DRD DISCUSSION PAPER

Report Noo DRD261

TAXATION OF INVESTMENT IN EAST ASIAN COUNTRIES

by

Anthony J. Pell,echio Gerardo P. Sicat

and David G. Dunn

March 1987

Development Research Department Economics and Research Staff

World Bank

The World Bank does not accept responsibility for the views e~pressed herein which are those of the author(s) and should not be attributed to t.he World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the' Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part 'of the World Bank or its affiliates conce.rning the legal status of any country, territory, city, area,. or of its authorities, or concerning the delimitations of its boundaries, or national affiliation.

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TAXATION OF INVESTMENT IN EAST ASIAN COUNTRIES

by

Anthony J. Pellechio Gerardo P. Sicat

David Ge Dunn

Abstract

This paper presents a comparative study of the taxation of capital

investment in nine East Asian Countries. The group of countries includes the

ASEAN countries: Indonesia, Malaysia, the Philippines, Singapore, and

Thailand; as well as Hong Kong, Japan, Korea, and Taiwan. This paper is one

of a series of studies comparing the taxation of capital investment by

region. The model used for these studies provides a common methodology for

examining the taxation of investment across countries.

Hong Kong has the lowest marginal effective tax rates for capital

investment due mainly to the fact that it has the lowest statutory corpor.ate

tax rate among the countries. Malaysia, Singapore, and Thailand have marginal

effective tax rates for capital investment below their respective statutory

corporate tax rates. The main reason for these less-than-statutory rates is

that all these countries have a dividend credit to avoid the double taxation

of dividends. Because debt service payments reduce the cash flow available

for dividends, debt financing can reduce the dividend credit and raise the

marginal effective tax rate.

The treatment of depreciation and capital gains is an important

determinant of the taxation of investment. Capital losses can change the

ranking of effective tax rates among countries, especially when there is

asymmetry in the treatment of capital gains and losses.

A richer set of calculations for each country can be pursued with the

model used in this study. The parameters of the model can be easily set for a

specific country~s actual experience. Such an application to a particular

country can provide tax policy analysts with a convenient tool for examining

the impact of policy options.

TAXATION OF INVESTNENT IN EAST ASIAN COUNTRIES

I. Introduction

This paper presents a comparison of the taxation of capital invest­

ment 1n nine East Asian countries. The sample includes the ASEAN countries:

Indonesia, Malaysia, the Philippines, Singapore, and Thailand; as well as

Japan, Korea, Hong Kong, and Taiwan. This paper is one of a series of studies

comparing the taxation of capital investment by regions. Other studies

include countries 1n Latin America, Africa, the Middle East, and other parts

of Asia.

The analysis focuses on the tax consequences of an investment in

physical capital at the corporate level in each country. l/ The objective is

to measure effecti,,e corporate tax rates by asset type and method of financing

across countries. The effective tax rate on capital investment depends not

only on the statutory tax rate but also on all provisions that affect the

definition of taxable income. Because these provisions will, in general,

cause taxable income to diverge from economic 1ncome, the effective tax rate

will differ from the statutory rate. Hence, this study represents an effort

to measure the difference betw~en statutory and effective tax rates on capital

investment in developing countries.

This study is to be distinguished from studies of aggregate tax

levels and ratios of tax revenue to GDP across countries. ~/ Such studies

provide useful measures of taxation from aggregate tax statistics of

countries. The approach deve:loped in this study takes into account the

structural components of ta7! systems (in this case, the corporate tax) across

countries. These :cmponents are combined into a single measure of taxation

- 2 -

(described below) that is comparable across countries. The effect of any

component of the tax system can be examined through its effect on this

measure. For example, the tax treatment of depreciation and capital gains in

different countries can be examined for its effect on investments in partic­

ular assets or in projects comprised of several assets. This study moves

comparative tax analysis substantially closer to the actual tax treatment of

investment projects -- an important step for understanding how taxation

influences the investment decision. The model used in this study provides a

common methodology for analyzing the taxation of investment across countries.

Structural tax analysis is an important and growing area of interest

in the economics of development. Several developing countries have commis­

sioned major studies of their tax system with the objective of implementing

comprehensive reform. ~/ Tax reform as an action to facilitate efficient

investment is a distinguishing feature of the Baker Plan. ~/ Against the

backdrop of the above mentioned country tax studies and reports by the World

Bank and International Monetary Fund, the Baker Plan marks an evolution of

attention to this subject.

The measure of taxation of investment used in this study 1s the tax

burden as a percentage of the rate of return from the investment. More spec­

ifically, this measure 1s the "marginal effective tax rate" for an investment

and equals the difference between the before-tax rate of return on the invest­

ment and the after-tax rate of return, as a percentage of the before-tax rate

of return. The marginal effective tax rate (METR) is useful for measurement

and comparative purposes because it converts all types of taxes to a common

value, and accounts for variations in timing of tax payments and in tax

- 3 -

bases. The METR approach is designed to shed some light on the efficiency

implications of a country's tax system.

The focus of this study is on the variation in corporate taxation

across countries. Some variation may follow from efforts by the government to

use components of the corporate tax to encourage investment or attract foreign

direct investment. For example, Hong Kong has a low statutory rate in order

to promote investment. In addition to these efforts, governments will com­

monly use tax incentives to encourage overall investment or certain invest­

ments relative to others. Tax incentives represent departures from the

regular corporate tax to achieve investment goals. In a related paper the

effect of tax incentives on the effective taxation of investment 1s ex­

amined. 21 To investigate the ways in which a country encourages or dis­

courages different types of investments requires a detailed analysis that

combines both the corporate tax and tax incentives, which is best pursued in a

country-specific context.

II. Corporate Tax Structure 1n East Asian Countries

The main components of corporate tax systems are depreciation,

capital gains, investment allowances and credits, carryover of losses and

credits, treatment of dividends and interest, and the statutory.tax rate.

