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Post-COVID-19: Responding to the Fiscal Challenges

Posted on Sep. 7, 2020

Charles E. McLure Jr. introduces the series, Post-COVID-19: How Governments Should Respond to Fiscal Challenges to Spur Economic Recovery, coordinated by the International Tax and Investment Center (ITIC) to offer tax policy guidance to developing countries during the post-pandemic recovery phase.

Charles E. McLure Jr. is a senior fellow, emeritus, with the Hoover Institution.

Copyright 2020 Charles E. McLure Jr. and ITIC. All rights reserved.

The COVID-19 pandemic has had unimaginably horrible effects on the health of people throughout the world, in both developed and developing countries. Social distancing and the widespread lockdowns imposed in the effort to halt the spread of the novel coronavirus, along with disruptions of supply chains and reductions in demand, have had devastating economic and fiscal effects. While tourism and air travel have been particularly hard hit, restaurants, hotels, theaters, car rentals, and activities that require close personal contact have also suffered disproportionately. In May Oxford Economics forecasted a 4 percent drop in world GDP for 2020, and in June the IMF forecasted a 5 percent global contraction. Governments have seen revenues fall, while expenditures — for healthcare, payments to households, and bailouts for business — and thus budget deficits — have skyrocketed.

The International Tax and Investment Center, for which I served as the economic adviser for a few years, beginning with its inception in 1993, has coordinated a set of seven articles dealing with the fiscal issues facing developing countries in the wake of the pandemic. Although the target audience is finance ministers and revenue officials responsible for tax policy in developing countries, a wider audience would benefit from studying these articles.

The first article, “Coronavirus — Fiscal Challenges for Emerging Markets,” by Oxford Economics, provides an overview of the problem and how and why it differs both from those in developed countries and among developing countries. It highlights factors that are likely to aggravate the healthcare crises, including inadequate healthcare, demographics (an older population), crowding in urban areas, connectedness with the developed world, and large informal sectors. The severity of economic effects is related to lack of broadband (making working from home and online ordering for delivery unlikely), dependence on tourism and commodity exports, reliance on foreign capital inflows, weak social security systems, and lack of fiscal space. On these criteria, the situation seems worst in the countries of Latin America and best in those of emerging Europe.

On the fiscal side, developing countries as a whole may be in a better position than their developed counterparts for several reasons. Their support packages, especially loans and guarantees, are thus far smaller than those in developed countries, in some cases because the countries lack the requisite institutional infrastructure and financial resources. In some cases, there may be less demand for spending, because the healthcare crisis has not been as bad where populations are younger, there is less international connectedness, and/or a less well-developed social safety net.

Coming articles discuss general aspects of corporate income tax (“Post-COVID Corporate Tax Policy,” by Jack M. Mintz) and the more specialized questions related to transfer pricing and withholding taxes (“Global Tax Policy Challenges After COVID-19: Transfer Pricing and Withholding Tax Aspects,” by Hafiz Choudhury and Peter Hann). Those making corporate tax policy face several crucial questions: Should corporate taxes be raised to increase revenues, or should they be reduced to spur economic growth? If corporate taxes are to be raised or lowered, should it be by changing rates or by changing provisions that have an “up-front” impact, such as the structure of depreciation allowances and investment credits? To set the stage for the discussion of post-COVID policy, Mintz examines what happened to statutory tax rates, tax bases, marginal effective tax rates, and revenues from 2010 to 2019. He then explores COVID’s effects on economic activity and considers the relationship between corporate tax policy and employment, (de)leveraging, trade and competitiveness of taxes, climate change, investment and technological adoption, and inequality. He ends with the sober conclusion that “Too much is uncertain now to even make any predictions.”

Choudhury and Hann’s article on transfer pricing and withholding taxes begins with a survey of the economic effects of COVID-19 that are particularly relevant for those aspects of corporate tax policy. The discussion of post-COVID administration of transfer pricing highlights (the often inadequate) capacity of the tax administration; the need to make use of existing information, including transfer pricing documentation; the difficulty of finding comparable companies and transactions, especially in developing countries, and the possibility of using the profit-split method; and the potential for fruitful exchange of information. Other topics discussed are business restructuring, intangibles, financial transactions, transfer pricing audits, and the taxation of digital services. The authors discuss withholding taxes on payments for the use of intellectual property and technical service and management fees and taxes on branch remittances.

An article by Richard Bird, “VAT in and After the Pandemic,” discusses the world’s “revenue workhorse.” As in 2008-2009, VAT revenues have fallen, but the impact of COVID-19 is likely to be more severe, because consumption, especially that subject to VAT, has fallen, tourism (important in some countries) has plummeted, trade has declined, and governments have reduced VAT in an attempt to shore up economic activity. In addition to rate increases, revenues can, in principle, be increased by closing the “VAT gap” — the difference between actual revenues and the hypothetical yield of a VAT with one rate and no exemptions.

Elizabeth Allen, in “Using Excises to Increase Government Revenue Post-COVID-19,” argues that “Of all the direct and indirect tax options” to increase tax revenues, “excise taxes should be the easiest source.” She examines the pros and cons of various types of excises, ranging from those on alcohol, tobacco, gambling, and motor fuels to those on sugar-sweetened beverages, other services, and luxuries, cataloguing the pros and cons of each. She then goes through the crucial nuts-and-bolts issues of tax design and administration.

The pandemic and measures to control it, by drastically reducing demand for petroleum products, caused prices to collapse and has reduced investment spending. The article “Oil and Gas Fiscal Policies: The Impact of Oil Price, Investment, and Production Trends,” by Carole Nakhle and Theo Acheampong, examines whether petroleum-producing countries should reexamine the fiscal regimes they apply to this sector. Besides providing an overview of the situation, the article presents case studies for 10 countries, of which all but three are developing countries.

There is general agreement that fiscal terms need to be eased to soften the blow on oil companies; the pressure to do so will increase, the longer lower oil prices prevail, but there will be a tendency to ease regulations before pursuing fiscal changes. Countries that depend heavily on revenues are likely to respond most slowly, as are those with nationalistic attitudes toward natural resources. Importantly, fiscal regimes that are profit based and/or emphasize recovery of investment are more likely to generate investment than revenue-oriented regimes such as royalties and signature bonuses, even if tax rates are lower.

The final article, “Taxation of SMEs to Support Economic Recovery Post-COVID-19,” by Elizabeth Allen and David Child, emphasizes the need for measures to increase cash flow to an especially hard-hit part of the economies of many developing countries, small and medium-size enterprises. It suggests options for changes in both tax policy and tax administration that would benefit the target businesses, focusing on customs duties, excises and environmental duties, VAT, income taxes on business profits, and withholding taxes on employee wages and other payments by SMEs. The articles described above deal with several of these at length. This article also outlines specific options for encouraging post-COVID recovery: simplification and reduction of compliance costs, rationalizing taxation of the informal sector, and new tax regimes that could be introduced to reduce reliance on existing revenue sources. Being realistic, the article also lists constraints on tax policy and administration. Finally, the article emphasizes the need to move quickly.

The fiscal effects of COVID-19 are likely to last longer — and perhaps much longer — than the present crisis. These articles, even though they do not provide cookie-cutter recipes, will provide valuable inputs to policymakers as they try to deal with these effects.

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