TERM PAPER OF FINANCIAL INSTITUTIONA AND SYATEM

TOPIC:- Study how the variation in tax structure of different countries affects the investment
climate with the help of an example.

SUBMITTED BY:- SUBMITTED TO:-

PRIYANKA SINGH Mr. ANOOP MOHANTY

ROLL no. RS1903B41

REG. no. 10904448

DEPARTMENT OF MANAGEMENT
INTRODUCTION

TAXATION:- The word “tax” means “burden, strain or duty”. The act of laying a tax, or of
imposing taxes, as on the subjects of a state, by government or on the members of a corporation
or company, by the authority; the raising of revenue; also ,a system of raising revenue.

Types of Taxation- There are basically two types of taxation that can be processed in the SAP
System:

1. Taxes at federal level

2. Taxes below federal level

Hybrid types or taxation are also possible.

Taxes at Federal Level :-In most European states, in South Africa, and in Australia, for example,
taxes are levied by a federal authority. Tax percentage rates are defined at federal level and local
differences do not exist.

Taxes Below Federal Level :-In other countries, taxes are levied at local level when selling goods
(USA, Brazil, and so on). The local tax authorities can exist at state level, county level, or town
level. Taxes can be levied at lower levels again e.g. fire department district, school district, local
traffic area. Such taxes are then paid directly to these tax authorities. In some cases, however,
these taxes are also payable to higher-level tax authorities, in which case they are apportioned
between the two levels.

Sales taxes are a typical example of tax below federal level. Since sales tax is
usually multi-tier, it is processed using a tax jurisdiction code in addition to the tax code.

TAX VARIATION:- Countries are sovereign nations and have the right to tax individuals and
entities that come under their jurisdiction. There are no international standards that have been
developed in relation to taxation. This certainly leads to variation in tax policies and would have
some effect on regional tax harmonization. Countries have fashioned their tax policies according
to their circumstance. Some countries prefer high tax rates in order that they could offer citizens
significant social benefits. Other countries concentrate on lower rates. The policy in relation to
what should be taxed also varies. Taxes on income, expenditure, consumption and property are
some of the taxes that are used to collect revenue. Even within these various taxes one could
detect different rules. How and the extent to which such variation in tax policies affect regional
tax harmonization could be determined after analysis and discussion of the various tax policies in
some of the countries in CARICOM.

VARIATION IN TYPES OF TAXES

Countries in CARICOM obtain Government revenue through various taxes such as income tax,
corporation tax, Value Added Tax (VAT), sales tax and fees. Some countries use a combination
such as income tax, corporation tax and VAT. Other countries may have only income tax or fees.

DIFFERENCES IN CORPORATION TAX SYSTEMS

Most CARICOM countries levy corporation tax. In the calculation of this tax, generally income,
expenses, allowances, deductions and credits are taken into consideration to arrive at the taxable
income and tax payable. On examination of CARICOM countries several differences would be
detected. What is included as income may vary. For example, some countries include dividends
from foreign sources. In relation to expenses some items that are classified as expenses in one
jurisdiction may not be classified as such in another – for example, interest. Usually capital
allowances are deducted from income to arrive at taxable income. However it should be noted
that the amount deductible may vary from item to item in different countries.

VARIATION IN POLICIES OF SOME ITEMS

The following are some of the policies that exist in various CARICOM countries:

INTEREST - DEDUCTION

Policy A - paid on capital, only to banks and certain financial institutions.

Policy B - paid on capital – must be paid within two years with 3 respect to arm’s length
transaction and one year for nonarm’s length.
Policy C - can be interest paid on any money borrowed that was used on capital employed in
acquiring the income.

PENSIONS - DEDUCTION

Policy A - not mentioned in the legislation.

Policy B - Contributions paid to registered retirement plan deductible, however with limits.
Lump sum contribution for past years is deductible over a period of not less than 10 years.

Policy C - contributions paid on an approved plan with no limits on deduction.

PREMIUM TAX

Policy A - Life Insurance – premium tax of 3% on both residence and non-residence companies -
taxed net of Commission (for agent).

Policy B - 5% Life Insurance – of gross direct premium income of resident and foreign life
insurance companies.

Policy C - Only on property insurance premiums payable in respect of local risk.

