Globalization and technological innovation have shaped the 1990s. They have spurred unprecedented capital flows and permitted virtually instantaneous capital mobility. Massive capital inflows have been linked to the sustained high growth rates that fueled the “Asian miracle,” and it was the sudden reversal of these flows that triggered the Asian crisis.
Few aspects of macroeconomic policy have been immune to the implications of globalization and technological innovation. Clearly, tax policy has struggled to keep pace with the extent and rapidity of these changes, and tax-induced distortions appear to have had a role in encouraging or intensifying the Asian crisis. David C.L. Nellor, Assistant Director in the IMF’s Regional Office in Tokyo, in his study Tax Policy and the Asian Crisis, argues that tax policy was part of a general policy stance feeding the bubble that ultimately triggered the crisis and that tax policy has an important role to play in fostering the recovery.
Drawing on the lessons learned from the Asian crisis, he recommends removing tax distortions—particularly those that promote foreign currency funding—and implementing a series of tax reforms that could facilitate the key task of corporate restructuring. More broadly, he adds, more attention needs to be paid to the complex, but critical, areas of tax administration and international and regional cooperation on tax issues.
Tax policy and capital flows
For the most part, capital flows reflect an efficient, and desirable, use of global capital. But in some instances, Nellor observes, capital moves to countries to exploit inconsistencies in macroeconomic policy. In some Asian economies in the lead-up to the crisis, a combination of effectively fixed exchange rates and attractive interest rate differentials offered nonequilibrating arbitrage—in effect, a “one-way” bet—that encouraged short-term capital inflows to take advantage of a seemingly high-profit, low-risk situation. Resident and nonresident investors borrowed foreign currency at low rates, converted that foreign exchange into local currency, and drew higher yields from local investments. Investors, confident of the fixed exchange rate arrangement, assumed the foreign-exchange-rate-denominated debt could be repaid at the original exchange rate. When investors perceived that this guarantee could not be sustained, it prompted a rush for the exits that precipitated the crisis.
In aggregate, capital flows grew sharply in the years before the crisis, but among them, “net other flows”—including lending by banks and residents related primarily to interest rate differentials and exchange rate prospects—grew disproportionately. The volume of these flows quintupled in Thailand between 1993 and 1995 and accounted for more than three-fourths of all private capital flows. In the Philippines, “other” flows constituted 90 percent of all private capital flows in 1996.
Did tax policy encourage these foreign-exchange-related flows? Nellor finds that “other” flows—particularly those channeled through banks—did receive favorable tax treatment. A recognition of the benefits of globalization encouraged countries to use tax breaks to attract capital at the same time that rapid technological changes were diminishing their ability to tax income on capital effectively. Countries rationalized that heightened competition, or the need to compensate investors for perceived infrastructure or other disadvantages, necessitated tax breaks for direct investment as well as financial flows. The export orientation of these economies and the vigorous use of tax incentives and discretionary privileges took tax competition to a new level, according to Nellor. And tax competition compounded the task of tax administration, which was already failing to keep pace with the scale and complexity of capital flows.
Tax breaks created “a myriad of tax arbitrage possibilities” that encouraged investors to reduce their tax burdens by shifting deductible expenses and taxable income. And tax incentives of various types proved both difficult to administer and easy to abuse. Tax competition was also a difficult issue to address in Asia’s existing regional arrangements, which had traditionally focused on trade and investment policy matters, and lacked the institutional mechanisms needed to coordinate a regional approach to tax competition.
Ultimately, the tax systems in the Asian crisis countries afforded special treatment to capital, with particularly favorable treatment extended to foreign funding and borrowing. Many countries also permitted high levels of leverage that reduced the tax base and, given administrative constraints, exempted some forms of capital returns that were proving difficult to capture. While the quantitative impact of exemptions is difficult to measure, Nellor suggests that the scale of these distortions and the degree of leverage argue for the removal of these distortions, albeit with due attention to the state of a country’s capital account, the health of its corporate sector, and revenue considerations.
Tax systems in the Asian crisis countries offered particularly favorable treatment to foreign funding and borrowing.
