TAX POLICY AND ECONOMIC GROWTH: EVIDENCE FROM GHANA BY NYAMADI GODFRED (10246036) THISTHESIS IS SUBMITTED TO THE UNIVERSITY OF GHANA, LEGON IN PARTIAL FULFILMENT OF THE REQUIREMENT FOR THE AWARD OF MASTER OF PHILOSOPHY ECONOMICS DEGREE. JULY, 2014 University of Ghana http://ugspace.ug.edu.gh i DECLARATION This is to certify that this thesis is the result of research undertaken solely by NYAMADI GODFRED towards the award of Mphil Economics in the Department of Economics, University of Ghana. I hereby declare that in exception of references made, this thesis is the product of my own work under the guidance of my supervisors and that no part or whole of it has been presented for another degree anywhere. ………………………………… NYAMADI GODFRED (10246036) SUPERVISORS DR. ERIC OSEI - ASSIBEY DR. ALFRED BARIMAH SIGN……………………………….. SIGN…………………………. . DATE………………………………. DATE………………………… University of Ghana http://ugspace.ug.edu.gh ii DEDICATION This dissertation is dedicated to the Lord, God Almighty, for empowering me throughout the successful completion of this course and to all my family members who in diverse ways offered me support during the study period of this project. University of Ghana http://ugspace.ug.edu.gh iii ACKNOWLEDGEMENTS It is my ultimate desire to express my deepest heartfelt gratitude to the good LORD, JEHOVAH ALMIGHTY for showering HIS grace, anointing, strength, knowledge and protection for the successful completion of this work. Also, I wish to thank my entire family members for the able support granted me in this study. Again, I wish to register my utmost appreciation to my supervisors, Dr. Eric Osei- Assibey and Dr. Alfred Barimah for guiding and shaping my thoughts as well as the ideas into the subject matter of this work. My profound thanks to all the lecturers in the Economics Department for their immense contribution in taking me successfully through the course work which gave me an insight into this area of study. My acknowledgements will not be completed if I fail to recognize the sincere efforts of Dr. William Bekoe who in diverse ways worked tirelessly to read through this work and whose suggestions, pieces of advice, guidance and constructive criticism brought this work to a successful end. I do also acknowledge the efforts of officials in Bank of Ghana, Ghana Revenue Authority and Ghana Statistical Service for assisting me with data used in this study. All in all, my gratitude is particularly extended to all my course mates, friends and all well- wishers for their diverse contribution towards the successful completion of this thesis. University of Ghana http://ugspace.ug.edu.gh iv ABSTRACT An evaluation of the budgetary process in Ghana depicts that annual expenditure proposals are continuously anchored on projected revenue. This means that the accuracy of revenue projection is a necessary condition for devising a suitable framework for fiscal deficit management in Ghana. This study explores the impact of tax policy measures on economic growth using time series data for the period 1970 2013 to devise a reasonably accurate estimation of Ghana‟s sustainable revenue profile in a general Autoregressive Distributed- Lag model. This further leads in the design of an appropriate expenditure profile as a means of averting the persistent non- sustainable fiscal deficit in Ghana. The findings depict that economic growth benefits from increases in import taxes more than the other types of taxes both in the short and long run. However, increases in the share of personal income taxes have deleterious effect on economic growth in Ghana over time. This is because personal income taxes are progressive in nature having a higher marginal tax rates that discourages economic growth as compared to the lower average rates intended to generate more revenues. Consumption taxes and excise taxes have negative effect on economic growth in the long run. However, the short run dynamic results indicate that consumption and excise taxes at one period lag exert a positive and statistically significant effect on economic growth. University of Ghana http://ugspace.ug.edu.gh v The study concludes that the current revenue path is sustainable if broadening the tax base should be the utmost target of policy and this would be the most feasible solution to the problem of unsustainable fiscal deficit in Ghana. All in all, the study underscores the immediate need for the enhancement of the tax administration system to improve the assessment of the performance of Ghana‟s tax system as well as facilitating adequate macroeconomic planning and implementation. University of Ghana http://ugspace.ug.edu.gh vi TABLE OF CONTENTS Content Page DECLARATION ............................................................................................i DEDICATION .............................................................................................. ii ACKNOWLEDGEMENTS ........................................................................ iii ABSTRACT.................................................................................................. iv TABLE OF CONTENTS ............................................................................ ix LIST OF FIGURES ....................................................................................... x LIST OF ABBREVIATIONS ..................................................................... xi CHAPTER ONE ............................................................................................ 1 INTRODUCTION ......................................................................................... 1 1.0 Background .............................................................................................................. 1 1.1 Problem Statement ..................................................................................................... 5 1.2 Research Questions .................................................................................................. 8 1.3 The Objective of the Study ...................................................................................... 9 1.4 Significance of the Study ......................................................................................... 9 1.5 Organization of the Study ...................................................................................... 11 CHAPTER TWO ......................................................................................... 12 LITERATURE REVIEW ........................................................................... 12 2.0 Introduction ............................................................................................................ 12 2.1 Theoretical Underpinning ..................................................................................... 12 2.1.1 The Solow Growth Model ............................................................................. 12 2.1.2 Endogenous Growth Model ........................................................................... 15 2.1.3 Theoretical Effect of Tax Policy on Economic Growth ................................. 16 2.2 Empirical Literature Review .................................................................................. 20 2.3 Conclusion ............................................................................................................... 31 CHAPTER THREE ..................................................................................... 33 OVERVIEW OF THE GHANAIAN TAX SYSTEM AND ECONOMIC GROWTH ... 33 3.0 Introduction ............................................................................................................ 33 University of Ghana http://ugspace.ug.edu.gh vii 3.1 Tax System and Economic Growth ...................................................................... 33 3.2 Ghana‟s Fiscal Development ................................................................................. 34 3.3 The Tax System in Ghana ....................................................................................... 35 3.3.1 Direct Taxes ................................................................................................... 35 3.3.2 Indirect taxes ................................................................................................ 39 3.3.3 International Trade taxes ............................................................................... 41 3.4 Performance of the Ghanaian Tax System prior to 1983 ...................................... 42 3.5 Reforms in the Ghanaian Tax System .................................................................... 44 3.5.1 Restoring the Tax Base .................................................................................. 44 3.5.2 Strengthening production incentives ............................................................ 46 3.5.3 Enhancing Tax Efficiency and Equity .......................................................... 47 3.6 Challenges of the Tax Reforms............................................................................... 51 3.7 Tax Revenue Performance ....................................................................................... 52 3.8 Recent Macroeconomic Development ...................................................................... 58 3.9 Conclusion .............................................................................................................. 61 CHAPTER FOUR ....................................................................................... 64 METHODOLOGY ...................................................................................... 64 4.0 Introduction ............................................................................................................ 64 4.1 Theoretical Framework ........................................................................................... 64 4.2 Model Specification ................................................................................................ 67 4.3 Data ........................................................................................................................... 70 4.4 Techniques of Analysis ............................................................................................. 72 4.4.1 Unit Root Test ................................................................................................ 72 4.4.2 Pairwise Granger Causality Test .................................................................... 74 4.4.3 Durbin Watson Statistics (DW) .................................................................... 75 4.4.4 Bounds Testing Approach ........................................................................... 75 4.5 Summary ................................................................................................................... 78 CHAPTER FIVE ......................................................................................... 80 PRESENTATION AND DISCUSSION OF RESULTS .................................................. 80 5.0 Introduction ............................................................................................................ 80 5.1 Unit Root Test Results ........................................................................................... 80 University of Ghana http://ugspace.ug.edu.gh viii 5.3 Cointegration Analysis............................................................................................. 83 5.4 Long -Run Analysis of Tax Policy and Economic Growth ...................................... 84 5.5 Short -Run Analysis for Tax Policy and Economic Growth .................................... 90 5.6 Pairwise Granger Causality Tests Analysis ........................................................... 