On the road to a speedy economic recovery
A broad-based tax system is key to Solomon Islands’ pandemic response
Broadening the tax base will help Solomon Islands recover from the pandemic’s economic effects more quickly. Photo courtesy of ADB
A more sustainable revenue base for the Pacific Island nation could better manage changing economic conditions and the impact of shocks such as Covid-19.
While being largely shielded from the health impacts of Covid‑19, the economy of the Solomon Islands has felt a severe shock.
Travel restrictions shuttered tourism throughout 2020, major construction activity has been delayed, and the drop in global demand and lower domestic economic activity has had negative impacts on business and is placing a strain on households.
Real gross domestic product for 2020 is estimated to have contracted by 6%, according to the Asian Development Bank. Like most Pacific island countries, reduced activity throughout 2020 led to lower domestic revenue collections, while expenditures increased. Solomon Islands has gone into 2021 with little fiscal headroom and only a slight rebound to 1% real GDP growth currently forecast for this year.
The impacts of the pandemic have highlighted the inherent challenges facing small island developing states. These challenges include their acute exposure to shocks beyond their control and their narrow economic and fiscal bases, which further exacerbates their inability to manage the economic ramifications of shocks.
Countries the world over are set to implement fundamental reforms in the wake of the pandemic to improve country settings to achieve more sustainable, balanced and inclusive growth and development.
Solomon Islands is prioritizing a comprehensive tax reform agenda, alongside other reforms, to support growth and development in the recovery phase. Comprehensive tax reform will provide a conducive business environment, while reforms to broaden the tax base allow for lower rates to enhance growth and reduce distortions. Tax policy settings are a key component of fiscal policy and the broader economic framework. The tax system influences economic activity, business decisions – where to locate or how much to produce − and taxes also alter incentives to work, save and consume.
But taxes are imposed also matters for growth. Likewise, ensuring an adequate, sustainable revenue base is critical for the smooth functioning of government and the provision of vital services, as well as the ability to manage the economy and fund development after Covid-19.
Solomon Islands’ tax settings have remained largely unchanged for over 30 years. The tax system is outdated, inefficient, complex, expensive to administer, and anti-competitive. It imposes comparatively high effective tax rates on a narrow tax base, disincentivizing work, increasing the costs for business and consumers, discouraging new businesses from commencing operation, and encouraging tax avoidance and the informal economy.
Broadening the tax base provides an opportunity to lower the current high tax rates, while collecting a similar amount of revenue.
The tax law does not accommodate the digital age and the modern way of doing business. The tax system is complex (with many taxes and multiple tax rates) and hard to understand. Complexity causes added costs for both businesses and the tax administration, which is further compounded by uncertainty in how the laws are meant to apply and how they will actually be applied in individual cases. The current tax settings are significantly anti-competitive due to the widespread use of highly discretionary exemptions which create an unfair playing field and constrain growth throughout the economy.
The existing tax law does not fully support international trade. Solomon Islands is unique in the region as it does not have a value-added tax and therefore firms cannot get a tax credit for the input costs in selling their good or service. Instead, consumption taxes are levied on the final good or service which means that trading partners incur additional expenses in ensuring they are compliant with local laws.
Solomon Islands importers and exporters have similar problems dealing with other countries. Further, as the consumption tax regime does not provide exporters full relief from domestic taxation, Solomon Islands products may face additional competitiveness barriers in the global market.
The current tax settings have long been recognized as being a drag on growth .Expected structural changes over the medium term will place added pressure on the ability of the tax system to collect adequate, sustainable revenue.
The Solomon Islands’ proposed reforms aim to tackle the myriad problems identified with the current outdated tax system to ensure a more sustainable revenue base.
The first element of the comprehensive tax reform agenda is the establishment of a sound administrative base. This requires the implementation of comprehensive legislation, simplification of the current system and support to the tax authorities to improve their administrative arrangements.
The next step recognises the complexity of the current tax arrangements, particularly indirect taxes. It is proposed to remove five current taxes (goods tax, sales tax, stamp duty, accommodation levy and most customs duty) and replace them with a broad-based value added tax.
Future plans include a review of the income tax law and of other taxes including resource taxation and the gaming tax.
Broadening the tax base provides an opportunity to lower the current high tax rates, while collecting a similar amount of revenue. Lower rates increase the incentive to work and distortions created by the tax system. It also reduces incentives for non-compliance.
A broad-based tax system (i.e., one with minimal exemptions or concessions) provides a fairer, more competitive business environment. A simpler system, characterized by less taxes, a rationalization of rates for different taxes and clear, aligned administrative processes, would further enhance taxpayer certainty and help to assist with compliance – increasing the efficiency of the tax and therefore enhancing collections.
Although the devil may be in the details, a broad-based tax system can contribute greatly to achieving a more sustainable revenue base that is better able to manage the changing economic conditions and the impact of shocks. This can ensure certainty for financing core services and funding development expenditures into the future.
So, while the comprehensive tax reform may take several years to complete, Solomon Islands is on a promising path for reform to support its economic recovery.
Matthew Hodge is senior country specialist for the Pacific Department of thr Asian Development Bank. He specializes in public financial management issues and private sector development. (ADB)