taxation of investment in east asian countries march …€¦ · this paper presents a comparative...
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DRD DISCUSSION PAPER
Report Noo DRD261
TAXATION OF INVESTMENT IN EAST ASIAN COUNTRIES
by
Anthony J. Pell,echio Gerardo P. Sicat
and David G. Dunn
March 1987
Development Research Department Economics and Research Staff
World Bank
The World Bank does not accept responsibility for the views e~pressed herein which are those of the author(s) and should not be attributed to t.he World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the' Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part 'of the World Bank or its affiliates conce.rning the legal status of any country, territory, city, area,. or of its authorities, or concerning the delimitations of its boundaries, or national affiliation.
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TAXATION OF INVESTMENT IN EAST ASIAN COUNTRIES
by
Anthony J. Pellechio Gerardo P. Sicat
David Ge Dunn
Abstract
This paper presents a comparative study of the taxation of capital
investment in nine East Asian Countries. The group of countries includes the
ASEAN countries: Indonesia, Malaysia, the Philippines, Singapore, and
Thailand; as well as Hong Kong, Japan, Korea, and Taiwan. This paper is one
of a series of studies comparing the taxation of capital investment by
region. The model used for these studies provides a common methodology for
examining the taxation of investment across countries.
Hong Kong has the lowest marginal effective tax rates for capital
investment due mainly to the fact that it has the lowest statutory corpor.ate
tax rate among the countries. Malaysia, Singapore, and Thailand have marginal
effective tax rates for capital investment below their respective statutory
corporate tax rates. The main reason for these less-than-statutory rates is
that all these countries have a dividend credit to avoid the double taxation
of dividends. Because debt service payments reduce the cash flow available
for dividends, debt financing can reduce the dividend credit and raise the
marginal effective tax rate.
The treatment of depreciation and capital gains is an important
determinant of the taxation of investment. Capital losses can change the
ranking of effective tax rates among countries, especially when there is
asymmetry in the treatment of capital gains and losses.
A richer set of calculations for each country can be pursued with the
model used in this study. The parameters of the model can be easily set for a
specific country~s actual experience. Such an application to a particular
country can provide tax policy analysts with a convenient tool for examining
the impact of policy options.
TAXATION OF INVESTNENT IN EAST ASIAN COUNTRIES
I. Introduction
This paper presents a comparison of the taxation of capital invest
ment 1n nine East Asian countries. The sample includes the ASEAN countries:
Indonesia, Malaysia, the Philippines, Singapore, and Thailand; as well as
Japan, Korea, Hong Kong, and Taiwan. This paper is one of a series of studies
comparing the taxation of capital investment by regions. Other studies
include countries 1n Latin America, Africa, the Middle East, and other parts
of Asia.
The analysis focuses on the tax consequences of an investment in
physical capital at the corporate level in each country. l/ The objective is
to measure effecti,,e corporate tax rates by asset type and method of financing
across countries. The effective tax rate on capital investment depends not
only on the statutory tax rate but also on all provisions that affect the
definition of taxable income. Because these provisions will, in general,
cause taxable income to diverge from economic 1ncome, the effective tax rate
will differ from the statutory rate. Hence, this study represents an effort
to measure the difference betw~en statutory and effective tax rates on capital
investment in developing countries.
This study is to be distinguished from studies of aggregate tax
levels and ratios of tax revenue to GDP across countries. ~/ Such studies
provide useful measures of taxation from aggregate tax statistics of
countries. The approach deve:loped in this study takes into account the
structural components of ta7! systems (in this case, the corporate tax) across
countries. These :cmponents are combined into a single measure of taxation
- 2 -
(described below) that is comparable across countries. The effect of any
component of the tax system can be examined through its effect on this
measure. For example, the tax treatment of depreciation and capital gains in
different countries can be examined for its effect on investments in partic
ular assets or in projects comprised of several assets. This study moves
comparative tax analysis substantially closer to the actual tax treatment of
investment projects -- an important step for understanding how taxation
influences the investment decision. The model used in this study provides a
common methodology for analyzing the taxation of investment across countries.
Structural tax analysis is an important and growing area of interest
in the economics of development. Several developing countries have commis
sioned major studies of their tax system with the objective of implementing
comprehensive reform. ~/ Tax reform as an action to facilitate efficient
investment is a distinguishing feature of the Baker Plan. ~/ Against the
backdrop of the above mentioned country tax studies and reports by the World
Bank and International Monetary Fund, the Baker Plan marks an evolution of
attention to this subject.
The measure of taxation of investment used in this study 1s the tax
burden as a percentage of the rate of return from the investment. More spec
ifically, this measure 1s the "marginal effective tax rate" for an investment
and equals the difference between the before-tax rate of return on the invest
ment and the after-tax rate of return, as a percentage of the before-tax rate
of return. The marginal effective tax rate (METR) is useful for measurement
and comparative purposes because it converts all types of taxes to a common
value, and accounts for variations in timing of tax payments and in tax
- 3 -
bases. The METR approach is designed to shed some light on the efficiency
implications of a country's tax system.
The focus of this study is on the variation in corporate taxation
across countries. Some variation may follow from efforts by the government to
use components of the corporate tax to encourage investment or attract foreign
direct investment. For example, Hong Kong has a low statutory rate in order
to promote investment. In addition to these efforts, governments will com
monly use tax incentives to encourage overall investment or certain invest
ments relative to others. Tax incentives represent departures from the
regular corporate tax to achieve investment goals. In a related paper the
effect of tax incentives on the effective taxation of investment 1s ex
amined. 21 To investigate the ways in which a country encourages or dis
courages different types of investments requires a detailed analysis that
combines both the corporate tax and tax incentives, which is best pursued in a
country-specific context.
II. Corporate Tax Structure 1n East Asian Countries
The main components of corporate tax systems are depreciation,
capital gains, investment allowances and credits, carryover of losses and
credits, treatment of dividends and interest, and the statutory.tax rate.
