Tax reform: A make-or-break policy

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“Build, Build, Build” is a new development mantra signifying the largest infrastructure push in Philippine history to propel economic growth in the next five to six years. Among the key investments that the Philippine government will make are big-ticket infrastructure projects, specifically roads and bridges, mass urban-transport systems and alternative green city solutions. These are envisioned to solve the problems attributed to traffic congestion, inadequate mass-transport facilities, air pollution and lack of green, healthy community spaces.

Nevertheless, in a world of scarce resources, there is no such thing as a free lunch, which simply means that there is a cost to bear for every benefit one enjoys. “Build, Build, Build” is no exception to this rule, so the importance of tax reform comes to the fore, as it will largely contribute to the funding of these infrastructure plans. This column attempts to provide a condensed explanation of tax reform for everyone’s benefit.

For starters, one must consider the government, which, like any other productive unit in society, needs to raise revenues in order to spend. Government spending typically encompasses operating expenses, basic services provision, infrastructure investment and other items. Revenues, in turn, are raised from various sources, notably taxes from firms and individuals.

If government collection exceeds spending, there is a budget surplus. If government spending exceeds its collection, there is a budget deficit. If “Build, Build, Build” were to figure prominently on the expenditure side, while no compensating measures were taken on the revenue side, there would likely be a budget deficit that could reach about 3 percent of total economic output for 2017 (approximately P478.1 billion).

So, how could the budget deficit be managed? One way is to decrease government spending, which might not be a wise decision, because it could decrease aggregate spending and slow down economic growth. Another way is to borrow money, whose potential drawbacks are higher interest rates and lower private investment—a so-called crowding-out effect.

A more innovative approach is the ongoing (and long overdue) comprehensive review of the tax system, known as Tax Reform for Acceleration and Inclusion (TRAIN). It aims to institute progressive tax reform and more effective tax collection, which would require taxes to be indexed to
inflation.

As our Prof. Dr. Cielito Habito explains, progressivity means that the higher one’s income is, the larger the percentage of that income should be paid in taxes. This is based on the notion of vertical equity, which means that those with a higher capacity to pay should be compelled to pay more, in both absolute and proportionate terms.

More effective tax collection means that revenue agencies, most prominently the Bureau of Internal Revenue and the Bureau of Customs, should collect as much of what is due the government as tax laws provide. Tax compliance should increase, or equivalently, tax evasion and tax avoidance should be curbed.

Indexing taxes to inflation has two aspects. One aspect relates to the periodic review of income-tax brackets to inflation so that an ordinary income earner will not be penalized with higher tax rates as nominal income goes up with inflation, even if actual purchasing power remains the same (or even declines). Another aspect relates to the review of certain taxes, fees and charges—particularly those set at an absolute value rather than as a percentage—to ensure that government revenues from these sources will not be substantially eroded over time.

Simply put, tax reform is a delicate balancing act where the government will be giving with its right hand while taking with its left hand, so to speak, in order to push economic growth even further (acceleration) by putting more money in the hands of more people who are also likely to spend more (inclusion).

A critical success indicator is the tax effort ratio (tax revenues in proportion to total output), as it is believed to be a reliable predictor of economic growth. Currently, the Philippines has a lower tax effort than most of its neighbors, and yet, it has higher tax rates. This observation points to much leakage in the tax system, which the ongoing tax reform would presumably address.

So, what would likely happen if “Build, Build, Build” were to push through, sans tax reform? There could be a reversal of the current good fiscal condition, since pursuing an ambitious infrastructure plan without the necessary compensating reforms would lead to huge fiscal deficits. Investments could suffer, and so would economic growth.

Moreover, with global uncertainty facing business process outsourcing revenues and overseas Filipino workers remittances, the Philippines must undergo an internal transformation to unleash its growth potential. This is why tax reform is a make-or-break policy.

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Ser Percival K. Peña-Reyes and Justin Jerome G. Valle are graduate students at the Ateneo de Manila University Economics Department.