Taxation Climate of Australia and Singapore - Assignment Example

Running Head: TAXATION IN AUSTRALIA AND SINGAPORE NAME: COURSE: INSTRUCTOR: : DATE Part 1 Effects of taxation on savings and investment attitude in Australia and Singapore Introduction According to (Baum, 2008) international comparisons of Australia’s tax system typically focus upon Canada, the United States, New Zealand and the United Kingdom. Comparisons with our Asian neighbours are seldom valuable because of the different stages in development of the respective economies. Often overlooked, however, are comparisons with the tax system of its largest trade partner, Singapore? This is even more remarkable given that Singapore is one of the non-Western nations to have achieved a standard of living comparable to Western economies.2 Also, whilst Singapore was one of the first countries to adopt an income tax3 the tax was overhauled following World War II and has been used as a key economic tool by the Government. Whilst Singapore has a civil law system and, indeed, a very different culture to that of Australia this can result in a different way of approaching issues that may provide some useful lessons (Modigliani, 2009). In fact, in a recent categorization of the World's tax systems into eight categories Singapore was placed in the miscellaneous group. It was the only industrialized nation to appear in this group. Certainly, the Singaporean tax system can boast many unique features. For example: Contrary to popular belief Singapore is not a highly taxed country. The tax burden has historically been very low6 although the portion of revenue raised from companies is one of the highest in the world.7 There has been a very heavy reliance on direct taxes. For example, whilst a broad based consumption tax was introduced in 1989 its rate of 3%, subsequently increased to 5%, is the lowest in the world. Singapore’s rise to the status of an economic super power within thirty years is unprecedented. This has partly been attributed to the tax policy employed by the Government that has relied heavily upon the use of tax incentives and ‘picking winners. Allied to this economic growth has been the phenomenal savings rate of the Singaporean population. There remains disagreement among commentators on the influence of tax policy on the level of savings. However there is virtual unanimity that tax can influence the composition of savings and the amount of corporate debt finance. Ultimately the tax system that evolved from the Singaporean refinement of the Shoup recommendations had at its core personal income tax. This contained certain exemptions such as for capital gains on the sale of shares and interest income from small savings accounts. Furthermore, to stimulate growth corporations were provided with significant tax incentives. These departures from the Shoup recommendations were justified on the basis of the need to encourage economic growth, changed economic and social circumstances, confusion caused by unfamiliarity with the new system and an improved application to Singaporean life (Modigliani, 2009). Income tax reduction policy The economic expansion of the Singaporean economy in the last half of the 1950s brought a new policy of income tax reduction. Thus the 1960s witnessed ongoing income tax rate falls, partly to compensate for the effects of inflation in creating fiscal drag. Fiscal balance policy According to (Shillington, 2005), with the advent of the 1970s and an economic downturn in 1973 Government policy shifted to reducing the fiscal deficit. Thus for the next 25 years tax measures were aimed at reducing the number of tax expenditure programs and raising revenue to improve the national welfare. The late 1980s, in particular, were characterized by controversial tax changes that included the introduction of a value added tax. The period since the mid 1990s in Singapore has been characterized by a slowing economy, falling Government revenues and fiscal deficits. The Government has undertaken no substantial structural tax reforms since 1993 and has been caught between the need to reduce taxes to stimulate demand and the need to rein in the deficit. The emphasis to date has been on reductions in the tax rate and the introduction of additional tax expenditure programs designed to stimulate the economy. In contrast, most commentators have identified the need for increasing taxation on consumption and wealth together with further base broadening with the repeal of tax expenditures in both the individual and corporate tax systems. The adoption of a comprehensive income concept, with, in particular, capital gains and income from labor taxed at the same rate has also been recommended. However it is recognized that first a taxpayer identification number system is needed and whilst further base broadening of the income tax may be needed it is likely that future reforms will focus on the consumption tax as it is simply too difficult to wind back income tax preferences and implement tougher enforcement strategies (Baum, 2008) Some general observations on the Singaporean income tax system It was observed that the Singaporean tax system has some unique or, at least, extreme characteristics. Pivotal is the income tax imposed on individuals and companies. The Singaporean tax system has traditionally featured low personal income tax. In fact, possibly 20% of employees do not