Data for these components of the corporate tax systems in the countries in
this study are used to calculate the METR for capital investment in these
countries. A useful comparison of these corporate tax systems is given by
presenting the components of corporation taxation in each country side-by
side. Such a comparison is given in Table 1. The format of Table 1
Provis1ons
Corporate Income Tax Rates and Bases a/
~dditional
Taxes on lncoae
DeDreciation b/
Capital 6ain~/Losses e/
Carryover Provisions
Taxes on Dividends
faxes on Interest
tti scell aneous Notes
Thailand
30X for coapanies register2d under the Securittes Exchange Act;
35t.for all others; Standard Base
- none -
Straight Line Method Annual Rate/Asset Life
Bld H'E Veh cl 51 20X 20X
20vrs 5yrs 5yrs Higher rates are available for
assets with lives less than 5 years
Treated as ordinary 1nco~e. Standard Base
Carry forward 5 years
30% credit on dividends pa1d to resident individuals.
20X withholding tax on dividends aaid to nonresidents.
10% withholding tax an interest paid to nonre~1dent, f1nance co.
25X withholding tax on interest 11aid to other nonresidents. ·
The 30X credit on dividends reduces the double taxation of corporate incoae. Also, dividends issued by fir1s registered under the Thailand Securities Exchange Act are exe1pt fro• personal inco1e tax.
- 4 -.
fABLE 1
Coapartson of Coroorate Tax Structure 1n East A~;an Countries
Malaysia
404; Standard Base
51. Excess Profits Tax on taxable 1ncoae greater than M~200,000. for resident uo1panies, the base 25t of equity. if that is more than 11$200,000.
5t Develop1ent Tax on taxable inc.
Staight Line Method with Initial Allowance and Balanc1ng AdJust•ent
Bld H~E V~h
Initial AlloNances d/ lOX 20~ 20% Annual Allowances 2t B-20X 20X
(124) Standard Balancing Adjust1ent
5-40i. for resident coMpanies 40t if asset held < 2 years
30t if asset sold in 3rd fear 201 if asset sold in 4th vear lOl if asset sold in 5th year 5X if asset held > 5 years
40% for nonresidents Base = sale p~ice - original cost
Carry forward indefinitely
407. withholding tax
15t withholding tax
Cornorate incoae taxes paid by the coapanv are credited toMards the withholding tax due. In principle, doubl~ taxation of corporate incoae is avoided.
S1ngapore
40X; Standard Base
- none -
Staight Line Method with Initial Allowince and Bilancing Adjus~•ent
Bld M'E Veb Initial Allowances 25t 20% 20~ Annuil Allowances
3% 16% 161 Note: The bases for annual allows on "'E+Veh are adj. by init allow.
Standard Balancing Adjust•ent
EKe1pt Capital losses cannot be ussd to
offset ordinary inco1e.
Carry forward indefinitely
40X withholding tax
40% withholding tax on interest paid to nonres1dents.
{can be appealed>
Corporate incoae taxes paid by the co1paoy are credited towards the withholding tax due. In principle, double taxation of corporate incoae is avoided.
Prov1sions
Corporate Inco1e Tax Rates and Bases a/
Additional Taxes on Incoae
Depreciation b/
Capital Siins/Losses e/
Carryover Provisions
Taxes an Dividends
Taxes on Interest
Miscellaneous Motes
Indonesia
35X; Standard Base with a liMited interest deduction. Available for interest piid on debt up to 3:1 debt/equity ratio.
- none -
Staight line Hethod for build1ngs. Double Declining Balance for other depreciable assets.
Buildings: 5t for 20 years Far other assets, rates depend on asset life:
>Byrs 4-Svrs <4yrs 10~ 25~ 50~
Treated as ordinary Income. Standard Base
Carry forward 5 years (8 years for spetified industries}
15% withholding tax on dividends paid to residents.
20l withholding tax on dividends paid to nonresidents.
151 "ithholding tax on interest paid to residents.
20t withholding tax on interest paid to nonresidents.
- none -
- 5 -
TABLE 1 -- page 2
Co~parison of Corporate 1ax Structure in East Asian Countries
Philtppines
35Y.; Standard Base
·- none -
Double Declining Balance Met~od with Switchover to Straight Line
Annual Rate/Asset life Bld M~E Veh lOX 25' 40%
20yrs Byrs Syrs
Treated as ordinary tncoae. Standard Base
Japan
43.3%; Standard Base 33.3~ on inco1e ear1arked for
dividends.
Local/Prefectoral lnco•e Taxes 17.3% (in generalj Inhabitant's Tax
on corporate incoae tax liability 12X Enterprise Tax on taxable
incote. This tax is a deductible froa next year's incoae tax.
Declining Balance Kethod Depreciation Rates Bld M~E Veh
2.3X 20.bi 43.BX Note: the basis for assets other than buildings is 90% of original cost, in the initial year. 5X of orig cost is allowed in the sale yr Total allowances for these assets are li1ited to 951 of orig cost.
Treated as ordinary inco1e. Standard Base
207. add1t1onal tax {plus 1nhab tax) on the transfer of land, if tne land is held < 10 years. Basis = Sale price - Orig Cost
None in general. · Carry forward 5 years, back 1 year, Forward b years for registered cos. for fires filing a blue fori.
15~ withholding tax on dividends paid to resident individuals.
30% withholding tax on dividends patd to nonresident individuals.
151 Nithholding tax on interest paid.
10~ Tax Credit on dividends, 20X withholding tax on dividends,
nonrefundable for nonresidents.
20i. withholding tax on interest, nonrefundable for nonresidents.
The withholding taxes on diYidends The 10t credit on dividends reduces and interest are finil taxes. But the double taxation of corporate this 1av be changing as the indivi- incote. dual inco1e tax gets revised.
Provis1ons Korea
Corporate 30%; Standard Base Inco;e Tax Rates and Bases a/
Additional Surtaxes Taxes on Inco1e 7.5l Inhabitant's Tax (local)
25~ D~fense Tax (eav have expired) Excess Profits Tax
100l of inco•e derived froM prices set above the gavt standard.
