MONDAY MACRO: This simple economic concept shows how government revenues post-tax reform may not drop as forecasted, but actually improve long-term
With the corporate tax reform close to passing, businessmen will be able to breathe a sigh of relief. However, there are still concerns about the downsides of the bill, particularly the decline in government revenue.
This simple chart shows there’s nothing to fear and that government revenue forecasts may even be too pessimistic.
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Last Monday, we discussed the recently ratified Corporate Recovery and Tax Incentives for Enterprises (CREATE) Act and the general impact of tax cuts to the Philippine economy. As the country continues to recover from the pandemic, many are depending on the CREATE Act to stimulate the economy.
Once President Duterte signs the bill, the corporate income tax rate will be lowered from 30% to 20% for small and medium enterprises and from 30% to 25% for large corporations. The tax savings would help many businesses survive and expand capacity in the future, improving the country overall.
However, the major downside of the CREATE Act is the reduced tax revenue. The Department of Finance estimates that passing the bill would lead to government revenues falling by PHP 40 billion in H2 2021 and by nearly PHP 500 billion in total for the next five years.
Lower government revenue means lower government spending. If we look at the computation of GDP under the expenditure approach (GDP = consumption + investment + government expenditure + exports – imports), while investments would see an increase, government expenditures would experience a drop.
There’s a possibility that the pros and cons of the CREATE Act would just offset each other, ceteris paribus. However, proponents of the bill argue that lowering the corporate tax rate would make the country more competitive internationally.
Currently, the Philippines has the highest corporate tax rate in Southeast Asia. Passing the CREATE Act wouldn’t just invite local businessmen to invest in the Philippines, but foreigners as well. As a result, investments in the country should outgrow any lost government revenue.
Even if we assume that the CREATE Act would not attract additional foreign capital, there is another reason why it would be a net good to the country. Strangely, proponents have never mentioned this to justify the bill, as it is such a simple picture.
The chart above is what economists call the Laffer Curve. It essentially shows that in its extreme case, while a 0% tax rate sensibly doesn’t generate revenue, neither does a 100% tax rate because it disincentivizes people from working.
As such, there is a particular tax rate between 0%-100% where going above it would start reducing revenues. The optimal scenario would be to lower the tax rate.
In the case of the Philippine corporate income tax, it is difficult to determine the perfect tax rate. There is little historical data to make an estimation and the corporate tax rate has only ranged from 30%-35% since 1986.
However, the available evidence suggests the 35% tax rate is too high along the Laffer Curve and possibly the 30% rate as well.
In 2005, concerns about the budget deficit led the government to pass the Expanded Value Tax (E-VAT) reform. The law hiked the corporate tax rate from 32% to 35% until 2009. This drove corporate tax revenue to grow by 27% in 2006 and to continue growing until 2008.
However, when the corporate tax rate dropped back to 30% in 2009, corporate tax revenue temporarily dropped before making a full recovery in 2010 as the economy grew more rapidly.
Thereafter, corporate tax revenue consistently rose to new highs through 2018, before slightly dropping in 2019 due to reduced withholding tax compliance.
Given that the last corporate tax reduction did not lead to a long-lasting decrease in tax revenue, it seems likely the CREATE Act will have a similar impact.
If that were the case, then the forecasted PHP 500 billion of foregone government revenue is perhaps too pessimistic. As echoed by many of our Uniform Accounting charts, the government and the economy may be in a better position than previously thought.
About the Philippine Market Daily
“The Monday Macro Report”
When just about anyone can post just about anything online, it gets increasingly difficult for an individual investor to sift through the plethora of information available.
Investors need a tool that will help them cut through any biased or misleading information and dive straight into reliable and useful data.
Every Monday, we publish an interesting chart on the Philippine economy and stock market. We highlight data that investors would normally look at, but through the lens of Uniform Accounting, a powerful tool that gets investors closer to understanding the economic reality of firms.
Understanding what kind of market we are in, what leading indicators we should be looking at, and what market expectations are, will make investing a less monumental task than finding a needle in a haystack.
Hope you’ve found this week’s macro chart interesting and insightful.
Stay tuned for next week’s Monday Macro report!
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