Why Flat Tax In Panama Is Not The Answer

The Panama Flat Tax Band Wagon

Posted by Tropiland Editor on November 11, 2009 Leave a comment (0) Go to comments

Flat tax has always been on the main radar of president Martinelli both as a presidential candidate and commander in chief. A lot has been said and written on the Panama press and Panama’s blogging community.

It seems that every one is on the same band wagon, tooting flat tax as some sort of economic snake oil that, when implemented, will miraculously fix all of Panama’s many taxation and general socioeconomic problems.

I’ve always been cautious when it comes to Mr Taxman. What follows here is an attempt to argue that Flat Tax in Panama may not been as beneficial as its proponents say. At the very least, a flat tax rate for Panama should be examined and analyzed under Panama’s socioeconomic reality as a developing country and not using arguments fit for developed countries.

Many in Panama, especially those with liberal views, have talked about following the Eastern European “flat tax” model in drafting new fiscal reforms. However, even when flat tax did look as a promising case some time ago, today’s world economic downturn, coupled with “its flat taxes” are making the country… “flat footed”. I am talking about the Baltic State’s flat tax system.

The Baltic states are facing dire straits due to loss of income, and are implementing devaluations to prop their exports. In times of capital inflow, flat taxes attract foreign investment but when investors get their money out of emerging markets (like the Baltics and Panama), these countries, with weak national sources of income, have nowhere else to go but to the wage and program axes.

Let’s explain: in a flat tax system, the rate is across the board and retained at the source. In this case, if a company earns a profit and spends (n) income in salaries, bonuses and investments (all taxable income), then it will pay a (n)*(r) where r will be the tax rate. Workers will not need to pay more taxes on their wages, except for “other” personal income.

But there are some problems, centered especially around deduction design and overall implementation, and regarding the marginal utility of money in more broad aspects. If there is a flat tax, deductions need to be overhauled.

In Panama, deductions generally benefit those with money (after all, Panama is a “tax” haven). If people with large incomes are left to deduct many of their expenses as “business” or “other deductible” expenses, then they will pay less taxes than under a progressive tax system.

For this reason, their “real tax level” (the money they really pay to the government) will be lower. On the other hand, wage-earners, who have less opportunities to deduct wage-earned income given less access to offshore savvy counsel and inelastic sources of income, will pay the full flat plus other oddities. In that sense, instead of having a flat tax you have a regressive tax system. In Panama, this problem will be hugely compounded by the fact that the overall tax structure is modeled to be an off-shore one. I mean…come on lets face it!

Profit rates for businesses especially would need to be above (n), so their markup will have to be equal to it if expenses are not deducted. Without a doubt, businesses will be forced to deduct current expenses, but what will they deduct? One thing is to buy raw materials or capital goods for production, and other thing is that they invest in capital expansion or other “business expenses” (like bonuses!) to shelter their income –reserves in Panama are taxed! In small countries, where capital expansion is more intimately linked with foreign markets, booms and busts are compounded by the overall economic climate. In the latter case, aggregate behavior in this direction might lead to some regrettable economic straits if demand doesn’t keep pace – like for instance, in the Baltic.

The solution would be to have an across-the-board elimination of many superfluous deductions… but then, our business elite would not be happy. Panama has long profited from having a loose tax regulatory system, seldomly enforced. But doing this elimination could be counterproductive too: what about mortagage deductions? property taxes? If you eliminate these many deductions, this will increase the prices of many items (for instance, houses without mortagage deductions, etc.) Some businesses will be forced to raise their markups. But, on the other hand, if you keep these under a flax tax rate, they might compound to the regressivity of the system. Again, we are between a rock and a hard place.

Also, their is a more broad argument, which is weaker but worth noting. An additional 100 dollar bill for a person who earns $500 could be assumed to be more valuable than one who earns a million. If you tax a flat rate on both, you are punishing the poor at the expense of the rich, especially if the poor guy has to pay sales taxes and what not.

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