Oeprec1at1on b/ Straight Line Hethod
Capital Sains/Losses e/
Carryover Provisions
Taxes on Dividends
Taxes on Interest
Hiscellaneous Notes
RateiAsset Life Bld M~E Veh lOX lOX 251
10yrs 10yrs 4vrs or Declining Balance Method
Oeprec1ation Rates Bid M&E Veh
20.6% 20.bX 43.8%
Treated as ordinary incoMe. Standard Base
25% additional tax on sales of land Basis = Sale price - Inflat1on
Adjusted Orig Cost lnflAdj = annual Y. change in WPI x
nusber of years property was held (ann change in WPI l11ited to 5%}
Carry forward 3 years.
lOX withholding taK on dividends fra1 a ca1pany listed on the Korean Stock Exchange.
25X otherwise and for nonresidents.
lOX or 25X withholding tax on interest paid to restdents.
25% withholding tax on interest paid to nonresidents.
Assets aay be revalued to adj for inflition, if the WPI increases by 25% or acie. There is a 3% tax on the inreased valued of the assets less carried ov~r losses.
- 6 -
TABLE 1 -- page 3
Coaparison of Corporate Tax Structu?e in East Asian Countries
Hong Kong
18.5X; Standard Base
- non~ -
Buildings - Straight Line Method Other Assets - Declining Balince
with Initial AlloMances Initial AllDMince Bld M~E Veh 20X 351 354
Annual Rate Bld H~E Veh
4X 20t 30i. Standard Balancing AdjustMent
Exetpt Capital losses cannot be used to
offset ordinary inco1e.
Carry forward indefinitely.
- none -
17X withholding tax on interest. (this is a final tax)
There are no further taxes on divi-dends. Hence, double taxation of corporate incote is avoided.
Taiwan
35%; Standard Base 25~ for •productive" enterprises;
Standard 'Dase
- none -
Straight line Hethod Rate/Asset Life
Bld MlE Veh 51 10X 251
20yrs 10yrs 4yrs (10-26) (8-16l (3-5)
Treated as ordinary incoae. Standard Base
Additional tax on sales of land Basis = Sale price - Inflation
Adjusted Orig Cost
Carry forward 3 years.
15% withholding tax an dividends paid to residents.
20% Nithholding tix on dividends paid to nanresidents.(see Notes)
15X Nithholdin1 tax on interest paid to residents.
20% withholding tix on interest piid to nonresidents.
There is a 1ini1u1 tiK of i5X on dividends re1itted abroad. TaiMan has recently iaple•~nted a Value Added Tax.
- 7 -
TABLE 1 -- page 4
Coaparison of Corporate Tax Structure in East Asian Countries
Sources; Tax infortation published by the International Bureau for Fiscal Docu;entation.
Price Waterhouse information Gu1des.
a. Standard base for the corporate inco;e tax equals revenue less wages, cast of aaterials, deprectat1on allowances, 1nterest, and other expenses.
b. Standard balancing adjust~ent equals the sale prtce less the adjusted basis (ie, or1ginal cost less realized allowances, including initial alloMances), Positive adJustMents are limited to the sua of realized allowances.
c. Bid = Buildings, H~E = Hachinery and Equip~ent, Veh = Vehicles.
d. Typically, initial allowances are granted in addition to annual alloMances wh1ch cover 100~ of depreciation. Also, the basis for the annual allowances is not adjusted for the initial allowances. Execeptions are specifically 1entioned in the table.
e. The standard base for capital gains is the sale price less the adjusted basis.
- 8 -
simplifies cross-country comparisons as well as providing a fairly comprehen
sive presentation of tax policy structure.
There are several interesting similarities aud differences among the
countries in our sample. The most striking, initially, are the statutory
rates. They predominantly lie in the 30-40 percent range, but there are some
note~orthy exceptions. Hong Kong's statutory rate, 18.5 percent, is signifi
cantly lower. Taiwan also offers a particularly low rate, 25 percent, if the
firm is considered a "productive" enterprise.
But the ~ost significant observation is more subtle. In this sample
of nine countries, five of them make an attempt to eliminate or reduce the
double taxation of dividend income. In Hong Kong, dividends are not taxed at
the personal level. That is, the corporate income tax is the final tax on
corporate income. In Thailand, as in Malaysia and Singapore, a credit is pro
vided to recipients of dividends that approximates the taxes already paid by
the firm. The credit is used to offset the individual's tax liability at the
personal level. Japan offers a similar, but smaller, credit on dividends,
which partially offsets this double taxation. These credits significantly
lower the effective tax rate at the corporate level (as the results in the
next section illustrate).
No two countries offer identical depreciation allowances, but they
basically follow one of two methods, straight line or declining balance.
Several countries have variations that are standard features, i.e. available
to all corporate investment in depreciable assets. In particular, Malaysia,
Singapore and Hong Kong use an initial allowance that is similar to an invest
ment deduction. Also, increased rates for declining balance depreciation
- 9 -
(double declining balance, roughly) are available in Indonesia, Philippines,
Japan, and Korea.
None of the systems employ automatic indexing for inflation. This
implies that the real value of depreciation allowances will erode over time,
especially at high inflation rates. Korea has a procedure in which companies
can revalue their assets for depreciation purposes, if the price level rises
by 25%. But this is a somewhat discontinuous process. We should note that
initial allowances and double declining balance techniques used in some
countries in the region (mentioned above) place depreciation allowances
towards the earlier part of the asset's life. Hence the allowances retain
more of their real value with inflation.
Capital gains treatment follows two basic procedures$ The key ele-
ment is whether capital gains are treated as ordinary income. If this is the
case, then the sale price less the adjusted basis (i.e., original cost reduced
ry allowed depreciation) is added to income in the sale year and taxed accor
ding to the statutory rate. When capital gains are taxed at a rate that dif
fers from the statutory rate, a balancing adjustment usually enters the calcu
lation of taxable income. The balancing adjustment attempts to correct for
the difference between allowed depreciation and the economic depreciation that
actually took place. It may be positive or negative. For example, if the
sale price is less than the adjust~ basis, then the asset actually depre
ciated faster than the allowances granted. In this case, the taxpayer is
granted a balancing allowance equal to the difference which reduces ordinary
taxable income. If the sale price is greater than the adjurted basis,· then
depreciation allowances were too large and the balancing adjustment is an
- 10 -
addition to taxable income. This adjustment is limited to the total allow
ances already granted for depreciation.