94 5.8 Summary ................................................................................................................ 99 CHAPTER SIX .......................................................................................... 101 SUMMARY, CONCLUSION AND RECOMMENDATIONS ..................................... 101 6.0 Introduction .......................................................................................................... 101 6.1 Summary ............................................................................................................... 101 6.2 Recommendations ................................................................................................. 103 6.3 Limitations of the Study....................................................................................... 105 6.4 Suggestions for further study ................................................................................ 106 REFERENCES .......................................................................................... 107 APPENDICES ............................................................................................ 114 University of Ghana http://ugspace.ug.edu.gh ix LIST OF TABLES Table Page Table 3.1: PIT Annual Tax Rates in Ghana –Effective 23 May 2013 .............................. 36 Table 3.2: PIT Monthly Tax Rates in Ghana – Effective 23 May 2013 ........................... 36 Table 3.3: Sources of Government Revenue :1970 - 1982 ( As Percentage of GDP) ..... 43 Table 3.4: Government of Ghana Finances, 1983 - 2013 (% of GDP) ............................. 54 Table 3.5: Sources of Government Revenue, 1983-2013 (% of Total Revenue) ............. 57 Table 4.1: Variables and Measurement ............................................................................ 71 Table 5.1: Results of Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) unit root test at levels ....................................................................................................................... 81 Table 5.2: Results of Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) unit root test at first difference ........................................................................................................ 82 Table 5.3: Order of Integration of the Regression Results ............................................... 83 Table 5.4: Results of the testing between long run relationships of the variables ............ 84 Table 5.5: Estimated Long Run Coefficients Using the ARDL Model ............................ 85 Table 5.6: Short -Run Estimation of the ARDL model .................................................... 91 Table 5.7: Results of Granger Causality ........................................................................... 96 University of Ghana http://ugspace.ug.edu.gh x LIST OF FIGURES Figure Page Fig 3.1: Ghana‟s economic growth rate from 1970 -2013 ................................................ 60 Fig 5.1: Plot of Cumulative sum of recursive residuals .................................................... 98 Fig 5.2: Plot of cumulative sum of squares of recursive residuals ................................... 98 University of Ghana http://ugspace.ug.edu.gh xi LIST OF ABBREVIATIONS AIC Akaike Criterion Information ADF Augmented Dickey Fuller ARDL Autoregressive Distributed Lag BoG Bank of Ghana CEPS Custom Excise and Preventive Service CIF Cost, Insurance & Freight CIT Corporate income Tax CST Communication Service Tax CUSUM Cumulative Sum of Recursive Residuals CUSUMSQ Cumulative Sum of Square of Residuals DW Durbin Watson ERP Economic Recovery Program ECM Error Correction Model EXTAX Excise Tax GDP Gross Domestic Product GCM Ghana Custom Management System GC-Net Ghana Community Network GRA Ghana Revenue Authority IMF Internal Monetary Fund IMPDU Import Tax IRS Internal Revenue Service ISSER Institute of Statistical Social & Economic Research LTU Large Taxpayer‟s Unit NHIL National Health Insurance Levy NRS National Revenue Secretariat OECD Organization for Economic Corporation & Development University of Ghana http://ugspace.ug.edu.gh xii OLS Ordinary Least Square PAYE Pay as You Earn PIT Personal Income Tax RGD Registrar General‟s Authority SSPP Single Spine Pay Policy SAP Structural Adjustment Program TIN Taxpayer‟s Identification Number UNESCO United Nations Educational, Scientific & Cultural Organization VAT Value Added Tax VIT Vehicle Income Tax WDI World Development Indicator University of Ghana http://ugspace.ug.edu.gh 1 CHAPTER ONE INTRODUCTION 1.0 Background Todaro and Smith (2003) describe economic growth as „the steady process by which the productive capacity of the economy is increased over time to bring about rising levels of national output and income‟. This means that economic growth is predominantly a quantitative measure that is the rate of change of real GDP. Also, Myles (2007) perceives economic growth as the foundation of increased prosperity. Growth comes from accumulation of both physical and human capital, and from innovations that lead to technical progress. Innovation and accumulation raise the productivity of inputs into production as well as increasing the potential level of output. Growth modeling relies on exogenous models for many years. This means that the technological progress is given and output per worker remains constant. Assuming this, the impact of government policy is inadequate, if not non- existent. However, the development of endogenous growth models with technological progress is an internal feature of the model. This is because the impact of policy becomes increasingly significant. This naturally creates the possible correlation between tax policies and growth (Lee and Gordon, 2005). Growth rate can be affected by policy through the effect that taxation has on economic decisions. Goode (1984) refers to taxes as compulsory payments from households and firms to governments. Taxes must possess certain attributes. Adam Smith (1776) captions University of Ghana http://ugspace.ug.edu.gh 2 the attributes as “cannons of taxation”. Thus a good tax system must be economically efficient, convenient, certain and equitable. Tax policy is the choice by a government as to what taxes to levy, in what amounts and on who is to be levied. On the macroeconomic side, it takes into consideration the growth of the economy. Tax policies from time to time have been implemented for a variety of reasons. The key objectives of taxation are: revenue generation for financing government spending capable of raising the growth rate, resource allocation, re-distribution of income and reducing inequalities arising from the distribution of wealth among consumers. Romer and Romer (2010) also attest to the fact that tax policies are implemented either to: finance a budget deficit and counter other influences in the economy. The tax policy is beneficial if it is designed to mobilise additional revenue and to afford the fiscal authorities the opportunity to realise a wider set of socio economic objectives example stabilization of prices, incentive to industrial development and prohibition of consumption of certain goods and services. The tax policy measures also reflect the government desire to make taxation as a main policy instrument to accelerate economic growth. To these ends, reforms have encompassed outrights reliefs as well as incentives signals to households and business sectors. Also, the tax policy measures suggest how to manage the tax system more especially the tax laws and information so that the households and businesses can make their savings, consumption as well as investment decisions in the most efficient way. University of Ghana http://ugspace.ug.edu.gh 3 Governments in developing countries are beset with situations where there is an ever- increasing demand on governments‟ services and public budget deficits. The widening imbalance between government revenues and expenditures normally result into huge and chronic fiscal deficits. Ghana was among the developing countries that experienced fiscal imbalance in the 1970s and 1980s. The public debt with respect to gross domestic product (GDP) ratio was relatively high and consequently tax policy has for the most part been geared towards filling a financing gap. The fiscal imbalance resulted into undesirable impacts on domestic prices, interest rates and balance of payments. In most cases, measures that were adopted to address these failed. It is therefore obvious that chronic deficits stifle the growth of the economy and impinge on other macroeconomic aggregates (Broadway et al., 1994). As a result, this compels government to look at domestic revenue mobilization which constitutes part of the structural adjustment programme to address the issues. The growth in government revenue must approximate the growth in government spending for macroeconomic stability to hold (World Bank, 1990). The tax structure therefore must be stable as well as flexible. This is because stability of the tax structure guarantees revenue to be predicted with certainty. Revenue instability can impede on fiscal management more especially if expenditures are inflexible downwards. In response to the decline of the economy, the government of Ghana in 1983 embarked on various forms of fiscal and structural adjustments programme aimed to stimulate economic recovery issues. One of the major adjustment processes was the reform of the University of Ghana http://ugspace.ug.edu.gh 4 tax policy 1 . This was done in order to expand the revenue generating policy for the Ghanaian government as well as removing existing distortions and then strengthening economic incentives. Also, there were several attempts made to enhance efficiency of the administration and equity of the overall tax system. The tax reforms have undergone broadly three main overlapping stages, namely: restoration of the tax base, strengthening production incentives and enhancing efficiency & equity in the tax administration. For instance in 1998, one of the reforms was the introduction of the value added tax (VAT) that replaced the sales tax at a rate of 12.5 per cent. This was one of the main shifts of the tax system in Ghana envisioned for improving the tax productivity as well as promoting economic growth. Again, in January 2014, there was another policy dimension and as a result the VAT rate was increased to 17.5 per cent, the current rate. This was due to the shift of the standard rate from 12.5 per cent to 15.5 per cent while the National Health Insurance Levy (NHIL) remained at 2.5 per cent. One important aspect of the new VAT rate is the widening of the tax scope. Over the last decade, Ghana‟s tax composition favours indirect taxes. This bias is essentially in line with the taxation characteristic for many developing countries. One of the key questions in macroeconomics is how changes in tax policy affect economic activity. In theory it is mostly considered that taxes are in a negative correlation with growth. So, higher taxes mean lower economic growth rates. 