Allowable depreciation of physical assets for tax purposes is an important structural element in determining the cost of capital and the profitability of investment. The most common shortcomings found in the depreciation systems in developing countries include too many asset categories and depreciation rates, excessively low depreciation rates, and a structure of depreciation rates that is not in accordance with the relative obsolescence rates of different asset categories.
Rectifying these shortcomings should also receive a high priority in tax policy deliberations in these countries. In restructuring their depreciation systems, developing countries could well benefit from certain guidelines: Classifying assets into three or four categories should be more than sufficient—for example, grouping assets that last a long time, such as buildings, at one end, and fast-depreciating assets, such as computers, at the other with one or two categories of machinery and equipment in between.
Only one depreciation rate should be assigned to each category. Depreciation rates should generally be set higher than the actual physical lives of the underlying assets to compensate for the lack of a comprehensive inflation-compensating mechanism in most tax systems. On administrative grounds, the declining-balance method should be preferred to the straight-line method. The declining-balance method allows the pooling of all assets in the same asset category and automatically accounts for capital gains and losses from asset disposals, thus substantially simplifying bookkeeping requirements.
Value-Added Tax, Excises, and Import Tariffs While VAT has been adopted in most developing countries, it frequently suffers from being incomplete in one aspect or another. Many important sectors, most notably services and the wholesale and retail sector, have been left out of the VAT net, or the credit mechanism is excessively restrictive that is, there are denials or delays in providing proper credits for VAT on inputs , especially when it comes to capital goods.
As these features allow a substantial degree of cascading increasing the tax burden for the final user , they reduce the benefits from introducing the VAT in the first place. Rectifying such limitations in the VAT design and administration should be given priority in developing countries. Multiple rates are politically attractive because they ostensibly—though not necessarily effectively—serve an equity objective, but the administrative price for addressing equity concerns through multiple VAT rates may be higher in developing than in industrial countries.
The cost of a multiple-rate system should be carefully scrutinized. The most notable shortcoming of the excise systems found in many developing countries is their inappropriately broad coverage of products—often for revenue reasons. As is well known, the economic rationale for imposing excises is very different from that for imposing a general consumption tax.
While the latter should be broadly based to maximize revenue with minimum distortion, the former should be highly selective, narrowly targeting a few goods mainly on the grounds that their consumption entails negative externalities on society in other words, society at large pays a price for their use by individuals. The goods typically deemed to be excisable tobacco, alcohol, petroleum products, and motor vehicles, for example are few and usually inelastic in demand. A good excise system is invariably one that generates revenue as a by-product from a narrow base and with relatively low administrative costs.
Reducing import tariffs as part of an overall program of trade liberalization is a major policy challenge currently facing many developing countries. Two concerns should be carefully addressed. First, tariff reduction should not lead to unintended changes in the relative rates of effective protection across sectors. One simple way of ensuring that unintended consequences do not occur would be to reduce all nominal tariff rates by the same proportion whenever such rates need to be changed.
Second, nominal tariff reductions are likely to entail short-term revenue loss. This loss can be avoided through a clear-cut strategy in which separate compensatory measures are considered in sequence: Tax Incentives While granting tax incentives to promote investment is common in countries around the world, evidence suggests that their effectiveness in attracting incremental investments—above and beyond the level that would have been reached had no incentives been granted—is often questionable.
As tax incentives can be abused by existing enterprises disguised as new ones through nominal reorganization, their revenue costs can be high. Moreover, foreign investors, the primary target of most tax incentives, base their decision to enter a country on a whole host of factors such as natural resources, political stability, transparent regulatory systems, infrastructure, a skilled workforce , of which tax incentives are frequently far from being the most important one.
Tax incentives could also be of questionable value to a foreign investor because the true beneficiary of the incentives may not be the investor, but rather the treasury of his home country. This can come about when any income spared from taxation in the host country is taxed by the investor's home country.
Tax incentives can be justified if they address some form of market failure, most notably those involving externalities economic consequences beyond the specific beneficiary of the tax incentive. For example, incentives targeted to promote high-technology industries that promise to confer significant positive externalities on the rest of the economy are usually legitimate.
By far the most compelling case for granting targeted incentives is for meeting regional development needs of these countries. Nevertheless, not all incentives are equally suited for achieving such objectives and some are less cost-effective than others. Unfortunately, the most prevalent forms of incentives found in developing countries tend to be the least meritorious.
