Cameroon - A Tax Reform Strategy (Vol. 1 of 2) : The Summary and Recommendations

OFFICIAL DOCUMENT CONFIDENTIAL Report No. 10036-CM SUMMARY AND RECOMMENDATIONS A TAX REFORM STRATEGY FOR CAMEROON I /i(9 I - OVERVIEW 1. Fiscal strategy is central to the attainment of financial stabilization and sustainable growth in Cameroon. An overhaul of the entire tax system is required to arrest the deterioration in government revenues, to correct the incentive environment for economic activity and to preserve the nation's critical resources. Piecemeal changes or increases in tax rates will yield little revenue and only at the risk of introducing greater distortions which would threaten sustainability of revenue in the longer term. 2. Non-oil revenues are currently ten percent of non-oil GDP and falling, whereas a reasonable medium-term target would set this ratio at closer to 15 percent. This tax effort is among the weakest in the region and the level of public revenues is so low as to threaten the Government's ability to maintain even the highest priority public expenditures. In addition, the level of the budget deficit is inconsistent with macroeconomic stability and a sustainable debt burden. 3. This report evaluates the Cameroonian tax system with respect to the traditional public finance criteria of equity, efficiency, simplicity and administrative feasibility. Efficiency is evaluated relative to the objective of minimizing the effect of taxes on economic behavior, including savings, investment, production and individual work. Equity encompasses three concepts: horizontal equity refers to the equal treatment of taxpayers with the same amount of income regardless of its source, vertical equity relates to the differential treatment of taxpayers as a function of their ability to pay while inter-generational equity has to do with the proper valuation of the welfare of future generations in today's consumption and production decisions. The report also explores the contribution that the tax system can make to sustainable development by raising issues regarding environmental protection; the rural- urban terms of trade and the pace of internal migration; and, in general, the role of the tax system in helping to shape the economic and social choices which will determine the nature of Cameroon's adjustment in the next ten years and more. 4. The report seeks to construct a blueprint which indicates where the tax system should move in the longer-term and which provides guidelines for shaping immediate actions. The aim is to design a staged program which takes into account the urgent need to raise revenue while moving the overall system toward greater efficiency and a fairer post-tax income and wealth distribution, as well as addressing the resource and sustainability issues. While recognizing the importance of tax administration, the report focuses principally on the design of a tax policy reform; additional work will be required in identifying the implications of the proposed reforms for tax administration. 5. The agenda for tax reform in Cameroon is daunting as no less than a complete revamping of the general tax system is required. Priorities will therefore need to be established for the implementation of reform proposals taking into account the country's limited administrative capacity. The timing and sequencing of reforms will have to be carefully engineered to take into account the country's revenue needs and the implication of changes in one set of taxes on the structure of another. 6. Priorities for reform include the redesigning of the system of trade and indirect taxes. The stages of reform for both set of taxes will have to take into account the evolution of relative prices in the Cameroonian economy; specifically, the introduction and the phasing-in of the value-added tax will be a function of revenue requirements in the short term as well as the administrative capacity to prepare and implement this reform. The overhaul of the system of personal taxation is important both from the equity and the efficiency perspective. While this reform, including its integration with the corporate tax, should be initiated as soon as possible, its implementation can and should be phased-in over 3-5 years. Most proposals for changes in the orporate income tax can be undertaken without much disruption or administrative cost. Sequencing issues arise with regard to tax expenditures (through the Investment Code or other legal/contractual arrangements) which should be eliminated once the general tax regime has been reformed. Similarly, while the reform of registration taxes and duties would alleviate administrative burden, this is not a top priority and should be undertaken once the indirect tax system has been reformed to make up for revenue shortfalls. 7. Forestry tax reform is urgent if this important resource is to be preserved and government rent maximized. The fiscal agenda also needs to be coordinated with the legal and institutional reforms currently underway. Certain aspects of taxation/pricing in the Uetrlup sector need to be modified urgently to encourage investment in exploration and increased efficiency at the refining stage. A revamping of urban taxation with the objective of decentralization can only be undertaken once a functional system of property taxation has been established. Agriculture sector txaion is a thorny and important issue but not a top priority in the first phase, especially since the sector continues to be taxed implicitly on account of the current relative price misalignment. 8. The following sections provide, for each of the main category of taxes, a summary of: i) the current system; ii) the failings in meeting the efficiency, equity and administrative enforceability criteria; iii) the recommendations for reform; and iv) the impact of proposed reforms. II. CORPORATE TAXATION i. Current System. 9. Corporations operating in Cameroon are subject to the minimum presumptive tax and the corporate profits tax, which is assessed on realized profits. In addition, corporations withhold at the source the proportional tax on income from securities and the tax on royalty and other payments made abroad. Despite sharp declines since 1985/86, the oil sector still accounts for about 40 percent of corporate taxes. Corporate taxes from other companies represented 10 percent of non-oil revenues or about 1 percent of non-oil GDP in 1989/90. 10. The rate of the corporation tax is 35%, plus 10% earmarked for local government, yielding a total tax rate of 38.5%. The minimum tax is paid at the beginning of a fiscal year by all corporations regardless of level of profits at the rate of CFAF 600,000. Final tax liability is computed as the normal profits tax, or 1 percent of turnover, or the initial minimum flat payment, whichever is higher; the initial payment is credited against this liability. Dividend distributions are subject to the proportional tax on income from securities and are aggregated into the recipient's total personal income for the purposes of the progressive surtax on total personal income. The proportional tax rate is 15 percent (plus centimes additionnels) and is withheld at the source by the company. Interest income is subject to the same tax with varying rates depending on the borrower and the savings instrument. Royalties and other payments made abroad are subject to the special tax on revenues at the rate of 15%. - iii - ii. Issns 11. While the central features of the corporate profits tax compare favorably with current best practice, the rules regarding the calculation of taxable profits are unnecessarily complicated, due in large part to the lack of coherence and integration between business and personal taxation. The partial and differential taxation of capital income, on the other hand, creates distortions in corporate finance decisions, with a bias in favor of debt over equity financing and in favor of certain forms of debt and equity over others. Finally, the treatment of in-kind benefits raises questions of both equity and efficiency. iii. Recommendations. 