The case for CITIRA’s lowering the Corporate Income Tax

Dedicated to amigisimo and contrarian thinker Ernest Leung.

THERE is no question that the Philippines needs a boost to its dismal investment rate (22-24% of GDP while our neighbors are punching at 25-35%). But the question is how? The government’s Corporate Income Tax and Incentive Rationalization Act (CITIRA) claims that a lower statutory corporate income tax has to be part of the mix! The subsequent strident debate on CITIRA mostly centers on how the replacement of gross income tax (GIT) at 5% with a corporate income tax (CIT) will impact locators and foreign investment in PEZA, the source of most of our manufactured exports. But truth to tell, this replacement issue, as important as it is, is a derivative one. While overstaying incentives are a legitimate issue, the major prior reason for the restructuring of PEZA incentives — including the replacement of gross with corporate income tax for locators — is to plug the potential fiscal hole punched by the proposed lowering of the statutory corporate income tax (CIT) rate from 30% to 20%. The crucial claim is that lower statutory CIT will boost investment and growth — a claim, mind you, that is by contrast largely glossed over. Surely, the Department of Finance (DoF) team must have this issue well-covered. But merely pointing to the lower average CIT in our Asian neighborhood (average 20% today), where the investment rate today is higher, is no proof that higher investment rate will result in the Philippines. In 1980s when they were making their move, Malaysia’s and Singapore’s CIT was at 40% while Indonesia’s was at 35%. Nor does it suffice to point to Sweden’s and Denmark’s corporate income tax at 22% in 2019, since Sweden’s was at 60% in 1989 and Denmark’s was at 50% in 1985. A cursory check of the evidence seemed in order if only to confirm the claim.

The CITIRA position finds support in Lee and Gordon (2004) who, over a panel data throughout the period 1970-1997 for 70 countries, found a negative and significant relation between growth per capita and CIT. However, Shevlin et al.’s (2016) cross-country regressions found that the association between statutory corporate income tax and per capita income growth for the period 1995-2011 disappears altogether when area and year fixed effects are added — questioning the robustness of the Lee and Gordon result. Of even more interest is their result that statutory corporate income tax does not associate at all with long-run (two- to five-year horizon) economic or employment growth. Shevlin et al. however find that lower effective tax rate (what firms actually pay, accounting for tax avoidance and on average 7.2% lower than the statutory rates) does associate significantly with higher growth. Hunady and Orviska (2015) find a non-linear relation between economic growth and statutory corporate income taxation for the EU economies from 1999 to 2011: positive for lower corporate income tax rates but becomes negative for higher rates (see also, Misuru and Nakamura, 2019). They do not say whether 30% is high. Rebelo and Jaimovich (2018), conceding at the outset that there is no relation between the long-run growth of the US economy and corporate tax rate, nevertheless argue that the 2017 Trump corporate income tax cut can still deliver a bump in economic growth in the short run if the initial tax rate is exceptionally high. They do not say where the high tipping point lies.

How about firm level investment? Djankov et al. (2008) find that the statutory corporate income tax has no effect on the investment behavior of firms across the world. FDIs do fall with statutory corporate income tax rates, but the FDI issue in CITIRA is different — a switch from a 5% GIT (with CIT equivalence of 13% as per DoF computation) to a 20% CIT, an effective rise in statutory rates for FDI. By contrast, a higher effective corporate income tax rate (see also Ohrn, 2018, for the case of US firms) does have a negative effect on investment. While the number of studies cited here is limited, the overall flavor is clear: within a reasonable range, statutory CIT and growth/investment are not associated.

The Djankov et al. results draw from cross-country regressions for only one year, 2004. Most of the results in this area of study are for affluent developed economies, such as the EU or USA with no allowance made for low income economies as a group. The behavior of the poor is markedly different than the economic behavior of the rich — ask the authors of Poor Economics and 2019 Nobel Memorial Prize winners Banerjee and Duflo.

That the link between statutory CIT, on the one hand, and economic growth and corporate investment, on the other, seems so tenuous was a surprise. In the long debate over low investment rate in the Philippines in the last two decades, the weak rule-of-law on property rights and contracts, the high power cost, the unstable regulatory environment, and the licensing hurdles for investors were the recognized binding constraints. The corporate income tax came up occasionally only because ours is higher than regional average. If there is no real progress in those other identified binding constraints, the envisioned growth and investment boost from lower CIT may be a mirage. Lower CIT may only finance higher dividends for shareholders, more spirited stock buybacks which rewards shareholders, or, if higher corporate investing materializes at all among local firms, it may find its home not in the Philippines but in Vietnam, Indonesia, or Thailand. To embark on a reduction of the statutory CIT and make the export manufacturing sector foot the bill on such unsolid ground seems reckless. I hope I am mistaken and merely missed something really important in this cursory review.

References:

Ohrn, Eric, 2018. “The Effect of Corporate Taxation Investment and Financial policy: Evidence from DPAD,” American Economic Journal: Economic Policy 10 (2): 272-301.

Rebelo S and N Jaimovich, February 2017. “Non-linear Effects of Taxation on Growth,” Journal of Political Economy, 126 No. 1, 265-291.

Djankov S, T Ganser, C MacLiesh, R Ramalho, and A Shleifer, “The Effect of Corporate Taxes on Investment and Entrepreneurship,” NBER Working Paper 13756. Available at https://www.nber.org/papers/w13756.

Ueshina M and T Nakamura, 2019. “An Inverted U-shaped Relationship between Public Debt and Economic Growth under Golden Rule of Public Finance,” Theoretical Economics Letter, 09(06): 1792-1803).

Hunady J and M Orviska, 2015. “The Non-Linear Effect of Corporate Taxes on Economic Growth,” Timisoara Journal of Economics and Business, 8: 14-31.

Shevlin T, L Shuvakumar, and O Urcan, 2016. “Macroeconomic Effects of Aggregate Corporate Tax Avoidance: A Cross Country Analysis.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2800466.

Lee, Y and R Gordon, 2005. “Tax Structure and Economic Growth,” Journal of Public Economics 89, 1027-1043.

Raul V. Fabella is a retired professor of the UP School of Economics, a member of the National Academy of Science and Technology and an honorary professor at the Asian Institute of Management. Weaving ideas in coffee shops and evidence-checking of policy proposals is an integral part of his day. He gets his dopamine fix from hitting tennis balls with wife Teena, watering plants, and bicycling.