CORPORATE INCOME TAX RATES: INTERNATIONAL COMPARISONS

The corporate income tax has the potential to distort economic incentives and generate
inefficiency in at least six ways. First, because it is imposed on income from capital, it biases
individuals’ decisions about how much to save and can therefore influence overall capital
investment and economic growth. Second, because the corporate income tax is imposed only on
some kinds of business profits (in the United States, typically those of corporations that have
many shareholders) and not on others (such as the profits of partnerships and sole
proprietorships), it affects the ways in which businesses are organized and creates biases in
investment and production toward those types of business structures that are not subject to the
corporate income tax. Third, it creates a bias in corporate financing toward the use of debt—
because the tax is imposed on income from equity-financed investment and not on the return to
debt-financed investment. Fourth, because the law treats a corporation as a separate taxable
entity from which shareholders subsequently realize income in the form of either dividends or
capital gains, the relatively beneficial tax treatment of capital gains under the individual income
tax creates a bias toward them and against the payment of dividends. Fifth, because the United
States levies corporate income tax on the basis of schedules for depreciation that do not
correspond to economic depreciation, it taxes different kinds of assets and industries at different
effective rates, creating a bias in investment and production toward the more lightly taxed assets
and sectors. Finally, the corporate income tax may distort the allocation of resources by making
corporations’ compliance with taxation costly and by creating additional opportunities for tax
planning.

Saving and Investment The corporate income tax is part of the broader taxation of income from
capital. Consequently, it may affect capital investment through its effects on both the supply of
and demand for capital. The corporate income tax may affect the supply of capital by reducing
the returns that individuals receive from saving. It may affect the demand for capital by changing
what businesses must pay to acquire capital for investment.

Saving by Individuals. Saving is income that is not currently consumed. Saving is positive
when individuals consume less than their current income to finance their future consumption. It
may be negative if individuals consume more than their current income, either borrowing or
using accumulated wealth to finance their current consumption. Taxes on income from capital
introduce a bias into the incentives for saving because they make consumption in the future
relatively more expensive than consumption today. Thus, such taxes may alter when an
individual chooses to consume (although whether those taxes increase or decrease saving is
uncertain because it is the temporal decision that they affect). For example, in the face of taxes
on capital income, an individual who decides to keep future consumption at a fixed level must
save more and consume less now. Alternatively, the same individual could decide to save less
now and also consume less in the future.

The net effect of capital income taxes on how much individuals save therefore depends on two
offsetting factors. First, such taxes reduce the after-tax rate of interest that a saver (or investor)
receives and thus decrease the price of current consumption relative to future consumption. That
decrease in the relative price tends to cause people to increase their current consumption and
save less (the “substitution effect”). Second, capital income taxes may decrease current
consumption or future consumption, or both, by making less income available for consumption
both now and in the future (the “income effect”). The income effect may lead people to respond
to capital income taxes by consuming less now (and in the future) and saving more. Whether the
overall effect of capital income taxes is to cause people to save less or more depends on whether
the substitution effect is stronger or weaker than the income effect—and that depends on
peoples’ preferences and can only be determined by empirical investigation. A variety of
empirical studies have tried to measure the net effect on saving of changes in the rate of interest,
but the results have been inconclusive.4 No researcher has made a compelling case that a
significant net effect exists in either direction. However, the shortcomings of the studies and of
the data they use are such that a realistic chance remains that taxes on capital income affect
saving.

Investment by Businesses. How the corporate income tax affects businesses’ demand for capital
is less ambiguous the tax diminishes the demand for capital in the corporate sector by increasing
the cost of capital (the before-tax rate of return that is just high enough for an investment to be
funded). A business will undertake a particular investment only if the business expects to earn a
before-tax rate of return that is high enough to satisfy its financial investors after taxes are paid;
otherwise, the investors will supply their funds elsewhere. The corporate income tax increases
the cost of capital by driving a wedge between the after-tax return that investors demand and the
pretax return that a business’s investment must earn to pay both taxes and investors.