Tax Holidays Of all the forms of tax incentives, tax holidays exemptions from paying tax for a certain period of time are the most popular among developing countries. Though simple to administer, they have numerous shortcomings. First, by exempting profits irrespective of their amount, tax holidays tend to benefit an investor who expects high profits and would have made the investment even if this incentive were not offered. Second, tax holidays provide a strong incentive for tax avoidance, as taxed enterprises can enter into economic relationships with exempt ones to shift their profits through transfer pricing for example, overpaying for goods from the other enterprise and receiving a kickback.
Third, the duration of the tax holiday is prone to abuse and extension by investors through creative redesignation of existing investment as new investment for example, closing down and restarting the same project under a different name but with the same ownership. Fourth, time-bound tax holidays tend to attract short-run projects, which are typically not so beneficial to the economy as longer-term ones.
Fifth, the revenue cost of the tax holiday to the budget is seldom transparent, unless enterprises enjoying the holiday are required to file tax forms. In this case, the government must spend resources on tax administration that yields no revenue and the enterprise loses the advantage of not having to deal with tax authorities.
Tax Credits and Investment Allowances Compared with tax holidays, tax credits and investment allowances have a number of advantages. They are much better targeted than tax holidays for promoting particular types of investment and their revenue cost is much more transparent and easier to control.
A simple and effective way of administering a tax credit system is to determine the amount of the credit to a qualified enterprise and to "deposit" this amount into a special tax account in the form of a bookkeeping entry. In all other respects the enterprise will be treated like an ordinary taxpayer, subject to all applicable tax regulations, including the obligation to file tax returns.
The only difference would be that its income tax liabilities would be paid from credits "withdrawn" from its tax account. In this way information is always available on the budget revenue forgone and on the amount of tax credits still available to the enterprise. A system of investment allowances could be administered in much the same way as tax credits, achieving similar results.
There are two notable weaknesses associated with tax credits and investment allowances. First, these incentives tend to distort choice in favor of short-lived capital assets since further credit or allowance becomes available each time an asset is replaced. Second, qualified enterprises may attempt to abuse the system by selling and purchasing the same assets to claim multiple credits or allowances or by acting as a purchasing agent for enterprises not qualified to receive the incentive.
Safeguards must be built into the system to minimize these dangers. Accelerated Depreciation Providing tax incentives in the form of accelerated depreciation has the least of the shortcomings associated with tax holidays and all of the virtues of tax credits and investment allowances—and overcomes the latter's weakness to boot. Since merely accelerating the depreciation of an asset does not increase the depreciation of the asset beyond its original cost, little distortion in favor of short-term assets is generated.
Moreover, accelerated depreciation has two additional merits. First, it is generally least costly, as the forgone revenue relative to no acceleration in the early years is at least partially recovered in subsequent years of the asset's life. Second, if the acceleration is made available only temporarily, it could induce a significant short-run surge in investment.
Investment Subsidies While investment subsidies providing public funds for private investments have the advantage of easy targeting, they are generally quite problematic. They involve out-of-pocket expenditure by the government up front and they benefit nonviable investments as much as profitable ones. Hence, the use of investment subsidies is seldom advisable.
Indirect Tax Incentives Indirect tax incentives, such as exempting raw materials and capital goods from the VAT, are prone to abuse and are of doubtful utility. Exempting from import tariffs raw materials and capital goods used to produce exports is somewhat more justifiable. The difficulty with this exemption lies, of course, in ensuring that the exempted purchases will in fact be used as intended by the incentive. Establishing export production zones whose perimeters are secured by customs controls is a useful, though not entirely foolproof, remedy for this abuse.
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Triggering Mechanisms The mechanism by which tax incentives can be triggered can be either automatic or discretionary. An automatic triggering mechanism allows the investment to receive the incentives automatically once it satisfies clearly specified objective qualifying criteria, such as a minimum amount of investment in certain sectors of the economy. The relevant authorities have merely to ensure that the qualifying criteria are met. A discretionary triggering mechanism involves approving or denying an application for incentives on the basis of subjective value judgment by the incentive-granting authorities, without formally stated qualifying criteria.
A discretionary triggering mechanism may be seen by the authorities as preferable to an automatic one because it provides them with more flexibility. This advantage is likely to be outweighed, however, by a variety of problems associated with discretion, most notably a lack of transparency in the decision-making process, which could in turn encourage corruption and rent-seeking activities. If the concern about having an automatic triggering mechanism is the loss of discretion in handling exceptional cases, the preferred safeguard would be to formulate the qualifying criteria in as narrow and specific a fashion as possible, so that incentives are granted only to investments meeting the highest objective and quantifiable standard of merit.
On balance, it is advisable to minimize the discretionary element in the incentive-granting process. Summing Up The cost-effectiveness of providing tax incentives to promote investment is generally questionable. The best strategy for sustained investment promotion is to provide a stable and transparent legal and regulatory framework and to put in place a tax system in line with international norms.