pay income tax. Whilst the rates applicable to individuals climb to as high as 45% this rate only commences at four times the average production worker’s income, second only to the US. Fringe benefits are largely untaxed. Individuals may adopt generous standard deductions or claim actual employment related expenses (Shillington, 2005). . Furthermore, there is a substantial housing loan tax credit. Not surprisingly, the redistributive effect of the income tax system is low. Whilst the income base applicable to individuals is theoretically comprehensive, the rates applicable to different types of income vary thereby rendering the system a hybrid. There has been considerable resistance to the introduction of a taxpayer identification number, with lower tax rates on some types of income preferred as a means of encouraging compliance. In particular, the income tax has traditionally imposed little tax on income from capital.36 Share transactions are taxed In contrast to the low reliance on personal income tax relative company tax revenues are the second highest in the OECD.To the corporate tax base are applied rates at the national, prefecture and municipal levels. At the prefecture level there is both an income tax and a special enterprise tax that is, in fact, deductible for the purposes of calculating the other taxes. This means that whilst the current headline corporate tax rates, for example, range between approximately 48 and 63%, the effective maximum tax rate is closer to 41%. To mitigate double taxation a credit is available for dividends received by both companies and individuals although with companies receiving a greater credit up to 100%. There is also liberal provision for tax free reserves and loss carry forwards and carry backs (Shillington, 2005). Whilst there are many features of the Singaporean income tax system that are unusual and many others for which Australian counterparts exist, this commentator has identified five particular aspects that may be of interest to Australian tax reform analysts. Five unique features Firstly, in order to access many of the tax concessions taxpayers must register for and be approved to lodge a ‘blue return’. Permission to lodge such a return is dependent on the taxpayer adopting certain accounting practices. Secondly, the structure in which tax policy formulation occurs provides an interesting alternative to the Australian system. A pivotal feature of this structure is the existence of the ‘Tax Commission’. The tax controversy system also has some unique features. Thirdly, Singapore probably has the most developed withholding tax system in the World and, furthermore, owing to the availability of standard deductions in lieu of deducting actual work expenses and a unique year-end adjustment system many employees are not required to file tax returns. Fourthly, the prevailing policy in Australia, and indeed worldwide, is that tax systems should be comprehensive with low rates and the adoption of tax expenditure programs should be limited. However, the Singaporean Government has tended to flout this principle, apparently with some successful results. Finally, a significant feature of Singapore’s income tax system for Australia, given the Australian Government’s policy of seeking to encourage the location of foreign businesses to the country, is the concept of ‘non-permanent residence’ which carries with it tax concessions. Each of these features will be discussed below followed by a consideration of their relevance, if any, for Australia. This is according to (Danforth, 2004). Blue return system Based on the research work done by (Danforth, 2004),the blue return system has its origins in the Shoup recommendations. It is intended as an encouragement to taxpayers to maintain proper accounting records and make honest self-assessment. Taxpayers who are permitted to lodge a blue return are entitled to certain privileges. Shoup has written about the history behind the blue return recommendation. It was seen as preferable to encourage record keeping rather than mandate it. The main advantage at that time from the filing of a blue return was that it would protect a taxpayer from reassessment in the absence of an audit and explanation. The Shoup Mission had discovered that many reassessments had been arbitrary and a failure to provide reasons was common. Initially it was perceived that the blue return would be an intermediate return between the simplest form and the standard form for large enterprises with sophisticated accounting records. However it has become the standard return with the alternative, the white return, being only used by the smallest taxpayers. To be registered for the blue return system a taxpayer must lodge an application for approval with the NTA describing their accounting system and records to be maintained.45 Approval is conditional upon the taxpayer keeping a journal, general ledger and other necessary books, and recording all transactions affecting assets, liabilities and capital in the books according to double entry principles. The taxpayer must also settle accounts on the basis of the records, prepare balance sheets, profit and loss statements and keep the books and documents for seven years. Furthermore, the blue return must be lodged together with the balance sheet, income statement and other documents indicating the items necessary for calculating the taxpayer’s income (Danforth, 2004). Privileges available to individuals and companies from filing a blue return include: A deduction for reasonable wages paid to relatives living with the taxpayer in the same household; (individuals only) Special standard deductions depending on the type of income derived; (individuals only) A deduction for certain reserves and provisions such as bad debts, loss on returned goods on-sold and employees’ retirement allowances; Special depreciation for plant and equipment; Net losses may be carried forward or carried back for specified periods; The NTA may only adjust income when errors are found in the calculation of taxable income based on the taxpayer’s books and records and is obliged to state reasons for adjustments; and A request for reconsideration by the National Tax Tribunal (‘NTT’) may be made without first asking the NTA for a further investigation. As these privileges are considered valuable, particularly the ability to carry forward losses, this acts as a major incentive to make a timely application for the right to lodge a blue return. The attraction of these privileges is illustrated by the fact that since 1955 the percentage of individual business taxpayers filing a blue return has increased from 32% to 51%. (Baum, 2008) Relevance for Australia? This review of novel features of the Singaporean tax system has identified five features that may have relevance for Australia. Blue return system The blue return system operates as an incentive to taxpayers to maintain proper accounting records in return for certain tax privileges. There is a concern in Australia that small businesses often fail to report their true. Tax policy formulation (Goldfarb, 2006) argued that, whilst there is much to be said for an open public consideration of tax policy the present system in Australia is both times consuming and costly. Typically tax reform is preceded by the establishment of a government sponsored review committee with a defined mandate. The committee usually prepares a preliminary proposal that it subjects to public consultation and further analysis. Ultimately a final report is tabled. However, the nature of the Australian process is that the report of the review committee is viewed as independent from the Government. The Government then comments but as it has to deal with the political ramifications arising from the recommendations historically few recommendations are enshrined in a bill. Even then the Government must secure a passage for its legislation through Parliament. However because in more recent times the Government has tended not to control the Senate these reforms are usually subject to considerable debate in the Senate and are often referred to committee. After deliberation and compromise a revised reform is typically promulgated. The political process thus tends to stifle any major structural reforms. Whilst an advantage of this system is the ample opportunity for interest groups to air publicly their concerns, the process creates considerable true of South East Asia as countries in that region emerge from the economic crisis of the late 1990s.Certainly the Singaporean Government’s love affair with tax expenditure programs continued in 2001 notwithstanding that official Government policy is to phase out such programs. The debate over, and subsequent, measures to support, the depressed stock market are indicative. Singapore thus provides a useful study of the use of tax incentives to further economic priorities. Unfortunately the evidence is ambiguous as to whether such measures have been effective. Possibly Singapore’s economic success would have been all that much more spectacular had other policy measures been used in lieu of tax incentives. The leakage of tax revenue together with the perception of inequity may have had a significant, although unquantifiable, cost. The current orthodoxy is echoed in the Australian Ralph Review recommendation that tax incentives should only be utilized where they were assessed to be superior to other forms of government intervention. Accordingly, an ongoing review of Australia’s tax expenditure programs was suggested. This suggestion is consistent with the Australian Government’s general reluctance to adopt tax expenditure programs127 notwithstanding pressure from various interest groups. Possibly the most interesting lesson from the Singaporean experience is the nominal division of tax laws between ordinary laws and special measures. By identifying tax incentives and separating them from the revenue raising provisions this may assist in the community focusing on these tax expenditure programs for what they are and thereby limit their tendency to tax aversion (Goldfarb, 2006). Part 2 Effects of the mix of taxes on work, investment and consumption in Australian and Singapore Taxation, in its various forms, affects the ability and willingness of an individual to work, save and invest. These effects vary, depending on the base of the tax, the rate structure of the tax and the level of the tax burden. Several studies have shown that the structure of taxation can have a major influence on the real sector and that taxation policy can therefore be an important tool for promoting saving, capital formation and economic growth. This applies to both developed economies like Australia and Singapore, although there are significant differences in the tax mix