For a country like Nigeria—with a high inflation rate, astounding poverty levels and slow economic growth—indexing taxes should be considered for the effectiveness and fairness of the tax system.
Inflation is a dilemma that standard economic theory suggests has adverse effects on the economy. The effects of inflation occur across all sectors of the economy and for Nigeria, a country with an average annual inflation rate of eleven per cent (as at December 2019), inflation severely affects consumer spending and investor activity. The effect of inflation is best explained by the principle of the Time Value of Money (TVM), which stipulates that any amount available today is worth more than the same amount in the future. To wit, N100 in 2002 could buy five loaves of bread, while the same amount presently would only buy one loaf of bread.
Similarly, where an individual earned a particular amount in 2002, the individual has less disposable income today thanks to inflation, as the value will have less purchasing power. This situation affects investors and their investments, too. According to Section 12 of the Central Bank of Nigeria Act 2007, the Monetary Policy Committee of the Central Bank of Nigeria is tasked with the responsibility of ensuring price stability in Nigeria. Despite the measures proposed and adopted by the Monetary Policy Committee to tackle inflation, the annual inflation rate in Nigeria remains stubbornly high.
In Nigeria, both taxpayers and tax authorities feel the effects of inflation. Since the value of money changes over time, high inflation can affect taxpayers if taxes are not adjusted in line with the changing value of taxable income. When taxes are not adjusted, the real income available to the consumer or investor reduces. ‘Real’ in this context refers to the present value of the income in terms of its purchasing power as opposed to the value at a different time. Unadjusted taxes also affect tax authorities, the punitive effects of whose sanctions (placed in tax legislations) become eroded as inflation diminishes the monetary value of the sanctions.
To avoid these losses, a typical solution is to require taxpayers to pay taxes on their real income. This requires ensuring the tax rate reflects the real value of the income expressed in the tax legislation and not the income’s nominal value (typically expressed at a different time). This additional step is what is called indexing. Proponents of indexing argue that because of inflation, taxes should be adjusted to ensure that rates applicable to the taxpayers are adjusted in line with the real value of the profits and incomes, and not just the nominal values of these figures. Consider, for instance, a taxpayer made to pay seven per cent in personal income taxes on their first N300,000 in 2011. In 2020, when N300,000 has even less purchasing power, leaving the nominal tax rate at seven per cent of 300,000 naira (rather than increasing it to say seven per cent of 450,000 naira) effectively reduces that individual’s consumer income. This discrepancy exists because the tax rates remain fixed as the real value of income continues to fall.
When taxes are not indexed for inflation, this situation can heighten the negative effects of inflation on consumer spending and investors’ investment yields. Furthermore, with non-indexation, the tax system fails to possess flexibility, efficiency and simplicity—qualities economists have generally agreed indicate an effective tax system since the Adam Smith era (18th century).
Tax Authorities (the Government), Inflation and Taxes
The adverse effects of inflation on tax authorities typically occur through the reduced value of the government’s tax revenue. This reduction occurs for two major reasons: Firstly, the taxes collected by the government would have a lower value compared to when the tax obligation arose or the period the tax covers. Furthermore, the penalties expressed in the tax legislation remain time-bound and, consequently, begin to have less value as time goes by.
In Nigeria, most penalties for defaulting taxpayers are expressed in fixed amounts. With inflation in the picture, the real value of these penalties falls over time. When the penalties become insignificant in value, they fail to achieve their intended objective of deterring non-compliance. For instance, the penalties expressed in the Companies Income Tax (Amendment) Act 2007 are relatively insignificant today, compared to 2007 when they were fixed. For instance, according to Section 41 of the Companies Income Tax Act, the penalty for late filing of companies’ income tax is N25,000 for the first month and N5,000 for every month after the first month the default occurred. The real value of these figures today is double the amount as of 2007 when the nominal penalties were set. The punitive and economic value of this sanction has eroded substantially in that time.