1 Tax reforms deals with improving the welfare through making marginal changes in the structure and design of the tax system. It occurs as a result of introducing new taxes & then abolishing old ones. Changes in the tax mix. Radical transformations in administrative guidelines and practices as well as varying the tax rate brackets or make changes in the tax base. University of Ghana http://ugspace.ug.edu.gh 5 1.1 Problem Statement Economic growth increases the taxable capacity of a country of which Ghana is of no exception and enables a higher share of the private sector‟s resources to be surrendered to government as taxes to provide public goods and services. Several countries, therefore, depend mainly on taxation as means of generating the required resources to meet their expenditure requirements. These countries will likely find themselves in growing fiscal imbalance when their revenue productivity falls below their expenditures. Hence the need for fiscal adjustment becomes particularly necessary to restore balance in the government budget. Wagner„s law 2 posits that public expenditure is a natural consequence of economic growth (Demirbas, 1999). Economic theory postulates that instability in an economy may arise out of deficit financing primarily via foreign borrowing which may affect balance of payments, domestic interest rates and the rate of exchange of the domestic currency in relation to other currencies and thereafter may plunge the economy into crisis. As a result, numerous tax reforms aim at attaining optimal fiscal policies with emphasis on the role of tax policy measures as an instrument of economic development have been implemented yet the outcomes seem not to be that encouraging. Information from the World Development Indicators of the World Bank indicates that tax revenue in Ghana as a ratio of Gross Domestic Product (GDP) was 14.31 per cent in 2007, lower than the sub Saharan African average of 18 per cent. Also, in 2012, it was 17.31 per cent as compared to 26.9 per cent in sub Saharan African. 2 According to Adolph Wagner (1835-1917), Wagner‟s Law is known as the law of increasing state spending. A country public expenditure rises constantly showing upward sloping trend. University of Ghana http://ugspace.ug.edu.gh 6 Ghanaian experience with fiscal performance from 1971-1982 periods was very much disappointing. Due mainly to the low productive capacity of most establishments coupled the low tax collection efforts by tax collection agencies. The budget in each year of 1971- 1982 was in deficit ranging from 0.4 to 12.3 as percentage of GDP. During this time, macroeconomic analyses and forecasts were not thoroughly undertaken to provide a base for effective and stable fiscal policy formulation. Instead, fiscal policy measures were taken on ad hoc basis, not coordinated and haphazardly executed, leading to a severe deterioration in the country‟s public finances. The rapid growth in the government spending accompany by a relatively low growth in revenue result in a persistent budgetary deficit which was mostly financed by the banking system. Similarly, the Ghanaian fiscal stance from 1992 – 2013 was characterized by a wide persistent gaps between revenues and expenditures, the only exception been the 1986- 1991 fiscal years. From a deficit of 5.37 percent in 1992 (an election year), the fiscal deficit ratio oscillated year after year until it reached its highest level in 1997 (a year after the 1996 election). The oscillatory pattern in the deficit ratio continue and in the year 2000 (another election year) the ratio was 8.02 percent. With the exception of 2004, what is pretty obvious is that the fiscal deficit was very high in all the subsequent election years (2008 and 2012). Whilst total government expenditure grew at alarming rates during the aforementioned periods, the growth in tax revenue lagged behind that of government expenditure. With the available tax receipts inadequate to meet the ever increasing government quest to spend in most of the years, deficit financing was the natural resort and it was not surprising that inflation outturn was very poor. The exchange University of Ghana http://ugspace.ug.edu.gh 7 rate also tumbled as rates of depreciation of the cedi were also above policy targets set by the government and the Bank of Ghana. Also, there was considerable unevenness in economic growth rate particularly in the 1970s (Figure 3.1). However, it began to stabilize from 1984. There had been numerous years of negative growth and these were often years that experienced changes in government most importantly with explosive policy changes or reversals. The lowest ever growth of 12.4 per cent was experienced in 1975 which coincided with oil –price shock in addition to policy reversals from a market –oriented stance to an inward-looking protectionist regime. In response to the decline of the Ghana‟s economy, a series of major policy reforms were undertaken in 1983 aimed at laying the bases for sustained economic growth and also envisioned to increase domestic revenue mobilization to meet expenditure demands via a comprehensive reform in the system of taxation. The Structural Adjustment Programme (SAP) was to remove existing distortions, strengthening economic incentives, promote efficiency and equity in the economy. In spite of the various efforts made, there were numerous challenges in administering of the tax system. There was heavy reliance on indirect taxes since about 70 per cent of the total revenue in the country was realised from VAT and trade taxes. Revenue from the direct taxation increased over the last decade however it did not exceed 30 per cent of total revenue from taxation. Disaggregated data shows that the tax system relied on a small number of tax payers who normally contribute the greatest share of the tax revenue (Fumey et al., 2009). University of Ghana http://ugspace.ug.edu.gh 8 Furthermore, there are ranging debate on how should additional tax revenues be raised and which tax type to increase over the countries since no one likes paying higher taxes and additional rises in rates could be highly distortive and damaging to incentives as implied by the Laffer curve. This is because in the world of growing international integration, increasing taxes on incomes could be predominantly harmful to growth. Besides, the burden of taxation may be switched more towards consumption taxes (OECD‟s Current Tax Agenda, June 2010, page 16). The study therefore attempts to examine the quantitative impact of four major tax categories, that is, excise duty, VAT, import tax and personal income tax on economic growth in Ghana. Because policy/reform is expected to impinge on economic growth through their impact on the various tax categories, the significance and magnitudes of the various coefficients associated with the different tax categories in the growth equation will direct government efforts at particular areas where more efforts should be placed in raising the ever needed revenue for development. Therefore, we will use a growth equation appropriately augmented with the four major tax categories to answer the research problems and objectives in this thesis. 1.2 Research Questions The main research question in this thesis is: which tax type is more beneficial to economic growth? The following are the specific research questions:  What are the short-and long run effects various types of taxes have on economic growth in Ghana? University of Ghana http://ugspace.ug.edu.gh 9  What causal relation is between the types of taxes and economic growth? 1.3 The Objective of the Study The main goal of this study is to investigate the impact of tax policy on economic growth in Ghana and to address this objective we specifically assess the impact the various tax categories has on economic growth. More specifically, the study seeks to: o analyze the effectiveness of different tax components on economic growth in Ghana o evaluate the short and long-run effect of the various types of taxes on economic growth o examine the causal relationships between types of taxes and economic growth 1.4 Significance of the Study Despite the growing interest in the growth effects of tax policy reforms, there are only a small number of empirical studies on this subject. Early studies (Kneller et al., 1999; and Widmalm, 2001) embark on traditional econometric tools like pooled Ordinary Least Squares (OLS) and fixed -effects within groups‟ regression to estimate the impact of tax policy measures on income per capita in the long run. Implicitly, these economic techniques restrict the slope parameters in the growth model to be common across countries. If these restrictions are invalid, the resulting estimate may be biased and the inference may be invalid. This study therefore rigorously tests the validity of the parametric restrictions using the ARDL model on the grounds that the model University of Ghana http://ugspace.ug.edu.gh 10 specification has no bias to the order of integration since it has a merit of yielding consistent estimates especially for the long run coefficients that are asymptotically normal. Similarly, some recent studies on the growth effects of tax policy (Gemmell et al., 2007; and Arnold et al., 2011) apply the Pooled Mean Group (PMG) estimator which allows parameters on the short-run dynamics to be heterogeneous across board and at the same time not robust under less restrictive parametric assumptions. This study rigorously tests the validity of the parametric restrictions imposed by the PMG estimator using the general Autoregressive Distributed- Lag (ARDL) model which reveals that the results are sensitive to the model specification. In similar manner, we investigate the robustness of the “tax and growth system” proposed in Arnold et al., (2011). Also, we will show if some of the restrictions imposed by using PMG estimator will be rejected by the alternative Wald test. Also, most of the major studies are cross country based on a panel of OECD countries (Kneller et a., 1999, Widmalm, 2001 and Arnold et al., 2011). The OECD study emphasizes on tax structure rather than levels in terms of tax types to GDP ratio because cross –country differences in tax levels mostly reflect public choices as to the appropriate level of societal spending. However, there are only a small number of empirical studies on the link between tax policy and economic growth in the developing countries hence the need to carry out this study. University of Ghana http://ugspace.ug.edu.gh 11 Moreover, previous research within this field of study fails to offer consistent conclusion. Results for taxes on consumption and import are not consistently significant (Scarlett, 2011). However, the findings from this study will go a long way in determining how consumption and import taxes affect economic growth in Ghana. All in all, this study is very essential as it will help ascertain if the government is keeping track on the effectiveness of types of taxes with GDP growth. Moreover, estimation of individual tax type on growth would help the fiscal authorities to identify those tax types which are productive or otherwise and therefore aim at directing their efforts at the more productive ones to raise overall productivity of tax revenue. Furthermore, estimation of our augmented growth equation in the period 1970-2013 will help shed more light on the weaknesses and strengths of the tax systems. This study contributes to the literature by examining the impact of tax policy on economic growth in Ghana. 1.5 Organization of the Study This thesis proceeds as follows. The second chapter provides a review of the relevant literature which is made up of both theoretical and empirical in the perspective of types of taxes and economic growth. The third chapter looks at an overview of the general tax system and economic growth in Ghana. Chapter four presents the data to be used for estimating the impact the various tax types have on economic growth. This is followed by chapter five that discusses the empirical results while chapter six gives the closing remarks and the policy recommendations. University of Ghana http://ugspace.ug.edu.gh 12 CHAPTER TWO LITERATURE REVIEW 2.0 Introduction This chapter presents a review of relevant literature on the impact of tax policy on economic growth. The review covers both theoretical and empirical literature. The theoretical literature starts with discussion of the essential features of growth models and thereafter we discuss theories on how changes in tax policy measures affect economic activity. The empirical literature reviews empirical studies that deal with the topic using different data and econometric models. 2.1 Theoretical Underpinning 2.1.1 The Solow Growth Model Solow (1956) model takes the rates of saving, population growth, and technological progress as exogenous. There are two inputs namely capital and labour which are paid their marginal products. Since the model assumes that factors are paid their marginal products, it envisages not only the signs but also the magnitudes of the coefficients on saving and growth of the population. The model assumes a single good economy where output is either saved or consumed. The only source of saving is investment in capital. Output must be divided between consumption and investment. With inputs of capital (K) and labour (L) at time employed in production, the level of output is expressed as: ( ) ( ) University of Ghana http://ugspace.ug.edu.gh 13 It is assumed that there are constant returns to scale in production where output can either be consumed or saved. The fundamental assumption of the model is that the level of saving is a fixed proportion of output( ). In equilibrium, saving must be equal to investment. At time , investment (I) in new capital is expressed as: ( ) ( ) The use of capital in production results in its partial depreciation. Solow assumes that this depreciation ( ) is a constant fraction. So, the capital available in period is given by the new investment plus depreciated capital. Hence, the basic capital accumulation relationship is given as: ( ) ( ) ( ) The fact that population is growing makes it preferable to express variables in per capita terms. This is done by exploiting the assumption of constant returns to scale in the production function as; ( ⁄ ) ( ) where ⁄ . Dividing ( ) by and representing constant population growth rate by , the labour supply grows according to ( ) . Embarking on this growth relationship, the capital accumulation relation depicts that the dynamics of the capital/labour ratio are governed by: ( ) ( ) ( ) ( ) Removing the time trends in( ), the long run equilibrium capital/labour ratio becomes: ( ) ( ) ( ) or University of Ghana http://ugspace.ug.edu.gh 14 ( ) ( ) ( ) This is referred to as the steady state capital/ labour ratio( ). The steady state is attained when the capital stock is constant with . Once, the new steady state is attained after the policy transformation, the growth rates of the per capita variables will return to zero. In addition to that any policy that only increases saving ( ) cannot sustain growth. This is because has an upper limit of 1 which must eventually be reached. In the production function, if any policy intervention is to result in sustain growth, it has to produce a continuous upward movement. The Solow (1956) neoclassical model suggests that tax policy has no impact on economic growth in the long run. This model assumes that labour and technological advancement which are the main factors of production are often determined outside the model. In the framework of neoclassical Solow growth model, if different types of taxes affect the equilibrium capital labour ratio differently, then the choice of the nature of the tax policy measures would affect the steady state level of income per capita. The tax policy also matters for short run growth when the economy approaches its equilibrium. Even though, growth solely depends on exogenous progress technically, once the economy reaches its steady state, the transitional process can be as long as many decades. The Solow model therefore leaves a very little room for the tax policy actions. University of Ghana http://ugspace.ug.edu.gh 15 2.1.2 Endogenous Growth Model The endogenous growth theorists posit that tax policies do have an impact on economic growth over time since economic expansion is being determined within the system. The only way to create continuous growth in the production function is to include variable like human capital. Including human capital can potentially change either the theoretical modeling or the empirical analysis of growth of the economy and as a result leads to a stronger case for economic policy. With respect to tax policies, the fascinating theoretical case lies in the effect on the decision to invest in human and physical capital. Once the saving and population growth rates affect the human capital, we should anticipate human capital to be positively related with the saving rate and negatively related to the population growth. The human capital variable( ) can be treated in the production function in two distinct ways. One way is to view the level of human capital input as a distinct variable to labour time. Another way is to consider the level of human capital input as the product of the quality of labour and labour time. The latter allows labour time to be made more productive by investment in education as well as training which raise human capital. In addition to that technical progress is then embodied in the quality of labour time. Using the latter, the standard form of production for such a model is expressed as: ( ) ( ) Here, if the production has constant returns to scale in human capital and physical capital jointly, then investment in both can raise output without limit even if the quantity of University of Ghana http://ugspace.ug.edu.gh 16 labour time is fixed. As human capital is incorporated into the model, it has resulted into a stronger case for tax policy actions. The theoretical underpinning on the link between innovation and growth is investigated by Schumpeter (1934). The author‟s idea of creative destruction whereby new products replace old ones becomes the theoretical foundation for technological progress. The role of tax policy is therefore to increase the net returns of innovation. Another important factor that stands out from the classical growth framework is that of economic, legal and political institutions. North (1991) refers to institutions as “the humanly devised constraints that structure political economic and social interaction”. Based on this, institutions matter for growth because it affects transaction costs. However, since this study does not concern the connection between the institutions and growth per se, no in –depth review will be made theoretically. 2.1.3 Theoretical Effect of Tax Policy on Economic Growth One of the essential questions in macroeconomics is how changes in tax policy affect economic activities. In theory, it is usually assumed that taxes are in negative correlation with economic growth. This means that higher tax results in lower growth rates of the economy. This is explained with the fact that higher taxes introduce distortions to the economy and as result normally leads to loss of efficiency. Thus higher taxes encourage people to change their behaviour. This is because whichever way tax payers choose to come to terms with taxes, they will be worse off than in the world without taxes. University of Ghana http://ugspace.ug.edu.gh 17 A country‟s tax system is a main determining factor of other macroeconomic indexes. Specifically, for both developing and advance economies, there exists a correlation between tax policy and the level of economic growth as well as development. Certainly, it has been debated that the level of economic growth and development has a very strong effect on a country‟s tax system (Hinricks, 1966; Musgrave, 1969) and similarly tax policy objectives vary with the stages of development. According to endogenous growth theory, tax policy can affect both the level and the growth rate of output per capita. A detail representation of the mechanism through which tax policy influences growth can be found in Barro (1990) and Barro & Salai –i – Martin (1992, 1995). The authors employ a Cobb – Douglas –Type production function with government providing goods and services as an input to depict the positive impact of productive government spending. Also, in the endogenous growth model, long –term steady state is determined by the accumulation of reproducible capital. Thus any tax policy that distorts the motivations to accumulate physical and human capital will permanently reduce the growth rate. It is expected that taxes on capital and accumulation of capital like corporate and income taxes would have adverse growth effects. But all taxes may not be equally distorting and hence the tax mix becomes a vital growth determinant. If supply of labour is highly inelastic, neither taxes on consumption nor a flat tax on labour income may distort an individual‟s inter-temporal consumption choice which leaves capital accumulation decisions and growth unaffected (Rebelo, 1990). University of Ghana http://ugspace.ug.edu.gh 18 In the framework of the neoclassical growth model, if varied taxes affect the equilibrium capital labour ratio in a different way, the choice of the tax policy measures would affect the steady –state level of per capita income. Tax policy measures also matters for the short –run growth whenever the economy approaches its equilibrium. Even though growth solely depends on the exogenous progress technically once the economy reaches its steady state, the transition process can be as long as many decades. One of the sources of technical progress that leads to long –run growth in the neoclassical growth model is based on new ideas generated by entrepreneurial activities (Schumpeter, 1934). The neoclassical investment theory pioneered by Jorgenson (1963) and Hall & Jorgenson (1967) propose that tax system on corporate income which implies higher cost of capital may lower investment, resulting into a lower level of capital –labour ratio in the long – run. However, lowering the tax –adjusted user cost of capital possibly by providing more generous investment tax credits, it would reduce the statutory corporate income tax rate and thereby induce additional investment. It has been posited by Keynesians that reducing direct taxation particularly personal income tax would aid as a catalyst for transferring greater spending power of the taxpayer. This would then facilitate an increase in the consumption expenditure, increase savings and then enhance investment ventures as well as promoting economic growth. However, any attempt to increase tax collected from direct taxation may serve as a disincentive to work. Thus, there would be a reduction in supply of labour since people would prefer leisure to work and hence a fall in production level. University of Ghana http://ugspace.ug.edu.gh 19 Arnold et al (2011) postulate that changes in tax system that is directed towards entrepreneurship and innovation may have persistent and positive long run effects on growth. On the other hand, it has been argued by the Ricardians that it would entail the government to balance its budget in the short run by increasing borrowing if taxes are reduced. Thus, the potential fiscal imbalance of any country has to bear in mind implementation of the tax policy. Also, the effects that a tax policy is likely to have on the growth of the economy will vary because this would depend greatly on the country‟s stage of development and production level. Jones (2001) argues that distribution of income with the aim of promoting factors of production such as labour and capital plays a key role in the production level. He also stresses that external factors do contribute to the level of growth in output because there exist a close correlation between the growth in output and in volume of international trade. Again, tax policy should foremost affect growth through economic variables. Heckman et al, (1998) discuss