Tax Reforms in Developing and Transition Economies Utrecht University, July 1, 2005

1. Tax Reforms in Developing and Transition EconomiesUtrecht University, July 1, 2005 Policy Aspects of Tax Reforms Michael J. McIntyre Professor of Law Wayne State University Law School Visiting at Utrecht University

3. Economic Context For Tax Reform Challenges Facing Developing and Transition Countries • Broken Promises on Agricultural Subsidies • Pressure to Liberalize Capital Flows • Reduction in Revenues from Import Duties • Tax Competition • Int’l Rules Limiting Source Taxation • Tax Haven Abuses • Capital Flight by Wealthy Individuals • Evasion/Avoidance by Companies

4. “New” Features of the Global Economy Changes in the Economic and Political Landscape • Production of many goods is relatively easy. • Redistribution of income and wealth is hard. • Transportation, communication, financial • transactions, and energy are relatively cheap. • “Trade secrets,” etc. available for sale. • Absolute comparative advantage is unimportant. • High-tech workers are mobile, but not • absolutely. • Tax fraud is easy and cheap.

5. Nature and Limitations of Tax Advice Tax Reform is Local, and Tax Advice is Custom Work • Best tax system for any country depends on many • factors, including its: • economic structure, • capacity to administer taxes • public service needs • political organization (national or federal) • income inequalities (individual and regional) and political willingness to address them. • Still, some tax goals and methods of achieving them are • common.

6. Common Tax Goals “Middle-level” Developing & Transition Countries • Raise enough revenue to pay the bills — mobilizing • resources for development. • Good taxes are better than bad taxes, but most • bad taxes are better than no taxes (inflation). • Redistribution of Wealth and Income. • Income (corporate and personal) promote regional • and individual equality. • VAT can be progressive in some countries. • Economic growth. Avoid high rates and use taxes that • can be administered.

7. Leverage to Tax Conditions that Make Taxation a Practical Possibility • Although taxes are compulsory, taxpayers have a lot of • leeway in avoiding tax. A country needs some hook to • make its tax effective (and not shifted). • Access to market. A country with a good domestic • market has a capacity to tax because foreign taxpayers • who do not pay can be denied access to that market. • High profit opportunities. A country has power to tax if • taxpayers can make good money there.

9. Taxing Multinational Corporations Corporate Tax As Tool for Development • The story from many economists since the 1980s has • been to avoid taxes on capital, including a corporate tax. • Claim is that avoiding taxes on capital promotes growth. • BAD ADVICE. • In a developing or transition economy, the corporate tax • serves three important functions even if growth is only • goal: • Taxes monopoly rents earned by MNEs. • It is less bad than any likely alternative tax. • It protects the personal income tax.

10. Other Advantages of Corporate Tax Growth is Just One Important Goal • Revenue — Most Developing and Transition Countries • Have Impoverished Public Sector. • Captures gains in modern sector — benefit taxation, in • that much government revenue spent for the modern • sector. • Regional Redistribution — Socially Acceptable Method • for Taxing Prosperous Regions. • Regulation of Business — Some Check on Private • Corruption and Protection of Shareholders

11. Earnings Stripping Methods for Removing Income of MNEs from Tax • Excessive deductions for interest and royalties. • Countries should preserve right to tax in treaties, • especially for royalties. • Thin Capitalization Rules Needed. • Currency manipulation and other use of derivatives with • related entities. Countries should not allow deductions • for hedging, etc. with related persons. • No exemption or special treatment of capital gains.

12. International Aspects of Reform Treaties and Domestic Law Rules • The first requirement is that a country have sensible • domestic laws governing international income. • Goal is to tax income arising in the country. • That goal is best achieved by taxing worldwide • income with a credit system. Exemption system • provides more tax avoidance opportunities. • The second requirement is administrative capacity.

13. Some Tax Treaty Issues UN Model Favored Over OECD Model • OECD Model limits source taxation on both business • and investment income. UN Model also limits source • taxation improperly, but less so than OECD Model. • PE Rule. OECD Model creates too high a threshold for • taxation. Better rule is to allow taxation if business • activity is substantial (.e.g., above € 200,000). • OECD limits taxation of e-commence to residence • country.

14. More Treaty Issues Transfer Pricing • OECD has read its 1995 Guidelines into the Article 9 • (Associated Enterprises). In fact, only method that works • for most developing countries is the Transactional Net • Margin Method (TNMM), called Comparable Profit • Method (CPM) by US. • New Guidance from OECD on allocation of profits to a • PE. Favors arm’s length method for banks and • insurance companies.

15. Capital Flight Huge Problem for Many Developing Countries • Capital flight problems are increased as a result of • greater freedom to move capital. Developing and • transition countries should be cautious in liberalizing • capital movement rules. • For Africa, outflow of capital appears to exceed the • inflow. But the problem is nearly universal. • EU saving directive, which goes into effect today, tries to • deal with capital fight out of EU but will not be helpful in • limiting capital flight from developing countries into EU.

16. Concluding Notes Taking a Stand • Developing and transition countries both promote tax • avoidance/evasion and are the victims of it. They need • to decide which side they favor. • Private investment, although important for development, • needs to come on terms beneficial to the host country. • Cooperation among developing and transition countries • is critically important — the developed countries have • their own agenda.