Finally, the difference between the sale price and the original cost
of the assets represents a capital gain that can be taxed at a special rate.
It is worth noting that capital gains are exempt from taxes in Singapore and
Hong Kong, but both are subject to the balancing adjustment. Also, since
depreciation is not indexed for inflation, the adjusted basis does not account
for inflation. Thus, purely nominal increases in prices are taxed as capital
gains. This tends to increase marginal effective tax rates.
All of the countries in the region provide for the carryover of
losses. Malaysia, Singapore and Hong Kong allow for losses to be carried
forward indefinitely, while the others like Thailand offer a fixed period.
Only Japan has an option for carrying losses back a year.
Withholdings taxes on dividends and interest are a common feature.
The only exception is that Hong Kong has no further taxes on dividend~ and,
thus, does not withhold anything.
Finally, all countries offer investment incentives. Although tax
holidays and various othe~ investment incentives are available in all the
countries in the sample, they are granted under special conditions. For
example, export industries may be eligible for added incentives. Or a company
may receive extra benefits for locating in a particular area. In this study,
we have considered only the standard tax code provisions available for an
ordinary industry.
- 11 -
III. Marginal Effective Tax Rates for Capital Investments in East Asian Countries
The.corporate tax data presented in Section II were used to calculate
marginal effective tax rates for capital investment in the East Asian
countries under study; a description of the cash flow calculation of effective
tax rates is given in Appendix A. For the purpose of these calculations.,
investments were chosen to capture the variation in capital taxation in each
country. More specifically, separate investments in each of the three basic
depreciable assets presented in Table 1 -- buildings, machinery and equipment 1
and vehicles -- were examined. Also, a representative investment project that
consists of all three depreciable assets and land was examined as well. ~/
This representative project was assumed to be 40 p~rcent building, 40 percent
machinery and equipment, 10 percent vehicles, and 10 percent land.
Several assumptions were made in order to carryout the cash flo~
calculation of the METR. The single asset investments and representative
investment project are assumed to be in operation for ten years. As mentioned
in Appendix A, replacement investment is undertaken at the rate of economic
depreciation for each asset. II Such replacement investment holds the real
value of each depreciable asset constant. At the end of the tenth year the
assets are sold at s nominal value that reflects their real value plus
inflation over the ten years. ~/ Sale of the assets is included in the
analysis to capture the effect of capital gains treatment and any balancing
adjustments in each country. ~/
Only the corporate tax is considered in the calculations presented
here. The taxation of dividends at the personal level or of interest on debt
to the lender are not included. The personal incoro~ tax in some countries
- 12 -
provides a credit for corporate tax paid on dividends. Such credits reflect
an attempt to eliminate (or approximately eliminate) the double taxation of
dividends. When such credits exist, the corporate tax paid on dividends (at
Least to the extent it equals the credit) really functions as a withholding
tax for the personal income tax. Consequently, such credits are subtracted
from corporate taxes in the calculation of effective corporate tax rates.
These credits are an important determinant of the level of effective tax rates
in the results below.
The distribution of the corporate after-tax income as dividends and
retained earnings is important, especially because of the dividend credit. As
important, if not more so, is the allocation of sale proceeds between divi
dends and capital gains. Empirical evidence on dividend payout rates, re
tained earnings, and capital gains is hard to obtain in many of the countries
under study here. Further, the focus of this study is not on determining an
empirical effective tax rate for an existing capital stock. Rather, the focus
is on effective tax rates for new investments. Consequently, an assumption
that reflects a middle course for future dividend payout, retained earnings,
and capital gains is made. Specifically, corporate after-tax income flow is
divided evenly between dividends and retained earnings while the investment is
in operation; sale proceeds plus accumulated retained earnings are divided
evenly between dividends and capital gains at the time of sale. Of course,
actual practice can favor those forms of income that receive the most advan
tageous tax treatment, thereby lowering the effective tax rate of the invest
ment. However, given the focus on calculating an ex ante effective tax rate
with a common set of assumptions across countries, the dividend payout ratio
- 13 -
was taken, albeit arbitrarily, to be SO percent during operation and at the
sale of the investment.
METR's for capital investments in East Asian countries are reported
in Table 2. !Q/ These results were obtained with the real before-tax rate of
return fixed at 10 percent. The rationale of this approach is to approximate
the ex ante calculation of the effect of a country's tax system that an
investor would make using a standard before-tax rate of return. !!/
Results are obtained for all equity financing and SO percent debt
financing. Also, two alternative assumptions about the treatment of losses
are examined. The first is that negative taxable income is not allowed (i.e.,
negative taxes on negative taxable income are not allowed) and losses are
carried forward to be deducted against future income. The second assumption
is that negative taxable income and negative taxes are allowed. This does not
mean that the government pays refunds. The idea instead is that the company
can use losses to offset positive taxable income elsewhere. In other words,
full loss offset is assumed. This can happen within a company or among com
panies through mergers.
Case I: All Equity ~inancing and Loss Carryforward
The first row of results presents METR's for Hong Kong for all equity
financing in the loss carryforward situation. Hong Kong has the lowest METR's
for investment among the countries. The main reason for Hong Kong's low ef
fective rates is a low statutory rate.
The METR's in Malaysia, Singapore, and Thailand are lower than their
respective statutory rates for all assets. The main reason for these less
than-statutory rates is that all these countries have a dividend credit at the
personal level to avoid the.double taxation of dividends.
TABLE 2: 'Marginal Effective Tax Rates for Capital Invest1ent in Eist Asian Cbuntries
Cas~:~ I: All Equity Financing and loss Carry-fonu1rd
Asset: Building~ I'I&E Vehicles Project Statutory Country: Rate
Hong Kong 20.0I lb. 7t 16.0% 18.4% 18.5X Jndonesia 45.1t 39.0I 37.2% 41.6~ 35.0% Japan 42.01 37.3% 33.2X 39.27. 33.3! Korea 30.9% 34.8t 32.U 33.27. 30.04 Malaysia 37.6% 27.91. 20.04 31.7l 40.0! Philippines 41.81. 39.9'/. 41.bX 40.5% 35.07. Singapore 27.Bt 29.44 32.5% 29.51 40.0% Taiwan 3t.BI 32.6~ 2B.4X 31.9Z 25.0t Thailand 28.71 19.14 28.1/. 24.91 35.0!
Case II: 50 Percent Debt Financing and loss Carrv-forMard
Asset: Buildings M~E Vehicles Project Statutory Country: Rate
Hong Kong 16.2X l6.U 16.41 lb.U 19.5% Indonesia 40.2t 34.n 37.bt 36.01 35.04 Japan 34.1% 27.2'1. 23.2% 29.8% 33.3I Korea
1 34.77. 31.8t 35.9% 32.81 30.Q7.
l'lahysiil 30.81 2l.BI 4.n 24.2'1. 40.0'1. Philippines 38.3' 42.1Z 45.U 40.2t 35.0t Singapore 19.U 23.6t 25.7I 23.27. 40.0'% Taiwan 2B.Ol 29.6I 24.5'1. 28.21 .25.0I Thailand 25.1I 17.8I 24.9'1. 20.01 35.0%
----------·· "·--------------------------------------------------------------------Notes: Annual retained earnings are set equal to 501 of after tax tncome.
-In the sale year, equity is purchased with SOt of that year's proceeds plus accu1ulated retained earnings.
The Philippines do not allow the carry-over of losses for ordinary industries.
Case lll: All Equity Financin~ and Full Loss Offset
Asset: Buildings 1'1~E Vehicles Project Statutory Country: Rate
Hong Kong t9.Bt 13.Sl 10.9{. 17.31. 18.S:t Indonesia 45.1! 38.7'/. 34.5i. 41.bZ 35.0I Japan 42.0'/. 37.37. 32.6'/. 39.n 33.3% Korea 30.2t 34.8t 31.1l 33.1l 30.01 l'lalaysia 37.6% 24.3I 15.1Z 32.(1'/. 40.01 Phi lip pines 41.87. 38.1?: 37.6t 40.44 35.01 Singapore 26.lt 23.5Z 32.6t 2B.4I 40.0% TaiMan 31.Bt 32.64 28.1% 3!.9t 25.01 Thailand 28.7t 18.9% 28.11 24.n 35.0l
Case IV: 50 Percent Debt Financing and Full Loss Offset
Asset: Buildings ttttE Vehicles Project Statutory Country: Rate
Hong Kong 14.27. 2.9k -1.8% 9.6'/. 18.5'1. Indonesia 40.21 2B.Bt 21.0t 34.1~ 35.01 Japan 34.1% 26.0% 17.84 29.4% 33.3% Korea 1l:f.51 27.7'1. 21.0l 24.6Z 30.0% 11alaysia 30.21 10.8I -9.7% 20.5'1. 40.0% Philippines 34.41 27.81 26.8% 31.9X 35.0'1. Singapore 15.01 2.71 25.5% 15.2% 40.0'1. Taiwan 28.01 29.6'1. 21.bi 28.21 25.01 Thailand 25.1lt 7.3t 2l.U 18.6% 35.0%
f-1 +=--
- 15 -
Another reason for the lower-than-statutory effective tax rates in
Malaysia~ Singapore, and Thailand is that tax depreciation rates for buildings
and machinery and equipment exceed their respective economic depreciation
rates. However, as discussed in Section II, all assets are subject to tax
ation of nominal capital gains as ordinary income. This implies that purely
inflationary increases in the price of assets are taxed as real income. This
taxation of nominal gains falls heaviest on assets whose tax depreciation ex
ceeds their economic depreciation. However, the deferral of tax implied by
the fact that tax depreciation exceeds economic depreciation yields a net tax
advantage for buildings and machinery and equipment in Malaysia, Singapore,
and Thailand.
The METR for the representative investment project is an average of
the METR's for the individual assets. More specifically, it is a weighted
average in which the weighting occurs through the income statement for the
combined use of the assets in a single project. In other words, the depre
ciation and capital gains treatment for all assets and project-wide flows are
combined into a single after-tax cash flow for the project as a whole.
The fact that the METR for machinery and equipment is higher in
Singapore than in Malaysia brings out an inte~esting point. As Table 1 shows,
there are features of Malaysia's corporate tax, at least with regard to mac
hinery and equipment, that would appear to make its METR higher than in
Singapore. These features are: a 5 percent development tax that does not
exist in Singapore; a lower initial allowance and annual depreciation rate for
machinery and equipment than in Singapore; and a 5 percent capital gains tax
when, in Singapore, capital gains are exempt from taxation. The reason for
Malaysia's lower METR for machinery and equipment is two-fold. First, the
- 16 -
initial allowance does not reduce the basis for depreciation in Malaysia but
does in Singapore. Second, there is a capital loss for the investment in ma
chinery and equipment. In Malaysia, this capital loss can be used to offset
ordinary income; this is allowed because capital gains are taxed. In
Singapore, where capital gains are tax exempt, capital losses are not allowed
to offset other income. The difference in the treatment of capital losses
between the two countries is in large part responsible for the lower METR for
machinery and equipment in Malaysia.
There are several observations to draw from the comparison of the
taxation of machinery and equipment in Malaysia and Singapore. First, the
treatment of capital gains is an important component of the METR. Second,
capital losses can change the ranking of METR's between countries, especially
when there is an asymmetry in the treatment of capital gains and losses.
Also, adjustments in the basis for depreciation for investment incentives re
duce the effect of these incentives.
The METR for buildings is the lowest for assets in Singapore. This
is a consequence of the fact that buildings receive the largest initial allow-
ance.
The results are interesting for Indonesia especially in light of the
major tax reform that was recently implemented. Indonesia's tax reform was
designed, in part, to bring effective tax rates in line with statutory rates
and minimize the variation in effective rates among assets (the "level playing
field" objective). The results in Table 2 for Indonesia show that the disper
sion of effective rates seems to be no less in Indonesia than in other
countries. However, the dispersion in the effective rates in the countries
- 17 -
under study is not large, whether these rates ~re below, around, or above the
level of the statutory rate.
Depreciation in Japan is based on the declining balance method but
without switchover to straight-line. In other words, depreciation allowances
stretch out indefinitely. This tends to produce higher METR's for longer
lived assets. The results for Japan in Table 2 bear this out. The METR for
buildings is higher than for machinery and equipment or vehicles. Also,
METR's in Japan have a wider dispersion than in the Philippines where the de
clining balance method is also used but with switchover to straight-line.
METR's for the individual assets and the representative project are
higher than the statutory rate in Japan. As is the case for Thailand,
Malaysia, and Singapore, a dividend credit is largely responsible for this
result. The dividend credit of 10 percent in Japan is not as large as in the
other countries where it approximately equals the statutory corporate rate.
Consequently, METR's in Japan are not below the statutory rate while the
METR's in the other countries with larger dividend credits are lower than
their respective statutory rates.
METR's for Korea are close to the statutory rate. It is interesting
to note that buildings have the lowest METR. As Table 1 sho~s, the depre
ciation rate is the same for buildings and machinery and equipment. The METR
for buildings is lower because its economic depreciation rate is lower than
that for machinery and equipment. In other words, the excess of tax depre
ciation over economic depreciation is greater for buildings and, therefore,
the tax advantage is greater. This also happens with respect to vehicles. 121
The Philippines has a narrow dispersion of METR's for the three de
preciable assets around 40 percent. The METR for buildings, 41.8 percent,
- 18 -
departs the most from the statutory rate. The narrow dispersion of the METR's
in the Philippines is due, in part, to the method of depreciation which is
double declining balance with switchover to straight-line. 13/
METR's in Taiwan are higher than the statutory rate by over seven
percentage points.
Case II: Debt Financing and Loss Carryforward
Table 2 presents the effect of 50 percent debt financing on capital
investment in the countries under study. This is carried out with an interest
rate set equal to the before-tax rate of return. As a result, the before-tax
rate of return is unchanged by the use of debt. 14/ This was done to isolate
the pure tax effect of the interest deduction in the ex ante calculation of
METR's presented in this analysis.
Debt financing has two opposing effects on the METR. Interest pay
ments introduce an CJ.dditional deductible expense which reduces the METR. How·'
ever, total debt service payments, i.e. interest and principal, reduce the
amount that can be distributed as dividends from investment income. This re
duces the credit that is granted in some countries for corporate taxes paid on
dividends. This reduction in the dividend credit raises the effective
corporate tax rate.
The net effect of debt financing for the three. depreciable assets and
the representative project in Malaysia, Singapore, and Thailand is to lower
the METR~ The tax-raising effect of the reduction in the dividend credit due
to debt service payments does not exceed the tax-lowering effect of the
interest deduction.
- 19 -
The tax-reducing effect of capital losses in Malaysia contributes to
the decr~ase in the METR for machinery and equipment to 21.8 percent for 50
percent debt financing from 27.9 percent for all equity financing. Debt fi
nancing enhances the effect of capital gains taxation on the METR. This hap
pens because the rate of return calculation underlying the METR is a return on
equity. Debt reduces the amount of equity used to finance the investment.
When a smaller amount of equity capital is factored together with the same
amount of capital gains or losses, the tax treatment of the latter becomes
more important. Consequently, debt financing enhances the tax-reducing effect
of capital los~es for machinery and equipment in Malaysia.
Indonesia's METR for vehicles increases with debt financing for two
reasons. First, as mentioned above, debt financing enhances the effect of
capital gains taxation. Second, even with all equity financing, losses were
being carried forward. Consequently, in the first several years of operation
of the investment, interest deductions are merely being carried forward and
used later which mitigates their tax-reducing effect.
Korea's METR for buildings increases with debt financing for the same
reasons Indonesia's METR for vehicles increases. As mentioned, debt financing
enhances the effect of capital gains taxation. If capital gains are not
taxed, the METR would decline with debt financing-
In the Philippines the METR's for machinery and equipment and vehic-
les increase. If debt financing produces losses in the Philippines, they are
not carried forward but lost (under the current assumption that losses do not
offset positive taxable income elsewhere).
The changes in the METR's for Hong Kong, Japan, and Taiwan are the
net result of the same opposing effects on the METR of debt financing
- 20 -
described above. In these countries, the net effect of debt financing is to
reduce the METR for investment in each depreciable asset and the represent
ative project. The tax reducing effect of the small (10 percent) dividend
credit in Japan is enhanced by debt financing.
Case III: Full Loss Offset
The set of results on the right-hand side of Table 2 presents the
calculation of METR's allowing full loss offset. This means that companies
can receive negative taxes with an investment that produces losses. This
happens, as mentioned, because a company can use losses to offset taxable
income elsewhere. As with the first set of results, METR's for all equity anc
50 percent debt fina1cing are calculated.
The METR's in the full loss offset case are equal to or less than
what they are in the loss carryover case. They are equal when no losses are
being carried forward; i.e., when not allowing full loss offset is not
binding. When this constraint is binding, the METR's will decrease when full
loss offset is allowed. Knowing when there are losses can help in under
standing the changes in METR's.
The METR for an investment in vehicles in Hong Kong with full loss
offset and 50 percent debt financing is -1.8 percent, which essentially is a
zero METR. It is important to note that a zero METR does not imply that no
tax revenue is obtained from an investment in vehicles. ~/ A zero METR means
that an investment in an asset is effectively expensed as a cost of doing
business; i.e. the asset is treated like any other deductible input. However,
as long as the marginal product of the asset is positive, tax rev~nue is ob
tained from the income that is generated by the asset. Full expensing of
- 21 -
capital investment implies that the corporatA tax is a cash-flow or consump
tion tax.
The METR for vehicles in Malaysia declines dramatically with debt.
In fact, 50 percent debt financing produces the most negative METR, -9.7 per
cent, of all the results. This investment produces negative taxable income
and positive dividends in the first several years of operation. However, the
dividend credit in Malaysia is limited by the amount of corporate taxes.
Because corporate taxes are zero in the loss carryforward case, the dividend
credit is zero. Allowing full loss offset reduces corporate taxes (in the
sense that negative taxable income can reduce taxes elsewhere) but does not
reduce an already zero dividend credit. Thus, because the dividend credit is
limited by corporate taxes in Malaysia, full loss offset cannot have a tax
raising effect by reducing the dividend credit. Debt financing further
reduces corporate taxes and, also, does not reduce an 'already zero dividend
credit.
The METR for buildings in Thailand remain the same for both all
equity and 50 percent debt financing. The METR decreases with debt financing
which, as before, is the net result of the tax-reducing effect of the interest
deduction and the tax-raising effect of the reduction in the dividend credit~
In Thailand, the METR for machinery and equipment with all equity
financing, 18.9 percent, declines slightly from the loss carryforward case,
19.1 percent. This happens because losses previously carried forward are
being taken when they are incurred. Fifty percent debt financing reduces the
METR to 7.3 percent because the additional losses implied by the interest
deduction more than offset the reduction in the dividend credit. The METR for
- 22 -
vehicles decline slightly with full loss offset in the 50 percent debt
financing case.
The rest of the results can be explained in much the same fashion as
was done for the METR's in the loss carryforward situation. The reasons for
changes in METR's repeat what has been described above. Being able to deter
mine when the constraint on losses is binding helps to sharpen the explanation
of results, as was done for Malaysia and Thailand.
IV. Conclusion
An important conclusion to draw from the results presP.nted in this
study is that the dividend credit is instrumental in reducing the METR below
the statutory corporate tax rate. In fact, the three countries with METR's
below their statutory tax rates for all single-asset investments and the
representative investment -- Malaysia, Singapore and Thailand have a
dividend credit. The credits in these countries are designed to eliminate the
double taxation of dividends and subject dividends to personal income taxation
only. Any tax~tion of dividends at the corporate level essentially becomes a
withholding tax for the personal tax. Consequently, the dividend credit
reduces effective corporate taxation.
The METR's presented in this paper are not empirical or equilibrium
rates. The anglysis was carried out with the real before-tax rate of return
fixed at 10 percent. This was done to approximate the ex ante calculation of
taxes that an investor would make to compare the impact of taxation on invest
ment across countries. However, after-tax rates of return many differ sub
stantially among assets. This can induce a reallocation of investment into
lower taxed assets in order to bring after-tax rates of return into
- 23 -
equilibrium. Although the effective tax rates in equilibrium can be different
from those present~d in this study, the METR's given in Table 2 nonetheless
represent the signals given by a country•''s tax policy to investors.
The ex ante calculations of METR's presented here were done under
alternative assumptions about financing and the treatment of losses. The
corporate tax defined the base for taxation of investment which, in turn,
determined the after-tax cash flowa Investors may be influenced by many
factors other than corporate taxation, such as the quality of the infra-
structure~ ~,he availability and quality of labor, the economic depreciation of
physical capi.:-·.~.i, and the inflation and i11terest rates in a particular
country. Nonetheless, when these factors are taken into account, the
effective taxation of investment as measured by the METR presented here can
also be an important factor.
The METR calculations presented in this study were done with a common
set of parameters (other than those that pertain to a particular country's tax
structure) and economic assumptions applied to all countries. This provided a
common framework for analyzing the taxation of capital investment across
countries. For example, a single inflation rate and fixed dividend payout
ratio r. are assumed for all countries. These assumptions may not conform with
actual experience in a specific country.
A richer set of calculations for each country can be pursued with the
model used in this study. The parameters of the model can be easily set for a
specific country's actual experience. Alternative provisions of the corporate
tax can be compared in terms of their impact on the METR. Such an application
to a particular country can provide tax policy analysts with a convenient tool .
for examining the impact of policy options.
- 24 -
Endnotes
la This investment does not entail an increase in the employment of labor.
Consequently, investment income is the marginal increase in net revenue
that results from the investment project, where "net" means net of wages
and purchases of intermediate goods and services. This is the standard
line of analysis in the literature on effective corporate taxation, e.g.
Gravelle (1982) and King and Fullerton (1984). An excellent summary of
this literature is given by Ebrill (1986).
2. S~e Tanzi (forthcoming).
3o See Bahl (1987), Conrad (1986), and Musgrave (1981).
4. See U. S. Depratment of Treasury (1985).
Sa Pellechio, Sicat, and Dunn (1987).
6. This representative investment is intended to give some idea of the com
bined effect of the tax treatment for all three assets together. It also
is intended to give some idea'of the tax treatment of an actual invest
ment~ e~g. a factory. For this reason land, which ·is not depreciable, is
included.
1. The economic depreciation rates where obtained. from Hulten and Wykoff
(1981) and are 3.6 percent for buildings, 12.25 percent for machinery and
equipment, and 3U percent for vehicles.
- 25 -
8. Inflation is taken to be 5 ~ercent per year.
9e A balancing adjustment is an addition to taxable income when an asset is
sold. It usually equals the sale price of the asset or its original cost,
whichever is lower, minus the undepreciated balance for the asset. In the
U.S. this type of adjustment is referred to as recapture of deprecia
tion. See Table 1 for details on balancing adjustments in the countries
under study.
10. Calculations cf marginal effective tax rates were obtained from a model
con-tructed expressly for this purpose; a description of this model is
given in Pellechio (1986). The model uses financing and economic factors
as well as the tax parameters given in Table 1 for each country to calcu
late the cash flows that can be expected from an investment. This calcu
lation yields a single before-tax cash flow and single after-tax cash flow
for the investment which are used to compute a marginal effective tax rate
(METR).
11. This approach, of course, produces different after-tax rates of return.
If after-tax rates of return were significantly different among assets
within a particular country then investment would be reallocated to
equilibrate after-tax rates of return. METR*s based on a fixed before-tax
rate of return indicate the direction in which investment would be allo-
cated to achieve equilibrium.
- 26 -
12R The tax depreciation rate for vehicles, 43.8 percent, is higher than for
buildings, 20.6 percent. However, the excess of the tax depreciation rate
over the economic depreciation rate is higher for buildings (17 percent)
than for vehicles (13.8 percent). For this reason the METR for buildings
is lower.
13. The switchover occurs when the depreciation allowance obtained from the
double declining formula is less than that obtained from applying the
straight-line formula to the remaining basis with the remaining number of
depreciable years. It is to be noted, however, that the straight-line
formula is commonly used as a option in the Philippines in the computation
of depreciation allowances.