Some objectives, such as those that encourage regional development, are more justifiable than others as a basis for granting tax incentives. Not all tax incentives are equally effective. Accelerated depreciation has the most comparative merits, followed by investment allowances or tax credits.
Translating taxes into money-saving English
Tax holidays and investment subsidies are among the least meritorious. As a general rule, indirect tax incentives should be avoided, and discretion in granting incentives should be minimized. Tax Policy Challenges Facing Developing Countries Developing countries attempting to become fully integrated in the world economy will probably need a higher tax level if they are to pursue a government role closer to that of industrial countries, which, on average, enjoy twice the tax revenue.
Developing countries will need to reduce sharply their reliance on foreign trade taxes, without at the same time creating economic disincentives, especially in raising more revenue from personal income tax.
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To meet these challenges, policymakers in these countries will have to get their policy priorities right and have the political will to implement the necessary reforms. Tax administrations must be strengthened to accompany the needed policy changes. As trade barriers come down and capital becomes more mobile, the formulation of sound tax policy poses significant challenges for developing countries.
The need to replace foreign trade taxes with domestic taxes will be accompanied by growing concerns about profit diversion by foreign investors, which weak provisions against tax abuse in the tax laws as well as inadequate technical training of tax auditors in many developing countries are currently unable to deter. A concerted effort to eliminate these deficiencies is therefore of the utmost urgency.
Tax competition is another policy challenge in a world of liberalized capital movement. The effectiveness of tax incentives—in the absence of other necessary fundamentals—is highly questionable. A tax system that is riddled with such incentives will inevitably provide fertile grounds for rent-seeking activities.
To allow their emerging markets to take proper root, developing countries would be well advised to refrain from reliance on poorly targeted tax incentives as the main vehicle for investment promotion. Finally, personal income taxes have been contributing very little to total tax revenue in many developing countries. Apart from structural, policy, and administrative considerations, the ease with which income received by individuals can be invested abroad significantly contributes to this outcome.
Taxing this income is therefore a daunting challenge for developing countries. It was a mess hanging onto all those sales slips and a bigger hassle tallying them. So the next year, I used the average sales tax amount from the table the Internal Revenue Service provides for each state in the Schedule A instructions.
Tax deductions & credits affected in by inflation - Don't Mess With Taxes
There you'll find your state, then look for where your income range and exemption amounts meet in the table. The Schedule A state tables use only the state's general sales tax rate. So if you live and regularly buy in a city or county or both that also collects an added tax on your purchases, you'll need to figure that amount, too. Or you can go to the IRS' online sales tax calculator. Or if you use tax preparation software, it should figure this amount for you. The IRS calculator still has the data, but it should be updated by the time filing season opens on Jan.
The IRS state and local worksheet, as well as the online calculator, also instructs you to "Enter your state and local general sales taxes paid on specified items, if any.
GENERAL AND ADMINISTRATIVE EXPENSES
This is where you count the sales tax on major purchases. And what does the IRS accept here? The following are sales tax deductible big-ticket items:. There are a few other considerations, however, before you can claim the sales tax amount on your major purchase. In most cases, in order to deduct the sales tax as an itemized expense, it must the same as the general sales tax rate. But -- and there's always a "but" or two when it comes to taxes! What if the auto or RV or etc. The IRS says that in this case, you can deduct only the amount of tax that you would have paid at the general sales tax rate on the vehicle.
Tax: which expenses are you allowed to deduct?
As for the home-related sales taxes you can count, the IRS says the deduction is allowed if your state or locality imposes a general sales tax directly on the sale of a home or on the cost of a substantial addition or major renovation. You also can count the sales tax paid on materials you purchased to build a home or substantial addition or to perform a major renovation and paid the sales tax directly. If you're not the do-it-yourself kind and had a contractor do the work, that person is considered your agent in the construction of or substantial addition to your home, meaning you will be considered to have purchased any items subject to a sales tax and to have paid the sales tax directly.
To make things easier for you in case the IRS asks, have your builder list the materials tax amount on a separate line in your final statement. A few final details: Remember, allowable deductible big-ticket buys are those for personal use only. Don't include sales taxes paid on items used in your trade or business. And to substantiate the sales tax paid on these specified items, the IRS says you must keep your actual receipts showing general sales taxes paid. So if you're planning on buying a car and you itemize your tax deductions, then head to your local car lot sooner rather than later.
Your new vehicle will be a great Christmas present for yourself, as well as a tax gift like these 12 more tax moves to make by Dec. You also might find these automotive items of interest: