Upgrading a country’s tax system is important to boosting productivity because it can reduce distortions that prevent resources from going to where they are most productive, according to a report released by the International Monetary Fund.
According to the paper, countries can reap substantial productivity gains by reducing resource misallocation across firms.
Resource misallocation results from a number of government policies or poorly functioning markets that allow less efficient businesses to gain market share at the expense of more efficient businesses.
Estimates show that eliminating the distortions that cause resource misallocation could generate sizable productivity gains and lift annual real GDP growth rates by roughly 1 percentage point for about 20 years, according to the report.
Made for business
The report further notes that countries can chip away at resource misallocation by upgrading the design of their tax systems to ensure that firms’ decisions are made for business and not tax reasons.
In particular, countries can achieve important productivity gains by reducing tax discrimination by asset type, by sources of financing, or by firm characteristics such as formality and size, says the report.
Minimizing differentiated tax treatments across capital asset types and financing can help tilt firms’ decisions toward investments that are more productive, rather than more tax favored.
For instance, tax treatments that favor debt over equity financing create resource misallocation by imposing a higher marginal tax on research and development investment, which is more dependent on equity compared to other capital spending.
Impact of disparity in taxes
Disparity in taxes across capital asset types also affects firms’ investment decisions. These two distortions can be eliminated by shifting to a cash flow tax or by adopting an allowance for corporate equity system, which allows a tax deduction for the normal rate of return on equity.
Governments should encourage the growth of productive firms by leveling the playing field. For example, informal firms, by evading taxes, are able to stay in business despite low productivity.
Stronger tax administration can help reduce the unfair cost advantage that these firms enjoy over their more productive, tax-compliant competitors.
Another example of leveling the playing field is to encourage growth and productivity among small firms by reducing tax compliance costs and by targeting tax relief to new firms rather than small firms in order to avoid disincentives to growth that result in the “small business trap.”
“In sum, how governments tax matters for productivity. Improving the design of tax policies helps remove the distortions that are holding more productive firms back, generating a positive impact on aggregate productivity and growth,” says the report.