Introduction

Discretionary income tax changes made after the 1979-1980 Budget no doubt alleviated the tax burden to a certain extent, but it was still high. There were three key issues. The real value of deductions and allowances was declining steadily, the narrow tax bands discriminated against the lower-income groups, and the top marginal tax rate remained at 70%, a rate that was not very encouraging for additional work effort.

Government had overhauled corporation tax in 1984-1985, which resulted in a uniform tax rate of 35% before the payment of dividends, compared to previous rates of 66% and 55% after the payment of dividends for private and public companies, respectively. The reform drew a wedge between the corporation tax rate and the existing top marginal rate of personal income tax, which was twice as high. Expectations were building up for a reform of personal income tax.

Bold reforms

The much-awaited reform was announced in the 1985-1986 Budget by the then Minister of Finance, Hon. Vishnu Lutchmeenaraidoo, following consultations with stakeholders. It was comprehensive and addressed the three concerns mentioned above.

First, the personal deduction increased from Rs 7,500 to Rs 10,000, or by 33%. Other deductions were also raised substantially. For example, the deduction for dependent relatives was doubled from Rs 1,250 to Rs 2,500, and the deduction for children rose from Rs 2,900 to Rs 5,000. It is worth noting that the deduction for a dependent relative had earlier been far lower than that for a child below 12!

Second, the most fundamental change was the tax rate structure, which was completely revamped. The top marginal tax rate was slashed from 70% to 35%, the tax bands were widened, and the eight marginal tax rates were reduced to four. It is well known that highly progressive taxation encourages both tax avoidance and tax evasion. Taxpayers resort to diverse or devious ways and use the services of accountants and tax experts to minimise their tax liabilities, to avoid or evade taxes. Lower tax rates moderate progressivity but encourage greater compliance, as there is less incentive to evade taxes at the risk of paying penalties.

Third, while the emoluments relief remained at 6%, subject to a ceiling of Rs 6,000, pensioners and disabled persons were entitled to higher relief of 12% and 10%, respectively.

The reform was a masterstroke in public relations as well and caught taxpayers off guard, as they were not expecting such a drastic change. The changes even went beyond the proposals of the Mauritius Tax Payers’ Association, which considered a 50% top rate reasonable. Even one year earlier, the corporation tax rates had gone beyond the proposals of the private sector. Taxpayers were pleasantly surprised by the sharp reduction in tax rates, which no doubt provided a stimulus to greater work effort and higher productivity, as well as an incentive to save and invest, while also enabling higher consumption since disposable income increased.

Fourth, most of the elements of the reform took place in 1985-1986, but this was not the end of the story; the process continued. Tax revenue increased by 26% and 19% in 1986-1987 and 1987-1988, respectively. As the budgetary situation improved, the government could afford another round of concessions. In the 1988-1989 assessment year, the emoluments relief was raised to 8% and the ceiling was removed. The personal deduction went up by 20% to Rs 12,000.

The impact

Of course, the changes initially occasioned a shortfall in income tax revenue, which, however, picked up quickly within two years. This can be attributed to higher economic growth, employment and incomes, as well as a lesser incentive to evade taxes.

The immediate consequence of these changes was that the average tax rate fell from 8.4% to 6.5% between 1984-1985 and 1985- 1986. In fact, it had been steadily declining since the changes of 1979-1980, as shown in the graph on the average tax rate, which is computed as total income tax as a percentage of total gross income. Subsequently, the rate assumed an upward trend as more taxpayers were moving up the income ladder. This was particularly the case with the introduction of the Small Income Relief in 1984-1985. Taxpayers who claimed this relief benefited from a higher exemption limit of Rs 15,000 for an individual or Rs 30,000 for a joint return in 1975-1976. The share of gross income of taxpayers earning less than Rs 40,000 dropped from 40% in 1984-1985 to 20% in 1987-1988.

We have also computed the effective tax rates at different income levels, which reveal that taxpayers at higher income levels benefited more than lower-income taxpayers. For example, the effective tax rate for an income earner exceeding Rs 500,000 declined by more than 50%, from 53.7% to 25%, while the corresponding decrease for a taxpayer earning Rs 40,000 was 12%. This means that the average taxpayer was paying less than one month's income in tax, whereas high-income earners paid three months' income in tax, compared to over six months earlier.

For middle-income groups, the tax reductions increased their disposable income, which provided an opportunity to boost their consumption, which had been severely constrained by high taxes on imports. The stamp duty, which was imposed in 1979- 1980 at 2% on imports, had shot up to 17% by 1985-1986. For higher-income earners, who have a higher propensity to save, the lower tax rates no doubt encouraged more savings. It is not surprising that savings doubled between 1984 and 1986, from Rs 2.6 billion to Rs 5.6 billion; the savings rate jumped from 18.7% to 28.6%. It would be simplistic to assume that only the tax reduction was responsible for higher savings. There were other contributory factors, such as declining inflation, positive real interest rates and rising incomes.

The reforms of both individual and company taxes in two consecutive years created a psychological impact in the country, instilled confidence in the business community and contributed to creating a business-friendly environment conducive to investment, growth and employment. The changes came at the right time, when the economic revival was gathering momentum.

The bold decisions marked a difference in budget-making, contrasting with our experience of the seventies, when it was more of an accounting exercise aimed at maximising revenue. With hindsight, we can say that the policies paid dividends. Savings, investment, employment and growth all picked up. Sixty thousand jobs were created between 1985 and 1988. The unemployment rate declined consistently from 16.2% in 1985 to 4% in 1989. Real investment increased by almost 20% in 1986 and 25.6% in 1987. The economy grew by 9.7% in 1986 and 10.4% in 1987.

Compared to the changes of 1979-1980, this reform had a more substantial impact on income tax revenue, which dropped by 30% in 1985-1986, from Rs 264.8 million to Rs 185.8 million. Its share in recurrent revenue dipped to 4.8%. The shortfall was temporary, and in absolute terms, income tax revenue kept rising year after year and even more than doubled by 1989-1990. The fall in revenue was not a matter of serious concern, since economic growth was picking up, yielding more revenue from other sources, in particular the sales tax, which was introduced in 1983.

Moreover, there was a gradual shift away from direct taxes towards greater dependence on indirect taxes, a shift that has been reinforced over the years. The emphasis on indirect taxes has been more by design than as a natural development. The tax system was buoyant, which obviated the need for higher tax rates. The cliché “No-Tax Budget” was in vogue. Inflation and economic growth were doing the trick.

Conclusion

Both corporate and individual tax reforms were a significant step towards the modernisation of the economy, encouraging investment and sustaining growth. These objectives were also supported by appropriate monetary policies and the enactment of the new Banking Act in December 1988, which, inter alia, laid the foundation for offshore banking activities. The vision was for the financial sector to develop as a pillar and contribute to the diversification and modernisation of the economy.

Attractive tax incentives were provided, such as concessionary personal income tax rates for expatriate staff. It was during the late eighties that the Stock Exchange was set up. Both monetary and fiscal policies were working in tandem for the emergence of new pillars of the economy, which have today become a reality. But it should not be forgotten that the seeds were sown in the eighties, a decade fertile in ideas, innovation and leadership.