Tue, 29 Jul 2003

Tax on mutual funds

The government is preparing an overall tax reform in another bid to broaden the tax base and consequently increase tax receipts. Different to the 2000 amendments to the tax laws that emphasized revenue, the upcoming reform of the tax laws will be designed to improve taxation procedures and certainty in tax law enforcement.

Unfortunately, though, public debate about the tax law amendments paid too much attention to the government's plan to impose tax on income accrued from mutual funds invested in bonds. Tax Law No.17/2000 does exempt income gained by mutual funds invested in bonds for the first five years of the fund operations.

Staunch supporters of the tax relief argue that lifting income tax exemption from mutual funds could kill the nascent mutual fund industry. They even blamed the sudden, steep fall in the rupiah exchange rate against the U.S. dollar on jittery investors who shifted their investment from mutual funds to dollar assets.

The mutual fund industry has indeed dramatically expanded from a mere Rp 15.6 trillion (US$1.8 billion) in 2001 to Rp 67 trillion as of May due mainly to the steady decline in the central bank's benchmark interest rate to as low as 9.2 percent today from 13 percent early this year. This, in turn, pushed down the interest rates offered by banks to time deposits, thereby prompting depositors to shift their funds to mutual funds invested in fixed-income money market instruments, notably bonds.

The government rightly argues that the planned lifting of the tax relief for incomes from mutual funds is designed to establish equal tax treatment in all economic activities.

After all, businesspeople and investors should also have realized that tax relief that violates the principle of equal tax treatment has never been designed to be a permanent policy instrument. It is usually meant only as a temporary incentive to encourage activities in a particular sector. Such an incentive is usually terminated after the targeted sector has already reached a certain stage of development to enable it to compete with other sectors for investments.

The government apparently considers it high time to terminate the tax incentive next year, as the mutual fund industry has achieved the desired stage of development and the secondary market for bonds has advanced enough to make this debt instrument fairly liquid as an investment vehicle.

That the initial reaction to the planned policy has been so negatively strong should be seen in the light of the yet limited number of viable sectors into which banks can place their excess liquidity. This can be noted, among other things, from the active role of banks themselves in the promotion of mutual funds to keep their depositors.

The government, we think, should go ahead with its plan to include the termination of the tax incentive for incomes from mutual funds in the overall tax reforms that will be proposed to the House of Representatives later this year.

Creating a favorable investment climate does not necessarily mean granting tax incentives. In fact, investors prefer equal tax treatment and legal certainty in tax law enforcement to tax relief. After all, income tax is due only when investment makes earnings.

However, the principle of equal tax treatment should not be so narrowly defined as to apply only to tax collection. This principle should also cover procedures to enforce the tax laws. This means that taxpayers and tax officials should have equal treatment and status in light of the enforcement of tax laws. Further down the line, such an equality principle means that the penalties liable for taxpayers who violate the tax laws should be equally harsh as those applied to tax officers who wrongly apply the tax rules.

The blunt reality now is that legal position of taxpayers is always much weaker than that of tax officials with regard to law enforcement.

Take for example, the rule on tax audit. Taxpayers are supposed to be subject to tax audits only when there is preliminary evidence that they have not correctly filed their tax returns or not fully disclosed their earnings.

The reality, though, is that tax audits are carried out indiscriminately upon all taxpayers who ask for refunds of overpayment, even though there is no strong evidence of misreporting.

The problem, though, is that tax officials are not liable to penalties if their tax audits find nothing wrong with the returns. This has put taxpayers at the mercy of tax auditors.

Unequal treatment also occurs in the event a taxpayer files an objection to the tax court over tax assessment. However legally strong the case filed by the taxpayer, it must still pay up front at least 50 percent of the disputed tax. This not only breaches the principle of equal treatment but also assumes the presumption of guilt.

Hence the principle of equal treatment, which will be strengthened in the upcoming tax reforms, should not only be applied to tax collection but also to the status of taxpayers and tax officials before the tax laws.

This principle is quite important to nurturing a higher degree of trust between taxpayers and tax officials, which, in turn, is vital to improving the overall climate for increasing voluntary tax compliance.