Data for these components of the corporate tax systems in the countries in

this study are used to calculate the METR for capital investment in these

countries. A useful comparison of these corporate tax systems is given by

presenting the components of corporation taxation in each country side-by­

side. Such a comparison is given in Table 1. The format of Table 1

Provis1ons

Corporate Income Tax Rates and Bases a/

~dditional

Taxes on lncoae

DeDreciation b/

Capital 6ain~/Losses e/

Carryover Provisions

Taxes on Dividends

faxes on Interest

tti scell aneous Notes

Thailand

30X for coapanies register2d under the Securittes Exchange Act;

35t.for all others; Standard Base

- none -

Straight Line Method Annual Rate/Asset Life

Bld H'E Veh cl 51 20X 20X

20vrs 5yrs 5yrs Higher rates are available for

assets with lives less than 5 years

Treated as ordinary 1nco~e. Standard Base

Carry forward 5 years

30% credit on dividends pa1d to resident individuals.

20X withholding tax on dividends aaid to nonresidents.

10% withholding tax an interest paid to nonre~1dent, f1nance co.

25X withholding tax on interest 11aid to other nonresidents. ·

The 30X credit on dividends reduces the double taxation of corporate incoae. Also, dividends issued by fir1s registered under the Thailand Securities Exchange Act are exe1pt fro• personal inco1e tax.

- 4 -.

fABLE 1

Coapartson of Coroorate Tax Structure 1n East A~;an Countries

Malaysia

404; Standard Base

51. Excess Profits Tax on taxable 1ncoae greater than M~200,000. for resident uo1panies, the base 25t of equity. if that is more than 11$200,000.

5t Develop1ent Tax on taxable inc.

Staight Line Method with Initial Allowance and Balanc1ng AdJust•ent

Bld H~E V~h

Initial AlloNances d/ lOX 20~ 20% Annual Allowances 2t B-20X 20X

(124) Standard Balancing Adjust1ent

5-40i. for resident coMpanies 40t if asset held < 2 years

30t if asset sold in 3rd fear 201 if asset sold in 4th vear lOl if asset sold in 5th year 5X if asset held > 5 years

40% for nonresidents Base = sale p~ice - original cost

Carry forward indefinitely

407. withholding tax

15t withholding tax

Cornorate incoae taxes paid by the coapanv are credited toMards the withholding tax due. In principle, doubl~ taxation of corporate incoae is avoided.

S1ngapore

40X; Standard Base

- none -

Staight Line Method with Initial Allowince and Bilancing Adjus~•ent

Bld M'E Veb Initial Allowances 25t 20% 20~ Annuil Allowances

3% 16% 161 Note: The bases for annual allows on "'E+Veh are adj. by init allow.

Standard Balancing Adjust•ent

EKe1pt Capital losses cannot be ussd to

offset ordinary inco1e.

Carry forward indefinitely

40X withholding tax

40% withholding tax on interest paid to nonres1dents.

{can be appealed>

Corporate incoae taxes paid by the co1paoy are credited towards the withholding tax due. In principle, double taxation of corporate incoae is avoided.

Prov1sions

Corporate Inco1e Tax Rates and Bases a/

Additional Taxes on Incoae

Depreciation b/

Capital Siins/Losses e/

Carryover Provisions

Taxes an Dividends

Taxes on Interest

Miscellaneous Motes

Indonesia

35X; Standard Base with a liMited interest deduction. Available for interest piid on debt up to 3:1 debt/equity ratio.

- none -

Staight line Hethod for build1ngs. Double Declining Balance for other depreciable assets.

Buildings: 5t for 20 years Far other assets, rates depend on asset life:

>Byrs 4-Svrs <4yrs 10~ 25~ 50~

Treated as ordinary Income. Standard Base

Carry forward 5 years (8 years for spetified industries}

15% withholding tax on dividends paid to residents.

20l withholding tax on dividends paid to nonresidents.

151 "ithholding tax on interest paid to residents.

20t withholding tax on interest paid to nonresidents.

- none -

- 5 -

TABLE 1 -- page 2

Co~parison of Corporate 1ax Structure in East Asian Countries

Philtppines

35Y.; Standard Base

·- none -

Double Declining Balance Met~od with Switchover to Straight Line

Annual Rate/Asset life Bld M~E Veh lOX 25' 40%

20yrs Byrs Syrs

Treated as ordinary tncoae. Standard Base

Japan

43.3%; Standard Base 33.3~ on inco1e ear1arked for

dividends.

Local/Prefectoral lnco•e Taxes 17.3% (in generalj Inhabitant's Tax

on corporate incoae tax liability 12X Enterprise Tax on taxable

incote. This tax is a deductible froa next year's incoae tax.

Declining Balance Kethod Depreciation Rates Bld M~E Veh

2.3X 20.bi 43.BX Note: the basis for assets other than buildings is 90% of original cost, in the initial year. 5X of orig cost is allowed in the sale yr Total allowances for these assets are li1ited to 951 of orig cost.

Treated as ordinary inco1e. Standard Base

207. add1t1onal tax {plus 1nhab tax) on the transfer of land, if tne land is held < 10 years. Basis = Sale price - Orig Cost

None in general. · Carry forward 5 years, back 1 year, Forward b years for registered cos. for fires filing a blue fori.

15~ withholding tax on dividends paid to resident individuals.

30% withholding tax on dividends patd to nonresident individuals.

151 Nithholding tax on interest paid.

10~ Tax Credit on dividends, 20X withholding tax on dividends,

nonrefundable for nonresidents.

20i. withholding tax on interest, nonrefundable for nonresidents.

The withholding taxes on diYidends The 10t credit on dividends reduces and interest are finil taxes. But the double taxation of corporate this 1av be changing as the indivi- incote. dual inco1e tax gets revised.

Provis1ons Korea

Corporate 30%; Standard Base Inco;e Tax Rates and Bases a/

Additional Surtaxes Taxes on Inco1e 7.5l Inhabitant's Tax (local)

25~ D~fense Tax (eav have expired) Excess Profits Tax

100l of inco•e derived froM prices set above the gavt standard.