Tax policy and structural issues
The Asian crisis had several striking structural elements, notably a weakening in bank asset quality, excess real estate capacity, asset price inflation, and ineffective corporate governance. High rates of credit growth—in the Philippines, for example, private sector credit grew 51 percent in 1996—contributed to these developments. Tax policy appears to have abetted these structural weaknesses in a number of respects:
- Favorable treatment of foreign currency lending encouraged credit growth. (Demand for credit may have been promoted by weak corporate governance reflected in excessive leverage. The absence of thin capitalization rules may also have played a role.)
- The inability in some countries to treat specific provisions for bad loans as a deductible business expense may have discouraged banks from managing their assets appropriately. Even in those countries that did permit such deductions, prudential rules were weaker than internationally accepted standards.
- Extensive incentives for fixed capital investment combined with the failure of the tax system to capture capital gains meant that the tax system encouraged asset acquisition and possibly contributed indirectly to asset price inflation.
Tax policy and recovery
One of the critical steps in resuming sustainable growth in Asia is corporate restructuring. The scale of leverage, maturity mismatches, exchange rate developments, and demand and price conditions make a compelling case for corporate restructuring. Indeed, the importance of getting assets back to work has prompted countries to re-examine corporate laws, bankruptcy provisions, and tax policies. If the tax system, Nellor notes, is to support corporate restructuring, a number of aspects should be addressed, namely:
As Asia looks to the future, it should revise its tax systems to facilitate corporate restructuring.
- Foreign exchange gains and losses. Large, and unfavorable, exchange rate movements have resulted in substantial foreign exchange losses, typically in the non-bank corporate sector. In the absence of a standard income tax treatment for such losses (or gains), a financial accounting treatment, which would require that monetary assets and liabilities be translated at the closing exchange rate on the balance sheet, offers perhaps the best rule for taxation. Losses in some Asian corporations are so large, however, that use of an accrual system might trigger extensive bankruptcies. In these circumstances, Nellor advises that it might be appropriate to employ a special rule to provide a favorable loss carryover when the accrual system is used.
- Valuation of assets. Physical assets should be revalued following large currency depreciations. Setting foreign exchange losses against revaluation gains would be appropriate and may help to limit some of the problems noted above.
- Restructuring. In general, tax laws should be neutral with regard to the mergers or restructurings that shareholders choose to pursue. In particular, tax provisions that act as disincentives to restructuring should be removed to help overcome the crisis. As long as the restructurings are not undertaken to avoid taxes, gains or losses realized in this process should not be viewed as taxable events
- Insolvency-related debt restructuring. Debt forgiveness creates taxable income equal to the debt forgiven. But insolvent companies should be permitted to enter into bankruptcy proceedings under tax laws that permit debt forgiveness income to be spread over a period of time.
- Treatment of specific provisions of banks. More meaningful bank balance sheet information is an integral step in restoring growth in Asia. The true costs of doing business should be reflected in these balance sheets, including specific provisions being made for bad loans. Recognizing specific provisions as deductible expenses for tax purposes should encourage full recognition of bad or doubtful loans.
Lessons for tax policy
In the precrisis years, Asian tax policies typically favored returns on capital and encouraged a dependence on volatile short-term capital flows. Nellor recommends that these distortions be removed and that tax policies be scrutinized to ensure neutrality regarding business decisions. As Asia looks to the future, and to economic recovery, it should also revise its tax systems to facilitate corporate restructuring.
Beyond the vital immediate tasks of removing distortions and promoting effective corporate restructuring, there are broad and complex issues that will require longer-term and coordinated action. Nellor cautions that tax administration, like financial systems, needs to be strengthened if capital account liberalization is to be effective. And given trends in the global economy, tax reforms will increasingly entail external (regional or international) coordination as well as internal administrative or legislative action.
Copies of IMF Policy Discussion Paper 99/2, Tax Policy and the Asian Crisis, by David C.L. Nellor, are available for $7.00 each from IMF Publication Services. See page 92 for ordering information.
Photo Credits: Denio Zara and Padraic Hughes for the IMF, pages 81, 84 and 88; Joseph Diana for the IMF, page 90; Paul Van Riel for Black Star, page 96.