Precursors to the 2017 comprehensive tax reform

MANILA, Philippines - Qi?n suàn wàn suàn bù zhí ti?n yì huá, a Chinese proverb meaning a thousand or ten thousand schemes are no match to one stroke of heaven. John Steinbeck’s own take — “The best laid schemes of mice and men often go awry.” That was what happened to the 1997 comprehensive tax reform. Subsequent events conspired to frustrate the well laid plans and lofty objectives. This provided valuable lessons now being put to good use in this 2017 comprehensive tax reform package (CTRP).

Plethora of taxes for naught

The Tax Reform Act of 1997 overhauled the national internal revenue code. It was the work of the best tax and legal minds then in the executive and legislative branches of government. The reformed tax code was expected to provide fiscal support for decades to come. "The tax net covers anything that moves, figuratively speaking. There is a tax bite when income is earned, when it is spent and when it is distributed. Even after death, an individual’s assets accumulated during his lifetime and already taxed, is again subject to a levy – the estate tax”, this author wrote in “Simplifying the tax system: The way to go” on Aug. 16, 2010. But they were to no avail.

Single stroke of heaven

A single stroke of heaven intervened. Asia was hit with a financial crisis in 1997. The asset bubble burst, peso tanked, nonperforming loans and bankruptcies soared, the economy sank into recession and unemployment rose. The imperiled fiscal position was compounded by the drastic reduction in customs tariffs to qualify for accession to the World Trade Organization. Average nominal tariff rates tumbled sharply from the 28.1 percent high in 1996 to just 7.7 percent in 2001 with many items zero rated. External taxes, which is the second largest source of revenue, together with internal revenue were decimated. The ratio of tax revenue to gross domestic product or, tax effort, dived from the 15.3 percent high in 1997 to a perilous low 11.8 percent in 2014. The fiscal deficit soared to a record P314.1 billion and the country found itself on the brink of a fiscal crisis.

Achilles heel of the 1997 tax code

Rigidity and complexity, while being all encompassing, characterized the tax code. The name of the game was catch all and give no quarters. The tax system continued to rely on the cumbersome personal and corporate income taxes for its largest source of internal revenue. Inflexibility manifested in the personal income tax where brackets are graduated and fixed. Complexity is shown in the new value-added tax where small businesses perforce cope with added cost of administration. Real property is divided into “capital” and “ordinary” asset, each with a different tax treatment. Cigarette specific taxes are four-tiered, gasoline has 3 classifications – unleaded premium, leaded premium and regular, distilled spirits are classified and taxed based on raw materials used with some taxed based on volume, while others per bottle. Estate tax is graduated with a high 20 percent top rate. Gifts are subject to donor’s tax with different treatment for gifts to relatives and strangers. No provision is made for adjustment of the taxes for inflation.

Major shifts

The 1997 tax code saw major shifts in consumption and sin excise taxes. The US-styled sales tax was replaced by the European-modeled value-added tax (VAT) on goods and services at 10 percent. Transfer of real property held as stock in trade, classified as “ordinary” asset, is similarly taxed. Unlike the sales tax, the VAT applies to the net value added throughout the entire value chain from importation and production to wholesale and retail. Exempted were raw agricultural and marine products and a host of goods and services, particularly health, dental and education. The output VAT is reduced by the input VAT, which is a feature not found in the sales tax. VAT, being a border or domestic tax, exempts export sales, but unlike in other countries, no refund is given for purchases of tourists. It is a catch all tax system.

Another major shift was the replacement of the ad valorem taxes on tobacco products with specific taxes as the former was seen susceptible to “adjustment” through transfer pricing strategies. Cigarettes have unwieldy four-tier specific taxes at one, five, eight and twelve pesos per pack, classified based on the retail price. Specific tax on distilled spirits and fermented liquor were taxed per liter of volume, while wines are taxed per bottle.

Specific excise taxes on refined petroleum products are based on grade and volume. They ranged from a high P5.35 for leaded premium gasoline to, interestingly, diesel fuel at P1.63 per liter. The latter tax was subsequently scrapped in an amendment. Cooking fuel liquefied petroleum gas is exempt, while kerosene is taxed at P0.60 per liter. These excise taxes were likewise not indexed to inflation.

Limitations manifested

Structural limitations in the revamped tax code manifested themselves. Inflation wrought by higher fuel prices and drastic depreciation of the currency rendered the rigidly set personal income tax brackets and excise taxes irrelevant and outdated. The VAT was porous with many sacred cows spared. Rescue efforts were mounted, albeit piecemeal. The VAT law was twice revised, first by raising the rate to 12 percent from ten percent, and next, by expanding the coverage, called E-VAT, albeit with many exemptions. Excise taxes on "sin” products, particularly cigarettes, were revised with the institution of two-tier taxes. The tax effort bumped up to 13.7 percent in 2015, still far short of the pre-1997 tax reform 15.3 percent high.

Clamor for tax reform

It was clear the tax system had become outdated and inadequate for the fiscal needs of the government, while leaving taxpayers disgruntled. Yet, the 2010 presidential campaign had frontrunner Sen. Benigno C. Aquino III repeat George W. Bush’s line – “no new taxes” to loud applause. This prompted the author to write – “A matter of tax (mal) administration?”, Feb. 1, 2010, Philippine STAR, as candidate Aquino’s contention was that the tax system was structurally sound and it required only better administration to raise more tax revenues. But later events show this was not so and the sin tax law, for one, had to be restructured. Furthermore, the tax system went out of synch with those of regional peers. ASEAN went from complementation of industries to economic integration. Many instituted tax reform with lower tax rates and, in the process, undermining the competitiveness of local businesses in the region. Attempts, albeit piecemeal, were made in Congress to institute tax reform. Fiscal incentives reform did not prosper. Bills focused on revamping the personal income tax were filed. But, without support of the executive branch, these attempts withered in the vine. Adding to the voices for reform, this author wrote “Simplifying the tax system: The way to go” on Aug. 16, 2010 and reiterated the call in “Simplifying the tax system redux” on Aug. 18, 2014.

Part 2 to this article will cover our views on the comprehensive tax reform package (CTRP) of the reformist Duterte administration as proposed by the secretary of the Department of Finance, Carlos G. Dominguez.

(Eduardo H. Yap is a board governor of the Management Association of the Philippines (MAP), chairs the National Affairs Committee of the Financial Executives Institute of the Philippines (FINEX) and was a licensed certified public accountant (CPA).