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How tenable is the case against

reduction in corporate tax?

Zaid Bakht and Nazneen Ahmed
FOLLOWING the announcement by the National Board of Revenue of its plan to gradually reduce the rate of corporate tax in Bangladesh starting from the next fiscal year, views have been expressed from some quarters contesting the case for corporate tax reduction. This view seems to rest on the following five arguments.
i)The average corporate tax in Bangladesh is one of the lowest in South Asia and is close to the average corporate tax rate of South Asian countries.
ii)In the backdrop of overt dependence on debt-financing for investment by the corporate sector, a reduction in corporate tax may not have adequate positive impact on investment.
iii)If supportive measures such as conducive business environment and supportive infrastructure are not put in place, increasing investable surplus through lowering of corporate tax rate will likely have only a limited impact on investment.
iv) It is a common practice to impose higher tax rate on sectors that earn high rates of profit and on that ground the existing high rate of corporate tax on banks, insurance companies and mobile phone companies should continue.
v)Subsidised credit to domestic market oriented SMEs will be more successful in stimulating investment than reduction in corporate tax rate.
Let us examine these arguments one by one.
The evidence that has been put forward in support of the first argument shows that the rate of corporate tax is 34 percent in both Pakistan and India, 22 percent in Vietnam, 20 percent in Thailand, and 17 percent in Singapore against 27.5 percent in Bangladesh. Among these countries, Vietnam, Thailand and Singapore have better track records of attracting foreign direct investment compared to both Pakistan and India. Given that Bangladesh desperately needs FDI to supplement its meagre indigenous investable resource base, the suggestion that Bangladesh should follow the example of the later countries instead of the former hardly makes sense.
In presenting the evidence, it has been argued that the corporate tax rate applicable to publicly traded companies (27.5 percent) in Bangladesh is the relevant tax rate to compare with the tax rate in other countries. This does not sound very logical given that listed companies constitute a tiny fraction of the corporate sector in Bangladesh unlike most other countries mentioned in the evidence. Also, as argued in a recent article in a local daily, the comparative position with respect to the corporate tax rate presented in the evidence gives a distorted picture as it compares the lowest corporate tax rate in Bangladesh with the highest rate in the neighboring countries.
When corporate tax is reduced, it raises after-tax profit of the company and, thereby, provides the incentive for further investment. As long as the cost of fund remains unchanged, this incentive will be there irrespective of the mode of financing - debt or equity. So, the second argument that the high incidence of debt financing in Bangladesh will result in lower investment response against reduction in corporate tax rate, does not seem to make much sense.
Again, one reason behind the high incidence of debt financing in Bangladesh
is the system of double taxation on corporate profit entailed in deducting interest payment but not dividend payment from gross profit for calculating taxable net profit and then taxing dividend income again as part of personal income. Reduction in corporate tax rate will bring down the ill effect of this double taxation and will take away the bias towards debt financing as opposed to equity financing.
The third argument that reduction in corporate tax rate will fail to create adequate investment response is based on the assumption that reduction in corporate tax rate will be accompanied by status quo in infrastructure and investment climate situation. This assumption does not seem to be very realistic.
The instance of some countries imposing higher tax rate on sectors earning super normal profit (fourth argument) does not seem applicable to banks and mobile phone companies in Bangladesh currently because of the following reasons.
a)The rate of profit in these sectors has come down sharply in recent years.
b)Year-to-year fluctuations and intercompany variations in the rate of profit have also increased significantly in these sectors in recent years.
cJBoth these sectors have important forward linkages with the rest of the economy, which justifies the case for reducing
corporate tax rate in these sectors. Banks constitute the main source of credit to the private sector. A reduction in corporate tax rate for this sector will facilitate growth of credit to the private sector by favourably affecting the lending rate. Similarly, rapidly expanding use of mobile phone in Bangladesh has played a critical role in bringing down transaction costs and facilitating accelerated growth of the economy. A reduction in the corporate tax rate on mobile phone companies is likely to strengthen this process by encouraging more investment by these companies that will improve the coverage and quality of their service and may bring down costs substantially.
The fifth argument that expanded flow of subsidised credit to domestic market oriented SMEs will spur investment is quite perplexing. Several questions arise here.
First, why is the recommendation limited to domestic market oriented SMEs? Why have the export oriented SMEs been left out?
Second, if expanded flow of subsidised credit to domestic market oriented SMEs spurs investment, why would the same not happen when lending rates are favourably affected through reduction in corporate tax for banks and financial institutions?
Third, if investment response in the case of reduction in corporate tax rate is constrained by lack of improvement in infrastructure and investment climate, why should the same not happen in the case of expanded subsidised credit to domestic market oriented SMEs?
Finally, studies and empirical evidence have time and again shown that a lack of access to collateral free credit rather than the high cost of credit constitutes the binding hurdle to financing SME development in Bangladesh. Hence the prospect of increased investment in the face of expanded flow of subsidised credit to domestic market oriented SMEs remains suspect.
So, on the whole the case against reduction in corporate tax rate appears quite weak and untenable.
The authors are research director and senior research fellow respectively at the Bangladesh Institute of Development Studies (BIDS).