Competitive Global Tax Structures As Major Investment Determinant

When you read economic articles from the mainstream media or from popular "experts", one would accrue two significant but misleading impressions:

1. governments are the sole entities that are engaged in trade (from discussions of trade imbalances)

2. low wages are the only criteria that ensures success or economic prosperity (from discussions of currency manipulation)

But of course, such discussions is far from the truth or reality.

Governments generally don't produce anything but generates its revenues by taxation. This means that people through various forms of enterprises, and NOT the government itself, are engaged in trade.

Next, investment is a function of returns: particularly, the rate of return on investments. Of course before establishing the rate of investments, the most important factor would be the return OF investments (via security of property rights).

In other words, expected profits (revenues-costs) determine investment activities.

In contrast to mainstream polemics, the fact is that wages constitute only one of the many variables that adds up to the long list of costs.

Yet there are other factors that determine the profitability of an enterprise among them: as stated above is the varying degree of property rights, different conditions of existing infrastructure, operational institutions, legal framework (which secures contracts and resolves disputes), cultural variables (traditions, superstitions etc.), security, political stability, capital and production structure, access to markets, access to raw materials, access to finance, degree of labor and skills available, education of the labor force, cost of energy, transportation and connectivity, quality of management, regulatory structure, transaction costs, tax policies, degree of economic freedom and etc...

Importantly these cost structures can be nuanced by the operating principles of the comparative advantage and specialization or the division of labor.

Yet all these very important variables are frequently ignored when arguments get oversimplified but cloaked with technical gobbledygook.

Below is an example of a more important factor that influences business activities.

It's about tax structures.

The chart taken from the Economist, highlights on the world's declining corporate tax rates.

The Economist with a tinge of demur from falling tax rates writes, (bold highlights mine)

``CORPORATE-TAX rates in OECD countries have fallen remorselessly over the past 30 years. A survey by Robert Carroll of American University in Washington, DC, found that the top rate in OECD countries (excluding America) had dropped from 51% in the early 1980s to 32% by 2009. Competition among countries to attract business and with it bring employment was fierce in the late 1990s and early 2000s. Ireland reduced its corporate-tax rate to just 12.5% and chose not to raise it last year during an emergency budget. Such differentials may not last long. High-tax European governments have complained in the past about competition from countries such as Ireland and the current economic crisis may lead to more calls for co-ordination of tax policies."

Of course, coordination of tax policies won't work. Competition among governments will still determine investments.

This from World Bank's Paying Taxes 2010

According to Doing Business 2010 (all bold and italics emphasis mine)

``The size of the tax burden on businesses matters for investment and growth. Where taxes are high and corresponding gains seem low, the incentive for businesses to opt out of the formal sector increases.

``A recent study shows that higher tax rates are associated with lower private investment and fewer formal businesses. A 10 percentage point increase in the effective corporate tax rate is associated with a reduction in the ratio of investment to GDP of up to two percentage points and a decrease in the business entry rate of about one percentage point. Other research suggests that a one percentage point increase in the statutory corporate tax rate would reduce the local profits of existing investments by 1.31 percentage points on average and lead to an 18 percentage point increase in average debt-to-asset ratios (part of the reason for the lower reported profits). A one percentage point increase in effective corporate tax rates reduces the likelihood of establishing a subsidiary in an economy by 2.9 percentage points.

``Besides the taxes paid, there are costs of complying with tax laws and of running the revenue authority. Worldwide on average, a standard small to medium sized business still spends three working days a month complying with tax obligations as measured by Doing Business. Where tax compliance imposes heavy burdens of cost and time, it can create a disincentive to investment and encourage informality. Particularly in developing economies, large informal sectors contribute to the creation of an uneven playing field for formal small and medium sized enterprises, squeezed between smaller informal competitors and larger competitors whose greater resources can help win a more effective audience with government and thus greater tax concessions."

``Worldwide, economies that make paying taxes easy tend to focus on lower tax rates accompanied by wider tax bases, simpler and more efficient tax administration and one tax per tax base. They also tend to provide electronic filing and payment systems, which reduce the tax burden for firms while lightening their administrative requirements."

So as the multilateral government institution World Bank points out, tax rates juxtaposed with tax and regulatory compliance plays a major role in the shaping of trade balances among nations and in domestic economic development.

The sub-Saharan Africa has the highest tax rates around the world along with dubious recognition for property rights and mired with political instability ,which offsets its lowest wage framework, hence remains the least attractive venue for investors which has stagnated their economies.

On the other hand, the reasons why Asia and many Emerging Markets has been generating increasing investments is due to the relative advantage of their tax structures.

As we said above competition among governments will ascertain the flow of investments and the recent bubble bust just drove a wedge between responsible and profligate governments.

To wit, the responses by the OECD governments to the recent bubble bust is likely to amplify these differences: higher taxes-lower return for OECD economies as against lower taxes-higher return for Asia and emerging markets.

Guess where investments will flow to?

Doing Business In The Philippines

In an earlier post, we featured why the Philippines severely lags the global competitive environment, see 2009 Global Competitiveness Report And The Philippines.