Countries with higher labor income share had a higher share of personal income tax in
the total income tax revenue. The results also suggest that, in periods of growth, the
corporate/personal income tax ratio tends to increase. The other results are not as significant. Of
the other controlled economic variables, informality is the only one which appears to be relevant,
with the expected sign. This suggests that countries with higher informality tend to collect
relatively more corporate income taxes. Considering the variables related to political aspects,
only right-wing governments increase the share of corporate income tax in relation to personal
income tax. This result was not expected.
 Tax systems in 2009-2010
corporate rate of tax metr labour consumption
tax rate allowances tax rate tax rate
AUT 34.0% 7.7% 6.2% 3 8.7% 24.7%
BLU 34.0% 6.1% 8.0% 38.1% 22.9%
CZE 28.0% 6.9% 6.1% 35.3% 23.8%
DEU 39.6% 5.0% 12.4% 34.1% 19.6%
DNK 30.0% 7.1% 6.3% 34.1% 47.5%
ESP 35.0% 7.7% 6.2% 27.9% 16.6%
FIN 29.0% 5.7% 8.1% 38.2% 35.0%
FRA 35.4% 7.6% 6.5% 38.2% 22.4%
GBR 30.0% 5.7% 8.4% 21.3% 19.7%

Tax revenues consist of source-based taxes on corporate income and residence-based

taxes on labour income, dividends, capital gains, interest income and consumption. The
expenditure side contains government consumption, unemployment benefits, interest payments
on public debt and lump-sum transfers. Government behavior is exogenous. We
keep government consumption and public debt constant as fractions of GDP.
The corporate tax base is defined as the value of output (for a headquarter including the
value of intermediate inputs supplied and for a subsidiary minus the value of intermediate
inputs used), minus wage costs, interest payments on debt, and tax allowances. Tax
allowances capture more than fiscal depreciation and are specified proportional to the
capital stock. Country-specific corporate tax rates and tax allowances are presented in
Table 4. Statutory tax rates are taken from Devereux et al. (2009), except for the new
member states (Finkenzeller and Spengel, 2009). The first column in Table 4 shows that
statutory tax rates range from 12.5% in Ireland to 39.6% in Germany (in 2009). The rate
of tax allowances is calibrated so as to reproduce marginal effective tax rates (METR)
reported by Devereux et al. (2009) Thereby, we take the METR for domestic firms for the case
where 25% of a new investment is financed with debt and 75% with equity.12 The allowance
rates thus identified are presented in the second column of Table 4. It suggests that Portugal,
Italy and Greece feature relatively narrow tax bases, while Ireland and Germany feature
relatively broad tax bases. Note that in countries with a narrow tax base, the METR is typically
small as the corporate tax is largely a tax on rents, rather than a tax at the margin of new
investment. As we will see, this will have implications for the distortionary effect of corporate
tax increases. In contrast, countries with a broad tax base, like Germany and the Netherlands,
feature a higher initial METR. In Ireland, the METR is relatively low due to a low corporate
tax rate, not because of a narrow tax base. The last two columns in Table 4 show the
initial labour and consumption tax rates, which represent effective taxes computed from
tax revenue data of the OECD. The initial rates matter for the distortions of labour and
value-added taxes, which will be analyzed in section

