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DPM Tharman at G20 High Level Tax Symposium on "Tax Policies for Innovation-Driven & Inclusive Growth"

24 Jul 2016

Session I: Tax Policies for Innovation Driven and Inclusive Growth

DPM Tharman Shanmugaratnam was a speaker for the session on Tax Policies for Innovation-Driven and Inclusive Growth. The Moderator of the session was the International Monetary Fund Managing Director Christine Lagarde. The other panellists were Mr Lou Jiwei (Minister of Finance, China), Mr Pietro Carlo Padoan (Minister of Economy and Finance, Italy) and Mr Pravin Gordhan (Minister of Finance, South Africa).

Background: Future growth is increasingly driven by innovation. Structural tax reforms focused on innovation can contribute to the repositioning of economies and sectors, and tax policy more generally can also strengthen broad and inclusive economic growth. The discussion in this session will therefore focus on how the design and implementation of tax policy can promote innovation, as well as economic growth that generates opportunities for all segments of the population. Principles for the design of specific taxes and tax systems, which aim at increasing growth, efficiency and equity will be discussed.

Each speaker addressed two questions posed by the moderator.

Question 1:
What are some of the key challenges that governments face in creating a tax system that drives innovation and growth, while reducing inequalities? What has been your country’s experience in implementing policies to create such a tax system?

Question 2:
There is much to learn in this area. Recent work has highlighted for instance, cross border spillovers from R&D. What are the key issues with respect to tax policies to support innovation-driven and inclusive growth that further research could consider how to address?

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1.This seminar addresses a central challenge for tax policy, which is to promote innovation and growth while at the same time favouring an equitable society.

2. The traditional prescription for promoting innovation and growth is to keep income taxes low, and to shift the focus of revenues to consumption taxes (GST or VAT). Policies that favour inclusion and equity are just the reverse – they rely more on progressive income taxes and less on consumption taxes, because consumption taxes on their own are regressive.

3. So how do we resolve this conundrum, and achieve both innovation-driven and inclusive growth? They are both critical objectives for us, so we don’t want to achieve one without the other.

4. There are indeed ways we can do so, and we know we can from experiments in several of our countries. There are ways in which we can encourage enterprise and innovation without shifting the burden of taxes to the poor or middle class. And ways we can implement a fair and progressive fiscal policy without reducing the incentive for businesses and individuals to innovate, work, grow their incomes and save. That space for achieving both innovation-driven and inclusive growth does in fact exist, and it’s the space we want fiscal policy to be in. It’s how we can inject ‘new vitality into inclusive growth’ as Minister Lou Jiwei just put it.

5. Let me highlight some of the ways, drawing on what we are learning from each other.

6. Our first priority when we think of how fiscal policy can support inclusive growth should be to grow incomes, especially for the lower-paid, before we think of how we can redistribute incomes.

7. That’s a growing challenge in many of our countries, and we have to provide full incentive especially for people from disadvantaged backgrounds to be included in the labour market and to grow their incomes. It’s not just an economic objective, not just about reducing wage inequalities. It is also about ensuring people feel included in society; when we look at the problems we have around the world today, there is this sense of whether you are included or excluded, and it becomes even more an issue when the differences are based on ethnicity. So it’s not just an economic priority but a broader, strategic priority: including everyone in the formal labour market, giving them a real chance to improve their skills and incomes, and to feel they can earn their own success.

8. What has worked?

  • Negative income taxes for lower-paid workers are a very useful device. They encourage people to be part of the workforce. It’s being used in several countries, and we have some experience with our own scheme (called Workfare) in Singapore. Negative incomes taxes are an example of a policy that not only promotes equity, but does so in a growth-friendly way.

  • Tax credits and subsidies for upskilling are another example of a policy that supports equity as well as innovation and growth. It helps workers who face dislocation in the market; it leads to skills accumulation across society; everyone benefits. Tax credits for employers, and subsidies to both employees and the unemployed, have to be one of our most active strategies as we move ahead, and here too we can learn from each other on what works best.

  • We also have to give special support for innovation and productivity amongst SMEs. Studies in the US and some other places show that a fair amount of the inequality in our workforces is about inequality between enterprises – people employed by SMEs tend to get paid less than people who work in the same jobs in large firms. When designing our policies to boost innovation, we have to be especially friendly to small firms and young firms, and maximise spillovers of ideas from the large or leading firms to the small, so that new techniques spread quickly.

    • We have to build this SME-friendly approach into the design of our tax incentives. That typically means that when we have a tax allowance for investments in innovation or skills upgrading, it should come with a dollar cap, so that we focus the benefits on SMEs. A dollar cap also allows us to use the same fiscal resources to give a higher percentage of earnings an allowance, and that too tends to benefit SMEs more.

  • A dollar cap on total income tax deductions is also a useful reform in personal income tax regimes. As the OECD points out, those who get the most benefit from some tax allowances are the rich, and in many countries we need a way to cap total tax deductions so as to preserve the progressivity of income tax.

9. These are examples of how we can design tax and fiscal policies to support broad-based income growth, and that has to be our first priority. To put the point more broadly, we should focus not just on the Gini coefficient, which looks at inequality or relative incomes, but also on the absolute growth of incomes. Take China as an example. It has one of the highest Gini coefficients in Asia, and probably the largest increase in Gini coefficients over the last three decades. That’s a challenge, but China more than any other developing economy has also had the four greatest success in uplifting people from poverty and in achieving broad-based, absolute growth in incomes. The Gini coefficients are relevant but they are not everything. We have to focus first on how we can help people grow through education, help people to be in the formal labour market, and give full incentive for both workers and employers to invest in continuous upskilling.

10. A second priority in tax policy concerns property taxes. It is the most efficient tax, ie the least damaging to income growth – that’s a long-standing tenet, and it’s backed by the evidence internationally. There is in fact more scope in many of our economies to increase taxes on immovable property: land as well as developed real estate. But we also have to make property tax progressive, and there are examples of how this can be done. We need to provide allowance for properties of low value, and provide higher tax rates for properties of high value. And to distinguish between primary or owner-occupied residences, which should be taxed less, and investment properties. That’s our approach in Singapore. And we must tax land, even when it is not developed. In many countries, private land ownership is heavily concentrated, held mainly by the wealthy. From a growth and equity point of view, there is hence a good economic case for taxing land adequately.

11. There is also a role for taxes on property transactions (such as through stamp duties), besides taxing ownership. The traditional, theoretical view is that taxes on transactions are distorting – they distort market decisions. But I would say it is the right sort of distortion. Not all distortions are bad. Taxes on property transactions have been especially useful in the Asian context, where speculation in the property market is almost a habit. Taxes on property transactions can be varied depending on the state of the property cycle. But they are also an essential part of the permanent landscape of taxes – always distinguishing purchases for owner-occupation from those for investment. They are a better way to collect tax than income taxes, with less harm to growth, and more likely to encourage an economic culture conducive to innovation and entrepreneurship.

12. A third priority is in ensuring fair subsidies for public services, targeted at those who need it most. Healthcare financing is especially the challenge in more mature societies, and those which are getting older. Fair and targeted subsidies are at the heart of ensuring both social equity and sustainable budgets – and if we don’t address this well we will see taxes go up even more as our societies age.

13. The basic problem in many countries is that most of the subsidies don’t go to the poor. They go to the middle-class and a large proportion in fact goes to those who are above the middle-class. That happens when government subsidises the supply of healthcare for everyone, rather than subsidising based on people’s financial circumstances. So people pay high income and consumption taxes, and then feel they should get it back in benefits. It’s not going to be sustainable, and I think we all recognise that. Minister Prat-Gay just spoke about a critical reform that Argentina is implementing – shifting from an unsustainable system based on heavy 5 subsidy of supply of services, to a system which subsidises based on need. So that’s a key issue for all of us – how we can target the benefits for those who need it the most, and avoid what would otherwise be a significant increase in taxes.

14. A fourth priority is to mitigate the regressive feature of consumption taxes (GST or VAT). They are efficient taxes, but on their own they hurt the poor more. That’s why in most countries we try to offset their impact on the poor. Minister El-Garhy was just telling us of Egypt’s ambitious new VAT system, to be set at a 14% rate. It’s a key piece of their reforms, and they are looking at how to mitigate its impact on the poor. The usual way is to exclude food and other essentials from the tax, or to tax these items at lower rates. One of the problems with that approach is that while it is of greatest help to the poor, the bulk of the benefits in absolute terms usually goes to people who are not poor. The OECD and others have pointed this out. That’s true of most essentials, and more so when restaurants, theatres and cinemas are excluded as they are in many developed countries. And the more the exclusions, the higher the VAT or GST rate will have to be.

15. There is no perfect way to mitigate the regressive feature of a consumption tax, but whichever way has to be fair and easily implemented. One alternative is provide benefits directly to the poor, rather than exclude items from the tax. For example, we have a system of vouchers (GST Voucher) in Singapore to mitigate the impact of the GST on the poor. It allows us to keep the GST a flat tax, which greatly helps in business compliance, makes sure that we collect consumption tax in full from those who are better off, and hence helps to keep the GST rate low. This too is an area in which we can learn from each other’s imperfect experiences.

16. Fifth, in the same vein of achieving progressivity in our tax systems, a dollar cap on total personal income tax deductions is a useful reform. We have recently instituted this in Singapore. As the OECD points out, those who get the most benefit from some tax allowances are the rich, and in many countries we need a way to cap total tax deductions so as to preserve the progressivity of income tax.