the impact of progressivity on investment in human capital taking into consideration personal income tax. Taxes with higher marginal rates would induce lower education. The reason is that if it is treated as investment, then the return of human capital reduces with higher marginal income taxes. Another equally impacts of personal income tax concerns the supply of labour. Higher marginal taxes on wages and salaries have theoretically two possible effects known as University of Ghana http://ugspace.ug.edu.gh 20 income and substitution effects. The former is impact on one‟s income which in the case of a higher tax means lower income. In theory a person would have to work more to earn the same amount of money than before and hence causing more hours of work. In case of the substitution effect, it implies that the relative price of leisure goes down and hence causing less hours of work. 2.2 Empirical Literature Review The impact of tax policy on growth of the economy varies across countries in terms of the short and long run effects. Most of the empirical studies have utilised growth models with diverse specifications to ascertain the testing of theories of directional and the degree of impact of tax policies across countries and territories. The standard Solow growth model is being used comprising human capital, physical capital and growth of labour force to which tax indicators are incorporated. Further in the text, we shall tackle the research on the relation between tax policies and growth that is mainly based on endogenous growth models. This is because the goal of this study is to present those studies which are essential for building a foundation for an efficient tax policy. The relation between taxation policy and growth was established in the mid-eighties using neoclassical growth model most commonly associated with a single good and infinitely lived individuals (Lucas, 1985 and Skinner, 1988). The result shows that taxes have no impact on the output growth in the long run. This is because a steady state growth of output is determined by some exogenous factors such as population growth and University of Ghana http://ugspace.ug.edu.gh 21 technological progress. Nevertheless, growth rates will be affected during the transitional path between the two steady state equilibra. Skinner (1988) noted that there is little reason to believe that Africa and some other countries are in study state equilibrium. This is because only 5 sub –Saharan Africa countries had achieved independence before 1960 and the regime changes will presumably lead to different growth paths. Besides, the transition path was lengthy. By means of testing the hypothesis that taxes affect output growth rates, Marsden (1983) matched 10 high tax countries such as Zambia, Britain, Chile and Zaire with other 10 low tax countries such as Singapore, Korea, Uruguay, and Japan. Marsden calculated the difference in growth rate of output and compared the 20 countries. Marsden found out that an increase of one percentage point in the tax to GDP ratio decreases the economic growth rate by 0.36 percentage point. Translating from rates of growth to differences in income per capita, Marsden‟s coefficient indicates that a 3 per cent increase in the tax to GDP ratio will reduce the level of GDP 20 years in the future by 20 percentage point (Skinner, 1989). One drawback in the study is its lack of theoretical framework. The neoclassical growth theory envisages that tax rates in this model only affect the level but not the growth rates of GPD in steady state equilibrium. University of Ghana http://ugspace.ug.edu.gh 22 However, since late eighties, endogenous models have been developed. This is because it is possible for the growth to be based on optimizing decisions of economic subjects. As soon as long term growth rate acquired endogenous characteristics, a theoretical base for research of the role of economic policy in determining the growth rate of economy was established. Economic subjects stimulate growth with accumulation of human and physical capital in endogenous models. The motivation variable is the real rate of the return on capital. Taxes in endogenous growth models influence growth in that they reduce it with taxation of factor incomes since they reduce the real rate of return on human and physical capital. Harberger (1964) examines the relation between taxation policy and growth. He believes that taxation policy using structure of direct and indirect taxes are very important determinant of investments and growth in theory. However, the impact of taxation policy on growth is negligible in practice. Also, he assesses that changes in taxes could not increase the growth rate of national income by more than 0.1 to 0.2 per cent (Mendoza, Milesi-Ferretti and Asea, 1995). In Harberger‟s opinion, changes in taxation policy have no significant effect on growth of the economy in practice. In other words, taxation policy seems to be “superneutral”. Using endogenous growth models, Mendoza, Milesi-Ferretti and Asea (1995) try to test Harberger‟s work. Their research attest Harberger‟s assertion that the impact of taxes on growth is very small. This means that large changes in a taxation system are needed for any visible changes in economic growth to take place. But, they do not consider that University of Ghana http://ugspace.ug.edu.gh 23 Harberger‟s superneutrality means that tax reforms are useless. The fact is that reduction of tax distortions contributes to a substantial increase in welfare (Mendoza and Tesar, 1995). Further, Milesi-Ferretti and Roubini (1995) employ endogenous growth model to examine the effects of current taxation system on economic growth in USA. This is mostly based on taxation of income and consumption taxes. They conclude that taxation of factor income from human and physical capital reduces growth. This is because introduction of taxes lower the rate of return from factor input and hence discourages accumulation of labour and capital. Besides, they believe that the effect of consumption taxes on growth is not negligible but largely depends on the elasticity of labour supply. Thus the more elastic the labour supply is the more consumption taxes motivate workers to substitute their work and education with leisure. Consequently accumulation of labour factor becomes lower and the economic growth also reduced. Yet still, they conclude through their model that this is the only distorting effect that consumption taxes have on growth whereas income taxes not only affect the link between work and leisure however lower also the accumulation of capital and economic growth by means of other mechanisms. These considerations show that optimal tax structure should be more based on consumption taxes than taxes on income. Cashin (1994) examines the effect of taxes, public investment and public transfers on economic growth rate using endogenous model. The model indicates that distorting taxes have a strong negative effect on growth. This is because taxes reduce the marginal return University of Ghana http://ugspace.ug.edu.gh 24 on private capital and hence reduce economic growth. Besides, productive public expenditure in the form of public investments and transfer payments stimulates growth. Cashin concludes that in countries with a small scale state, a positive effect of public investments on growth of the economy is predominant while in the case of large scale states a reduction impact of distorting taxes on growth is predominant. Esterly (1993) examines the impact of taxes on growth. Esterly, rather than looking at tax rates directly, places the emphasis on the distortions generated by those tax rates. These distortions are found by using the data of Summers and Heston (1988) on 1980 price data for 151 commodities in 57 countries relative to the US. The variance of the prices within countries is then taken as a measure of the relative degree of distortion that exists in those economies due to taxation, price restriction, quotas and other forms of intervention. The reported estimates depict that the variance of input prices is a statistically significant variable in the determination of growth after controlling for other determinants of growth such as initial country income and school enrolment. However, this approach has two deficiencies. In the first place, the variance of prices is not proven to be a good proxy for the degree of distortion in the economy, it is only assumed to be so. Secondly, there is no immediate obvious way to translate the impact of price variation into the impact of changes in tax rates. To do so would call for knowledge of how taxes feed through market equilibrium into prices. Plosser (1993) examines the link between tax policy and economic growth. Plosser regresses the growth rate of per capita GDP on the ratio of personal income tax to GDP University of Ghana http://ugspace.ug.edu.gh 25 for OECD countries and finds a negative significant relationship. The limitation of this discovery is that the OECD countries differ in their income levels since income has been found to be one of the most significant determinants of growth (Barro, 1991). Considering this, Esterly and Rebelo (1993) show that the negative relationship all but disappears when the impact of initial income is accounted for. This observation makes the assertions of Plosser rather doubtful. Esterly and Rebelo (1993) extend this investigation by using various different tax policy measures in regressions involving other determinants of growth. These include initial income, school enrolments, revolutions and war casualties. In response to some of the difficulties identified, four different measures of the tax policy are used: statutory taxes, revenue as a share of GDP; income-weighted marginal income tax rates and marginal rates from a regression of tax revenue on tax base. Based on a number of regressions involving these variables, Esterly and Rebelo conclude that the evidence of tax policies matter for economic growth is disturbingly fragile. Engen and Skinner (1996) focus on the impact of taxes on economic growth. They underline the negative correlation between taxes and growth. They take Solow‟s approach to the growth rate of the economy as their starting point. This is because in this approach economic growth rate depends on the availability of human and physical capital as well as changes in productivity. University of Ghana http://ugspace.ug.edu.gh 26 After reviewing the results of some of the cross- country studies, Engen and Skinner label the regressions as “top-down” since those works involve aggregate measures of taxation. Instead, Engen and Skinner propose a “bottom –up” method which involves calculating the impact of taxation on labour supply, investment and productivity, and then summing these to obtain a total measure. Doing this suggests a cut of 5 per cent in all marginal rates of tax and 2.5 per cent in average rates would raise the growth rate by 0.22 per cent. However, such a modest impact on growth has substantial consequences on living standard. Kneller et al. (1999) using annual panel data set of twenty two (22) countries within the Organization for Economic Cooperation and Development (OECD) for the period 1970 to 1995 estimated the impacts of tax policy measures on economic growth. The approach contains complete specification of the government budget constraint in terms of revenue and expenditure. This is in contrast to other endogenous growth models which only incorporate the revenue aspect. The authors build on the methodological approach suggested by Barro (1990). Here, the complete specification of the government‟s budget constraint is corrected for the biases that exist with a partial