
Despite the government authorities’ brave words that illicit trade would not take place even with the quantum rise in cigarette taxes, it makes more sense to admit that such a problem is imminent.
Doing nothing would result in a tidal wave of smuggled cigarettes into the country.
Doing the right thing could be very expensive. The national government has to beef up the budgets of the Philippine Coast Guard, the Philippine National Police, the Philippine Navy, the Bureau of Customs, and the Department of Justice.
The additional costs of better tax enforcement should be deducted from the incremental benefits from higher taxes on cigarettes. The higher the tax, the more intense illicit trade is, and the higher the incremental costs of stricter tax enforcement.
Bottom line: the promised incremental ₱40-billion revenue from higher taxes on cigarettes and liquor is grossly overstated. Its net revenue yield after deducting the incremental costs of better tax enforcement is much less.
The other disturbing aspect of the quantum rise in taxes on cigarettes and liquor is its impact on farm owners, factory workers, and firm shareholders. In theory, the long-run, “general equilibrium effect” of such a tax those that will be displaced would be absorbed in other industries, although the return on the factor that is used most intensively in the taxed industry would suffer the most. It goes without saying that a tax would reduce the welfare of everyone, both in the taxed and untaxed sectors.
But the general equilibrium analysis (GEA) of tax incidence is based on some restrictive assumptions.
First, it assumes small changes in tax rates. Yet the proposed tax bill assumes quantum jumps in tax rates. And the higher the adjustment in the tax rate, the higher the reduction in people’s welfare.
Second, GEA looks at the long-term impact of a tax. While the long-term impact could be smooth, short-term adjustments could be disruptive. As the noted economist John Meynard Keynes said: “In the long run we are all dead.”
Third, GEA assumes factor mobility. Labor and capital can move freely from one sector to another, that is, labor and capital in the taxed sector can move to the untaxed sector, with little transaction costs.
Fourth, GEA assumes full employment. This means land, labor, and capital in the taxed sector can move (see previous assumption) and be absorbed in other untaxed sectors. But in an economy where serious unemployment and underemployment exists and where factory capacity is idle part of the time, this process of adjustment may not happen. And if it happens at all, the process of adjustment may be very, very slow.
Bottom line: with such a quantum jump in tax rates for cigarettes and liquor, expect a volatile, potentially disruptive, adjustment period for farmers, workers and firm owners in the short and medium term.
Benjamin Diokno is former secretary of budget and management and is Professor of Economics at the UP School of Economics.