While the tax obligation of the taxpayer arises when the profit or income is earned, the obligation to file returns for the corporate income tax may not arise until months after the income is earned (when the tax obligation commences). This lag (sometimes up to permissible eight-month period) sees inflation erode the real value of tax revenues. Consequently, the revenue generated by the government is of lower value when compared with the real value of the tax to be paid when the obligation began.
Taxpayers (Consumers/ Investors), Inflation and Taxes
For taxpayers in Nigeria, the negative effects of inflation play out across the various kinds of taxes (viz, personal income tax, companies income tax and the capital gains tax, etc.).
Personal income tax in Nigeria is charged on a progressive basis. This means that there are various tax brackets considered by the tax authorities for personal income tax—the higher your income, the higher the tax you are required to pay. For instance, income on the first N300,000 is charged at seven per cent, for the next N300,000 it is charged at eleven per cent, and so forth. While the tax brackets recognized under the Personal Income Tax Act have been fixed in the legislation since its last amendment in 2011, the monetary value expressed in the tax brackets have since changed. Accordingly, the taxation of nominal income, as opposed to real income, has placed more consumers within higher tax brackets than was envisaged by the Personal Income Tax Act at the last amendment due to the inflationary trend. This has also increased the effective tax rate for low and middle-income consumers, reducing the disposable income available to low and middle-income earners while the rate for high-income consumers remains unchanged. For instance, the taxpayer who earned a fixed income of N500,000 in the last decade would have been subjected to the same rate even as the real value reduced, when the taxpayer really should have been subjected to the tax rate for a lower tax bracket. On the flip side, the higher income (extremely wealthy) taxpayer stays within the same tax bracket and pays taxes at the same rate.
In addition, while the Personal Income Tax Act creates reliefs and allowances in fixed and nominal terms, these amounts remain unchanged even as the real value of that amount increases annually. This has the effect of reducing the real value of the relief that consumers are entitled to in the computation of the personal income tax. For instance, Section 33 of the Personal Income Tax Act, entitles taxpayers to: a deduction of N300 from taxable income where the taxpayer has paid alimony in the preceding year; a deduction of N2,500 for every unmarried child under 16 depending on the taxpayer’s income, etc. Despite the fact that these figures were stipulated in the 1993 Act and have not been amended even in the 2011 amendments, the real value of these figures today differs from the reliefs and allowances conceived of in 1993. This means that the tax liability of the consumers in real terms has gone up while the nominal amounts identifying the tax brackets remain unchanged.
Furthermore, the effects of inflation on capital gains taxes are severe. Taxation of capital gains from the disposal of assets can affect the real income available to consumers or investors as it is the nominal as opposed to real gains that are subjected to a capital gains tax. This approach does not consider whether the investor or individual has made a gain in real terms from the disposal of the asset. For instance, a taxpayer who bought a plot of land for N50,000 in 1980 and sells the property for N2 million in 2020 would be required to pay the capital gains tax on the difference between the two sums. This is so even if the taxpayer might have made a loss in real terms on that investment as the value of N50,000 today might exceed the N2 million for which it was sold.
For companies operating in Nigeria, Section 33 of the Companies Income Tax Act sets the threshold for the application of minimum tax at N500,000, an amount set in 1991 when the legislation was first passed. The real value of N500,000 in 1991 should be at least N5 million today considering the inflationary rate fluctuation between 1991 and 2020. A company making N500,000 today would have made less by the monetary value of the naira in 1991. Thus, leaving the tax threshold at N500,000 in 2020 means more companies have been subjected to the payment of taxes not envisaged by the principal companies’ tax legislation. This is because these taxes were once reserved for the more profitable companies. Ultimately, by failing to index taxes for inflation, policymakers subject smaller companies today (it is comparatively easier to attain a turnover of N500,000 today than it was in 1991) to higher tax burdens.
Who’s Got Time to Index Taxes?