14. There are, of course, substantial changes in this cash flow. The amount
of equity put up for the investment is reduced by, the amount of
financing. Interest and principal payments reduce the before-tax cash
flow while the investment project is in operation. However, because the
real interest rate equals the real before-tax rate of return, these
changes in the cash flow do not change its present value. Consequently,
the level of investment income that yields a 10 percent real before-tax
rate of return remains the same at different debt ratios.
15. See McLure (1986) and Squire and Shalizi (1986) for analytic and empirical
examples of this point.
- 27 -
Appendix A
The Cash Flow Calculation of the Marginal Effective Tax Rate
The calculations presented in this study use tax, financing, and
economic factors to compute the cash flows that can be expected from an 1n-
vestment project. The cash flows combine the individual streams for each
asset (credits, depreciation, replacement investment) with the income gener-
ated by the project and other project-wide flows (e.g. debt service payments,
dividends, retained earnings) to yield a single before-tax cash flow and
single after-tax cash flow for the entire project. These two cash flows are
used to compute a marginal effective tax rate (METR) for the project as a
whole.
The before-tax (BTCF) and after-tax (ATCF) cash flows can be
summarized as follows:
(1) BTCFi
(2} ATCFi
where
d
K· 1
= - E· - dK· + R· - Int· - Prin. + NetSales· 1 1 1 1 1 1
= BTCFi - t{l+s) [Ri - Depi - InvDedi - IntDedi - Carryoveri;
+ CapGain· + BalAdj·] + cDiv· 1 1 1
= amount of equity used to finance the investment in period i
= economic depreciation rate for capital stock
= capital ·stock in period i
- 28 -
R· = investment income in period i 1
Int. = interest payment in period i 1
Prini = principal payment in period 1
NetSalesi = net sales proceeds in period i
t = statutory tax rate
s = surtax rate
Dep· = depreciation allowances in period i 1
InvDedi = investment deductions in period i
IntDedi = interest deductions in period i
Carryoveri = carryover losses in period i
CapGaini = capital gains 1n period i
BalAdji = balancing adjustment in period i
c = dividend credit rate
Div. = dividends in period i 1
The equity used to finance the investment is a positive amount in the
period before the investment generates income, i.e. E0
> 0, and is zero after-
wards. The rate of return underlying the METR calculation is a return to
equity.
Replacement investment is undertaken which reduces the before-tax
cash flow. 'Replacement investment equals the amount of economic depreciation
for each asset. !1
The investment project starts generating income in period 1. Invest-
ment income is the marginal increase in net revenue that results from the in
vestment project. ~/ Investment income keeps pace with inflation because
repla,cement investment preserves the productive capacity of the p~oject.
- 29 -
Interest and principal payments on debt used to finance the invest
ment are subtracted from the before-tax cash flow. When the investment is
sold, the proceeds ar~ added to the before-tax cash flow. Net sale proceeds
equal the sale price minus the payoff of the bal~nce of a loan, if applicable.
The after-tax cash flow equals the before-tax cash flow minus taxes
paid and plus credits. The statutory tax rate, t, plus any surtax rate, s,
are multiplied by taxable income.to yield the regular tax liability. Taxable
income is given by the term in brackets. Taxable income, in its most basic
form, equals investment income minus depreciation allowances, investment de
ductions, and interest deductions. Investment deductions are given in addi
tion to depreciation and are intended to serve as an incentive for invest
ment. They may be given for the project as a whole or on an asset-specific
basis. A positive taxable income may be reduced by losses being carried for
ward. If taxable income is negative and full loss offset is not assumed then
the loss is carried forward. 11 When the a~set is sold, any taxable capital
gains or balancing adjustment are added to taxable income. 11
The last term in equation (2) refers to any special tax treatment for
dividends. In particular, and as described in Section III, a credit may be
given on dividends at the personal level to offset the taxation of dividends
at the corporate level. As explained in Sections III and IV, this credit re
duces corporate taxes and, therefore, is added to the after-tax cash flow in
equation (2).
If b denotes the real before-tax rate of return and a, the real
after-tax rate of return, then the marginal effective tax rate is given as
follows:
(3) METR = (b - a)/b
This formula has bee~ used. extensively in the literature on·the tax
ation of capital investment. 11
- 30 -
Appendix Endnotes
1. If the investment project includes more than one asset then dK represent&
the sum of the depreciation rates for each asset times their respective
capital stocks.
2. "Net" is taken to mean net of wages and purchases of intermediate goods
and services.
3e The full loss offset assumption is discussed in Section IV. Results are
presented in Section IV with and without this assumption.
4. Section III describes now capital gains and balancing adjustments are
defined.
5. See Gravelle (1982), Auerbach (1983), and King and Fullerton (1984).
- 31 -
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Some RG~ent DRD Discussion Papers
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242. Adjustment with a Fixed Exchange Rate: Cameroon, Cote d'Ivoire and Senegal, by S. Devarajan and J. de Melo.
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248. The Importance of Trade for Developing Countries, by B. Balassa.
249. The Interaction of Domestic Distortions with Development Strategies, - by B. Balassa.
250. Economic Incentives and Agricultural Exports in Developing Countries, · by B. Balassa.
251. Lessons from the Southern Cone Policy Reforms, by v. Corbo and J. de Melo.
252. On the Progressivity of Commodity Taxation, by s. Yitzhaki.
253. A Full Employment Economy and its Responses to External Shocks: The Labor Market in Egypt from World War II, by B. Hansen.
254. Next Steps in the Hungarian Economic Reform, by B. Balassa.
255. On the Progressivity of Commodity Taxation, by S. Yitzhaki.
256. Government Deficits, Private Investment and the Current Account: An Intertemporal Disequilibrium Analysis, by S. van Wijnbergen.
257. Cooperation, Harassment, and Involuntary Unemployment: An InsiderOutsider Approach, by A. Lindbeck and D.J. Snower.
258. Investment i~ Segmented Capital Marketa, by I. Nabi.
259. Privatizing the Financial Sector in LDC's: Lessons of an Experiment, by N. Hamid and I. Nabi.
260. Hercules - A Modeling System with Knowledge about Economics, bY. A. Drud.