specification. The model includes the regression of non –fiscal and fiscal variables on economic growth rates. The findings indicate that increasing direct taxation significantly reduces growth whenever compare to consumption taxes having less discernible negative impact on growth. But, the estimation implicitly uses average tax rate rather than the marginal tax rate. University of Ghana http://ugspace.ug.edu.gh 27 Embarking on panel data from 22 OECD countries over the period 1970 -1995, Gemmell et al. (1999) estimate the impact of different types of taxes on the growth rates of per capita income. Their pooled OLS and fixed –effects estimation results suggest that imposing a higher level of taxes reduces per capita income. They emphases that the estimated impacts of different types of taxes may be biased if other elements in the budget like expenditures are omitted from the model. As propose by Arnold et al. (2011), the feasible solution is to focus on the growth effects of revenue neutral changes in tax policy. This avoids the complication that changes in the total tax revenue are reflected in changes in the public spending. Arnold et al (2011) examine the long run effects of revenue neutral changes in tax policy on economic growth based on panel data for 51 OECD countries over the period 1970- 2004 provided by OECD Tax Revenue Statistics. The Pooled Mean Group (PMG) estimation results in Arnold et al, (2011) indicate that shifts in total tax revenue towards immovable property taxes and taxes on consumption in addition to improving the design of individual taxes are associated with a higher level of per capita income in the long – run on economic growth. The authors propose that if there is a “tax and growth ranking” in terms of the impact of each type of tax on the long –run level of per capita income, property tax would come first of this ranking. This is followed by taxes on consumption; taxes on personal income, and then taxes on corporate income. This is because it has been realised that personal & corporate taxes and immovable property taxes has the least detrimental effect on GDP per capita in the long run. University of Ghana http://ugspace.ug.edu.gh 28 Further, Arnold et al, (2011) find that to enhance economic growth as well as promoting economic recovery, the best option is to reduce income tax on low income earners. This falls in a context where a reduction of income tax for low income earners would stimulate demand, minimize income disparity and increase work incentives. Besides, they find that the ranking remains robust in varied model specifications with additional independent variables like inflation rate. Widmalm (2001) examines the growth effects of revenue- neutral changes in tax policy base on the data provided by the OECD Tax Revenue Statistics covering 23 OECD countries from 1965 to 1990. The author group taxes into five categories namely: corporate income taxes, labour & capital income taxes for individuals, property taxes, taxes on goods & services and taxes on payroll & social security contributions. Employing the Extreme Bounds Analysis (Leamer, 1983), Widmalm (2001) finds that there is a robust negative relationship between the share of taxes on personal income and the growth rate of per capita GDP. However, He finds that corporate income taxes as a share of total tax revenue have a positive nevertheless fragile relationship with growth. Similarly, the evidence is also fragile in correlation to taxes on: payrolls & social security contributions, goods & services and property. Including investment to GDP ratio, the estimation result suggests that the tax type may affect growth through channels other than physical capital accumulation for example human capital accumulation or supply of effort. University of Ghana http://ugspace.ug.edu.gh 29 Romer and Romer (2010) investigate the impact of tax policy actions on growth of the economy in the United States during the post- war period. Regression of legislative tax measures from narrative sources especially presidential speeches is regressed on changes in real GDP over the period of 1947 to 2007. Changes in the tax system are separated into those related to prospective economic conditions and other exogenous reasons. The findings reveal that tax policy actions have very big impact on output resulting in reduction from 3.0% to 2.5%. Further, output effects are found to be more closely related to changes in actual taxes as compared to news about future changes. Myles (2007) views from an endogenous growth perspective the relation between taxation and economic growth. The results show that corporate taxation affects the return to innovation and hence influence the optimal amounts of research and development. Also, personal income taxation reduces the returns to education and hence reduces the accumulation of human capital. For studies that have direct bearing on this thesis, a number of recent studies on the growth effects of tax policy (Gemmell et al., 2007 and Scarlett 2011) apply autoregressive distributed lag (ARDL) model first developed by Pesaran, Smith and Shin (1999) which allow the coefficients on the short run dynamics to be heterogenous across board. Greenidge and Drakes (2009) use an unrestricted error correction model to examine tax policies and its impact on macroeconomic activities in Barbados. Pesaran and Shin University of Ghana http://ugspace.ug.edu.gh 30 (1997) initially propose this technique which captures both short and long run effects from a general autoregressive distributed lag model. The procedure has potentials to assess the co-integrated variables irrespective of the order of integration as well as handling small samples and dynamic source of biases. This model is initially estimated with standard growth variables where individual tax indicators are added. The tax indicators are constructed using tax index and principal component analysis. The results show that direct taxation has a negative impact on growth in both short and long run. But total and indirect taxation has a contractionary effect on the economy only in the short run without any long run impact. Scarlett (2011) uses autoregressive distributed-lag model to estimate the impact of tax policy on economic growth with a quarterly data in Jamaica. Also, a granger causality test is used to ascertain the directional correlation between the explanatory variables and growth of the economy. The results point out that increasing revenue from indirect taxes is more conducive to growth of the economy in the long run. Nevertheless, increasing the share of taxes from personal income precisely PAYE has the utmost detriment on GDP per capita over time. Therefore, correction to equilibrium needs a maximum of nine quarters from such an impact. Besides, an increase in tax revenue by policy makers on consumption tax would be favorable to economic growth in the short run. In an effort to stimulate demand, there is a need to reduce taxes on P.A.Y.E. In examining the impact of government‟s tax policy measures, the tax policy variable is defined as the share of tax revenue which is raised from a given tax as proposed by University of Ghana http://ugspace.ug.edu.gh 31 Arnold et al (2011). The tax measure basically provides an indication of the level of taxation as well as the policy action of the fiscal authority. Nevertheless, one has to bear in mind that the tax policy will take into consideration the targeted tax group. In this regard, the tax component is grouped into four categories namely: personal income tax, value added tax, excise duty and import tax. It is essential to know that an increase in the share of tax revenue for one tax group will automatically reduce the amount of taxes needed to be generated from the other tax groups. 2.3 Conclusion This chapter discusses the literature related to tax policy and economic growth. Under the theoretical literature, we discussed the Solow growth and Endogenous growth models as well as the theoretical effect of tax policy measures on economic growth. The Solow (1956) model takes the rates of saving, population growth, and technological progress as exogenous. The model incorporates two inputs namely capital and labour which are paid their marginal products. However, the Endogenous growth model includes human capital as the only way to create continuous growth in the production function. Besides the basic determinants of growth, the theoretical literature stresses on the theories of whether or not tax policy measures influence economic growth. As some schools of thought are of the view that government tax policy in economic activities is important for growth, the opposing groups posit that government actions are inherently bureaucratic and unproductive and hence stifles instead of promoting economic growth. University of Ghana http://ugspace.ug.edu.gh 32 Empirical research of the impact of taxation policy on economic growth varies across countries in terms of the short and long run effects. This is because different empirical studies yield varied results. This makes it hard to make clear conclusions on negative impact of tax policies on growth as the theory suggests. The difficulties that hinder unequivocal conclusions on the basis of empirical researches usually include the following: Different definitions of state in different countries and periods which means different levels of taxation, problems of measuring of individual tax variables, difficulties in sorting out the effect of individual tax variables on growth which is based on the complex interactions of fiscal variables, difficulties in separating the effect on growth of other economic variables from the effect of fiscal variables only and lack of empirical data which enables unambiguous acceptance or rejection of a conclusion of some model theoretically. All in all, ceteris paribus, moving from taxes on income to consumption taxes is expected to have positive impact on growth. Similarly, the effect of moving from taxes on corporate income to taxes on personal income is theoretically mostly unclear and any action is plausible. Finally, the empirical literature review portrays that the findings are mixed equally. The main objective of this study is not to resolve the raging controversies but to add to the level of tax policies and economic growth literature the differing quantitative effects of the major tax categories on economic growth model. In doing this we augment the basic Solow model with the four major tax components in Ghana. University of Ghana http://ugspace.ug.edu.gh 33 CHAPTER THREE OVERVIEW OF THE GHANAIAN TAX SYSTEM AND ECONOMIC GROWTH 3.0 Introduction The chapter contains an overview of fiscal developments in the Ghanaian economy since 1970s. Issues concerning fiscal decisions together with strategies adopted prior and post to the Economic Recovery Programme have been discussed. Again, this chapter discusses the various ex–ante and ex-post tax reforms and their achievements as well as the growth of Ghanaian economy. 3.1 Tax System and Economic Growth Taxation relates to growth of the economy and development in diverse ways. The rate of economic growth can be influenced by policy through the impact that taxation has upon economic decisions. This is because an increase in taxation reduces the returns to investment. Lower returns imply less accumulation and innovation and thereafter lower rate of growth. Taxation promotes transfer of available resources from the private to public sector. It also allows government to establish enabling environment for the private enterprises. Resources raised through taxation are used in construction of roads, improving the security system, and providing health and educational facilities among others. Sound administration of the tax system and public spending policies can also promote economic efficiency and equity. Also, sound economy policy seeks to facilitate the pros and cons of University of Ghana http://ugspace.ug.edu.gh 34 the tax system in achieving the net effect as means of stimulating growth and improving the social and economic welfare of the populace. 