Firms
CORTAX distinguishes between two types of firms: domestic firms and multinationals. A
domestic firm operates in the home country. A representative multinational headquarter
is located in each country. Multinationals own one subsidiary in each foreign country.10
Firms are assumed to maximise the value of the firm. Production in each firm uses
three primary factors: labour, capital and a location-specific factor (e.g. land). Labour
is internationally immobile so that wages are determined on national labour markets.
Capital is assumed to be internationally mobile so that the return to capital after source
taxes is given for each country on the world capital market. This fixed return to capital
implies that the user cost of capital depends on country-specific corporate taxes, which
thus affect investment behaviour. The location-specific factor is supplied inelastically and
is internationally immobile. Its return, being a rent, is subject to corporate tax. Income
from rents earned by subsidiaries accrues to the parent country. Accordingly, countries
can partly export the tax burden abroad through the corporate income tax.Firms finance their
investment by issuing bonds and by retaining profits (issuing new shares is excluded). The equity
capital of a subsidiary, defined as foreign direct investment (FDI), is provided by its parent. The
optimal financial structure of companies depends on the difference between the cost of debt
financing (deductible for corporate taxation) and the required return on equity. The latter is
determined by the marginal equity holder,which is assumed to live in the home country. As a
consequence, the required return on firms’ equity depends on the personal income tax on equity.
As debt financing is tax-favoured in corporate tax systems, extreme debt positions are avoided
by specifying financial distress cost that increases in the debt ratio of a company.
Production in a subsidiary needs in addition an intermediate input that is provided by its parent
company. A headquarter can charge a transfer price for these inputs that deviates from an arms-
length price. In particular, with separate accounting, a multinational has an incentive to shift
profits to low-tax countries by setting an artificially low transfer price. Profit shifting remains
bounded by specifying convex costs arising from manipulated transfer pricing. The capital and
labour parameters in the production functions are determined by country-specific labour income
shares. The amount of the location specific factor used by subsidiaries is calibrated from
data on bilateral FDI-stocks.
.
Development implications of international investment agreements
The universe of international investment agreements (IIAs) continues to expand and is becoming
increasingly complex. As of the end of 2006, more than 2,500 bilateral investment treaties
(BITs), 2,600 double taxation treaties and 240 other agreements with investment provisions –
such as free trade agreements – existed. This impressive IIA network has several characteristics:
(a) Firstly, it is universal, in the sense that nearly every country has signed at least one IIA, and
the great majority of countries are party to several, if not many, agreements relating to
investment.
(b) Secondly, the structure of agreements is atomized, i.e. no single authority coordinates the
overall structure or the content of the thousands of agreements that constitute the system.
(c) Thirdly, the IIA universe is multi-layered, i.e. IIAs exist at the bilateral, regional,
interregional, sectoral, plurilateral and multilateral levels, often resulting in overlapping
commitments of countries.
(d) Fourthly, the system is multi-faceted, meaning IIAs increasingly include not only provisions
specific to investment, but also rules addressing other related matters, such as trade in goods,
trade in services, intellectual property protection or movement of labour.
(e) Fifthly, the IIA universe can be characterized as having uniformity at the core, but increasing
variation at the periphery. This means that on a number of core issues – such as national
treatment and most favoured nation (MFN) treatment for established investment, fair and
equitable treatment, guarantees of compensation for expropriation and of free transfers, and
consent to investor-State and State-State dispute resolution – the agreements reflect a
considerable degree of commonality in terms of the treaty language. Other provisions, however,
such as non-discrimination with respect to the admission of foreign investors or prohibitions of
certain performance requirements, show more variation in the way they are drafted or appear in
only a minority of agreements.
(f) Sixthly, the IIA system is dynamic and innovative, meaning recent IIAs include new
provisions or important amendments to existing rules (see below). To a considerable extent, this
is a reaction to the substantial increase in investor-State disputes in the last couple of years,
resulting in more than 250 known arbitration cases at the end of 2009.
These characteristics of the evolving IIA universe present opportunities and challenges for
countries, in particular developing countries. This issue of the IIA Monitor sheds more light on
them from a development perspective.

Restoring economic growth after the global financial crisis need not thwart the fight
against climate change The decline in economic activity as a result of the crisis could cut global
greenhouse gas emissions by more than 2.5 percent in 2009, after rapid increases in recent years,
according to the International Energy Agency (IEA). But the serious damage of climate change
arises not from the flow of greenhouse gas emissions but from the accumulated stock. The sheer
scale of the existing stock and its very slow decay mean that even quite large reductions in
emissions over the short term will do little to reduce the damage to be expected from climate
change. For that, a massive change in the underlying trend of emissions is needed.

The downturn has not affected the market failures that underlie the climate problem—most
important, that polluters do not bear the full costs of emissions. Even with the mitigating effects
of the crisis, in the absence of additional policy intervention global emissions could rise by
40 percent by 2030. Broader and deeper international measures to raise the cost to firms and
households of emitting greenhouse gases must remain a priority.

The need to restore economic prosperity after the crisis may have weakened political support for
climate mitigation measures—centered on strong and broad carbon pricing to address basic
market failures—which could increase production costs and reduce household incomes. And the
effects could be persistent: compromising climate policy objectives when times are hard could
seriously undermine, for example, the credibility of future emissions pricing, which is a critical
guide to efficient long-term energy investments. Hasty investment decisions to stimulate
recovery could make reducing future emissions even harder.

Current macroeconomic weaknesses do not warrant less ambitious abatement objectives. If

anything, for two reasons, they argue for the opposite. First, the marginal costs of mitigation
have fallen (permit prices in the European Union Greenhouse Gas Emission Trading System—
EU ETS—are at roughly half their 2008 peak). The large drop in aggregate demand that
underpins these trends may of course be short lived relative to climate policy horizons, but the
point remains: lower private abatement costs mean that emission targets should, in principle, be
tighter rather than looser.

