Taxes give government more command over an economy

Direct corporate and personal income tax in the GCC is extremely low or even non-existent. Even when indirect taxes, usually in the form of fees and dues, are added in, the total tax burden in the GCC remains light relative to the rest of the world.

It is not hard to see how this is possible, and the usual debate surrounding this topic centres on the sustainability of such policies. The general position is that the absence of corporate and personal income tax is a unilaterally beneficial state of affairs and that any introduction of a tax would have no benefits to the residents of the GCC.

Perhaps such a view is too one-sided. Could there be benefits to an income tax?

One idea used by taxing governments is that the structure of taxes can be used to influence behaviour. At the top of this list is the saving and investment behaviour of corporations and consumers.

For example, tax breaks on capital investment and infrastructure encourage savers to increase their investment in these critical areas.

In terms of financial investments, normal tax characteristics form a natural corrective mechanism that slows down overheated markets and dampens the pain of bear markets.

Most tax codes are based on a progressive tax rate, in that the more money you make the greater your tax rate is. What this means in an overheated financial market is that as the market returns go from an acceptable 10 per cent to, say, 50 per cent, the actual income return to the investor decays because of the tax rate, as the increase in the tax bracket eats away more of the incremental return. What this means is that although investors might be highly incentivised to invest early in a bull market, towards the end of the bull market the tax slice of the incremental return is so large that the after-tax return is not worth the risk.

This does not mean that countries with an income tax do not exhibit irrational market behaviour, but a progressive tax should dampen the upswings.

On the downside, a financial loss can be usually used to offset other taxable income, lowering the overall tax burden. What this means is that when investors suffer large losses their total financial position will be relatively better because of the tax offset.

Taxes do not have an effect only on fluctuating markets. They can be used to penalise underused assets, encouraging investors to put their holdings to use. An actual example is currently unfolding in Saudi Arabia.

The country has gone through a multiyear – some argue a multi-decade – bull run in its real estate market. This has led to speculators buying huge tracts of land on the edge of developed areas and waiting for the price of land to increase dramatically before selling.

As these are speculators, the longer holding period and major capital expenditure of trying to develop the land does not appeal to them. Paradoxically, this has led to cases in which developed land has a lower market price than the empty plot adjacent to it.

This phenomenon has led to a dislocation between land price and development revenue, which in turn means it becomes too expensive to develop real estate. This is bad for the overall economy.

The Saudis have the idea of introducing a tax on undeveloped urban land as a way to combat the inefficient use of the land as a speculative asset.

Governments can also shift investments from mature, dividend-paying companies to growth companies that need to use cash flow for operations, not dividends, and therefore deliver returns only in the form of capital gains.

The method is well known – tax dividends at a higher rate than capital gains. This focuses the economy on growing rather than clipping coupons.

Although governments can manage the economy through revenue receipts, this is not the only fiscal tool available. Richer countries can apply the same logic to grants. There is far less in the way of global grant best practice that one can learn from, but it remains a potential tool nonetheless.

This article was originally published in The National.

1 Comment

  1. Taxation is typically associated with greater political representation – could be a can of worms (see Kuwait). Another perspective is that of a tax on capital, a la Thomas Picketty.

    Lower hanging fruit exists that could reduce the actual cost of capital in the GCC contributing to structurally higher economic growth: that of proper bankruptcy laws.

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