12. The principal recommendations are summarized below: - the corporation tax should be retained in its general form, with a tax rate of 35 percent on profits. - the tax on royalties should be maintained as it is one of the few ways in which foreign companies are taxed on income earned in Cameroon. - the lack of integration between business and personal taxation should be addressed through broad-based reform that would set the corporate tax rate equal to the top rate in a unitary progressive individual income tax. This would imply (for high-income individuals at least) that wages, capital gains, dividends, and any other form of business income paid out to individuals would be accorded the same tax treatment as earnings retained in the firm whatever the legal form of organization of the firm. - the deductibility of interest payments should be maintained while all interest earnings are taxed as personal income; the current system of withholding should be maintained but at a rate of 35%, with taxes withheld being credited against total personal income tax liability. In order to avoid a possible increase in lending rates with the proposed widening of the base and the increase in rates, the tax on the distribution of credit (1 percent on all bank loans) should be eliminated. - double taxation of dividends should be eliminated in the longer term, once the revenue constraint has been relaxed. This should be done by exempting dividends, which constitute a non-deductible expense, from taxation at the hands of the recipient; alternatively, dividends can be made deductible at the corporate level or individuals can be credited for the dividend tax paid at the corporate level. In the short term, given the acute revenue constraints, dividends would continue to be subject to a 15 percent withholding tax and would be incorporated in personal income for the p-,rposes of the individual income tax. - iv - all forms of capital gains should be taxed under the personal income tax, inter alia, in order to treat new shares and retained earnings symmetrically. the allocation of reserves from pretax profits should be permitted only under the adoption of an "all events test"; that is, pretax reserves should be permitted only when all events have occurred that establish with certainty me existence and amount of an otherwise deductible liability for which the reserve is to be accrued. the current system of linear depreciation should be maintained, with specific incentives for new investment being provided for the time being through the Investment Code; a specific study should, however, be undertaken to assess the feasability of immediate (or partial) expensing of all capital items. in view of the difficulties of assessing the market value of in-kind benefits, it is recommended to disallow the deductibility of these expenses for the company and exempt such income from taxation at the hands of the recipient. it is recommended to maintain the patente since this tax is generally well accepted by the population, is well-suited to informal sector taxation, is administratively simple, and represents a substantial source of revenue for local governments. However, activity categories and rates should be updated and the two tables in the Tax Code should be merged into one. the sales tax aspect of the minimum tax (i.e. 1 percent tax on turnover) should be eliminated with any consequent revenue shortfall made up in the choice of rates for the proposed general turnover/value-added tax. The minimum flat tax should be converted to a minimum corporation tax prepayment (paid in quarterly installments) by introducing refundability when actual liabilities are lower. tax payment, which is currently based on the previous year's actual profits, should be done on an installment basis (quarterly) during the current year based on esilmated profits. This switch will require a phase-in period in order to reduce the cash flow burden on enterprises. while inflation levels have historically been moderate, following a real exchange rate realignment, provisions may need to be made to introduce indexation. Such indexation of the tax base could be triggered when annual inflation levels consistently exceed 20% and would typically extend to depreciation, interest, inventories and capital gains. the forms required for tax filing should be radically simplified, relying as much as possible on standard financial statements of corporate taxpayers. A further level of simplification should be available to smaller incorporated businesses. -v- - the Investment Code should be viewed as a transitional instrument which isolates new investors from the currently unfavorable policy environment. It should be eliminated once the proposed reforms are effectively implemented. iv. Impact of Proposed Reforms. 13. It is difficult to evaluate the impact of the proposed reforms on Government revenues. However, most of the recommendations are designed to enlarge the tax base by reducing deductions and closing loopholes for tax evasion. Such proposals include: the incorporation of all capital gains and all interest earnings in the calculation of taxable income, the integration of personal and business taxes, the limitations on reserve accrual and the elimination of in-kind benefits as a deductible expense. The potential gains from these measures need to be weighed against the revenue loss which would ensue from the elimination of double taxation of dividends. III. PERSONAL INCOME TAX i. Current System. 14. The individual income tax system is based on the conceptual principles of schedular income taxation and is characterized by different partial taxes on different sources of income and a global general complementary tax at progressive rates. In a first step, individual income is subject to an array of proportional taxes, which comprise taxes each with unique schedules based on the functional type of income -- wages, rents, business profits, dividends, and so on. In a second step, the various sources of income are added together and subjected to a global general tax after various deductions. Unlike the proportional tax, the global general tax takes into account the taxpayer's family situation and has a progressive rate structure. The Cameroonian tax system also levies a ii..nimum income tax (poll tax) on all individuals with independent means. Rates vary by region to reflect their relative prosperity as an indicator of ability to pay and the proceeds of this tax are allocated to local governments. 15. Taxes on personal income represent approximately 50% of taxes on income and profits, about 16% of non-oil revenues and 1.7% of non-oil GDP. The progressive surtax and the proportional taxes account each for one-half of personal income taxes. Taxes on salaries constitute the bulk (50%) of proportional income taxes, with income from securities second in importance; both taxes are subject to withholding. 