Thursday 29 August 2013

A note on the IRC reform proposal

This note is based on the preliminary proposal for a reform of the corporate income taxation in Portugal.

The subtitle of the proposal states the scope of the reform: to improve competitiveness, increase growth and create employment. To achieve the latter goals the proposal stands on three elements. First a simplification of the IRC code, the fiscal-legal element. Second a gradual and certain decrease in the tax rate, the budget-macro element. Third a corporate tax coherent with the new international environment, the international cooperation element.

The legal-fiscal dimension is the central focus of the proposal. The authors have produced an impressive and detailed code that contains new articles and alterations to the older ones. Being a macroeconomist with a weak understanding of the legal technical language, I am not in measure of evaluating the contents of these articles. Surely the objectives of simplification and increased efficiency are of primary importance. Overall given the background of the commission this appears to be the strong element of the reform. 

The budget-macro dimension is weaker.  The key point of the document is the large decrease in the average corporate tax rates across the OECD and G20 countries that went from 40.9 percent in 1990 and decreased to 26.3 percent in 2013. The authors maintain that this decrease has caused growth, investment, employment and a reduction of tax fraud. To strengthen the causal link they present several graphs showing a negative correlation between the tax rates and tax revenues. The idea is that the reduction in the tax rates has increased the revenues partially through a broadening of the tax basis and especially in response to a “virtuous” supply side mechanism (that also caused growth, investment and employment). The analysis should be more nuanced. The international reduction in corporate tax rates started 30 years ago is most likely a response to the greater mobility of capital.  Increased profitability in the corporate sector explains, at least partially, why revenues as a percentage of GDP did not decrease despite the reduction in rates. The large increase of the financial sector during this period is also part of the explanation. The authors recognise that beyond the stylised evidence presented, no evaluative research to legitimate the practical implications on competitiveness, growth and employment of the proposal has yet been done.

The budget implications have been quantified for three different scenarios and are approximately 220 million euro per year, with a 5 years cumulative effect on fiscal revenues in the range of 1200-1400 million euro.  The quinquennial horizon of the reform responds to the necessity of spreading the loss in tax revenues during this period of budget consolidation.  A legitimate question is to ask if the decrease of the corporate tax rate from 31.5% to 19% that costs 220 million euro per year is welfare superior to different proposals such as decreasing the tax on labor. It might well be that this is actually the case but evidence would be welcomed.

The international cooperation dimension suggested is the one I more tenaciously debate. The stance of the reform is the one of a realist state-centric small economy. Somewhat a paradoxical posture for a European country, especially when the G20 is pushing for new international standards to be designed to ensure stronger coherence of corporate taxation across countries. The OECD, called to develop an action plan, has heralded the proposal of cooperation a “once in a century” opportunity to fix a creaking taxes system. Critics will call it a rhetorical statement and that taxation is the last line of defence of countries sovereignty. Perhaps, but I believe that only through cooperation, nation states, especially the small and medium sized, will be able to maintain their sovereignty.

Ultimately the Portuguese authorities want to implement a corporate tax reform to increase the welfare of all Portuguese citizens. Trade-offs are present: fiscal stability versus stimuli effects, allocational efficiency between capital and labor, short term versus long-term effects. Overall the case on the desirability of the reform can be made. I would suggest changing the methodology and riding the opportunity given by the G20-OECD action plan on corporate income tax reform. Become the first mover to launch and implement the coordinated plan. This could be the stance of a cosmopolitan nation state.