3.2 Ghana’s Fiscal Development The fiscal performance in Ghana prior to Economic Recovery Programme in 1983 was below expectation and very much disappointing. From 1970 to 1982, the macroeconomic projections and analyses were not exhaustively achieved to provide a base for effective consistent and fiscal policy formulation. As a substitute, fiscal policy measures were taken on ad hoc basis, not coordinated and haphazardly implemented. This led to severe deterioration in the country‟s public finances. A rapid growth in government spending accompanied by a relatively low growth in revenue resulted in persistent budgetary deficits. This was mainly finance by the banking system. Unfortunately, this action led to a sharp increase in the money supply causing rapid growth in the rate of inflation and an increasingly over-valued exchange rate. In an attempt to suppress inflationary pressure through official control of domestic prices added a further setback to the economic policy implementation by the government (Kusi, 1998). The price control system in addition to the over-valued exchange rate created severe distortions in the economy (World Bank, 1994). These as a result destroyed motivations for production and exports and stimulated speculation and smuggling. The World Bank (1984) also found that economic activity shifted from the monetary to the subsistence sector. This indicated a withdrawal from monetized economy by some people as well as the collapse of the organized markets. These developments led to a sharp contraction of University of Ghana http://ugspace.ug.edu.gh 35 the productivity of the tax system and consequently in the ability of the government to generate enough revenue to meet its expenditure requirements. 3.3 The Tax System in Ghana Ghana‟s tax system constitutes a variety of major tax categories which are direct, indirect and international trade taxes. 3.3.1 Direct Taxes It is a tax paid by the individual person or organization on which it is levied. This type of tax includes income and property tax levy directly on the tax payers. The income tax constitutes three broad categories, namely: personal income tax (PIT), corporate income tax (CIT), and “others” in Ghana. Personal income tax (PIT) is made up of Pay-as-you-earn (PAYE) and taxes for the self- employ. PAYE contributions are deductions withheld from employees‟ salaries or wages mostly at source in order to satisfy the income tax payers‟ responsibilities. The PAYE is introduced to lessen the burden of taxation on employees. The tax is routinely deducted from employees‟ emoluments each time they are paid. The payments serve as a final tax, with no further obligation by the employees to file a tax return unless he/she has more than one job or other sources of income in addition to the regular employment income. Pay-as-you-earn (PAYE) is calculated using personal income tax (PIT) rates. Tables 3.1 and 3.2 illustrate the current annual and monthly PIT rates respectively. University of Ghana http://ugspace.ug.edu.gh 36 Table 3.1: PIT Annual Tax Rates in Ghana –Effective 23 May 2013 Chargeable Rate Tax Cumulative Chargeable Cumulative Income (%) (GH₵) Income Tax (GH₵) (GH₵) (GH₵) First 1,584 Free NIL 1,584.00 NIL Next 792 5 39.6 2,376.00 39.6 Next 1,104 10 110.4 3,480.00 150 Next 28,200 17.5 4,935.00 31,680.00 5,085.00 Exceeding 31,680 25 Source: Ghana Revenue Authority The tax rates are graduated with rates ranging from 0 – 25 per cent. Annual income of GH₵ 1,584.00 is taxed free. The current minimum chargeable income is GH₵ 2,376.00 at a rate of 5 per cent. Also, the marginal top tax rate of the tax is 25 per cent for annual income exceeding GH₵ 31,680.00 (Table 3.1). Table 3.2: PIT Monthly Tax Rates in Ghana – Effective 23 May 2013 Chargeable Rate Tax Cumulative Chargeable Cumulative Income (%) (GH₵) Income Tax (GH₵) (GH₵) (GH₵) First 132 Free NIL 132.00 NIL Next 66 5 3.30 196.00 3.30 Next 92 10 9.20 290.00 12.50 Next 2,350 17.5 411.25 2,640.00 423.75 Exceeding 2,640 25 Source: Ghana Revenue Authority University of Ghana http://ugspace.ug.edu.gh 37 Self-employ persons are required to pay income tax at graduated rates in four equal installments. This covers individual businesses and is done especially by the end of every quarter of the year. That is March, June, September and December. Corporate income tax deals with corporate bodies which are incorporated under the Companies Code (Act 179) in 1973 or other specific legislation. This consists of the tax pays by companies on their profits in the year. The current tax rate is 25 per cent. Nevertheless, companies which were listed on the Ghana Stock Exchange enjoyed a reduction of CIT of 22 percent in the first three years of entry. Also, CIT for mining companies stood at 35 per cent whereas companies in the hotel industry attract 20 per cent rate of tax reduced from 22 per cent in 2011. Again, there is a reduction of CIT rate of 20 per cent for financial institutions which normally grants loans to farming enterprises. Similarly, to the rural and community banks as well as free zone developers and enterprises, an 8 per cent rate is applicable after a tax holiday of 10 years. Further, domestic together with the foreign companies operating in the country are taxed on their taxable incomes which involve net profits, interest, royalties and rent income of companies formed exclusively for real estate development. The third category is others which comprise of royalties, dividends, rental income, pensions and license fees. Rent tax is a tax being paid by rent income earners on the gross amount which is earned in a year of assessment. It is a final tax with 8 per cent rate of tax on gross rent income. University of Ghana http://ugspace.ug.edu.gh 38 Mineral royalty is a tax with rate of 5 per cent imposed on persons for the extraction of natural resources on or beneath the surface of the earth. Dividends are 8 per cent rate of tax and also a final tax. But, dividends earned from unit or mutual trusts are exempted from tax. Other equally important direct taxes administered in Ghana are: vehicle income tax (VIT), tax stamp, gift tax, capital gains tax, airport tax, and stamp duty. Gift tax is a tax payable by a recipient on the total value of taxable gifts receives and which must exceed GH50.00 in the year of assessment. Currently, the gift tax rate ranges from 5 per cent to 15 per cent. Gift tax is imposed on the following assets: land, buildings, securities, shares, bonds, business and business assets and money (including currency from abroad). Yet, exempt gifts from taxes levy on gifts include gifts receive by: a person under a will or upon intestacy, from that persons‟ relative, from a religious body for the benefit of the public and for charitable and educational purposes. Capital gains tax is the tax paid on gains from the realization or sale of chargeable asset. The rate is 5 per cent with the gains exceeding GH50.00. The tax is imposed on the following asset: buildings, land, shares of resident company, business asset including goodwill. However, shares issue on the Ghana Stock Exchange and capital gains by companies listed on the Ghana Stock Exchange are exempted. Tax stamp is a tax collected on quarterly basis from small scale self –employ persons in the informal sector introduced in February, 2005 in the country. The business operators are grouped University of Ghana http://ugspace.ug.edu.gh 39 according to types such as: dressmakers, susu collectors, chop bar owners, bucthers etc. and further group by class or size to arrive at equitable rates. Stamp duty is administered under the Stamp Duty Act, 2005 (Act 689). This Act is amended by Act 764 in 2008. The Stamp Duty is not a tax on transactions; however, it is on document brought into being for the purposes of recording transaction. Hence, it is regarded as a tax on document or specific instrument having legal effect. Vehicle income tax is a tax which is collected from commercial vehicle operators on quarterly basis introduced in the country in July 2003. The rate charge depends on the vehicles passenger capacity as well as the type of operation such as: taxis, tour buses and “trotros”. The VIT stickers are designed in various categories and are to be purchased on quarterly basis. 3.3.2 Indirect taxes They are taxes levied on goods and services consume in the country in question regardless of their origin. Indirect taxes administer in Ghana consists of Value-added tax (VAT), custom and excise duty, petroleum tax, National Health Insurance Levy (NHIL), and Communication Service Tax (CST). Valued –added tax is a broad based tax levy on the consumers‟ expenditure whenever goods and services are purchased. VAT is imposed on the value added of a product at each stage of the production and distribution process and form part of the price pay by the final consumers. Its collection by registered agencies or businesses charge the tax in stages on the value added from the manufacturing to the retail level. University of Ghana http://ugspace.ug.edu.gh 40 VAT was invented by Maurice Laure, a French economist in 1954. Initially, it was meant to cover large businesses however, was later extended to all businesses. Its adoptions by the European Union, many African countries, Asia and South America occurred by the end of the century. In 1993, the government of Ghana recognized the need for VAT in the budget statement and started preparation for its introduction. In October 1994, a bill introducing VAT was discussed and approved in parliament yet its implementation was deferred until March 1995. The VAT rate has been 12.5 per cent after successful implementation. However, due to the enactment of the Value Added Tax Act, 2013 (Act 870), the new VAT rate is 15 per cent which took effect from January, 2014.The VAT Act received presidential assent on December, 2013 and then notified in the Gazette on the December, 2013. This was done in order to widen the tax net by including many businesses making huge profits however operate outside the tax net. As a result companies that manufacture and/or supply pharmaceutical products other than operating at a retailing stage are to pay tax for the first time. Further, gymnasiums and spas together with the domestic airlines and companies dealings with haulage have also been roped in the outstanding tax net. National Health Insurance Levy still remains at 2.5 per cent. This in effect amount to a total charge of 17.5 per cent of the taxable value of the supply. Excise tax is a tax imposed on output of manufactured goods either at the production or sales of the products. It goes with a specific or ad valorem rate of 20 per cent. The aim of levy is to discourage production and consumption of certain goods. This type of tax is administered University of Ghana http://ugspace.ug.edu.gh 41 by domestic tax revenue division of GRA on products such as: beer, spirits, petroleum and tobacco (eg. cigarettes). Communication Service Tax (CST) is a tax imposed on charges for using communications services provided by communication service operators. The CST is paid by consumers to communications services providers who also in turn pay all collected CST on monthly basis. The providers are: public and corporate data operators, national fixed network operators, and broadcasting radio services providers, television services pay-per-view, providers of internet services, mobile cellular network operators and providers of free-on-air services. Petroleum tax is a tax levied on oil companies. This is done to cater for economic rent on land usage for mining. 