Oeprec1at1on b/ Straight Line Hethod

Capital Sains/Losses e/

Carryover Provisions

Taxes on Dividends

Taxes on Interest

Hiscellaneous Notes

RateiAsset Life Bld M~E Veh lOX lOX 251

10yrs 10yrs 4vrs or Declining Balance Method

Oeprec1ation Rates Bid M&E Veh

20.6% 20.bX 43.8%

Treated as ordinary incoMe. Standard Base

25% additional tax on sales of land Basis = Sale price - Inflat1on

Adjusted Orig Cost lnflAdj = annual Y. change in WPI x

nusber of years property was held (ann change in WPI l11ited to 5%}

Carry forward 3 years.

lOX withholding taK on dividends fra1 a ca1pany listed on the Korean Stock Exchange.

25X otherwise and for nonresidents.

lOX or 25X withholding tax on interest paid to restdents.

25% withholding tax on interest paid to nonresidents.

Assets aay be revalued to adj for inflition, if the WPI increases by 25% or acie. There is a 3% tax on the inreased valued of the assets less carried ov~r losses.

- 6 -

TABLE 1 -- page 3

Coaparison of Corporate Tax Structu?e in East Asian Countries

Hong Kong

18.5X; Standard Base

- non~ -

Buildings - Straight Line Method Other Assets - Declining Balince

with Initial AlloMances Initial AllDMince Bld M~E Veh 20X 351 354

Annual Rate Bld H~E Veh

4X 20t 30i. Standard Balancing AdjustMent

Exetpt Capital losses cannot be used to

offset ordinary inco1e.

Carry forward indefinitely.

- none -

17X withholding tax on interest. (this is a final tax)

There are no further taxes on divi-dends. Hence, double taxation of corporate incote is avoided.

Taiwan

35%; Standard Base 25~ for •productive" enterprises;

Standard 'Dase

- none -

Straight line Hethod Rate/Asset Life

Bld MlE Veh 51 10X 251

20yrs 10yrs 4yrs (10-26) (8-16l (3-5)

Treated as ordinary incoae. Standard Base

Additional tax on sales of land Basis = Sale price - Inflation

Adjusted Orig Cost

Carry forward 3 years.

15% withholding tax an dividends paid to residents.

20% Nithholding tix on dividends paid to nanresidents.(see Notes)

15X Nithholdin1 tax on interest paid to residents.

20% withholding tix on interest piid to nonresidents.

There is a 1ini1u1 tiK of i5X on dividends re1itted abroad. TaiMan has recently iaple•~nted a Value Added Tax.

- 7 -

TABLE 1 -- page 4

Coaparison of Corporate Tax Structure in East Asian Countries

Sources; Tax infortation published by the International Bureau for Fiscal Docu;entation.

Price Waterhouse information Gu1des.

a. Standard base for the corporate inco;e tax equals revenue less wages, cast of aaterials, deprectat1on allowances, 1nterest, and other expenses.

b. Standard balancing adjust~ent equals the sale prtce less the adjusted basis (ie, or1ginal cost less realized allowances, including initial alloMances), Positive adJustMents are limited to the sua of realized allowances.

c. Bid = Buildings, H~E = Hachinery and Equip~ent, Veh = Vehicles.

d. Typically, initial allowances are granted in addition to annual alloMances wh1ch cover 100~ of depreciation. Also, the basis for the annual allowances is not adjusted for the initial allowances. Execeptions are specifically 1entioned in the table.

e. The standard base for capital gains is the sale price less the adjusted basis.

- 8 -

simplifies cross-country comparisons as well as providing a fairly comprehen­

sive presentation of tax policy structure.

There are several interesting similarities aud differences among the

countries in our sample. The most striking, initially, are the statutory

rates. They predominantly lie in the 30-40 percent range, but there are some

note~orthy exceptions. Hong Kong's statutory rate, 18.5 percent, is signifi­

cantly lower. Taiwan also offers a particularly low rate, 25 percent, if the

firm is considered a "productive" enterprise.

But the ~ost significant observation is more subtle. In this sample

of nine countries, five of them make an attempt to eliminate or reduce the

double taxation of dividend income. In Hong Kong, dividends are not taxed at

the personal level. That is, the corporate income tax is the final tax on

corporate income. In Thailand, as in Malaysia and Singapore, a credit is pro­

vided to recipients of dividends that approximates the taxes already paid by

the firm. The credit is used to offset the individual's tax liability at the

personal level. Japan offers a similar, but smaller, credit on dividends,

which partially offsets this double taxation. These credits significantly

lower the effective tax rate at the corporate level (as the results in the

next section illustrate).

No two countries offer identical depreciation allowances, but they

basically follow one of two methods, straight line or declining balance.

Several countries have variations that are standard features, i.e. available

to all corporate investment in depreciable assets. In particular, Malaysia,

Singapore and Hong Kong use an initial allowance that is similar to an invest­

ment deduction. Also, increased rates for declining balance depreciation

- 9 -

(double declining balance, roughly) are available in Indonesia, Philippines,

Japan, and Korea.

None of the systems employ automatic indexing for inflation. This

implies that the real value of depreciation allowances will erode over time,

especially at high inflation rates. Korea has a procedure in which companies

can revalue their assets for depreciation purposes, if the price level rises

by 25%. But this is a somewhat discontinuous process. We should note that

initial allowances and double declining balance techniques used in some

countries in the region (mentioned above) place depreciation allowances

towards the earlier part of the asset's life. Hence the allowances retain

more of their real value with inflation.

Capital gains treatment follows two basic procedures$ The key ele-

ment is whether capital gains are treated as ordinary income. If this is the

case, then the sale price less the adjusted basis (i.e., original cost reduced

ry allowed depreciation) is added to income in the sale year and taxed accor­

ding to the statutory rate. When capital gains are taxed at a rate that dif­

fers from the statutory rate, a balancing adjustment usually enters the calcu­

lation of taxable income. The balancing adjustment attempts to correct for

the difference between allowed depreciation and the economic depreciation that

actually took place. It may be positive or negative. For example, if the

sale price is less than the adjust~ basis, then the asset actually depre­

ciated faster than the allowances granted. In this case, the taxpayer is

granted a balancing allowance equal to the difference which reduces ordinary

taxable income. If the sale price is greater than the adjurted basis,· then

depreciation allowances were too large and the balancing adjustment is an

- 10 -

addition to taxable income. This adjustment is limited to the total allow­

ances already granted for depreciation.

