Federalism, money, an taxes (Part 1)

By Benjamin R. Punongbayan

(First of two parts)

MY OWN understanding of the basic financial underpinning of Philippine federalism as I hear it from the proponents is quite simple: under the proposed federalism, each state will raise and spend its own money, except for a portion to be allocated by the states for the use of the central (federal) government to perform its assigned functions.

My interpretation of this underlying concept is that the taxing authority now resides in the states; the federal government does not impose its own taxes. I could be wrong, but it is a good place to start from.

I thought of examining this Philippine federalism basic finance concept to see whether it can translate into a workable overall Philippine federalism financial system that will serve to achieve the proponents’ objective of giving the states freedom of action and of moving them away from the domineering authority of Imperial Manila.

My analysis will cover the current national taxes; the existing national debt, its refinancing, and greenfield borrowings; and the transfer of national assets to see how all these fall into place following the stated concept.

INCOME TAX
Income tax can be restructured such that it will be paid direct to the state where a business entity is operating or where a person is working or doing business.

A state may also impose an income tax rate different from other states if it believes that doing so will be beneficial to it.

Note, however, that all Philippine business entities operating nationwide will now file an income tax return in each state on the basis of its income earned in the state.

Under this condition, it becomes very important to establish how a business entity’s revenue is recognized for each state and how the entity’s cost and expenses are allocated among its operations in the various states.

In cases where sales are initiated in one state and concluded when the sold goods are delivered to a user located in another state, there must be a clear rule as to which state the sales should be reported. This situation is particularly true for goods sold directly to users and not through distribution intermediaries located in the buying states.

While the answer to this issue may be deduced from existing accounting standards, the applicable provisions in these standards on this specific matter are not straightforward, because the standards are entity-focused and not geography-focused. Therefore, an applicable tax rule must be established to make the treatment clear.

Note, though, that paying income tax direct to the states will not help the poor states because their tax bases are narrow, but it will make clear how much amount of this tax each state earns.

CUSTOMS DUTIES
Intuitively, under the said basic finance concept, the state where the ports of entry of imported goods are located earn the customs duties that are collected in these ports.

Fair?

The no-point-of-entry states may not agree, because some of those imported goods will be transported to their states for conversion or sale. The resolution of this issue may not satisfy everyone.

However, an influencing factor may be how the existing entry ports are transferred to the states where these are located — will these be valued and paid for or be given for free? But, then again, the final answer will not be easy, especially in cases where the value of the imported materials forms a substantial proportion of the cost of the finished products, like electronics, if the production facility is located in a state different from where the entry port is located. The same is true for imported finished products if much of these are sold in other states.

The obvious solution is for the federal government to continue to impose and collect this tax and allocate it among itself and the states on some fair basis.

VALUE-ADDED TAX
If the VAT system is maintained under federalism and is applied throughout the federal territory, its imposition and collection will be straightforward. The net VAT (output less input) that is paid to the state is the tax on the value added on the goods in that state. However, in cases of products that require the use of high-value imported materials where their port of entry and where VAT is collected is in a state different from where their conversion into finished products is done, the issues discussed under Customs Duties will also apply. And so with imported finished products sold in non-port-of-entry states.

But there is a more fundamental issue.

Note that the non-producing states where the VATable goods are sold earn only a very small amount of VAT — essentially the VAT on the profit margin of the merchant that sells the goods in that state.

Under the VAT system that is imposed in the entire federal country, that is only fair. This system, however, does not help the poor states.

If I am a poor state, I will opt out of VAT and impose a sales tax on the entire selling price of the goods, making me earn more tax. Of course, the additional amount of tax will increase the price of the goods and which then will trigger other unfavorable consequences.

But if I am a poor state, my primary concern is to increase my tax take. Maybe this is the reason why the United States (US) does not have a federal (countrywide) VAT. Instead, each American state imposes a sales tax of varying rates.

The solution could be either of two ways.

One is to replace the VAT system with a sales tax that will be imposed by the state where the goods are sold.

However, this does not deal with the VAT on imported raw materials and finished goods that is collected at the port of entry. This VAT portion may have to be collected by the federal government and allocated among itself and the states. The other alternative is to maintain the VAT system and have the VAT imposed and collected exclusively by the federal government as before, and then allocate the total VAT take among itself and the states, just like the treatment for Customs Duties mentioned earlier.

OTHER EXISTING NATIONAL TAXES
These can be classified into two types: (1) taxes on goods when produced and taken out of the producer’s premises (like excise taxes on alcohol, tobacco, mineral products, and softdrinks and other non-essential goods; and percentage taxes on goods produced that are exempt from VAT); and (2) taxes on receipts for goods sold and services provided (like percentage taxes on carriers, financial institutions, insurance companies, amusement tax, and sale of shares in the stock exchange; excise tax on automobiles; and documentary stamp tax).

In the first case (Type 1), where the taxes are imposed on the produced goods when these goods are taken out of the producer’s premises, the goods are no longer taxed when sold. It may be argued that the states that host the production facilities shall get all the taxes on these goods. But that will not be fair to the non-host states where probably much of these goods are sold and consumed, but do not earn any tax on them at all.

As a solution, either this Type 1 tax be replaced by a sales tax or, again, have it imposed and collected by the federal government and have the total tax allocated among itself and the states.

In the second case (Type 2), where taxes are imposed when the goods are sold or services provided (actually the tax is imposed upon collection), a principle can be established that the tax is earned where the goods are sold or services provided.

But this principle can also be contentious.

Take gross receipts tax on financial institutions.

Because of the wide unevenness of the country’s economic development, bank deposits are funneled into the head office that handles the granting of all significant loans to borrowers in the entire country. Therefore, the gross receipts tax is earned by the state that hosts the head office, which is generally the National Capital Region. To try to get the gross receipts tax paid to the state from where the bank deposits come from or where the loan proceeds are used will be terribly messy. This condition extends to several other national taxes — taxes on insurance companies, tax on shares traded in the tax exchange, carriers’ tax (especially international air), and documentary stamp tax.

For imported goods where Types 1 and 2 apply and are imposed, the taxes are paid at the port of entry. Therefore, the issue on imported goods where customs duties and VAT are collected at the port of entry also apply.

There are two alternative solutions.

On some of the goods where Types 1 and 2 taxes are imposed, the tax may be changed into a sales tax, so that the tax can be directly earned by the state where the goods are sold.

For the rest of the goods, however, the federal government may have to impose and collect the tax and allocate the total among itself and the states.

To avoid this dual treatment, the only solution is for the federal government to continue to impose and collect the taxes on these other goods and allocate the total.

TAX COMPLIANCE
To the extent that much of the former national taxes can be structured such that these taxes are paid directly to the states, tax-paying business entities will now be paying the former national taxes to the various states (say, 12) instead of to one unitary government. This will entail much additional work on their part, including the determination of which state earns the tax.

Clearly, restructuring the national taxes to serve the objective of having the states to impose and collect much, if not all, of these taxes so that they can exercise direct control over the collection is a very complex matter.

Income tax can be restructured without too much trouble, but doing so will leave the poor states with a small income tax take, because of their narrow tax bases.

Benjamin R. Punongbayan is the founder of Punongbayan & Araullo, one of the Philippines’ leading auditing firms.

ben.buklod@yahoo.com

Read the second part here

As published in BusinessWorld, dated 28 May 2018