The Folly of the Modified Gross Income Tax

The author is coordinator and member of the Management Collective of Action for Economic Reforms.

Among some economists, the current joke is that they and their ilk
should be banned from seeking the presidency. One likely problem with
an economist-turned-president who thinks he knows his stuff is that he
would ignore advice and pursue an economic policy that does not make
sense to others.

Gloria Macapagal-Arroyo, a trained economist with a doctorate from the
University of the Philippines, has already spelled out her main
economic policies that on the whole, her fellow economists will
endorse. Yet, in a few areas – critical areas at that –
Macapagal-Arroyo’s policies are disputable. One point is
Macapagal-Arroyo’s certification to Congress of a priority measure to
enact a modified gross income tax for corporations.

Macapagal-Arroyo says she is out to tackle the budget deficit by its
horns. Her administration is committed to a prudent fiscal policy that
will focus on enhancing government revenues instead of cutting spending
– which would adversely affect anti-poverty programs. She has
identified enhancing tax administration and stamping out corruption in
the revenue-collecting agencies as the main challenge. For all this,
she has gained wide support.

Yet, in the same breath, she has proposed a new tax policy. This is a
combination of an across-the-board decrease in marginal tax rates for
individual income taxpayers, a higher level of personal income tax
exemption, the reduction of personal income tax brackets from seven to
four, and a modified gross income tax for corporations.

It is hard to figure out how this proposal can address weak revenue
collection. The significant reduction of revenues from personal income
tax, it is argued, will be more than offset by the increase in revenues
from the modified gross income tax for corporations. At first glance,
the modified gross income tax is tempting, for it suggests the
elimination of allowable deductible expenses. Ergo, there will be less
discretion and less harassment, resulting in higher tax payments.

Such hoped-for result, however, is doubtful; the proposition is flawed.
The tax is computed upon the subtraction of “cost of goods sold” from
gross income. Thus the discretion and the harassment will remain
because of various interpretations of what makes up the “cost of goods
sold.” We can foresee the endless debate as to whether an expense is
really part of the cost of goods sold. We can expect the firms to lower
their statement of gross income, but increase their expenses, including
personal or out-of-pocket expenses that can be passed off as part of
the cost of goods sold.

The computation for the modified gross income tax is very complicated.
For one thing, different firms and industries also have different cost
structures. And in some businesses, particularly in the service sector,
the application of cost of goods sold is vague. In the end, different
businesses and industries will clamor for their own set of rules. The
complexity that arises creates the conditions for discretion to once
again rear its ugly head. In a word, the modified gross income tax
violates a cardinal rule of tax policy: administrative simplicity.
The modified gross income tax violates another basic principle:
fairness and equity. For it penalizes the firms that have low profit
margins or have a small proportion of expenses that can qualify as part
of cost of goods sold.

All told, the outcome of Macapagal-Arroyo’s tax proposal will lead to a
drastic reduction of revenues from both the individual income tax and
the modified gross income tax for corporations.

Macapagal-Arroyo is aiming at the wrong target. Instead of insisting on
the passage of a modified gross income tax, she should focus her energy
on the main task of tax administration. This means providing all-out
support in a campaign to 1) clean up the revenue-collection agencies;
2) prosecute big-time tax evaders; 3) increase the withholding tax rate
on self-employed high-income earners; 4) complete the computerization
of the Bureau of Internal Revenue’s data base; and 5) widen the tax
base through third-party information.

The tax administration reforms should also be complemented with the
introduction of some desirable taxes to augment the tax effort
(measured as the percentage of tax revenues to gross domestic product).
Higher excise taxes should be imposed on affluent consumption (e.g.,
vehicles such as Pajeros and Expeditions). The specific taxes on
tobacco and liquor also have to be increased, at least to adjust for

Various quarters have criticized the modified gross income tax scheme,
and perhaps Macapagal-Arroyo and her Cabinet have realized the mistake.
One can perhaps interpret the Finance secretary’s statement that the
modified gross income is for the “medium term” a sign of retreat. The
modified gross income tax is not even part of the agenda of the
National Socioeconomic Summit.

Withdrawing the proposal will be a test of Macapagal-Arroyo’s
leadership. What makes her dilemma worse is that if she drops the
modified gross income tax, she would also have to withdraw the populist
measure to reduce across-the-board individual income tax rates. The
assumption that the modified gross income tax more than compensates for
the forgone revenues from individual income tax is completely
unfounded. Withdrawing a popular measure would inflict heavy damage on
her presidential bid in 2004.

Macapagal-Arroyo needs a graceful exit, which requires subtle political
and communication skills. The typical economist does not specialize in
this, but Macapagal-Arroyo is more honed as a politician than as an
economist. But above all, a good leader possesses the quality of being
humble and courageous enough to admit a mistake. We now wait and see
how skillfully she extricates herself from this dilemma.

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