RESTRUCTURING  OF  TAX  ON  INTEREST  INCOME  MULLED

MANILA, JULY 2, 2007
(STAR) By Des Ferriols - The Department of Finance (DOF) is considering the possible restructuring of the tax on interest income, including a proposal to impose a uniform final withholding tax rate of 10 percent on all interest income regardless of issuer, currency, or maturity.

The DOF has commissioned a study of the financial sector taxation to identify distortions created by the existing structure and remove biases that discourage savings.

In a paper penned by former economic planning secretary Felipe Medalla, the current structure of the final withholding tax (FWT) on income from interest was biased against savings.

According to Medalla, the FWT also imposes different taxes on income arising from the same or equivalent acts of saving depending on the currency denomination, maturity, and issuer of the financial instrument or asset in which the savings are invested.

“To make matters worse, a 20-percent final tax on nominal interest income is actually a very high tax on real interest income if inflation is large relative to nominal interest,” Medalla said. “This is the case even for modest rates of inflation, say five percent.”

The government decided to impose a 20 percent tax but long-term instruments were exempted from the FWT. Medalla pointed out that if the goal was to encourage savings, there was no real justification for exempting long-term deposits in banks from the tax.

“All this does is to encourage households to put their money in long-term instruments of banks, without necessarily affecting total household savings,” he said.

“Likewise, if long term instruments were effectively bearer instruments and were therefore tradable or negotiable, these instruments in the hands of constant traders are effectively short-term instruments that are exempt from the FWT,” Medalla pointed out.

On the other hand, Medalla said short term instruments (with maturity dates of less than five years) that were not traded and held until maturity were instead taxed at a higher rate.

“If savings are to be encouraged, all savings should be taxed similarly regardless of the issuer of the financial instrument,” Medalla said. “An individual should be able to save as much by leaving his money in a trust account administered by a trust company as with a bank.”

In addition, Medalla said having a final withholding tax of 20 percent was “hard to justify” if the goal was to remove the bias of the tax system against savings.

“There is therefore a strong rationale for both lowering and making the interest income tax rate a uniform or a single rate,” he said. “First, it does not make any economic sense to give banks better treatment than other financial intermediaries and institutions.”

Second, Medalla said there was neither empirical nor theoretical basis for saying that zero-rated taxes on interest from longer-term financial instruments would promote savings.

Finally, Medalla said the only reason that interest on foreign currency deposits could not be taxed as the same rate as interest on peso deposit was because the 20 percent tax on interest on peso deposits was high enough to induce many Filipinos (especially those with large deposits) to deposit their foreign currency holding in banks in countries that do not impose the same tax.

“Making the final withholding tax on interest uniform and independent of currency denomination would not cause the same problem if the tax rate is uniform at 10 percent rather than at 20 percent,” he said.

Medalla said the difference between the current rate of 7.5 percent on FCDUs and the proposed uniform rate of 10 percent was also not large enough to induce flight of foreign currency deposits to other countries.


Chief News Editor: Sol Jose Vanzi

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