Finally, the difference between the sale price and the original cost

of the assets represents a capital gain that can be taxed at a special rate.

It is worth noting that capital gains are exempt from taxes in Singapore and

Hong Kong, but both are subject to the balancing adjustment. Also, since

depreciation is not indexed for inflation, the adjusted basis does not account

for inflation. Thus, purely nominal increases in prices are taxed as capital

gains. This tends to increase marginal effective tax rates.

All of the countries in the region provide for the carryover of

losses. Malaysia, Singapore and Hong Kong allow for losses to be carried

forward indefinitely, while the others like Thailand offer a fixed period.

Only Japan has an option for carrying losses back a year.

Withholdings taxes on dividends and interest are a common feature.

The only exception is that Hong Kong has no further taxes on dividend~ and,

thus, does not withhold anything.

Finally, all countries offer investment incentives. Although tax

holidays and various othe~ investment incentives are available in all the

countries in the sample, they are granted under special conditions. For

example, export industries may be eligible for added incentives. Or a company

may receive extra benefits for locating in a particular area. In this study,

we have considered only the standard tax code provisions available for an

ordinary industry.

- 11 -

III. Marginal Effective Tax Rates for Capital Investments in East Asian Countries

The.corporate tax data presented in Section II were used to calculate

marginal effective tax rates for capital investment in the East Asian

countries under study; a description of the cash flow calculation of effective

tax rates is given in Appendix A. For the purpose of these calculations.,

investments were chosen to capture the variation in capital taxation in each

country. More specifically, separate investments in each of the three basic

depreciable assets presented in Table 1 -- buildings, machinery and equipment 1

and vehicles -- were examined. Also, a representative investment project that

consists of all three depreciable assets and land was examined as well. ~/

This representative project was assumed to be 40 p~rcent building, 40 percent

machinery and equipment, 10 percent vehicles, and 10 percent land.

Several assumptions were made in order to carryout the cash flo~

calculation of the METR. The single asset investments and representative

investment project are assumed to be in operation for ten years. As mentioned

in Appendix A, replacement investment is undertaken at the rate of economic

depreciation for each asset. II Such replacement investment holds the real

value of each depreciable asset constant. At the end of the tenth year the

assets are sold at s nominal value that reflects their real value plus

inflation over the ten years. ~/ Sale of the assets is included in the

analysis to capture the effect of capital gains treatment and any balancing

adjustments in each country. ~/

Only the corporate tax is considered in the calculations presented

here. The taxation of dividends at the personal level or of interest on debt

to the lender are not included. The personal incoro~ tax in some countries

- 12 -

provides a credit for corporate tax paid on dividends. Such credits reflect

an attempt to eliminate (or approximately eliminate) the double taxation of

dividends. When such credits exist, the corporate tax paid on dividends (at

Least to the extent it equals the credit) really functions as a withholding

tax for the personal income tax. Consequently, such credits are subtracted

from corporate taxes in the calculation of effective corporate tax rates.

These credits are an important determinant of the level of effective tax rates

in the results below.

The distribution of the corporate after-tax income as dividends and

retained earnings is important, especially because of the dividend credit. As

important, if not more so, is the allocation of sale proceeds between divi­

dends and capital gains. Empirical evidence on dividend payout rates, re­

tained earnings, and capital gains is hard to obtain in many of the countries

under study here. Further, the focus of this study is not on determining an

empirical effective tax rate for an existing capital stock. Rather, the focus

is on effective tax rates for new investments. Consequently, an assumption

that reflects a middle course for future dividend payout, retained earnings,

and capital gains is made. Specifically, corporate after-tax income flow is

divided evenly between dividends and retained earnings while the investment is

in operation; sale proceeds plus accumulated retained earnings are divided

evenly between dividends and capital gains at the time of sale. Of course,

actual practice can favor those forms of income that receive the most advan­

tageous tax treatment, thereby lowering the effective tax rate of the invest­

ment. However, given the focus on calculating an ex ante effective tax rate

with a common set of assumptions across countries, the dividend payout ratio

- 13 -

was taken, albeit arbitrarily, to be SO percent during operation and at the

sale of the investment.

METR's for capital investments in East Asian countries are reported

in Table 2. !Q/ These results were obtained with the real before-tax rate of

return fixed at 10 percent. The rationale of this approach is to approximate

the ex ante calculation of the effect of a country's tax system that an

investor would make using a standard before-tax rate of return. !!/

Results are obtained for all equity financing and SO percent debt

financing. Also, two alternative assumptions about the treatment of losses

are examined. The first is that negative taxable income is not allowed (i.e.,

negative taxes on negative taxable income are not allowed) and losses are

carried forward to be deducted against future income. The second assumption

is that negative taxable income and negative taxes are allowed. This does not

mean that the government pays refunds. The idea instead is that the company

can use losses to offset positive taxable income elsewhere. In other words,

full loss offset is assumed. This can happen within a company or among com­

panies through mergers.

Case I: All Equity ~inancing and Loss Carryforward

The first row of results presents METR's for Hong Kong for all equity

financing in the loss carryforward situation. Hong Kong has the lowest METR's

for investment among the countries. The main reason for Hong Kong's low ef­

fective rates is a low statutory rate.

The METR's in Malaysia, Singapore, and Thailand are lower than their

respective statutory rates for all assets. The main reason for these less­

than-statutory rates is that all these countries have a dividend credit at the

personal level to avoid the.double taxation of dividends.

TABLE 2: 'Marginal Effective Tax Rates for Capital Invest1ent in Eist Asian Cbuntries

Cas~:~ I: All Equity Financing and loss Carry-fonu1rd

Asset: Building~ I'I&E Vehicles Project Statutory Country: Rate

Hong Kong 20.0I lb. 7t 16.0% 18.4% 18.5X Jndonesia 45.1t 39.0I 37.2% 41.6~ 35.0% Japan 42.01 37.3% 33.2X 39.27. 33.3! Korea 30.9% 34.8t 32.U 33.27. 30.04 Malaysia 37.6% 27.91. 20.04 31.7l 40.0! Philippines 41.81. 39.9'/. 41.bX 40.5% 35.07. Singapore 27.Bt 29.44 32.5% 29.51 40.0% Taiwan 3t.BI 32.6~ 2B.4X 31.9Z 25.0t Thailand 28.71 19.14 28.1/. 24.91 35.0!