16. Schedular proportional taxes are levied on: (i) wages and salaries (including pensions) exceeding CFAF 25,000/mo at 6%; (ii) profits realized from unincorporated commercial and industrial activities at 22%; (iii) profits realized from agricultural and forestry activities at 15%; (iv) profits realized from non-commercial activities, which comprise mainly the liberal professions at 22%; (v) profits realized from artisanal activities at 11%; (vi) income received from investments in securities at 15%; and (vii) rental income at 20%. The progressive surtax is levied on top of the proportional tax with a view to enhancing the progressivity of the overall system and taking into account the individual taxpayer's family circumstances. The rates range from 0 to 60 percent, with annual income less than CFAF 500,000 exempt. The sum of partial bases of the proportional tax constitutes the gross income subject to the progressive tax. Deductible charges include all direct taxes and interest on debts and loans. -vi- 17. The differential treatment of income depending on its source and the legal form of economic activity has little economic justification, generates horizontal inequity in the treatment of taxpayers and is a source of considerable tax evaion. The pervasive resort to forfaits rather than taxation based on actual income reduces the dynamism of the tax system and attenuates the link between taxation and ability to pay while the system of family splits erodes the intended progressivity of the surtax, introducing a pro-natal balance in the process. In addition, the system is conceptually highly complex and its enforceability compromised by the obligation to file different forms according to a taxpayer's functional income group. iii. Recommendations for Global Reform 18. The proposed income tax system would consist of a flat tax rate on incorporated businesses and a unitary progressive personal income tax with few rates on taxable income, defined to exclude annual income below a reasonable threshold. All schedular taxation would thus be eliminated and income splitting replaced by a system of credits for each dependent. As already discussed, the personal and corporate taxes would be integrated by setting the highest marginal rate of the progressive income tax equal to the corporate profits tax rate (35%), and by eliminating "double taxation" of dividends. This would equalize taxes on alternative means of organizing business and remunerating its owners. The system would be administered primarily through a comprehensive system of withholding at source, and entail a radical simplication of current tax filing requirements. Specifically: - the proposed unitary personal income tax should comprise seven marginal rates: 0% for taxable income less than CFAF 500,000, 35% for taxable income above CFAF 7.5 million and five (10, 15, 20, 25, 30%) interim rates for levels in between. - taxable income should consist of gross income from all sources, including all interest income and realized capital gains, reduced only by ordinary and customary expenses of earning income for which documentary evidence exists. Thus, all presumed deductions and presumed costs of earning income and, all other exclusions, such as for rental income from related persons, would be eliminated. - the tax unit would become the individual, with a credit of 30,000 FCFA for each dependent family member (to a maximum of five) allowed against tax liability. - while the minimum aspect of the personal income tax is eliminated, the minimum income tax, or poll tax, should be maintained. - income should be withheld at source wherever possible. For wages, a schedule of withholding would be provided to employers and each individual would need to file a statement attesting to family status and expected non-wage income. Deductible payments of rent or interest by businesses to any party should be subject to withholding at 35 percent. Distributions of profits would be paid net of the 35 percent corporate tax, which thereby serves as withholding at source. - vii - the system of "prepayment" of corporate taxation proposed above should also be extended to all private businesses, be they subject to presumptive taxes or taxation based on actual earnings. Als9, the thresholds for the application of presumptive business taxation should be reduced to CFAF 5 billion in conjunction with the introduction of simplified filing forms for those with turnover below CFAF 20 billion. iv. Jrerim Recommendations 19. The overhaul of the system of personal income taxation will require some time to implement. In the interim, some measures should be adopted to address issues specific to the different proportional taxes. These measures, which in effect could constitute the first (and partial) steps in a staged program of implementation, are summarized below: - the treatment of in-kind benefits proposed for corporations should also be extended to unincorporated businesses. However, since this does not address the probiers specific to the provision of such benefits by the state, it is recommended that: a) family allowances and indemnities be included in the tax base of civil servants' income; and b) civil servants' in-kind income be incorporated into taxable income, with no overall limit and on the basis of updated presumptive rates which reflect the market value of such remuneration. - the standard deduction of 35% against rental income should be eliminated and replaced with the authorization of deductions subject to documentary evidence. The exemption from taxation accorded to newly constructed buildings (15 years) and to buildings occupied by the parents' or children of the property owner should also be eliminated. - the deductibility of interest charges on personal loans from the progressive surtax should be eliminated. v. Impact of Proposed Reforms 20. The above recommendations are designed to improve the efficiency and reduce the complexity of income taxation, improve the incentive structure by removing biases in favor of certain types or forms of income, ensure that taxpayers with the same amount of income receive equal tax treatment, except for differing family circumstances, and ease the administrative burden through simplified filing, exemption of taxpayers with less than twice per capita income from the tax net and continued use of presumptive and withholding taxes. In addition, an effort was made to improve the progressivity of the system and care was taken to close tax loopholes to the extent possible by integrating corporate and personal income, adopting as comprehensive a definition of gross income as possible and eliminating deductions which are not necessary business expenses. All of these measures should improve the revenue yield of the reformed tax system. 21. Simulations were done to evaluate the impact of the proposed system on government revenues and income distribution. The results show that totad revenues with the proposed - viii - reforms are higher by 27% compared to the current system. This implies an average effe::ive rate of taxation under the new system of 12.4% compared to 9.8% currently. Also the proposed system corrects for the anomalies on the income distribution front with rates of taxation ranging from 0% for the lowest income bracket to 25.8% to the highest (instead of the current 13.7% to 20.7%, after going down to 5.3%). At the highest end, the rate is higher by 25%, and at the lowest end, it is drastically reduced. The middle income brackets expc:ience an increased tax burden which nonetheless remains moderate. IV. TAXES ON WEALTH AND PROPERTY i. Current System. 