3.3.3 International Trade taxes Tax revenue from duties on imports and exports trade transaction constitutes revenues from international trade taxes. Import duty is a tax levied on all imports in exception of those items exempted by the law. It is charge on the Cost, Insurance and Freight (CIF) value of commodities. Also, it is levied at different rates. However, it must be noted that there is a clear distinction between import VAT and import duty. Import VAT is charged at a flat rate and levied on duty inclusive value of the goods. Export duties are grouped into two major categories; traditional and non-traditional exports. The traditional export commodities involve: beans, cocoa, logs, fresh fish and yam, electricity and mineral ore (eg. unprocessed gold). However, the non-traditional University of Ghana http://ugspace.ug.edu.gh 42 commodities consist of all commodities excluded from the traditional type. With the exception of cocoa beans and hydrocarbon, the other exports commodities attract zero per cent. Parrots, rattan canes, narcotics, bamboo, pornographic materials and Ghanaian currency in excess of GH 5000.00 are prohibited from export under the law in Ghana. 3.4 Performance of the Ghanaian Tax System prior to 1983 Government tax receipts are lodged into consolidated fund out of which disbursements are done. Tax revenue, non-tax revenue and grants constitute the revenue aspect. The revenue portion is further classified into three broad categories of taxes: direct, indirect and international trade taxes. Revenue from import tax declined from 2.42 per cent in 1970 to 0.66 per cent in 1982 as illustrated in Table 3 .4. Factors such as: corruption and tax evasion, artificial low value of imports in terms of domestic currency and the sluggish growth in non-oil imports which was caused by fall in import earnings and an increment in the import bill due to the oil shock in 1973/74 contributed to the fall in the import tax revenue. Consequently, this decline contributed to the economic deterioration in the late 1970s as the government did not have the requisite tax receipts to bridge its financial gap. Tax earnings from personal income tax remained fairly stable especially between 1970 and 1977(Table 3.3). Personal income tax was the most reliable source of government revenue because its deductions were made from source through PAYE although; its revenue contribution to the government was low. On the other hand, due to extensive University of Ghana http://ugspace.ug.edu.gh 43 evasion with lags in collection and assessment, revenue realised from self- employed tax was far below targeted deed. Table 3.3 represents performance of government revenue prior to the reform. Table 3.3: Sources of Government Revenue :1970 - 1982 ( As Percentage of GDP) Import Sales/ Excise Total Tax Years PIT Tax VAT Tax Revenue 1970 1.385 2.424 0.938 0.867 5.615 1971 1.564 2.945 1.068 0.851 6.427 1972 1.637 2.054 1.034 2.054 6.778 1973 1.477 2.713 0.968 2.713 7.871 1974 1.197 2.428 0.753 2.090 6.469 1975 1.582 1.758 0.795 3.419 7.554 1976 1.436 1.772 0.801 4.109 8.118 1977 1.534 1.707 0.511 2.821 6.573 1978 0.997 1.466 0.341 1.530 4.333 1979 1.091 1.411 0.325 1.647 4.473 1980 0.895 0.842 0.464 2.420 4.622 1981 0.927 0.649 0.410 2.094 4.080 1982 0.865 0.659 0.299 1.668 3.491 Source: Brown 1972, Government of Ghana Economic Survey, Quarterly Digest of Statistics In order to address the issue pertaining to the economic deterioration, the government of Ghana implemented an Economic Recovery Program (ERP) in 1983 which aimed at achieving external payment viability as well as sustaining economic growth. Restoration of fiscal discipline, regulating expenditure to reduce fiscal deficit, adopting fiscal policies geared towards economic growth and increasing the amount of revenue generated through comprehensive tax reform system were components of the ERP. University of Ghana http://ugspace.ug.edu.gh 44 3.5 Reforms in the Ghanaian Tax System The government of Ghana in 1983 embarked on various forms of fiscal and structural reforms aimed at stimulating economic recovery. One of the major adjustment processes was the reform of the tax system 3 . This was done in order to expand the revenue generating capacity of the tax collecting agencies as well as removing existing distortions and then strengthening economic incentives. Also, there were several attempts to enhance efficiency of the administration and equity of the overall tax system. The tax reforms have thus undergone broadly three main overlapping stages, namely: restoration of the tax base, strengthening production incentives and enhancing efficiency & equity in the tax administration. 3.5.1 Restoring the Tax Base During 1983-1984, adjustment of exchange rate was aimed at increasing receipts from cocoa export taxes together with import duties. Further, increment in the availability of foreign exchange as a result of donor inflows stimulated expansion of imports and hence the base of import taxes. Therefore, the tax reform measures were designed greatly to restore the base of the tax system which declined during this period due to persistent over –valuation of the domestic currency and the large margins between official and market prices (Kusi,1998) and (Osei and Quartey, 2005). 3 Tax reforms deals with improving the welfare through making marginal changes in the structure and design of the tax system. It occurs as a result of introducing new taxes & then abolishing old ones. Changes in the tax mix. Radical transformations in administrative guidelines and practices as well as varying the tax rate brackets or make changes in the tax base. University of Ghana http://ugspace.ug.edu.gh 45 Also, the reform of the tax system was aimed at widening the tax net, reducing evasion as well as minimizing the tax burden. Thus, the introduction of a multiple exchange rate system in 1983 was as a result of imposition of surcharges on foreign exchange payments together with granting of bonuses on foreign exchange receipts. In 1988, two exchange rates operated however were unified eventually. Again, between1983-1984, prices charge was de-regulated. Pricing of consumer goods were allowed to reflect fully production cost in addition to the profit margins whereas a flexible producer system of pricing was adopted to maintain prices in order to provide incentives for producers for items such as cocoa, rice, maize and palm oil. Additionally, budgetary subsidies for consumer goods and public utilities were removed gradually. For the public sector services; fees, levies and charges were revised upward as part of the new cost recovery measures. Moreover, revision of the tax system assessment for import duties, sales and purchase taxes were due to price reforms and exchange rate adjustments. These tax systems were reviewed to make basis for dutiable goods and then reflect the full face values plus certain surcharges. Also, the basis for corporate income tax assessment was likewise changed from profits of the preceding year to actual income earned during the recent year (Kusi, 1998). Furthermore, at the initial stage of each quarter, the system of advance payments of taxes which caused extensive evasion was discontinued. Instead, at the end of each quarter, corporate bodies as well as the self- employed were allowed to pay taxes. In all, the lowest tax- free personal income bracket was raised as the marginal rates were lowered to reduce the average effective rates. University of Ghana http://ugspace.ug.edu.gh 46 3.5.2 Strengthening production incentives Introduction of the investment code (PNDC Law 116, 1985) and a new minerals law (Minerals Commission Law, 1986) were the second stage of the tax reform process in Ghana. The code identified four priority areas of investment namely: agriculture, construction and buildings, manufacturing and tourism. In these areas, any enterprise engaging in any form of activities qualified for a broad range of incentives and tax benefits. For instance, when an enterprise having priority status undertook or supported an approved programme of scientific research for the purposes of developing or advancing the enterprise, then the related capital expenditure in respect of such research was fully tax deductible. Also, encouraging regional dispersion of industrial activities, enterprise located outside Accra-Tema metropolitan area qualified for a reduction in income tax ranging from 15-40 per cent depending on the located area. Again, the code made special provision for reduction or deferment of taxable income payable by enterprises especially in areas lacking in basic infrastructure and precisely where the enterprise undertook the costs of providing for such infrastructure. The new minerals law (Minerals Commission Law, 1986) modified eight existing laws, clarified mining rights and then made provision for new incentives for investors. The incentives covered corporate tax allowances, capital allowances from which companies would be able to write off between 40-100 per cent of capital investment against taxes. Also, companies were allowed to use offshore bank accounts for servicing foreign loans, dividend payments and expatriating staff remuneration. University of Ghana http://ugspace.ug.edu.gh 47 3.5.3 Enhancing Tax Efficiency and Equity Reformation of the Ghanaian tax system after 1985 focused on enhancement in the efficiency of the tax administration and ensuring equity in the tax system. Until 1986, the tax administration system was not adequately monitored neither was tax compliance ensured efficiently. Hence, a major component of tax reform was to strengthen the revenue collection agencies to ensure that they increase revenue and also to transform the structure of the tax system to make it more efficient and equitable. In 1985, the National Revenue Secretariat (NRS), Custom Excise and Preventive Service (CEPS) and the Internal Revenue Authority (IRS) were made autonomous institutions. The NRS responsibility was to supervise the activities of CEPS and IRS. Also, the NRS duty is to recommend revenue policies to the Ghanaian government. Further, conversions of IRS and CEPS into autonomous bodies with new organizational structures in close relation to the state- owned enterprises in 1986 was another measure aimed at improving efficiency in tax collection. Additionally, new incentive policies for the staffs of IRS and CEPS were introduced to enhance productivity of the tax collection system. Again, between 1986 and 1992, the IRS operated with ministerial powers alongside the ministry of finance nonetheless this whole autonomy was partially reversed (Kusi, 1998). Upon the advice of the World Bank in 1989, the Ghanaian government took the initiative to computerize the tax administration management information systems and also introduced a unique taxpayer identification numbering system. University of Ghana http://ugspace.ug.edu.gh 48 On the direct side of taxes, the goal of the corporate tax reform has been the gradual reduction of tax rates as well as elimination of the distortions that arise from application of multitude of tax rules to varied form of capital financing and incomes from the sectors. The corporate tax rate stood at 55 per cent in 1986 with the exception of mining and manufacturing which faced a tax rate of 50 per cent. The tax rate applicable to banking went down from 50 per cent in 1991 to 40 per cent in 1992. In 1993, all corporate tax rates reduced to 35 per cent excluding the rate applicable to the