“[The book’s] most important contribution, however, is undoubtedly with respect to consumption taxes. No one, anywhere, has thought through with such care just how the so-called ‘simplified alternative tax’ (essentially a direct personal consumption tax combined with a cash-flow corporate tax) might work in the real world. Since such taxes are increasingly being considered—if not adopted—all over the world, in developing and developed countries alike, for this reason alone this book should be high on the reading list of all those concerned with the design and implementation of efficient and equitable direct tax systems.”—From the Foreword by Richard M. Bird
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The Taxation of Income from Business and Capital in Colombia
By Charles E. McLure Jr., John Mutti, Victor Thuronyi, George R. Zodrow
Duke University PressCopyright © 1990 Duke University Press
All rights reserved.
An Overview of Objectives and Alternatives
In December 1986 Colombia enacted Law 75, making fundamental changes in its income tax. Tax thresholds were raised, withholding was made a final tax for many taxpayers, and the top bracket rate paid by individuals was reduced from 49 percent to 30 percent. Especially important were the changes in the tax treatment of income from business and capital.
The taxation of corporations (sociedades anónimas) and limited partnerships (sociedades limitadas) was unified. This was accomplished by subjecting all the taxable income of both types of companies (sociedades) to the 30 percent rate and excluding dividends paid by corporations and partners' shares in the earnings of limited partnerships from the tax base of individuals. Interest income and expense are to be indexed for inflation; except in the case of interest income received by individuals from financial institutions and other payors subject to government regulation, which immediately qualifies for indexation, this inflation adjustment is to be phased in over a ten-year period, beginning in 1986. Inflation adjustment was not extended to depreciable assets or to inventory accounting, which already benefit from accelerated depreciation and the use of last-in, first-out (LIFO) accounting.
Law 75 of 1986 provides the Government of Colombia with «extraordinary faculties» (facultades extraordinarias) that allow it, among other things, to specify further changes in law needed to eliminate the effects of inflation from the measurement of taxable income. The present Report is intended to provide guidance to the Government as it considers how best to satisfy that mandate.
The discussion of this Report goes beyond the narrow issue of whether and how the inflation adjustment scheme of Law 75 of 1986 might be improved. (Chapter 7 is devoted to an examination of that issue.) Rather, it takes the view that the rationale behind much of Law 75 — the achievement of equity and neutrality — requires the creation of a more accurate measure of real economic income for tax purposes. Since there may be little to be gained from making a highly defective tax System inflation-proof, the Report, especially in Chapter 5, examines fundamental issues of the taxation of income from business and capital that would arise even in the absence of inflation. Moreover, it recognizes that problems caused by the failure to make the tax system of Colombia inflation-proof extend beyond the income tax to include the measurement of net wealth; Chapter 6 thus examines the taxation of net wealth, and Chapter 5 also considers the measurement of presumptive income, which is based primarily on net wealth. Finally, the examination of the tax system of Colombia contained in this Report goes beyond merely reforming the existing income and net wealth taxes. The Report also considers a more drastic reform of a type that in many ways is attractive in concept but that has not been implemented in any country, a system of direct taxation based on consumption, rather than income.
II. Alternative Solutions
Before the reforms adopted in December 1986, little systematic allowance was made for inflation in the measurement of income under the Colombian income tax. As a result, taxable income could be either understated or overstated, resource allocation was distorted by taxation as it interacted with inflation, and equity suffered. All these defects, which are explained further in the next section, were generally more important, the higher the rate of inflation.
There are two primary alternative means of dealing with this Situation. One is to provide systematic Inflation adjustment for crucial items of income and expense, including interest, capital gains, depreciation and similar allowances, and cost of goods sold from inventories. The result would be an «inflation-adjusted» income tax in which only real income would be taxed. This was the general approach followed in the 1986 reforms, although these reforms stopped short of the complete adjustments that would be required to make the measurement of real income accurate and independent of the rate of inflation. Consistent application of this approach would also produce a net wealth tax (and a measure of presumptive income) based on current values of assets and liabilities. The 1986 reforms made little progress on this front. Part One of this Report (Chapters 2-7) describes current law and the changes that would be required to convert the current System to one based more closely on real economic income and net wealth.
An alternative would be to adopt a System of direct taxation based on consumption, rather than on income. Such a System is described in detail in Part Two (Chapters 8 and 9) of this Report. A consumption-based tax has the considerable advantage that inflation adjustment is generally unnecessary, since all quantities relevant for the calculation of tax liabilities are measured on a cash flow basis in current-year pesos. (That is, payments are realized for tax purposes when cash is received, and deductions are allowed for expenses when cash is disbursed.) Under one variant of a consumption-based tax, businesses are allowed immediate deductions for all purchases, including those of depreciable assets and inventories; interest income of businesses is exempt, and dividends paid and interest expense are not deductible, while at the individual level interest income and dividends are exempt, and interest payments are not deductible.
