TRAIN 2 and the features of a good tax system

The Philippines will not need tax reform for another two decades if this one is done right and done quickly.

on “vertical equity,” or how the tax system treats people with different incomes. Most tax systems aim for progressivity, where the rich pay a higher share of their income in taxes than the poor. The first phase of the tax reforms addressed this issue and succeeded in reducing personal income taxes for the bottom 99% of the population.

But another important element is “horizontal equity,” or how the tax system treats similar entities. The guiding principle is fairness — the playing field must be level, so that similar entities face similar tax rates. If we look at the current system, the incentives that some firms get but others don’t works against horizontal equity. Firms that manage to get tax incentives face much lower effective tax rates of 6-14%, whereas firms that don’t face a 30% rate. TRAIN 2 aims to improve horizontal equity by rationalizing fiscal incentives for businesses.

By rationalizing existing fiscal incentives, TRAIN 2 will allow for a reduction in the 30% corporate income tax rate, and this will help with the third and fourth features of a good tax system — efficiency and competitiveness. One of the principles in public finance is that distortions, or the decline in society’s well- being due to a tax, rise disproportionately with the tax rate. For this reason, it is more efficient to have a broader tax base and a lower rate, and that is what TRAIN 2 is trying to do for corporate taxation. A lower corporate tax rate will make the Philippines’ tax system more competitive, as it currently has the highest corporate tax rates in ASEAN.

One argument often leveled against TRAIN 2 and the tax reform program more broadly is that by changing things, the government is reducing the stability and predictability of the tax system — the fifth feature of a good tax system. But one cannot and should not keep a tax system fixed — especially a flawed one — simply for the sake of “stability.” The Philippines’ tax system is in dire need of fixing, and this is the first major tax reform in the Philippines in two decades. If we allow it to be done right, and done quickly, the Philippines will not need tax reform for another two decades.

When it comes to the sixth feature of a good tax system, ease of administration and compliance, two elements are very important — simplicity and transparency. TRAIN 2 aims to help by replacing the 123 special laws that govern tax incentives with a single law, and bring the 14 different investment promotion agencies under a single body, the Fiscal Incentives Review Board. One lesson from history is that the government should not be in the job of “picking winners” — the track record of countries around the world in doing this is not good, and it often stimulates lobbying for personal gain. Rather, incentives should be based on firms’ documented ability to deliver, whether it be creating more jobs, raising incomes, or increasing exports.

Which brings us to the final feature of a good tax system and of good policy more generally — that it be supported by solid evidence. The proliferation of large amounts of useful data have led to a “credibility revolution” in evidence-based policy making.

Thanks to the Tax Incentives Management and Transparency Act, it is now possible to analyze whether tax incentives — which reduced government revenues by P301 billion in 2015 — have delivered the employment, income,