Case II: 50 Percent Debt Financing and loss Carrv-forMard

Asset: Buildings M~E Vehicles Project Statutory Country: Rate

Hong Kong 16.2X l6.U 16.41 lb.U 19.5% Indonesia 40.2t 34.n 37.bt 36.01 35.04 Japan 34.1% 27.2'1. 23.2% 29.8% 33.3I Korea

1 34.77. 31.8t 35.9% 32.81 30.Q7.

l'lahysiil 30.81 2l.BI 4.n 24.2'1. 40.0'1. Philippines 38.3' 42.1Z 45.U 40.2t 35.0t Singapore 19.U 23.6t 25.7I 23.27. 40.0'% Taiwan 2B.Ol 29.6I 24.5'1. 28.21 .25.0I Thailand 25.1I 17.8I 24.9'1. 20.01 35.0%

----------·· "·--------------------------------------------------------------------Notes: Annual retained earnings are set equal to 501 of after tax tncome.

-In the sale year, equity is purchased with SOt of that year's proceeds plus accu1ulated retained earnings.

The Philippines do not allow the carry-over of losses for ordinary industries.

Case lll: All Equity Financin~ and Full Loss Offset

Asset: Buildings 1'1~E Vehicles Project Statutory Country: Rate

Hong Kong t9.Bt 13.Sl 10.9{. 17.31. 18.S:t Indonesia 45.1! 38.7'/. 34.5i. 41.bZ 35.0I Japan 42.0'/. 37.37. 32.6'/. 39.n 33.3% Korea 30.2t 34.8t 31.1l 33.1l 30.01 l'lalaysia 37.6% 24.3I 15.1Z 32.(1'/. 40.01 Phi lip pines 41.87. 38.1?: 37.6t 40.44 35.01 Singapore 26.lt 23.5Z 32.6t 2B.4I 40.0% TaiMan 31.Bt 32.64 28.1% 3!.9t 25.01 Thailand 28.7t 18.9% 28.11 24.n 35.0l

Case IV: 50 Percent Debt Financing and Full Loss Offset

Asset: Buildings ttttE Vehicles Project Statutory Country: Rate

Hong Kong 14.27. 2.9k -1.8% 9.6'/. 18.5'1. Indonesia 40.21 2B.Bt 21.0t 34.1~ 35.01 Japan 34.1% 26.0% 17.84 29.4% 33.3% Korea 1l:f.51 27.7'1. 21.0l 24.6Z 30.0% 11alaysia 30.21 10.8I -9.7% 20.5'1. 40.0% Philippines 34.41 27.81 26.8% 31.9X 35.0'1. Singapore 15.01 2.71 25.5% 15.2% 40.0'1. Taiwan 28.01 29.6'1. 21.bi 28.21 25.01 Thailand 25.1lt 7.3t 2l.U 18.6% 35.0%

f-1 +=--

- 15 -

Another reason for the lower-than-statutory effective tax rates in

Malaysia~ Singapore, and Thailand is that tax depreciation rates for buildings

and machinery and equipment exceed their respective economic depreciation

rates. However, as discussed in Section II, all assets are subject to tax­

ation of nominal capital gains as ordinary income. This implies that purely

inflationary increases in the price of assets are taxed as real income. This

taxation of nominal gains falls heaviest on assets whose tax depreciation ex­

ceeds their economic depreciation. However, the deferral of tax implied by

the fact that tax depreciation exceeds economic depreciation yields a net tax

advantage for buildings and machinery and equipment in Malaysia, Singapore,

and Thailand.

The METR for the representative investment project is an average of

the METR's for the individual assets. More specifically, it is a weighted

average in which the weighting occurs through the income statement for the

combined use of the assets in a single project. In other words, the depre­

ciation and capital gains treatment for all assets and project-wide flows are

combined into a single after-tax cash flow for the project as a whole.

The fact that the METR for machinery and equipment is higher in

Singapore than in Malaysia brings out an inte~esting point. As Table 1 shows,

there are features of Malaysia's corporate tax, at least with regard to mac­

hinery and equipment, that would appear to make its METR higher than in

Singapore. These features are: a 5 percent development tax that does not

exist in Singapore; a lower initial allowance and annual depreciation rate for

machinery and equipment than in Singapore; and a 5 percent capital gains tax

when, in Singapore, capital gains are exempt from taxation. The reason for

Malaysia's lower METR for machinery and equipment is two-fold. First, the

- 16 -

initial allowance does not reduce the basis for depreciation in Malaysia but

does in Singapore. Second, there is a capital loss for the investment in ma­

chinery and equipment. In Malaysia, this capital loss can be used to offset

ordinary income; this is allowed because capital gains are taxed. In

Singapore, where capital gains are tax exempt, capital losses are not allowed

to offset other income. The difference in the treatment of capital losses

between the two countries is in large part responsible for the lower METR for

machinery and equipment in Malaysia.

There are several observations to draw from the comparison of the

taxation of machinery and equipment in Malaysia and Singapore. First, the

treatment of capital gains is an important component of the METR. Second,

capital losses can change the ranking of METR's between countries, especially

when there is an asymmetry in the treatment of capital gains and losses.

Also, adjustments in the basis for depreciation for investment incentives re­

duce the effect of these incentives.

The METR for buildings is the lowest for assets in Singapore. This

is a consequence of the fact that buildings receive the largest initial allow-

ance.

The results are interesting for Indonesia especially in light of the

major tax reform that was recently implemented. Indonesia's tax reform was

designed, in part, to bring effective tax rates in line with statutory rates

and minimize the variation in effective rates among assets (the "level playing

field" objective). The results in Table 2 for Indonesia show that the disper­

sion of effective rates seems to be no less in Indonesia than in other

countries. However, the dispersion in the effective rates in the countries

- 17 -

under study is not large, whether these rates ~re below, around, or above the

level of the statutory rate.

