George M. Mangion | Wednesday, 17 September 2008

Taxation without tears

The merits of uprooting regressive taxes have recently hit the headlines again. The prime minister promised prior to elections to paint our taxes green. The idea is to smoothen down direct taxes and replace them with a new code based on environmental impact. This was linked to a drastic cut in car registration taxes.
A task force was to be entrusted with executing this reform but little or nothing has ensued so far. Tax is always an emotive issue, and did prove one of the battleground issues at the last tightly fought election. Gonzipn laboured to endear us by promising a drop in personal tax to 25 per cent.
Now seven months past election date, the feeling is that there is a hole in the bucket and it will take time to mend it (even though oil dropped from $147 to under $100). The international scene was riveted by bad news of a US recession coupled with the bankruptcy of Lehman Brothers and the massive bail-out of two national mortgage icons Freddie Mac and Fanny Mae. It pours and it rains as inflation in Europe is choking commerce while central banks dither to lower interest rates.
Back to local fiscal reform and we note that the textbook approach tells us that oppressive taxation wouldn’t be possible without an over-burdened welfare state; it’s useless opposing the former while “accommodating “ the latter. It goes without saying that promises to cut tax need a complete overhaul of alternative revenue, and not minor fixes. Apart from cutting taxes and lowering the burdensome cost of state bureaucracy one admires the FOI and GRTU lamenting on unwarranted red tape.
This has strangled our competitive edge.
While the Commission is trying hard to trim VAT, we have raised the ire of cash-strapped businessmen by a 20 per cent hike. They claim that domestic trade, particularly the tourist sector has plummeted. Politicians of all creeds have sung from the same hymn-book this spring saying tax competition is healthy. Such election war-cries are sugared down our palates with promises of a new dawn linked to enhanced GDP growth. Theoretically, this creates pressure for less wasteful and therefore more efficient use of public funds. The wiping off of €100m in debts plus another €50m in terminal benefits at the shipyards has not brightened our vision. This may be another reason, albeit not the only one why Malta seems to be caught in a time warp as it misses its share of FDI that is targeting EU hopefuls such as Slovenia.
Why is this, one may ask? The answer is simple that in times of contraction and relatively high oil prices, multinationals are free to structure and operate their businesses as they see fit, generally in a manner that makes most sense from a tax point of view. Our 35 per cent corporate and personal tax rate is one of the highest worldwide - even higher than the rate in so-called high tax countries such as France and Sweden. Ideally, we could afford tax-free overtime as a boost to export industries as has been successful introduced in one of Sarkozy’s reforms.
Should we be surprised that some jobs leave Malta when the tax code and other factors burden investors?
Another issue is corporate “inversions,” which take place when a company defends the interests of its shareholders by moving its manufacturing base to a jurisdiction with better tax laws and lower labour costs. This is partly the reason why Denim closed down. Party apologists prefer to blame the Eastern European block for attracting business by affording better tax laws than us. Surrealistically, politicians have also been squabbling about the fact that our corporate tax is the fairest. They recite that upon distribution of taxed profits the resulting effect on shareholders is nil. But again, this happens only in theory since due to acute cash flow problems, companies rarely afford to distribute 100 per cent of taxed profits. But we do know one thing: the entire debate would abate if we had a flat tax.
For a start we can implement a pilot regime targeting SMEs and the self-employed. Under a flat tax, SMEs would get no special deductions. The advantage of the reform is its simplicity and lack of loopholes.
It also minimises bureaucracy and paperwork which is enemy number one for small enterprises. They would simply add up all their revenues, subtract the wages they pay, as well as other costs, and pay a flat rate on their net income. Perhaps this looks too simplified and critics denigrate the system as it may also profit the laggards.
Our mentality needs revision since it exacerbates a disincentive to work particularly for working couples.
In any event, there is little doubt that our tax code is grossly unfair when comparing the lower flat rate paid in new member countries. In Malta due to successive hikes, total tax revenue has reached 33 per cent of GDP. Surrealistically, the national debt accumulated over past two decades years has created a short-lived feel good factor. It partly cushioned lack of job creation and was the price to subsidise certain inefficient State enterprises and the burgeoning cost of the civil service.
Ironically our ‘tax and spend’ mentality is now dead and buried. Commentators join in the chorus protesting that tax reform is imperative and overdue.
They warn us that complacency will lead us to be an envy-ridden nation that punishes people for being successful. This is why the flat tax makes so much sense. Such a system would ensure that the rich paid their “fair share”, but it would avoid the punitive tax rates that have caused so much economic misery in places such as Germany and Italy.
Simplicity means more transparency and higher fiscal morality. If you earn twice as much as your neighbour, you pay twice as much tax. Of course the flat tax system has to have inbuilt measures against tax evasion. The flat tax could even have specific measures to make sure that rich people couldn’t evade taxes on dividends, interest and gains on capital. Taxes on these kinds of income would be withheld at source and paid by businesses and financial institutions.
Does it sound too good to be true? Well, it’s already working in many other countries. Hong Kong has had a flat tax for a long time and has boasted the world’s fastest growing economy for the past 50 years. Accession countries like Estonia, Lithuania and Latvia implemented flat taxes in the 1990s after getting their independence from the Soviet Union. Obviously, socialist inclined nations that subject citizens and businesses to the burdensome costs of big government do not like this global economic reality. They’d rather not compete when it comes to issues like relative tax burdens.
Maybe it’s time for Malta to board the flat tax bandwagon at least where SMEs are involved. It’s frustrating to see other EU countries adopt the flat tax which in Malta has been resisted by tax lobbyists ostensibly as it may increase tax leakages.
This may well be true in the short term and there is no guarantee that a lower and simpler tax system will work magic. It takes years for the economic reforms to work through the system. Much depends on the superlative marketing joint efforts of Finance Malta, Malta Enterprise, the Dar Malta team in Brussels and the commercial acumen of diplomats at Embassies.

George Mangion
Partner at PKF – an audit and business advisory firm
[email protected]