22. Taxes on wealth and property include annual taxes as well as fees on transactions related to property. The annual taxes comprise the income tax on some forms of realized capital gains, the real property tax introduced in 1988/89, and the tax on corporate assets while the latter include registry taxes on inheritance and other property transfers. These taxes represent no more than 0.2% of non-oil GDP and account for less than 2% of non-oil revenues; the tax on real property represented in 1989/90 less than 3% of revenue from this category of taxes. 23. Capital gains realized by a corporation or a business on the sale of fixed assets are assimilated into regular business income and taxed accordingly; capital gains realized by individuals on the other hand are generally not taxable. The real property tax applies only to properties for which an ownership title is registered and is levied on total surface area with no reference to the property value. Tax rates are very low with a maximum of CFAF 50,000 for very large estates. The registration tax on transfers of real property is applied at a rate of 15% on the value of the transaction being registered. Companies are subject to the tax on corporate assets on the total amount of authorized capital plus reserves (except the legal reserve) as well as on bond issuances. Companies pay an additional duty at the time of company formation or capital increase. The inheritance tax is applied on the net value of the inheritance at progressive rates ranging from 2 to 10%. Gift taxes are assessed on declared value with tax rates ranging from 5% to 15% depending on family ties. Except for the capital gains tax, all of the above taxes are assessed by the Registry Department. ii. Issues 24. The main issue is the ineffective utilization of wealth taxation, an economically efficient fiscal instrument which can also contribute substantially to the achievement of vertical equity. In addition, the partial taxation of capital gains creates potential tax loopholes. iii. Recommendations. 25. The main recommendations relate to the need to improve the assessment and collection of the tax on real property. Specifically: - high priority should be given to the completion of the fiscal cadastre, an essential instrument for taxpayer identification which should improve substantially the real property tax yield as well as assessment of taxes due on rental income, registration fees payable on property * Ix - transfers and capital gains realized from the sale of property. The cadastral survey should be utilized in conjuncQ.on with a system to monitor property market values for the purposes of the application of an ad valorem tax. In the short term, the administration and yield of the tax on real property would benefit from: a) improved cooperation between the Registry Department and the Ministry of Housing and Urbanism; and b) rate differentiation based on improvements and location. - all capital gains accruing to individuals outside the ordinary course of business should be included in taxable income for the purposes of the income tax discussed above. - the tax an corporate assets, which can also be conceptualized as a fee for services rendered or benefits conferred upon enterprises by virtue of their incorporat!on, should be maintained. - the registration tax on the transfer of property should be eliminated once capital gains taxation is effective. - a study of the system of registration duties, stamp duties and taxes should be undertaken to determine the economic justification, if any, for their maintenance in particular as fees for services rendered by the state, Where no such justification exists, these taxes should be eliminated and any consequent revenue losses made up in the design of the system of indirect taxation. iv. Impact of Proposed Reforms 26. The proposed reforms will increase Government revenues from wealth taxes and improve overall income distribution in the country by adding to the tax burden of the richer segments of society. The impact is difficult to quantify and will become noticeable only in the medium term, however, when the groundwork would have been laid for an effective system of property and capital gains taxation. V. TAXES ON GOODS AND SERVICES AND INTERNATIONAL TRADE 27. The structure aad evolution of indirect and trade taxes are heavily influenced by the Customs and Economic Union of Central Africa (UDEAC) treaty. The margin for manoeuvre for national governments is therefore limited and partial reform is likely to have little influence on the pervasive distortions. This section of the report builds on the framework developed for UDEAC level comprehensive fiscal reform. i. Current System. 28. Taxes on goods and services and international trade represent primarily taxes linked directly or indirectly to the arrangements under UDEAC. They currently account for about 60% of non-oil revenues and represent 6% of non-oil GDP down from 8% in 1983/84. In nominal terms, revenues from international trade and the domestic turnover tax were halved - between 1985/86 and 1989/90; their share in non-oil revenues declined from 50% to 32% in the same period. 29. Domestic goods and services are subject to the turnover tax (ICAI), which has four rates besides zero with most activities being taxed at 9% plus the 10% surcharge for municipalities; the ICAI is due on sales at each stage in the processing of a product. Excise taxes include the special tax on petroleum products since 1984/85 and a 15 percent consumption surtax, introduced in February 1991, on beer, soft drinks, cigarettes, certain electrical applicances and light vehicles. Customs duties are composed mainly of four separate taxes yielding rates that range from 0 to 222 percent. The four taxes, of which the first three comprise the common external tariff of the UDEAC are: the customs tariff, the entry duty, the import turnover tax (TCAI) which is a flat 10 percent on the duty inclusive cif price and the complementary tax (TI), which is set by Cameroon rather than by UDEAC. 30. Many industrial firms benefit from special production regimes which include the UDEAC axeuni-que (TU) system and its Cameroonian relative, the taxe intdrieure A Ia production (TIP). TU status is negotiated with the UDEAC secretariat and applies to sales throughout UDEAC while TIP status is accorded by the national authorities and applies only to sales in Cameroon. The TU regime was designed to promote manufacturing activity to supply the regional marketplace; it is granted to firms exporting or likely to export manufactured goods to other UDEAC countries. For a firm with this status, the taxe unique replaces all border taxes and indirect taxes on inputs and outputs, except the new excise taxes. TU rates are negotiated on a firm-specific basis. As a result different firms may pay different rates for the same product. For the same firm, different rates are applied to a product depending upon the country in which the product is consumed. And, of course, any given firm may pay different rates for its various products. 31. Imports of enterprises benefitting from the 1984 Investment Code or from a regime stabilise and imports under public contracts also enter t6e country tax-exempt. In addition, goods falling into the categories of temporary admissions, entrepot or transit trade enter Cameroon without paying any ta?es; in principle these goods are destined for reexport or "importation" at a later stage. As a result of these special provisions, only 36% of imports and no more than 30% of goods arriving at Douala port pay tax. ii. Issues 32. The system of indirect and trade taxes has led to a distorted incentive environment (including a severe anti-export bias), sizeable foregone revenues and excessive administrative complexity. For the turnover tax, the main issues are the cascading nature of the tax as well as the lack of uniformity in the rates applicable on the same products as between imports and domestic production. The customs regime combines high nominal tariff rates with pervasive exemptions resulting in excessive and sometimes firm-specific levels of protection. As a result, the profluability of any venture is at least as much the result of its success in acquiring a prefer;ed tax status as in producing and marketing efficiently. This generates inefficiencies in domestic production, results in horizontal inequities, provides extensive opportunities for tax evasion and introduces unnecessary complexity in customs administration. Customs revenues foregone through perfectly legal means were estimated to be as high as CFAF 100 billion in 1988/89 or 1.5 times as much as revenues actually collected. - xi - iii, flIBndiina 33. While there is often a vonflict or trade-off between the four criteria of a good tax system mentioned earlier - i.e. revenue, efficiency, equity and enforceability -- the Cameroonian system of indirect and trade taxes can be reformed to yield improvements on all these fronts. This could be done on the basis of a reform that simplifies the tax system, broadens the tax base and rationalizes tax rates, improving industrial incentives and raising revenue in the process. Import,nt for achieving these objectives is the clear delineation of the functions of each of the tax it- -rents, with import taxes being used for protection, a VAT or assimilated tax for revenue g%. ation and excises for income distribution purposes. 34. The main recommendations which are summarized below are in line with the agenda developed under the regional SAL. - the TCAI and the ICAI should be abolished in favor of the introduction of a value-added tax (VAT) at a single rate but with exemptions for certain "essential" consumer products. In the medium term, the VA' would be levied on services as well as goods up to the retail level. This reform could, however, be phased, with initial application being limited to goods at the manufacturer and importer level. it this option is adopted, a separate interim tax would have to be created for services. - the TU/TIP schemes should be eliminated urgently; enterprises currently benefiting from these regime should become subject to the ICAI/TCAI until such time as the VAT is introduced. - while the introduction of a VAT would correct for some of the anti- export bias present in the tax system, additional incentives should be provided to export-oriented industries through a drawback scheme, by which import duties are paid on entry and then refunded after export. It is recommended that duty-free zones be situated physically at the port but failing that, always with a firm physical barrier patrolled by Customs personnel. - the tariff system should be simplified (a single rate to replace the four separate taxes) and rates rationalized. Given the overvaluation of the currency and the precarious fiscal situation, the tariff reform should increase the average tariff rate (revenue/imports) and maintain a reasonable level of protection for local industry, by combining lower nominal rates with a vast broadening of the tax base. For the longer term, a tariff regime with a single rate pitched at a relatively low level (10-15%) is recommended. For the medium term, a common external tariff comprising three rates is proposed: imports would be classified into three categories: (i) necessities, (ii) raw material and capital goods, and (iii) general consumption goods and luxuries. Over a 5-year period, the rate on category III imports would be progressively reduced to attain a final tariff - xii - structure with rates of 5%, 15% and 35% on category I, II and III products respectively. - a preferential tariff rate should be adopted for intra-UDEAC trade in manufactured products, subject to rules of origin; this rate would be set at 75% of the normal rate. - remaining quantitative restrictions on imports should be eliminated; some transitional arrangements in the form of degressive tariff surcharges may be appropriate for certain products to ease the process adjustment. iv. Impact of Proposed Reforms 35. Simulations were done on the basis of four scenarios (see main report for details), which in effect constitute the successive stages of the proposed reform program. In line with the revenue target established for the simulations, total receipts from the reformed taxes are at least 5% higher than in the base year in all four scenarios. This is achieved by reducing the proportion of imports subject to exemptions from 64 percent in 1990/91 to less than 37 percent in all scenarios. At the same time, the average effective rate on all imports increases while that on currently non-exempt imports declines substantially. The simulations also show that, holding the tariff structure constant, the VAT would have to be pitched at 15 percent and excise taxes at 24 percent to yield the same level of revenues as a turnover tax of 13 percent combined with excise taxes of 15 percent. 36. The tax burden on tobacco and drink companies increases in all scenarios but one while that on other TIP/TU enterprises remains relatively constant. The adoption of a VAT would reduce the tax burden only slightly given that the existing TU/TIP system does a good job of mimicking a VAT for firms that rely on inputs from abroad or from other TU/TIP firms. The proposed reforms will, however, reduce the dispersion in effective rates of protection for domestic production and provide for an improved incentive environment. Also important to note is the reduced role for the customs department in the post-reform era due to the elimination of the TU/TIP regimes and their replacement by the VAT, which would be administered by the tax department. This should ease the administrative burden on customs agents but signals the need to prepare carefully the transition toward a greater role for the tax department. VI. RESOURCE TAXATION 37. In this section of the report, fiscal arrangements in the forestry, agriculture, urban and petroleum sectors are examined not only because taxation of natural resoirces offers a potential broadening of the revenue base, but also because sustainable development in Cameroon requires the appropriate use of its natural resources and protection of its environment. The issues include the appropriate incentive framework for the development of domestic industry, the level of resource rents attributable to the Government as owner of the resource as well as questions of sustainability and inter-generational equity. A. Forest Resources 38. The total forest area in Cameroon is estimated at 22 million ha and contains the largest and most diverse pool of genetic resources known in Africa. Over one hundred - xiii - species are logged in the 7.6 million ha under licence, of which about 600,000 ha are actively exploited. Total production is around 2 million cubic meters annually. Exploitation of forest land requires a licence which is granted for a 20 year period. The Goverment recently decided to set aside an area of 6 million ha in the south-east, freezing the allocation of any further concessions, while new conservation, land use planning and management arrangements are explored. i. Current system. 39. In addition to the economy wide taxes, forestry activities are subject to a number of special taxes. These include: one-time taxes such as the licence fee and the exploration tax; annual area taxes comprising the county tax, the reforestation tax, the social contribution and the forestry development tax, for a total of CFAF 98/ha; a logging tax (based on volume) at 5% of the posted value of logs; and export taxes assessed at 40% of the posted value for logs. Forest revenue (around CFAF 2 billion annually) is allocated to three special accounts in addition to the Treasury, with the latter receiving no more than one-sixth of the total. ii. Issuos 40. The most important issues relate to the low level of taxation of the sector (collection rates are even lower) and the inability of the administration to ensure proper forest management. The tax burden is light especially when compared to the value of the output and to the rent which should be derived from the resource; area fees have been eroded by inflation while posted prices, which constitute the tax base for the logging and export taxes, have fallen substantially behind prices in the international market. Collection rates are low because forest fees are cumbersome to administer, requiring tallies and physical measurement of felled logs which are often infeasible. In addition to sizeable foregone revenues for the Government, the undervaluation of the resource and the absence of effective monitoring result in wasteful and environmentally damaging forestry practices. The combined effect of destructive logging practices and burning and clearance for the expansion of agriculture is that an apparently renewable resource may prove to be non-renewable, entailing irreversible loss of bio- diversity, of habitat for forest dwellers and of an exploitable economic resource capable of contributing to the growth of industry and exports. iii. Recommendations for Global Reform 41. It is proposed that the Government move to a radical reform of forest taxes along with a revamping of management and institutional arrangements in the sector. Specifically: - an annual concession rent should be instituted as the major revenue source to replace the current plethora of small forest fees; the export tax on logs should be maintained at least in an interim period. - a proportion (10 percent) of the annual concession rent should be allocated to the communities resident in the concession area. - the level of the concession rent should be set by competitive bidding to ensure that the Government receives the current market value for exploitation of the resource subject to the restrictions in the management contract (see point below). A minimum acceptable bid - xiv - should be established to serve as a barrier to collusive bidding and a pre-selection process may be appropriate to vet past performance of enterprises participating in the tender. - management concessions should replace the present logging concessions and each concession should have a forest management plan; - inspection of concessions should be undertaken by private firms, selected by international competitive bidding, on behalf of the Government. - holders of existing concessions should move to a system of annual rent payments by raising the rates of existing taxes and fees, and offering the holders a choice between paying the higher fees or an annual rent calibrated to be in line with average rents per hectare in new concessions. iv. Interim Recommendations 42. In an interim period when the above reforms are being prepared and inventories of new concessions drawn up, revenues from the sector can be increased and the system simplified, even while retaining the principal elements of the current arrangements. To this end: - the numerous area taxes should be combine into a single one; - the posted values should be brought in line with market prices, combined with a revision in the rate of logging and export taxes if necessary. In light of the unreliability of declared fob prices due to prevalent transfer pricing practices in the industry, a study should be undertaken to determine appropriate price indicators. These would be used to update regularly posted prices; they would also serve to determine the export tax on logs as well as the reservation price for concessions under the proposed system. - all revenue from forest taxes should go directly to the Government budget, abolishing the current system of tied revenues. v. Impact of Proposed Reforms 43. It is difficult to estimate the level of revenues that the proposed system would generate as it would be dependent on an auction process, the amount and value of forest land the administration decides to let out, and costs associated with extraction. However, it is clear that revenue from the sector can be substantially increased, especially if the rents which previously escaped are captured. At a minimum, revenue neutrality could be assured by setting the reservation price for the auctions at the level of revenues generated by the current system. - xv - B. AgricUltural Taxation 44. Cameroon has a rich endowment of fertile agricultural land an a favorable climate over much of the country. It produces for domestic consumption and export a variety of food crops, livestock, coffee cocoa, cotton, bananas, tea, palm oil and some horticultural products. Recent measures to price inputs and export crops at world market levels, together with the over-valued exchange rate, have severely depressed rural incomes; a shift out of export cror" is discernible. i. Current system. 45. The agriculture sector is lightly taxed, especially since the removal of export taxes on agricultural commodities. There remain the poll tax, the cattle tax, and direct taxes on personal and company income derived from agriculture. The schedular personal income tax is at a flat rate of 15 percent; the bulk of taxation, however, is presumptive, based on a number of factors including the kind of crop, area planted, and quantity harvested. ii. Issues. 46. Relative prices as between agricultural and urban industrial activity are seriously biased at the current exchange rate, with consequences for the relative profitability of agricultural activities. This contributes to rural-urban migration, which strains the inadequate urban infrastructure, raises unemployment and deprives rural areas of productive workers. A second issue is the difficulty of taxing the rural sector efficiently. Assessment of income and collection and enforcement of income taxes in rural areas are particularly problematic: the forfait system cannot work adequately in the absence of a cadastre of agricultural land; and taxation of marketed output and or inputs, while practical, gives economically inefficient signals. iii. Recommendations. 47. The relatively light tax burden on agriculture can be seen as some kind of compensation for the artificially low returns to economic activity in the sector, reducing the distortion in relative prices from which it suffers. In the short-run, therefore, no recommendation is made to increase substantially the tax burden. Instead: - privileged tax regimes (TU, TIP) designed to promote industrial activity should be renounced as soon as possible. - enforcement and collection of existing taxes, in particular from the modern sector agricultural enterprises, should be improved. - the tax on exports of agriculture commodities should be reintroduced as a proxy to a progressive income tax. Export crops would thus be taxed only when prices on the international market exceed a threshhold, taking into account the level of the real exchange rate; this would be done with a progressive rate structure designed to capture part of the rents which would accrue to exporters and farmers. - xvi - 48. In the longer run and in the context of creating rational incentive structures for resource management and for safeguarding the environment, taxation of land is attractive both from the efficiency and equity perspective. The appropriate valuation of land would help create incentives for more intensive cultivation and higher productivity, and inhibit encroachment on forests. To this end, * land should be taxed based on the potential value of production, taking into account access to amenities (e.g. water supply, access roads) and proximity to market and export centres. Once the rural-v. )an terms of trade have been redressed, the existing system of presumptive taxation would bc upgraded into a full tax on productive value and applied, in the first instance, at a low rate to modern sector agricultural enterprises. Its extension to the country as a whole would follow on from the establishment of a cadastre and land register. iv. Impact of Proposed Reforms. 49. It is expected that in the medium term, the proposed land tax would increase government revenues from the agriculture sector while promoting a more efficient exploitation of natural resources. In the interim, revenues from the sector would increase substantially only with a recovery in the international prices of export commodities. C. Urban Taxation 50. The urban proportion of the population in Cameroon is expected to increase from 40 percent currently to 50 percent by the end of the decade. The largest cities are Douala (about 1 million) and the capital Yaoundd (about 0.8 million), followed by the regional centres of Bameda, Bafoussam, Ngaoundere, Garoua and Maroua. Conditions in most Cameroonian towns are worse than in comparable middle-income developing countries, with unpaved streets, inadequate drainage and other facilities, and an unhygienic environment. i. Current system, 51. Local government activities are financed through additional levies tacked onto certain national taxes and through purely local taxes, some of which represent in fact user charges. Municipal revenue is extremely low at 0.74 percent of GDP (1986/87). Of this, only about 10 percent represents municipalities' own funds; the remainder is transferred from central Government, mainly through the system of "centimes additionnels". According to this system, the commune receives 10 percent of the turnover tax, the corporate tax, the proportional taxes on salaries, business income, and income from securities, and the progressive surtax on aggregate personal income. In addition, municipalities receive 25% of the revenue from the real property tax. Municipalities' own revenue is of two kinds. "Direct" revenue comprises: i) the poll tax, which is imposed on the economically active earning less than CFAF 25,000 per year; ii) the patente and licenses, whose rates are determined by a complicated system of evaluation of type of business, machinery used, and rule of thumb methods of estimating turnover; and iii) inheritance and gift taxes. "Indirect" municipal revenues cover a wide range of fees and charges including building permits, municipal abattoir and market fees, and charges for rubbish collection and other urban services. - xvii - ii. J e 52. As discussed above, the standard incentives to urbanization are reinforced in the case of Cameroon by the overvalued exchange rate. Thus, the rate of urbanization is faster than would be justified by movements in the real relative returns to economic activity in cities as opposed to rural areas. This bias is aggravated by the tax structure, which provides greater tax shelters for investment in real estate than for productive purposes. Furthermore, because the system of municipal finance does not tax dwellers based on the social costs of urbanization, urban space is treated as a virtually free good. In the process, municipalities cannot fund either the investment or the services necessary to upgrade urban infrastructure and cater for the flow of migrants from the countryside. 53. In addition to the poor collection performance of the general system, on which it is dependent for most of its revenues, municipal finances suffer from the unreliability of disbursements by the central government. Also, some of the indirect local taxes have been eroded by inflation and are currently at levels significantly below requirements for cost recovery. iii. Recommendations, 54. An effective system of urban taxation should: - help fund urban infrastructure in expanding towns and provincial centres; - provide a workable system of cost recovery for urban services; and - help counter allocative distortions by imposing some of the real costs of urbanization; - act as a proxy for progressive inocme and wealth taxation; - improve taxpayer identification in the tax system as a whole. 55. In the short-run, effort should concentrate on the better operation of the existing system through: - improving assessment and collection of the best yielding taxes, including the real property tax. - upgrading accounting standards and enhancing coordination among the departments of Taxes, Registry and Treasury within the Ministry of Finance. - the establishment of a locally based and computerized fiscal register, decentralization of operations, payment of communes for collection services and separation of municipal receipts offices from local offices of the central government. - rationalizing and improving recovery of local taxes by the municipalities. In some cases, tariff increases will be appropriate, in others revenues may be best increased by improving collection rates, including through coordination - xviii - with the electricity and water companies on their information base about subscribers. 56. In the longer run, a decentralized system of finance and expenditure would be appropriate, requiring the redefinition of the central versus the local tax base. The tax on property offers a suitable base for local taxation. Specifically, - the property tax should be assessed on market values; to this end, the fiscal cadastre, which will improve identification of taxpayers, should be accompanied by a system to monitor the evolution of property values. - as soon as the urban cadastre is available, a "taxe d'habitation" should be enacted, proportional to the rental value of each property and levied on the occupant without regard to the tenure arrangement. - a system of central grant finance should be considered to remedy the potential inequality among localities under the proposed system; the system of "centimes additionnels" should be transformed into an equalization fund for this purpose. iv. IMpact of Proposed Reforms. 57. In the medium term, the implementation of the property tax will provide municipalities with a reliable source of finance, enhance the overall progressivity of the system while permitting decentralized decision-making and a more readily perceivable link between taxpayer contributions and public services. The proposals aim to increase resource mobilization from the sector but given recommendations for decentralization, this will have little direct effect on central government revenues. Indirectly, improved taxpayer identification through the fiscal cadastre will also increase yields from other taxes. D. Petroleum sector taxation, 58. Cameroon has modest but valuable reserves of petroleum (crude oil and natural gas). Original economically recoverable crude oil reserves were some 135 million metric tonnes (MMT). Of these, approximately 60 percent have been produced. Oil production started in the mid-1970s, peaked in 1985/86 at 8.942 MMT, and has since been on the decline. Barring future discoveries of new reserves, Cameroon could be a net importer of petroleum fuel by the year 2000. Domestic consumption of petroleum products was 814,000 tonnes in 1987/88, with gasoline and diesel accounting for over one-half of the total. Officially registered consumption has been declining since 1985/86 due to the overall reduction in economic activity in the formal sector and to widespread smuggling from Nigeria. No natural gas is being exploited at present, despite the fact that proven gas reserves, estimated at 110 billion m3, are over 10 times the energy equivalent of the remaining proven crude oil reserves. i. Current System. 