Deep in the heart of taxes

Miller Report details the troubles with taxes

The first of 12 recommendations in
the report publically released Monday written by James C. Miller III and David
Shaw – now dubbed the Miller Report – is that the Cayman Islands Government not
impose direct taxation. 

“We considered the pros and cons of
this proposal very carefully, in the context of what would be best for the
citizens of the Cayman Islands and also what would be in the interest of the
U.K. government,” the report states. “We conclude that imposing a system of
direct taxation would be harmful to those interests.”

The three-person commission – which
also included Financial Secretary Kenneth Jefferson – listed five reasons to
support their recommendation not to impose direct taxation.

The commission found that the
fiscal problem in the Cayman Islands was too much spending, not too little
revenue.

“The government‘s fiscal shortfall
exists because spending has grown even faster than revenue,” the report stated.
“More specifically, the Cayman Government enjoyed a period of buoyant revenue
growth and spent money as if receipts would continue their rapid climb. When
the windfall of rapidly-rising revenue vanished and was replaced by a modest
drop in revenue, there ensued a severe fiscal challenge. But the challenge
developed only because spending grew so rapidly – and also because no plans
were made – such as a contingency fund – in preparation for the inevitable
recession-induced decrease in revenue.”

The Miller Report points directly
at the “substantial escalation in Government spending that began in 2006 as the
reason for the budget deficit.

“Interestingly, if the public
sector had grown at the same rate as the overall economy, the Cayman Islands
would be enjoying a budget operating surplus today.”

A second reason the commission
cited for not imposing direct taxation was that it would hinder the performance
of the economy.

“We base this observation on a
wealth of academic research indicating that higher tax burdens restrain
economic growth,” the report stated. “In part, this is because taxes discourage
economic activity, but it is also because higher tax burdens divert resources
to the public sector, where evidence strongly indicates they are used less
efficiently.”

The report cites the results of six
different studies to back its claim, including two from the Organisation for
Economic Cooperation and Development.  It
states research has concluded that to maximize economic growth, the public
sector should consume somewhere between 17 per cent and 23 per cent of Gross
Domestic Product.

“By these standards, the public
sector in the Cayman Islands is too large, now commanding nearly 30 per cent of
the Islands’ GDP,” the commission wrote. “Consequently, it would be unwise to increase
taxes or impose new taxes, which would almost inevitably lead to a further
expansion in the size of Government.”

The commission also stated there
was evidence that a system of direct taxation was more damaging to the economy
per dollar of revenue than alternative revenue systems.

The report stated personal income
tax and corporate tax are more likely to reduce economic performance than other
taxes.

“The important point is that all
taxes are paid out of current or past income, so any levy is going to alter the
trade-off between work and leisure,” the report states. “The real issue is
which types of tax cause the most or least distortions.”

The commission cited several OECD
studies. One concluded “…that income taxes are generally associated with lower
economic growth than taxes on consumption and property.” Another OECD study
found “Taxing consumption…appears to have significantly less adverse effects on
GDP than taxing income. Corporate income taxes appear to have a particularly
negative impact on GDP per capita.”

The problems cited in the studies
occurred because personal income tax and corporate income tax rates are
non-trivial, the commission stated. But even if the Cayman Islands started out
with what could be considered a trivial tax rate, the commission didn’t believe
it would stay that way.

“It is not realistic… to believe
that direct taxes if applied would remain at very low rates,” the report
states. “The history of every country which has imposed direct taxation belies
such optimism.”

A fourth reason given by the
commission for not imposing direct taxation would be that it would be extremely
harmful to the financial services industry, which is very mobile.

The report noted that Cayman’s
system of indirect revenue-raising has been a key factor in the growth of the
financial services industry.

“Any direct tax system, especially
a direct tax on income, would put the Cayman Islands at a competitive
disadvantage compared to other international financial centers. There are
larger financial centers in other nations that have the advantages of easier
communications and economies of scale. There are many financial centers that
have a cost advantage. The industry in Cayman has been able to offset these
factors because of an attractive revenue-raising regime. It is difficult to
imagine how the industry would prosper if that changed.”

The commission also pointed out
that establishing and maintaining a system of direct taxation would necessitate
extensive compliance.

“The Legislative Assembly would
need to pass legislation of immense complexity, and a new court system would be
required to deal with tax issues,” the report stated. “Government would need to
expand significantly with legal draftsmen, tax assessors, and tax collectors.
Such problems would be compounded by tax code complexity, which afflicts almost
every income tax system.”

The report also looked at various
kinds of direct taxation and the potential problems of implanting them in the
Cayman Islands.

In addition to the complexities of
personal income tax, the commission noted that Cayman’s tax base is very mobile.

“Moreover, there are some 30,000
guest workers in Cayman, and collecting taxes due from them might be very
difficult,” the report stated.

“Income taxes
would generate revenue, but they would impose high risks for the Cayman economy.”

The report also found difficulties
with payroll tax, which is only applied to labour income and not to other types
of income.

“Moreover, payroll taxes often are
at least partly paid
by the employer, though labour economists widely agree
that the burden – in the form of foregone wages – is borne by workers,” the
report stated.

“The work
permit system in Cayman has many of the attributes of a payroll tax, but is
more efficient in terms of administration, compliance, and collection.”

Although the report found that
payroll taxes would be less risky than income tax and would be capable of
generating substantial revenue, it would present difficulties if done in
combination with the work permit scheme.

“Cayman employers already regard
[work permit fees] as high relative to those in other jurisdictions,” the
report states. “A payroll tax in addition to work permit fees would add to
employment costs and make the Caymans less competitive in the market for
skilled professionals.”

The commission concluded income and
payroll taxes would be harmful to the economy.

“The Cayman
Islands [has] enjoyed substantial prosperity, in part because it is a reasonably
tax-neutral platform,” the report stated.  “Adopting any form of income or payroll tax
would remove much of the fiscal allure that has boosted the economy. Moreover,
any form of income or payroll taxation would require the imposition of an
entirely new tax system, with both high set-up costs and potentially
significant and permanent compliance costs.

“It also is
unlikely that a tax on income, regardless of form, would solve the problem of
variations in revenue collections.”

Even though
the commission found Cayman’s current stamp tax on property transfers was “probably
not the most efficient way to tax real estate” it didn’t recommend adopting
that form of taxation.

“To generate
substantial revenue, the rate must be set at a non-trivial level, yet that type
of rate may lead to a lock-in effect,” the report stated, referring to a
economic principle where sales volume would decline as a result of higher
taxes.

 “At the very least, it will lower the selling
price of homes,” the report stated. “It also raises horizontal equity concerns,
because the tax is borne solely by buyers/sellers of property rather than all
property owners.”

The commission
also pointed out that Cayman’s reputation for zero taxes on real estate would
be undermined, “perhaps dissuading many potential buyers”.

The report
also questioned the amount of potential revenue from a direct property tax.

“When we spoke
to people in Cayman about banding the tax and exempting a value level that
would remove many Caymanian-owned properties, it became apparent that a one-per-cent
levy would not raise as much money as its proponents were advocating.”

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