Depreciation in Japan is based on the declining balance method but

without switchover to straight-line. In other words, depreciation allowances

stretch out indefinitely. This tends to produce higher METR's for longer­

lived assets. The results for Japan in Table 2 bear this out. The METR for

buildings is higher than for machinery and equipment or vehicles. Also,

METR's in Japan have a wider dispersion than in the Philippines where the de­

clining balance method is also used but with switchover to straight-line.

METR's for the individual assets and the representative project are

higher than the statutory rate in Japan. As is the case for Thailand,

Malaysia, and Singapore, a dividend credit is largely responsible for this

result. The dividend credit of 10 percent in Japan is not as large as in the

other countries where it approximately equals the statutory corporate rate.

Consequently, METR's in Japan are not below the statutory rate while the

METR's in the other countries with larger dividend credits are lower than

their respective statutory rates.

METR's for Korea are close to the statutory rate. It is interesting

to note that buildings have the lowest METR. As Table 1 sho~s, the depre­

ciation rate is the same for buildings and machinery and equipment. The METR

for buildings is lower because its economic depreciation rate is lower than

that for machinery and equipment. In other words, the excess of tax depre­

ciation over economic depreciation is greater for buildings and, therefore,

the tax advantage is greater. This also happens with respect to vehicles. 121

The Philippines has a narrow dispersion of METR's for the three de­

preciable assets around 40 percent. The METR for buildings, 41.8 percent,

- 18 -

departs the most from the statutory rate. The narrow dispersion of the METR's

in the Philippines is due, in part, to the method of depreciation which is

double declining balance with switchover to straight-line. 13/

METR's in Taiwan are higher than the statutory rate by over seven

percentage points.

Case II: Debt Financing and Loss Carryforward

Table 2 presents the effect of 50 percent debt financing on capital

investment in the countries under study. This is carried out with an interest

rate set equal to the before-tax rate of return. As a result, the before-tax

rate of return is unchanged by the use of debt. 14/ This was done to isolate

the pure tax effect of the interest deduction in the ex ante calculation of

METR's presented in this analysis.

Debt financing has two opposing effects on the METR. Interest pay­

ments introduce an CJ.dditional deductible expense which reduces the METR. How·'­

ever, total debt service payments, i.e. interest and principal, reduce the

amount that can be distributed as dividends from investment income. This re­

duces the credit that is granted in some countries for corporate taxes paid on

dividends. This reduction in the dividend credit raises the effective

corporate tax rate.

The net effect of debt financing for the three. depreciable assets and

the representative project in Malaysia, Singapore, and Thailand is to lower

the METR~ The tax-raising effect of the reduction in the dividend credit due

to debt service payments does not exceed the tax-lowering effect of the

interest deduction.

- 19 -

The tax-reducing effect of capital losses in Malaysia contributes to

the decr~ase in the METR for machinery and equipment to 21.8 percent for 50

percent debt financing from 27.9 percent for all equity financing. Debt fi­

nancing enhances the effect of capital gains taxation on the METR. This hap­

pens because the rate of return calculation underlying the METR is a return on

equity. Debt reduces the amount of equity used to finance the investment.

When a smaller amount of equity capital is factored together with the same

amount of capital gains or losses, the tax treatment of the latter becomes

more important. Consequently, debt financing enhances the tax-reducing effect

of capital los~es for machinery and equipment in Malaysia.

Indonesia's METR for vehicles increases with debt financing for two

reasons. First, as mentioned above, debt financing enhances the effect of

capital gains taxation. Second, even with all equity financing, losses were

being carried forward. Consequently, in the first several years of operation

of the investment, interest deductions are merely being carried forward and

used later which mitigates their tax-reducing effect.

Korea's METR for buildings increases with debt financing for the same

reasons Indonesia's METR for vehicles increases. As mentioned, debt financing

enhances the effect of capital gains taxation. If capital gains are not

taxed, the METR would decline with debt financing-

In the Philippines the METR's for machinery and equipment and vehic-

les increase. If debt financing produces losses in the Philippines, they are

not carried forward but lost (under the current assumption that losses do not

offset positive taxable income elsewhere).

The changes in the METR's for Hong Kong, Japan, and Taiwan are the

net result of the same opposing effects on the METR of debt financing

- 20 -

described above. In these countries, the net effect of debt financing is to

reduce the METR for investment in each depreciable asset and the represent­

ative project. The tax reducing effect of the small (10 percent) dividend

credit in Japan is enhanced by debt financing.

Case III: Full Loss Offset

The set of results on the right-hand side of Table 2 presents the

calculation of METR's allowing full loss offset. This means that companies

can receive negative taxes with an investment that produces losses. This

happens, as mentioned, because a company can use losses to offset taxable

income elsewhere. As with the first set of results, METR's for all equity anc

50 percent debt fina1cing are calculated.

The METR's in the full loss offset case are equal to or less than

what they are in the loss carryover case. They are equal when no losses are

being carried forward; i.e., when not allowing full loss offset is not

binding. When this constraint is binding, the METR's will decrease when full

loss offset is allowed. Knowing when there are losses can help in under­

standing the changes in METR's.

The METR for an investment in vehicles in Hong Kong with full loss

offset and 50 percent debt financing is -1.8 percent, which essentially is a

zero METR. It is important to note that a zero METR does not imply that no

tax revenue is obtained from an investment in vehicles. ~/ A zero METR means

that an investment in an asset is effectively expensed as a cost of doing

business; i.e. the asset is treated like any other deductible input. However,

as long as the marginal product of the asset is positive, tax rev~nue is ob­

tained from the income that is generated by the asset. Full expensing of

- 21 -

capital investment implies that the corporatA tax is a cash-flow or consump­

tion tax.

The METR for vehicles in Malaysia declines dramatically with debt.

In fact, 50 percent debt financing produces the most negative METR, -9.7 per­

cent, of all the results. This investment produces negative taxable income

and positive dividends in the first several years of operation. However, the

dividend credit in Malaysia is limited by the amount of corporate taxes.