A consumption-based tax enjoys another powerful administrative advantage over an income-based tax, because realization is tied to cash flow. The timing of cash flow is a relatively easily identifiable event. By comparison, under an income tax it is much less obvious when a taxable event occurs, that is, when income and expense should be recognized for tax purposes. For example, if taxable income is to reflect economic income, depreciation allowances for tax purposes must reflect economic depreciation, that is, the decline in the value of a depreciable asset (as measured by its ability to generate a future flow of income). It is, however, notoriously difficult to know the appropriate pattern of depreciation allowances to use for tax purposes. A large number of other difficult «timing» issues, sometimes called «time value of money» issues, must also be addressed in designing an income tax; these are discussed in detail in chapter 5. By comparison, virtually none of these issues arises under a consumption-based tax.
Compared to the largely unindexed pre-1986 income tax of Colombia, the policy reforms needed to establish an indexed income tax, including those of Law 75 of 1986, can be seen as either a final destination or an intermediate step toward the variant of a direct consumption-based tax offered in this Report for consideration by Colombia. This can be seen by considering the tax treatment of several key items of income and expense under the income and consumption-based regimes. The disallowance of the «inflation premium» contained in interest payments is required under an inflation-adjusted income tax. But this partial disallowance of interest income and expense can also be seen as a movement toward the full disallowance required under the consumption-based tax described above. Similarly, the exemption of dividends under the 1986 reforms can be seen as either a very ad hoc and inexact way to integrate the corporate and individual income taxes (though one that is appropriate for Colombia) or as a component of a consumption-based tax.
The consumption-based alternative described above is clearly simpler than an inflation-adjusted income tax; for this reason it is called the Simplified Alternative Tax in this Report. There are, however, other important considerations that must be weighed in choosing between these two alternatives. First, the Simplified Alternative Tax essentially exempts all income from business and capital from tax. Thus, it raises severe equity concerns, especially in Colombia, which has a long tradition of attempting to achieve progressive taxation and in which the ownership of capital is highly concentrated. Second, if Colombia is to retain its net wealth tax (impuesto de patrimonio), as recommended in the Report, the simplicity advantages the Simplified Alternative Tax enjoys over the inflation-adjusted income tax would be less than if there were no net wealth tax. This is true because many (but not all) of the complexities of the income tax that would be avoided under the Simplified Alternative Tax must be addressed in calculating net wealth. (See also Chapters 6 and 9.) Third, the calculation of presumptive income, an important anti-evasion «backstop»under the present income tax regime which is based primarily on net wealth, is simply inconsistent with adoption of a consumption-based tax. Finally, there is at least some uncertainty whether the Simplified Alternative Tax would be eligible for the foreign tax credit allowed by some capital-exporting countries, especially the United States.
The Report which follows describes more fully these two basic alternatives, examines the pros and cons of each in the Colombian context, and provides detailed proposals for the implementation of each approach, including transition measures. The choice between these two tax Systems is a difficult one. It is not made easier by the fact that no country has practical experience with a tax such as the Simplified Alternative Tax. Nor are the Colombian data needed for a complete evaluation readily available. The decision on whether Colombia should take the path-breaking step of adopting the Simplified Alternative Tax must therefore be based largely on conceptual reasoning, rather than empirical analysis. Partly for these reasons, this Report makes no firm recommendation as to which of the two alternatives presented for consideration the Government of Colombia should adopt.
The remainder of this chapter describes briefly the objectives a tax System should achieve and applies the criteria used in this Report to provide an assessment of the two basic alternatives. Chapter 10 provides a more detailed comparison and evaluation of the pros and cons of the two Systems in terms of these objectives and criteria. This discussion should be useful to those responsible for choosing between the two Systems described in the remainder of the Report.
The tax System of a country ideally should satisfy certain basic objectives. These include simplicity, fairness or equity, economic neutrality (or, more generally, economic efficiency), and consistency with economic development. In addition (or as aspects of these primary objectives), the tax system must yield adequate revenues, it must not needlessly discourage investment in the country, and it must not result in unnecessary sacrifice of tax revenues to foreign governments.
Simplicity is an important objective of tax policy in all countries; after all, little is gained from enacting an elegant system that theoretically meets the goals of equity and neutrality (as well as others to be described below), but in fact does not achieve either, because it cannot be implemented effectively. Simplicity is especially important in developing countries, where the expertise required for both taxpayer compliance and tax administration is extremely scarce. In many instances it may be necessary to sacrifice conceptually desirable refinements in the definition of the tax base in order to keep the system simple, economize on these scarce talents, and achieve rough justice.
Fairness or tax equity has two dimensions, the horizontal and the vertical. Horizontal equity requires that taxpayers with the same real income (if income is agreed to be the proper measure of ability to pay, an issue to be discussed further below) who are in similar circumstances in other relevant respects should pay roughly the same amount of tax. Knowledge that others of equal incomes are paying vastly different amounts of tax can undermine taxpayer morale and compliance. Horizontal equity may also be especially important from a political point of view. Horizontal equity is violated if certain forms of income are exempt or taxed at preferential rates or if extraordinarily high rates are applied to certain forms of income, if only some of the expenses of earning income are allowed as deductions, or if deductions or credits are allowed for expenditures that do not represent costs of earning income. Perhaps as important in a developing country, horizontal equity is not achieved if some sources of income more easily escape tax illegally than others.
The absence of precise inflation adjustment can cause severe horizontal inequities, even in a System that would be judged to be fair from the perspective of horizontal equity in the absence of inflation, because income from business and capital is mismeasured. For example, in a time of rapid inflation, interest income and capital gains are overstated in an unindexed but otherwise «ideal» income tax; by comparison, interest deductions are overstated, but depreciation allowances are understated. These and other problems caused by the failure to provide inflation adjustment in the measurement of taxable income are explained further in Chapters 2 and 7. One purpose of inflation adjustment is to prevent these horizontal inequities by producing a more accurate measure of real income. Similarly, timing issues must be handled adequately if income is not to be measured inaccurately.
Vertical equity involves the pattern of differentiation of tax burdens experienced at different income levels, or the Progressivity of the tax system (tax as a percentage of income at various income levels). There is no scientific basis for judging the proper degree of progressivity in the tax system of a country or in any component of a tax system, such as the income tax. This is essentially a socio-political decision. It is generally agreed, however, that aggregate tax burdens should not fall as a percentage of income as income rises (that is, that Regressivity is not appropriate); some believe that proportional taxation (taxation equal to a given percentage of income at all income levels) is appropriate, but the majority of observers probably agree that some degree of progressivity (an increase in the percentage of income taken by tax as income rises) is appropriate.
The above discussion has implicitly accepted income as the most appropriate measure of ability to pay to use in appraising horizontal and vertical equity. Very much the same conclusions would hold if consumption, rather than income, were chosen as the measure of ability to pay. But the issue goes deeper than is apparent at first glance.
Annual income has traditionally been accepted as the most satisfactory measure of ability to pay. Others have, however, argued that annual consumption is a better measure of taxpaying ability; this Report rejects that view. More recently it has been argued that income received over a lifetime is a better measure than either of these. Under certain idealized circumstances a tax based on consumption that includes the value of gifts and bequests in the tax base of the donor (as well as in that of the donee) approximates in present value terms a tax based on lifetime income. While these exact conditions are unlikely to prevail in actuality, it may be that a consumption-based tax (with transfers being included in the tax base of both donor and donee) approximates a tax on lifetime income closely enough to be preferable to a tax on annual income. This has important implications for both horizontal and vertical equity.
Perhaps the most important implication involves the interpretation of the exemption of income from business and capital under the Simplified Alternative Tax. Judged from the viewpoint that accepts annual income as the proper measure of ability to pay, this exemption appears to constitute a fundamental violation of both horizontal and vertical equity. By comparison, under the viewpoint that accepts lifetime income as the proper measure of taxpaying ability, the Simplified Alternative Tax(with inclusion of gifts and bequests in the tax base of both the donor and donee) is consistent with both aspects of equity. (This is explained further in Chapter 8.)
Another important issue of equity involves taxpayer perceptions. If taxpayers regard annual income as the proper measure of ability to pay, the Simplified Alternative Tax is likely to be perceived to be unfair, despite sophisticated arguments indicating that it is consistent with a lifetime income view of equity.
Excerpted from The Taxation of Income from Business and Capital in Colombia by Charles E. McLure Jr., John Mutti, Victor Thuronyi, George R. Zodrow. Copyright © 1990 Duke University Press. Excerpted by permission of Duke University Press.
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Table of Contents
Part One: Inflation Adjusting the Income Tax,
1 An Overview of Objectives and Alternatives,
2 Overview of Taxation of Income and Wealth,
3 Summary Description of Colombian Taxation of Business and Capital Income,
4 Marginal Effective Tax Rates on Capital Income in Colombia Before and After the 1986 Tax Reform,
5 Appraisal of Colombian Taxation of Income from Business and Capital,
6 The Net Wealth Tax,
7 Inflation Adjustment,
Part Two: A Simplified Alternative Tax,
8 Structural Differences Between Income and Consumption Taxes,
9 The Simplified Alternative Tax,
10 A Comparison of the Two Proposals,
Postscript: The 1988 Reforms,