Indexing taxes adjusts the administration of taxes from the nominal value to the real value in order to reduce inflationary pressures on consumer incomes and investment yields. For investors, there is a nexus between a favourable tax regime and the attraction of foreign investments into an economy. With increased investment activity in a country, the economy enjoys rapid growth. Thus, where inflationary rates are high, it is good fiscal policy to index taxes.
The idea of indexing taxes is not a new concept, moreover; and OECD countries like the Netherlands and New Zealand already index taxes for inflation, especially the capital gains tax. According to the International Tax Competitiveness Index, these countries require taxpayers to pay capital gains tax on the real returns on their investments as opposed to the returns due simply to inflation. It is not uncommon for countries that index taxes for inflation to score highly on tax competitiveness on the Tax Foundation’s Competitiveness Index. In 2019, New Zealand and Netherlands ranked second and ninth on the list respectively, compared to Nigeria that did not rank at all.
In the United States, indexing taxes for inflation has been the subject of fiscal policy debates for decades. For income taxes in the US, tax indexation occurs either all or some of the tax bands, standard deductions and personal exemptions across the country’s different states. One of the rationales behind the US government’s decision to index taxes in the 1980s was premised on policymakers noticing that inflation was moving more taxpayers into higher tax brackets without any real increase in the personal income of the taxpayers.
In recent times, the Trump administration has hinted at changing tax policy in the US to ensure that the capital gains tax is indexed for inflation. Although for various political and administrative reasons, this policy proposal has been abandoned. Supporters of this proposal argue that it prevents a situation where investors who would have made a nominal gain but a loss (in relative terms) on the disposal of an asset, are made to pay capital gains on the disposal of the asset anyway. At the core of the argument in the US, as is applicable everywhere else, is the notion that taxing inflation is unfavourable to a nation’s economic growth and its ability to attract investors.
The Economic Impact of Indexing Taxes for Inflation
Some economists (Steven M. Fazzari and Benjamin Herzon, for instance) believe that indexing taxation for inflation has little impact on investment activity and does not affect the long-run growth rate of the economy. They argue that proponents of indexing taxation, especially the capital gains tax, exaggerate the impact tax indexation has on the economy. This position is premised on the belief that there is no reliable data to suggest that money saved when taxes are indexed for inflation will be reinjected by the investors into the economy in ways that can lead to real economic growth. In the US, evidence for this is very thin. The Trump tax cuts, for example, saw record-breaking stock buybacks by Fortune 500 companies in 2018, instead of the expanded operations in the US economy with the tax savings they got from the tax cuts.
It is doubtful whether this position—that indexing taxes has no real benefit on the economy—is true in hyperinflationary economies. Nonetheless, economists like Oluwatomisin Adebayo-Begun maintain that as inflation increases the tax liability of consumers in real terms, it could cause a fiscal drag. A fiscal drag occurs when consumers begin to pay more in income taxes since inflation causes them to move into higher tax brackets. This move substantially reduces consumer spending and has negative effects on the economy, including increased income inequalities for the formal personal income taxpayers as the lower-to-middle-income taxpayers enter higher tax brackets while the high-income earners stay within their tax brackets.
In Nigeria, academic research has revealed a positive correlation between a favourable capital gains tax regime and the attraction of foreign direct investments and investors. And yet a side effect on a tax system of indexing capital gains taxes will be that the regime only favours higher-income earners who own assets. This is because capital gains taxes are applied to assets and higher-income earners own more assets than any other income class. On that note, where monies saved are not reinvested into the economy or where they are repatriated—as is the case for foreign investors—such savings may have no favourable economic impact and may further exacerbate the problem of capital flight in the country. Arguably, this has been Nigeria’s experience in the last four-to-five years, where the majority of foreign investment coming into Nigeria has been ‘hot money’ aka portfolio investments. Many countries (typically emerging markets) that design their economies as open to foreign investment nonetheless retain some forms of capital controls (think the Asian Tigers during the Asian Financial Crisis of the 1990s and Argentina during its financial crisis of 2001 and even recently).