Because corporate taxes are zero in the loss carryforward case, the dividend

credit is zero. Allowing full loss offset reduces corporate taxes (in the

sense that negative taxable income can reduce taxes elsewhere) but does not

reduce an already zero dividend credit. Thus, because the dividend credit is

limited by corporate taxes in Malaysia, full loss offset cannot have a tax­

raising effect by reducing the dividend credit. Debt financing further

reduces corporate taxes and, also, does not reduce an 'already zero dividend

credit.

The METR for buildings in Thailand remain the same for both all

equity and 50 percent debt financing. The METR decreases with debt financing

which, as before, is the net result of the tax-reducing effect of the interest

deduction and the tax-raising effect of the reduction in the dividend credit~

In Thailand, the METR for machinery and equipment with all equity

financing, 18.9 percent, declines slightly from the loss carryforward case,

19.1 percent. This happens because losses previously carried forward are

being taken when they are incurred. Fifty percent debt financing reduces the

METR to 7.3 percent because the additional losses implied by the interest

deduction more than offset the reduction in the dividend credit. The METR for

- 22 -

vehicles decline slightly with full loss offset in the 50 percent debt

financing case.

The rest of the results can be explained in much the same fashion as

was done for the METR's in the loss carryforward situation. The reasons for

changes in METR's repeat what has been described above. Being able to deter­

mine when the constraint on losses is binding helps to sharpen the explanation

of results, as was done for Malaysia and Thailand.

IV. Conclusion

An important conclusion to draw from the results presP.nted in this

study is that the dividend credit is instrumental in reducing the METR below

the statutory corporate tax rate. In fact, the three countries with METR's

below their statutory tax rates for all single-asset investments and the

representative investment -- Malaysia, Singapore and Thailand have a

dividend credit. The credits in these countries are designed to eliminate the

double taxation of dividends and subject dividends to personal income taxation

only. Any tax~tion of dividends at the corporate level essentially becomes a

withholding tax for the personal tax. Consequently, the dividend credit

reduces effective corporate taxation.

The METR's presented in this paper are not empirical or equilibrium

rates. The anglysis was carried out with the real before-tax rate of return

fixed at 10 percent. This was done to approximate the ex ante calculation of

taxes that an investor would make to compare the impact of taxation on invest­

ment across countries. However, after-tax rates of return many differ sub­

stantially among assets. This can induce a reallocation of investment into

lower taxed assets in order to bring after-tax rates of return into

- 23 -

equilibrium. Although the effective tax rates in equilibrium can be different

from those present~d in this study, the METR's given in Table 2 nonetheless

represent the signals given by a country•''s tax policy to investors.

The ex ante calculations of METR's presented here were done under

alternative assumptions about financing and the treatment of losses. The

corporate tax defined the base for taxation of investment which, in turn,

determined the after-tax cash flowa Investors may be influenced by many

factors other than corporate taxation, such as the quality of the infra-

structure~ ~,he availability and quality of labor, the economic depreciation of

physical capi.:-·.~.i, and the inflation and i11terest rates in a particular

country. Nonetheless, when these factors are taken into account, the

effective taxation of investment as measured by the METR presented here can

also be an important factor.

The METR calculations presented in this study were done with a common

set of parameters (other than those that pertain to a particular country's tax

structure) and economic assumptions applied to all countries. This provided a

common framework for analyzing the taxation of capital investment across

countries. For example, a single inflation rate and fixed dividend payout

ratio r. are assumed for all countries. These assumptions may not conform with

actual experience in a specific country.

A richer set of calculations for each country can be pursued with the

model used in this study. The parameters of the model can be easily set for a

specific country's actual experience. Alternative provisions of the corporate

tax can be compared in terms of their impact on the METR. Such an application

to a particular country can provide tax policy analysts with a convenient tool .

for examining the impact of policy options.

- 24 -

Endnotes

la This investment does not entail an increase in the employment of labor.

Consequently, investment income is the marginal increase in net revenue

that results from the investment project, where "net" means net of wages

and purchases of intermediate goods and services. This is the standard

line of analysis in the literature on effective corporate taxation, e.g.

Gravelle (1982) and King and Fullerton (1984). An excellent summary of

this literature is given by Ebrill (1986).

2. S~e Tanzi (forthcoming).

3o See Bahl (1987), Conrad (1986), and Musgrave (1981).

4. See U. S. Depratment of Treasury (1985).

Sa Pellechio, Sicat, and Dunn (1987).

6. This representative investment is intended to give some idea of the com­

bined effect of the tax treatment for all three assets together. It also

is intended to give some idea'of the tax treatment of an actual invest­

ment~ e~g. a factory. For this reason land, which ·is not depreciable, is

included.

1. The economic depreciation rates where obtained. from Hulten and Wykoff

(1981) and are 3.6 percent for buildings, 12.25 percent for machinery and

equipment, and 3U percent for vehicles.

- 25 -

8. Inflation is taken to be 5 ~ercent per year.

9e A balancing adjustment is an addition to taxable income when an asset is

sold. It usually equals the sale price of the asset or its original cost,

whichever is lower, minus the undepreciated balance for the asset. In the

U.S. this type of adjustment is referred to as recapture of deprecia­

tion. See Table 1 for details on balancing adjustments in the countries

under study.

10. Calculations cf marginal effective tax rates were obtained from a model

con-tructed expressly for this purpose; a description of this model is

given in Pellechio (1986). The model uses financing and economic factors

as well as the tax parameters given in Table 1 for each country to calcu­

late the cash flows that can be expected from an investment. This calcu­

lation yields a single before-tax cash flow and single after-tax cash flow

for the investment which are used to compute a marginal effective tax rate

(METR).

11. This approach, of course, produces different after-tax rates of return.

If after-tax rates of return were significantly different among assets

within a particular country then investment would be reallocated to

equilibrate after-tax rates of return. METR*s based on a fixed before-tax

rate of return indicate the direction in which investment would be allo-

cated to achieve equilibrium.