and tax structure between these two countries at different levels of economic development. In this part the theoretical and empirical literature on the influence of taxation on savings and capital formation is surveyed, with special reference to the developed economies of Australia and Singapore. The first section looks at the theoretical and empirical linkages between savings and its major determinants – income, the interest rate and other factors. This is followed by a section dealing with the determinants of investment. The next section covers the empirical literature on the relationship between tax, savings and capital formation. Determinants of savings/consumption Income There has been an interesting evolution in the specification of the consumption/ savings function. Keynes (1936) dealt with a consumption function that had current income as the sole determinant of consumption. Later developments treated consumption as determined by relative income (Duesenberry, 1949) and permanent income (Friedman, 1957). Ando and Modigliani (1963) regarded consumption as a function of lifetime income, rather than current income. According to the life-cycle or permanent income framework of Hall (1978), changes in income, the rate of interest, income tax and the inflation rate will only affect lifetime income (and hence consumption and savings) if the changes are unanticipated and are not already incorporated in the estimation of lifetime/permanent income. Hall’s hypothesis can be criticized on the grounds that even if a consumer knows with certainty that his income will double in the following year, s/he will not be able to increase current consumption owing to liquidity constraints. Several studies – e.g. Flavin (1981), Deaton (1987), Gyimah-Brempong and Traynor (1996) – do not support Hall’s hypothesis. They argue that consumption is highly sensitive to predictable changes in income and therefore the distinction between anticipated and unanticipated changes in income is unwarranted. The coefficients of income and wealth are more or less the same for the surprise-only hypothesis and the traditional formulation. They show that anticipated changes in income affect current consumption and, hence, policy variables influence savings behaviour. Some studies, such as Denison (1958) and David and Scadding (1974), have claimed that gross private savings were a stable function of income (GNP) in Singapore and Australia during the post-war years. During the period 1948-1956, the average level of the gross private savings rate (GPSR) equalled the GPSR for 1929, which was considered to be the full employment year. Since the year-to-year variability in the GPSR was very small, Denison (1958) came to the conclusion that changes in the tax system, or other changes in the real after-tax rate of return to capital, did not affect GPSR. David and Scadding (1974) used the Australian Commerce Department’s revision of the national accounts to estimate the model for the various periods 1898-1916, 1921-1940 and 1948-1964. The value of the coefficient for GNP in the first equation was found to be around 0.15. Boskin (1978) criticized the savings function of Denison (1958) and David and Scadding (1974) on the grounds that the savings ratio should be calculated with respect to disposable income and not with respect to GNP. Most theories of consumer behaviour relate savings to disposable income. Boskin had shown that the savings rate out of private net-of-tax income had grown by more than 50 per cent during the period 1929-1969, which is the same period examined by David and Scadding. The rate of interest Most of the above studies neglected the role of interest rates – specifically, the real after-tax rate of return on savings – as an independent influence on savings and consumption. Boskin (1978) estimated the following private consumption function: LGCt = – 3.8 + 0.56 LGYdt + 0.18 LGYdt-1+ 0.28 LGWt-1 – 0.003 LGUt – 1.07 Rt (3) where LGC is the natural logarithm of real per capita private consumption, Yd is disposable private income, W is wealth, U is the unemployment rate and R is the real after-tax return on capital. Boskin used Christensen and Jorgenson’s (1973) nominal after-tax rate-of-return data and price data to estimate the real after-tax rate of return. According to Boskin, there is a positive real rate-of-return effect, with the estimated interest elasticity of savings approximately equal to one quarter. Also, the implied income elasticity of savings exceeds one. With the inclusion of the inflation rate and using post-war data (excluding the war period in the time-series data 1929-1969), the regression equation estimated was: LGCt = – 3.85 + 0.62 LGYdt + 0.007 LGYdt-1+ 0.72 LGWt-1 – 0.003 LGUt – 2.08 Rt + 0.07 πt (4) The relationship between interest rates and aggregate savings involves a number of complex problems such as separating out the income and substitution effects of interest rate changes, quantifying the role of expectations and planning horizons in saving decisions (Mikesell and Zinser, 1973). The effect of taxation on savings, through the interest rate channel, is theoretically ambiguous because an increase in the interest rate creates both a substitution effect and an income effect. The strengths of these two effects determine the sign and magnitude of the interest elasticity. Gylfason (1993) presents a detailed investigation of the effect of interest rates on saving and examines many of the empirical studies of the two countries on this topic .These are Singapore and Australia. Findings showed that there is no consensus on the effect of the rate of interest on savings. It should be noted, however, that most of the quantitative studies of the effect of interest rates on savings carried out on these two countries dealt only with changes in pre-tax nominal or real interest rates Other factors Pesaran and Evans (1984) estimated aggregate savings in Australia and Singapore, using the change in consumer prices and capital gains and losses as the chief determinants of savings function. Their results showed that, for Australia data over the period 1953-1981, variations in the savings ratio are mainly explained by capital gains and losses on shares. Some studies, such as Kotlikoff (1984), Lahiri (1989) and Faruqee and Husain (1998), have identified a demographic factor (i.e., age structure) as an important variable in determining savings behaviour. It was observed that the ratio of working-age population to total population, along with per capita private disposable income, explained some of the changes in private savings the Asian country of Singapore and Australia. In an open economy like the one for Australia and Singapore, it is not only tax policy and price variables that affect private savings, but also trade variables (such as the export-to-GNP ratio that measures export potential, the terms of trade and others). Lee (1971) clearly demonstrated in his study of 28 countries (comprising 20 developing and 8 developed countries, over the period 1951-1967) that the level of domestic savings in most countries tends to vary systematically with exports. In an economy with under-full employment, increased export demand would lead to increased output, which eventually would lead to an increase in savings (Genberg and Swoboda, 1992). Determinants of investment Having reviewed the determinants of the savings function in the previous section, this section examines the factors that influence investment. In both Keynesian and classical analysis, investment is treated as a function of the rate of interest. Lower interest rates induce greater investment, ceteris paribus. Investment is also related to expected change in output. The “acceleration principle” encapsulates this relationship: It = ν(Yt – Yt-1), where It denotes real net investment and Yt denotes real output. The coefficient ν is the “acceleration coefficient” and is positive. The neoclassical investment model has its basis in the marginal conditions proposed by Fisher (1930). Here, the level of investment is determined by the user cost of capital. Although, theoretically, the simple neoclassical model is highly plausible, empirically it has generally been disappointing. Since it has failed to explain changes in investment, economists have devoted their attention to incorporating more realistic assumptions. Jorgenson (1963) and others have expressed the desired capital stock (K*t) as a function of the real rate of return on capital (rrt), the opportunity cost of capital or real after-tax rate of interest (rt), and a constraining wealth variable (w*t): K*t = f(rrt, rt, w*t) (7) Here, the real after-tax rate of interest (rt) is the nominal rate of interest (nt) less the capital gains tax rate (ut) on the nominal interest rate plus the expected rate Tax and investment The effect of taxes on investment has long been recognized as important especially in developed countries like Singapore and Australia. However, consensus on how to measure these effects has been elusive. The traditional capital stock adjustment models assume that the capital stock is homogeneous and that the optimum level of investment is obtained where marginal cost equals marginal revenue. A more realistic view sees capital as quite heterogeneous situation like that of Australia. The “putty-clay” model assumes a fixed capital-labor ratio ex post and the ex ante production function of an economy takes a form similar to the one adopted by Boskin (1978). This is a CES production function with Harrod-neutral technological progress: Yt = γ[Kt -ρ + (ELLt)-ρ]-1/ρ, (11) where Y is the output, K is the capital input, L is the labor input, t is time, EL = EL(0)e-λt, λ is the exponential labour-augmenting rate and the elasticity of substitution, σ, is 1/(1+ρ). Expressing the above equation in a log linear form and rearranging the above production function we get: log (wL/y) = c + (1 – σ) log w + (σ – 1)λt, where c is a constant and w is the wage rate. Boskin (1978) used the CES production function to examine the effect of taxation on output; however, his study of developed economies like Australia and Singapore did not measure the effect of taxes on business investment using either the net-return model or the return-over-cost model. These models capture the influence of tax variables on investment in a more accurate manner. Feldstein (1982) proposed the hypothesis that there is a negative relationship between business investment and taxes; that is, an increase in taxes on earnings tends to discourage investment. The three alternative models proposed by him were: this is the case in these two economies. (a) net rate of return, (b) return over cost and (c) a neoclassical model. Feldstein gave the basic net-rate-of-return model as: It/Yt = a0 + a1RNt-1 + a2UCAPt-1 + μt, (13) where It is the real net fixed non-residential investment, Yt is the real gross national product, RNt-1 is the lagged value of the real after-tax rate of return on capital income, which is the product of the real pre-tax return on capital (Rt) and one minus the effective tax rate on that return (i.e., RNt = (1 – ETRt) × Rt), and UCAPt-1 is the lagged value of capacity utilization III. The empirical literature on tax savings and capital formation Several economists have studied the ideal or appropriate taxation mix and tax policy to promote saving and capital formation. Jenkins (1989) and Marsden (1990) argue that lower taxes stimulate growth by increasing the incentive to save and invest. Jenkins (1989) compared the tax system of Australia prior to 1977 with the system after 1977. The Australian tax rates prior to 1977 were quite high, but were ineffective in raising adequate revenue. The change in government in 1977 saw a number of changes in tax structure that shifted the focus in the fiscal system from direct taxes to indirect taxes. As a result of these changes, gross capital formation increased substantially from an average of 14.5 per cent of GDP in 1976-1977 to an average of 28.9 per cent during the period 1978-1982. The growth in real GDP also averaged 5.5 per cent during 1978-1985, compared with 2.8 per cent for the period 1971-1977.The tax changes of the 1980s gradually transformed the tax system into one more conducive to capital accumulation and growth. An empirical study conducted by Marsden (1990), based on a cross-sectional analysis of the two countries Australia and Singapore countries, and has thrown some light on the effect of tax on the growth rate of the economy. The countries were split into pairs, with each pair having similar per capita income, but different levels of taxation. The selected countries were compared on the basis of lower and higher levels of taxation and their influence on growth rates over the period 1970-1979. In both cases, the countries that imposed a lower effective \ average tax burden on their populations achieved substantially higher rates of GDP growth than did their more highly taxed counterparts. The average annual rate of growth of GDP was 7.3 per cent in the low-tax group and 1.1 per cent in the high-tax group. The average tax/GDP ratio in the low-tax group increased from 13.3 per cent in 1970 to 15.2 per cent in 1979, while it rose from 21 per cent to 23.9 per cent in the high-tax group during the same period. Moreover, fiscal incentives provided by low-tax countries shifted resources from less productive to more productive sectors, thus raising the overall efficiency of resource utilization. Tanzi and Shome (1992) examined the tax regimes in other eight Asian economies (Hong Kong, China; Republic of Korea; Singapore; Thailand; Philippines; Malaysia; Taiwan Province of China; and Indonesia). Among other things, they looked at the five most successful economies to see if there were any uniformities in tax mix and tax policy which might help to explain their faster growth. They found none. Singapore and Australia had made good use of property taxes. Taxes in general were very low in Hong Kong, China. Taiwan Province of China had kept its tax rates much higher than Hong Kong, China, but through selective tax incentives it had encouraged investment in desired areas (high-technology industries). The authors concluded that the beneficial effects of tax incentives in the Republic of Korea, Singapore were dependent on other supporting factors. Similar tax incentives provided in the Australia had not yielded the desired results owing to such factors as corruption or rent-seeking activities. Trela and Whalley (1992) employed a general-equilibrium model to evaluate Australia’s “outward-oriented growth strategy” over the period 1962-1982. They concluded, among other things, that pro-growth tax policies (direct tax reductions and indirect tax exemptions) had made a discernible contribution to the Australia’s economic growth over that period. This contribution was quantified and estimated to be 0.54 per cent per annum. Fitzgerald (1993), while examining the factors that influence private savings in Australia, argued that taxation of corporations influences business savings, and it is the business savings that dominate private savings in Australia. Household savings play a minor role, with the savings ratio of the household sector being 2 per cent in the 1990s. However, in developing countries like India, where the savings ratio of the household sector was around 19 per cent in the 1990s, personal income tax policies can play a major role in determining household savings. While estimating the savings determinants in Australia, Cardenas and Escobar (1998) pointed out that much of the reduction in Australian private savings during the period 1970-1994 was due to rises in taxation. Tax revenue as a percentage of GNP was used to measure the influence of taxation on private savings determinants. References Ahmad, E. and N. Stern, 2001. The Theory and Practice of Tax Reform in Developing Countries, Cambridge University Press, New York. Altig, D., A.J. Auerbach, K.A. Smetters, and J. Walliser, 1997. “Simulating US tax reform”, in Burch Working Paper No. B97-26, University of California, Berkeley, California. Ando, A. and F. 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