In this post, the World Bank provides the details why the economy hasn't been materially improving. Yes, some (marginal) improvements, but not sizeable enough to make a dent on the real economy.

It's primarily because policies have been less friendly (my adjective-averse/hostile) to business.

Here is the partial list of the world ranking according to doingbusiness.org.


Notice that the Philippines has ranked 144th out of 183 countries. Last year we ranked 141st.

Yet notice that the same countries, which are in the highly competitive order, have a pro-market economy environment.

We'd like to avoid saying pro-business as it may create a misplaced notion of supporting "big" business.

A market economy is an economy conducive to competitive entrepreneurial class, particularly small and medium scale enterprises.

In the East Asia & Pacific, the Philippines has been placed dismally in 21st out of the 24 countries. According to the doing business ratings, we lag almost across all categories- the worst being-starting a business, paying taxes, applying for permits and employing workers. Our best has been trading across borders.

Generally we have been relegated to lowest order just in front of Cambodia, Timor-Leste and Laos.

A better graphic from Doing Business Philippines

The Philippines' overall ranking fell, this year, not because of more deterioration but because more countries have aggressively worked to improve on their business environment. As the above graph would show.

Recently the Philippines reportedly adopted reform measures aimed at ameliorated the business environment:

``The Philippines enhanced access to credit with a new credit information act that regulates the operations and services of a credit information system.

``The government also cut the corporate income tax rate from 35 percent to 30 percent and promoted company reorganization procedures by introducing prepackaged reorganizations and regulating the receiver profession."

Unfortunately while necessary and quite laudable, it hasn't been sufficient.

The Philippines remains structurally trammeled by anti-business (anti competition) pro-government (politics) policies, laws and regulations.

Unfortunately, populism and personality based politics won't solve this.

Decoupling in Business Conditions?

Under the present financial crisis conditions, many parts of the world have tended to de-globalize or close interactive channels with the outside world which risks hampering trade, finance and investment flows.

In other words, the present environment could impair business conditions of some countries, but not all.

The Economist offers their estimate on the potential changes in business conditions, ``GLOBAL business conditions are set to worsen for the first time since 1996, according to a new report by the Economist Intelligence Unit, a sister company to The Economist. Its business-environment ranking for the next five years assesses 82 countries in categories including the economic and political environment, finance, and infrastructure. The outlook for half of the countries surveyed will deteriorate as the downturn takes its toll. While rich countries' scores will decline most, particularly those of Britain and America, they are still a better prospect for businesses than almost anywhere else. Countries with financial problems, such as Ukraine and Venezuela, will see conditions worsen considerably." (bold highlight mine)

The Economist gives a complete breakdown....
Countries impacted directly by the present financial crisis are likely to suffer most from deteriorating business conditions.

And these are the economies that experienced a national bubble bust (UK, US, Europe) and on economies that had their export markets directed to serving these bubble economy (Hong Kong, Singapore, Malaysia, etc.).

There are exceptions. Venezuela and Ecuador are economies that have been embracing socialism even prior to the bubble bust.

However some economies particularly the BRICs and other Emerging Markets have been expected to improve business conditions even as the others falters.

Clearly if these estimates hold true then it can be construed as decoupling in business conditions. And investments are likely to flow into nations with improving business than otherwise.

World Bank’s Doing Business in the Philippines 2008

Some important highlights from the World Bank’s Doing Business in the Philippines 2008

Best equity returns belong to countries with the most number of positive reforms.

Since many emerging markets have likewise been undertaking reforms, the competition to attract investments should be a continuing dynamic. Increasing competitiveness means constant in-depth reforms relative to our competitors. Tentativeness or lackluster actions translate to a decline in relative performance or our attractiveness as a place for viable investments decreases.

Aside from the national levels, reforms can also start with the local (LGU) levels.

The table above shows of the best performing “Doing Business” categories in the Philippines. At the right side of the table is the equivalent ranking based on global standards. This shows that there is much room for needed improvements.

For our leaders and prospective leaders this should be a great starting point for a meaningful governance agenda.

Good luck to them.

Economist: Business Environment Index

The global business environment ranking chart as constructed by the Economist magazine based on: macroeconomic stability, infrastructure, flexible labor market, quality of the workforce and policy conduciveness for businesses.

The chart is a mix picture which includes the best places to do business to important economies and their respective ratings.

This from the Economist,

``DENMARK is the best place to conduct business over the next five years, according to the Economist Intelligence Unit's six-monthly business-environment index. Out of 82 countries Denmark scores highest in most of the ten measures used, such as macroeconomic stability, infrastructure and policy towards private enterprise. Its flexible labour market and highly educated workforce are particularly attractive to businesses. America slips four places to its lowest position since the index began in 1997 as economic and financial conditions look set to deteriorate and trade protectionism to increase. Venezuela tumbles 12 places to languish just below another socialist bastion, Cuba. Only Angola is a worse place to do business.”

Overall, the chart exhibits the degree of openness to markets and its antipode…socialism.