Second, and perhaps more important, lower energy prices present an opportunity to introduce
and lock in some element of carbon pricing. While there will be opposition to increasing the
fiscal burden, this is a good time for countries with controlled fuel prices, in particular, to adopt
automatic pricing mechanisms that embody a green tax element. The recent uptick in medium-
term fossil fuel price forecasts highlights the urgency of such reforms.

The OECD Investment Compact is a leading program to improve the investment climate in
SEE based on OECD good practices
Strengths & limitations of the IRI methodology

Main strengths of the IRI methodology:

 Incorporates existing work already conducted by other organizations (e.g., World

Bank’s Doing Business report) and combined with data collected by the OECD-IC

 Use of a common ‘scoreboard’ facilitates public-private consultation & helps public

officials to communicate better with respect to policy progress and areas where more
reform is necessary.

 IRI incorporates regional ‘good practices’ from CEE countries, which are the most
relevant recent examples for SEE countries to learn from.

Indicators of the IRI have been structured to be fully compatible with the EU accession
process in SEE, and to cover other dimensions important for the investment climate that are
not included in the acquis communautaire - the dimensions of the IRI are based on a broad
definition of policy areas that affect the business climate, based on OECD cumulative experience
and Policy Framework for Investment
Limitations of the IRI methodology:

• IRI does not cover all the policy dimensions that affect the business climate (eg; financial
services).

• Measuring the effective implementation of government policy can be difficult. The

IRI combines available quantitative data (e.g. percentage of companies with ISO
certificates) with qualitative data (e.g. private sector feedback through interviews) -
countries are moved up on the scale of implementation only if there is concrete data to
support doing this.

• Distinctions between scoring levels can be challenged and not all of the indicators have
the same weight or importance. To address this issue, a simple weighting system has been
incorporated, but the assigned weights can always be questioned.

• All dimensions are not equally important for each country, as they are at different
stages of development. Each country therefore has to interpret the scores based on its
specific development context.

CONCLUSION

The variables that explain the differences between the tax structures of developed countries and
other countries, based on the determinants pointed out in the literature. These potential
determinants were tested through two ratios: the corporate income tax/personal income tax ratio,
and the income tax/consumption tax ratio. The determinants pointed out in the literature explain
much better the differences between countries in relation to the first ratio (corporate income
tax/personal income tax). Regarding the second ratio (income tax/consumption tax), the selected
characteristics certainly were not capable of explaining the differences observed between the
developed countries and other countries. There is some variable, not mentioned in the literature
and not included in the regressions, whose importance in explaining the income tax/consumption
tax ratio is expressive. There are two variables that are strong determinants of the corporate
income tax/personal income tax ratio: the share of labor income in national income, and the
product growth rate. As expected, the corporate income tax/personal income tax ratio is greater
in developed countries due to the larger share of labor income in the national income. This
ensures significant revenue via personal income taxes. On the other hand, in periods of higher
rate of growth, this ratio falls. Moreover, though less significant and robust, informality and
right-wing governments also influence the corporate income tax/personal income tax ratio. As
predicted in the literature, countries with higher levels of informality tend to collect more taxes
from businesses with regard to overall income tax revenue. Contradicting expectations, right-
wing governments collect more corporate income taxes. In spite of the low explanatory power of
the income tax/consumption tax ratio model, results show that during periods of growth this ratio
tends to decrease. There is evidence, which is not as significant, indicating that countries with
higher levels of informality actually tend to set up tax structures with a higher proportion of
consumption taxes. Greater income inequity is a factor that tends to increase the share of income
taxes, a result that was not expected. The rate of inflation is a factor that triggers an increase in
the proportion of income taxes in the overall tax structure. It was not detected any relation
between the political variables and the income tax/consumption tax ratio.
REFRENCE

• www.gsdrc.org/docs/open/HD713.pdf

• www.ifc.org/ifcext/fias.nsf/...TaxSimplification/.../FIAS-HTSfinal.pdf.

• www.caricom.org/jsp/community/.../variation_in_tax_policies.pdf.

• www.worldwide-tax.com

• www.eesp.fgv.br/_upload/publicacao/258.pdf.

• www.hertie-school.org/.../287_student_project_meyer_spasche.pdf.

• ideas.repec.org/p/unr/wpaper/06-018.html.