TRAIN 2 and the Features of a Good Tax System - Yasuyuki Sawada | Asian Development Bank

TRAIN 2 and the Features of a Good Tax System - Yasuyuki Sawada

Op-Ed / Opinion | 19 July 2018

Adequate government revenues are critical for a country’s development, and the Philippines is no exception. Improving infrastructure, reducing poverty and inequality, and investing in health and education—all require strong public finances. The Asian Development Bank estimates that the Philippines will need to invest about 7 percent of GDP annually in infrastructure alone to support the country’s rapid growth. The Duterte administration is targeting reaching that level of infrastructure investment by 2022, more than doubling it from less than 3 percent of GDP on average over the past two decades.

At present, the Philippine government’s revenues are just under 20 percent of GDP, well below the 25 percent of GDP average for developing Asia and the 36 percent of GDP average for advanced economies. Ensuring adequate revenues—one of the key features of a good tax system—is one of the primary motivations behind the government’s five-part tax reform program. The tax reform and improvements in tax administration aim to raise up to 3 percent of GDP annually in additional revenues, with 70 percent of this earmarked for infrastructure and 30 percent for social spending.

Just as important as mobilizing revenue, however, is ensuring that the tax system works well. There are several other features of a good tax system beyond revenue adequacy. These are equity, efficiency, competitiveness, stability and predictability, ease of administration and compliance, and the need to ground policies in evidence. Let’s see how the tax reforms, and particularly the second legislative package known as TRAIN 2, fare along these seven dimensions.  

Oftentimes when people think of equity in taxation, they focus on “vertical equity,” or how the tax system treats people with different incomes. Most tax systems aim for progressivity, where the rich pay a higher share of their income in taxes than the poor. The first phase of the tax reforms addressed this issue and succeeded in reducing personal income taxes for the bottom 99 percent of the population.

But another important element is “horizontal equity,” or how the tax system treats similar entities. The guiding principle is fairness—the playing field must be level, so that similar entities face similar tax rates. If we look at the current system, the incentives that some firms get but others don’t works against horizontal equity. Firms that manage to get tax incentives face much lower effective tax rates of 6-14 percent, whereas firms that don’t face a 30 percent rate. TRAIN 2 aims to improve horizontal equity by rationalizing fiscal incentives for businesses. 

By rationalizing existing fiscal incentives, TRAIN 2 will allow for a reduction in the 30 percent corporate income tax rate, and this will help with the third and fourth features of a good tax system—efficiency and competitiveness. One of the principles in public finance is that distortions, or the decline in society’s well-being due to a tax, rise disproportionately with the tax rate. For this reason, it is more efficient to have a broader tax base and a lower rate, and that is what TRAIN 2 is trying to do for corporate taxation. A lower corporate tax rate will make the Philippines’ tax system more competitive, as it currently has the highest corporate tax rates in ASEAN. 

One argument often leveled against TRAIN 2 and the tax reform program more broadly is that by changing things, the government is reducing the stability and predictability of the tax system—the fifth feature of a good tax system. But one cannot and should not keep a tax system fixed—especially a flawed one—simply for the sake of “stability.” The Philippines’ tax system is in dire need of fixing, and this is the first major tax reform in the Philippines in two decades. If we allow it to be done right, and done quickly, the Philippines will not need another tax reform for another two decades. 

When it comes to the sixth feature of a good tax system, ease of administration and compliance, two elements are very important—simplicity and transparency. TRAIN 2 aims to help by replacing the 123 special laws that govern tax incentives with a single law, and bring the 14 different investment promotion agencies under a single body, the Fiscal Incentives Review Board. One lesson from history is that the government should not be in the job of “picking winners”—the track record of countries around the world in doing this is not good, and it often stimulates lobbying for personal gain. Rather, incentives should be based on firms’ documented ability to deliver, whether it be creating more jobs, raising incomes, or increasing exports. 

Which brings us to the final feature of a good tax system and of good policy more generally—that it be supported by solid evidence. The proliferation of large amounts of useful data have led to a “credibility revolution” in evidence-based policymaking. Thanks to the Tax Incentives Management and Transparency Act, it is now possible to analyze whether tax incentives—which reduced government revenues by P301 billion in 2015—have delivered the employment, income, and export growth it promised. This lines up well with the objective of TRAIN 2 to make tax incentives more performance-based. 

In sum, TRAIN 2 and the broader tax package are critical to strengthening the Philippines’ tax system. Passage of this important legislation will demonstrate the commitment of Congress, and the country more broadly, to the reforms that are needed to spur growth, reduce poverty and inequality, and achieve upper middle-income status. It will also set the foundations for stronger and more inclusive growth for the next generation of Filipinos.