- 26 -

12R The tax depreciation rate for vehicles, 43.8 percent, is higher than for

buildings, 20.6 percent. However, the excess of the tax depreciation rate

over the economic depreciation rate is higher for buildings (17 percent)

than for vehicles (13.8 percent). For this reason the METR for buildings

is lower.

13. The switchover occurs when the depreciation allowance obtained from the

double declining formula is less than that obtained from applying the

straight-line formula to the remaining basis with the remaining number of

depreciable years. It is to be noted, however, that the straight-line

formula is commonly used as a option in the Philippines in the computation

of depreciation allowances.

14. There are, of course, substantial changes in this cash flow. The amount

of equity put up for the investment is reduced by, the amount of

financing. Interest and principal payments reduce the before-tax cash

flow while the investment project is in operation. However, because the

real interest rate equals the real before-tax rate of return, these

changes in the cash flow do not change its present value. Consequently,

the level of investment income that yields a 10 percent real before-tax

rate of return remains the same at different debt ratios.

15. See McLure (1986) and Squire and Shalizi (1986) for analytic and empirical

examples of this point.

- 27 -

Appendix A

The Cash Flow Calculation of the Marginal Effective Tax Rate

The calculations presented in this study use tax, financing, and

economic factors to compute the cash flows that can be expected from an 1n-

vestment project. The cash flows combine the individual streams for each

asset (credits, depreciation, replacement investment) with the income gener-

ated by the project and other project-wide flows (e.g. debt service payments,

dividends, retained earnings) to yield a single before-tax cash flow and

single after-tax cash flow for the entire project. These two cash flows are

used to compute a marginal effective tax rate (METR) for the project as a

whole.

The before-tax (BTCF) and after-tax (ATCF) cash flows can be

summarized as follows:

(1) BTCFi

(2} ATCFi

where

d

K· 1

= - E· - dK· + R· - Int· - Prin. + NetSales· 1 1 1 1 1 1

= BTCFi - t{l+s) [Ri - Depi - InvDedi - IntDedi - Carryoveri;

+ CapGain· + BalAdj·] + cDiv· 1 1 1

= amount of equity used to finance the investment in period i

= economic depreciation rate for capital stock

= capital ·stock in period i

- 28 -

R· = investment income in period i 1

Int. = interest payment in period i 1

Prini = principal payment in period 1

NetSalesi = net sales proceeds in period i

t = statutory tax rate

s = surtax rate

Dep· = depreciation allowances in period i 1

InvDedi = investment deductions in period i

IntDedi = interest deductions in period i

Carryoveri = carryover losses in period i

CapGaini = capital gains 1n period i

BalAdji = balancing adjustment in period i

c = dividend credit rate

Div. = dividends in period i 1

The equity used to finance the investment is a positive amount in the

period before the investment generates income, i.e. E0

> 0, and is zero after-

wards. The rate of return underlying the METR calculation is a return to

equity.

Replacement investment is undertaken which reduces the before-tax

cash flow. 'Replacement investment equals the amount of economic depreciation

for each asset. !1

The investment project starts generating income in period 1. Invest-

ment income is the marginal increase in net revenue that results from the in­

vestment project. ~/ Investment income keeps pace with inflation because

repla,cement investment preserves the productive capacity of the p~oject.

- 29 -

Interest and principal payments on debt used to finance the invest­

ment are subtracted from the before-tax cash flow. When the investment is

sold, the proceeds ar~ added to the before-tax cash flow. Net sale proceeds

equal the sale price minus the payoff of the bal~nce of a loan, if applicable.

The after-tax cash flow equals the before-tax cash flow minus taxes

paid and plus credits. The statutory tax rate, t, plus any surtax rate, s,

are multiplied by taxable income.to yield the regular tax liability. Taxable

income is given by the term in brackets. Taxable income, in its most basic

form, equals investment income minus depreciation allowances, investment de­

ductions, and interest deductions. Investment deductions are given in addi­

tion to depreciation and are intended to serve as an incentive for invest­

ment. They may be given for the project as a whole or on an asset-specific

basis. A positive taxable income may be reduced by losses being carried for­

ward. If taxable income is negative and full loss offset is not assumed then

the loss is carried forward. 11 When the a~set is sold, any taxable capital

gains or balancing adjustment are added to taxable income. 11

The last term in equation (2) refers to any special tax treatment for

dividends. In particular, and as described in Section III, a credit may be

given on dividends at the personal level to offset the taxation of dividends

at the corporate level. As explained in Sections III and IV, this credit re­

duces corporate taxes and, therefore, is added to the after-tax cash flow in

equation (2).

If b denotes the real before-tax rate of return and a, the real

after-tax rate of return, then the marginal effective tax rate is given as

follows:

(3) METR = (b - a)/b

This formula has bee~ used. extensively in the literature on·the tax­

ation of capital investment. 11

- 30 -

Appendix Endnotes

1. If the investment project includes more than one asset then dK represent&

the sum of the depreciation rates for each asset times their respective

capital stocks.

2. "Net" is taken to mean net of wages and purchases of intermediate goods

and services.

3e The full loss offset assumption is discussed in Section IV. Results are

presented in Section IV with and without this assumption.

4. Section III describes now capital gains and balancing adjustments are

defined.

5. See Gravelle (1982), Auerbach (1983), and King and Fullerton (1984).

- 31 -

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249. The Interaction of Domestic Distortions with Development Strategies, - by B. Balassa.

250. Economic Incentives and Agricultural Exports in Developing Countries, · by B. Balassa.

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252. On the Progressivity of Commodity Taxation, by s. Yitzhaki.

253. A Full Employment Economy and its Responses to External Shocks: The Labor Market in Egypt from World War II, by B. Hansen.

254. Next Steps in the Hungarian Economic Reform, by B. Balassa.

255. On the Progressivity of Commodity Taxation, by S. Yitzhaki.

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258. Investment i~ Segmented Capital Marketa, by I. Nabi.

259. Privatizing the Financial Sector in LDC's: Lessons of an Experiment, by N. Hamid and I. Nabi.

260. Hercules - A Modeling System with Knowledge about Economics, bY. A. Drud.