However, indexing personal income taxes for inflation favours the consumer and the economy since an increase in after-tax income will be a first step in dealing with the possible problems that may emerge from reduced consumer spending.
Taxes and Inflation under Buhari
On January 13, 2020, President Muhammadu Buhari signed the Finance Bill into law, introducing sweeping changes to the Nigerian tax system. The new bill seeks to promote fiscal equity and align domestic fiscal laws and regulations with global best practices. Just as significantly, the bill introduces some important fiscal changes, which seek to address some of the negative effects of inflation on the administration of taxes in Nigeria. For instance, the Capital Gains Tax Act enacted in the 1970s imposed capital gains tax on the compensation for loss of employment received by an employee for figures higher than N10,000. The Finance Bill seeks to increase that amount from N10,000 naira to N10 million. This is clearly a move towards indexing the amount imposed in the legislation since it no longer has the economic value it did in the 1970s and this move should be applauded.
Perhaps the most important tax indexation in the Finance Bill is the increase of the threshold for minimum tax obligations stated in the Companies Income Tax Act from companies with an annual turnover of N500,000 to companies with an annual turnover N25 million. This helps to index the amount first set in 1991 and to ensure that companies that were never supposed to pay companies’ income tax are exempted from paying those taxes. The economic benefits of this rule change for small and medium-sized enterprises are considerable, but the most important benefit is that it helps to foster economic growth for the businesses and for the economy.
Furthermore, the Finance Bill removes the tax relief of N2,500 for every child (up to a maximum of four) as stated in the Personal Income Tax Act. It also includes dependent relief of N2,000 naira (per dependent up to a maximum of two). The amendment, undoubtedly, presented an opportunity to increase the rates for these benefits, which was first set out in 1991 and have been impacted by inflation.
On the issue of liability for failure to carry out tax obligations, the Finance Bill pegs the penalty for failure of an agent to collect tax at the rate of ten per cent of the relevant tax collection failure. This is an efficient way to prevent tax evasion by making the collecting agent responsible and by ensuring that the punitive sanction prescribed by the legislation is immune from the effects of inflation.
Where Do We Go from Here?
Nigeria’s high inflation rate, astounding poverty levels, and slow economic growth make indexing taxes a necessary policy consideration. From a policy perspective, indexing taxation for inflations aligns with the principles of a good tax system. Indexing increases consumer savings and consumer spending and has the potential to make an economy more attractive for investments. For businesses and international investors, in particular, a functional tax system that indexes taxes for inflation suggests tax competitiveness and makes the country a more favourable destination for investors seeking to register and set up businesses. Economic growth resulting from an increase in foreign investments and an increase in consumer spending are a likely effect of this policy.
The Finance Bill is already a step in the right direction. The National Assembly has a role to play in continuing this good work by: empowering tax authorities to regularly readjust the tax bracket and tax benefits in the Personal Income Tax Act for inflation; making the penalties for defaulting on taxes a percentage of the tax payable; or adjusting the fixed-sum penalties regularly. Tax authorities will need to play a proactive role in administering the policy by ensuring that the indexation policy is not subjected to abuse or exploited by the taxpayers, particularly consumers and investors with deep pockets.
Furthermore, since the National Bureau of Statistics (NBS) documents the data relevant to the annual inflationary rate, tax authorities should be made to consider the data released by the NBS when computing the capital gains tax.
It is worth mentioning that the ensuing political and administrative challenges that will arise from an attempt to effectively index taxes will be unprecedented and akin to attempting to scale the Mount Everest of Nigerian fiscal policy. Tax indexation has the potential to lead to an intensive academic and political debate, which will revisit some of the issues typically mentioned by the opponents tax indexation, issues such as: how much the Government will lose in taxes if it begins to index taxes; whether tax indexation has any real impact on the consumers/ investors; how tax indexation can be administered effectively; and how to prevent tax indexation from being exploited as a tax loophole⎈
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