59. The petroleum sector plays an important, though declining, role in government finances. Revenues are derived from taxes on the production of crude oil and on the domestic consumption of petroleum products. Together these two sources amounted to CFAF 183 billion in 1989/90, or 38 percent of total revenues. -xix - 60. Taxation of upstream activities is subject to a combination of production sharing and tax-and-royalty arrangements. Under this system, production and operating costs are shared and taxes/royalties are applied in the context of a "mining rent" sharing mechanism which guarantees the contractor a fixed percentage of technical profit. In addition to the particularities of this system of taxation, company-specific contracts include substantial derogations from the general fiscal regime. Prices, including to the consumer, are fixed; since April 1991, gasoline is sold for CFAF 190/1, down from 280. Prices are set according to a schedule which includes: the ex-refinery price; distribution cost allowances; parafiscal levies, including for regional and temporal cross-subsidization; and taxes on petroleum consumption, mainly the excise tax (CFAF 95/1). ii. Issue& 61. Taxation of the petroleum sector is inefficient, complex and non-transparent. The incentives framework is highly unfavorable to exploration activity; the refinery benefits from a monopoly supply position and fiscal stabilization while its operations are subject to a cost- plus pricing mechanism; fixed consumer prices distort choices amongst competing sources of energy while the use of parafiscal taxes to attain social objectives has unnecessarily increased costs to the final consumer without corresponding revenues for the Treasury. 62. The main issue at the exploration and production stages relates to the system of rent sharing as between investors and the Government. The current fiscal regime is regressive, discouraging the development of all but the most obviously profitable discoveries, while encouraging premature abandonment of declining fields. In addition, the complexity of the system reinforces the advantage enjoyed by existing operators, reducing the likelihood that new investors will be forthcoming even with the changes recently introduced. The refinery operation imposes a cost on the country on account of: i) the process of refining itself as opposed to importing (CFAF 8 billion per annum); ii) SONARA's supply monopoly instead of a liberalized system for the procurement of refined crude; iii) refining as a cost-plus operation rather than placing the refinery under an appropriate incentives framework; and iv) setting administered rather than market equivalent prices. Finally, the current level of ex- refinery prices for SONARA imply inter-product subsidization while proceeds from the equalization and part of the stabilization levy are used to subsidize the consumption of kerosene. iii. Recommendations 63. The current legal, contractual and (especially) fiscal framework for exploration and production should strike a fair balance between the resource-generation needs and rights of the state as owner of the resource, and the investor's requirements to earn a rate of return which is adequate in the light of the technical and other risks taken. With a view to increasing transparency in the sector and enhancing incentives for exploration and production, it is proposed that the current framework should be revised. The main thrust of a new system should be: - redefinition of the role of SNH; - new petroleum legislation, separate from the mining law, with a view to consolidating Government policy in one central document and simplifying legal and contractual arrangements in the sector; - xx - - abandoning Government policy of participation in the equity of the petroleum companies. This implies no equity in new companies and the sale of existing holdings; failing the latter, SNH should be asked to remit all dividend earnings from these investments to the Treasury; - replacement of the hybrid productior -sharing plus tax plus "guaranteed mining rent" system, by a simple, clear and flexible one. Production-sharing using incremental ratios changing in function with an approximation of field profitability should be considered; - elimination of all inconsistencies between the common law fiscal regime and tax arrangements included in contractual agreements with the petroleum companies; - development of a state-of-the-art Model Contract which would be used in conjunction with the revised petroleum legislation as part of a promotion exercise and as a basis for negotiations with interested companies; and - assistance in exploration promotion by a firm with successful experience in such exercises. 64. Much can be done to improve the efficiency of downstream petroleum activities while increasing at the same resource mobilization from the sector. Increased competition and greater liberalization are essential to this process. Deregulation of all prices is recommended in the long term; even in the short term, a complete overhaul of the manner in which prices are set is required. The new system should: - provide correct price signals to the consumer, by adjusting the consumer price on a quarterly basis in response to changes of petroleum prices on the international market and in the exchange rate. The policy to subsidize kerosene should be modified on the basis of an analysis of cross-price elasticities with respect to both industrial (gasoil) and household (fuelwood) substitutes. - provide correct incentives to operators, moving away from cost-plus setting of ex-refinery prices which has stifled all incentives for the refinery. These and crude oil prices must be set at import-parity linked levels, with adjustments as necessary. In addition, it is recommended that: a) SONARA's supply monopoly be removed and the refinery be placed in competition with imports; and b) SONARA be allowed to source and purchase its own crude. The first recommendation may need to be phased in over a period so as to allow SONARA sufficient time to increase the efficiency of its operations and reduce its costs. This could be done in the context of a performance contract between SONARA and the Government, which would inter alia include measures to reduce fixed (in particular personnel) costs as part of the restracturing required to become competitive with imports. During the interim period, the ex-refinery price could incorporate a fixed, but declining, margin to compensate for SONARA's inefficiency while imported products could be made subject to an equivalent levy. - xxi - - subject SONARA to the ordinary tax regime before the end of its 25-year long privileged tax status. - simplify taxes by eliminating parafiscal levies and collapsing the fiscal content of the petroleum product price schedule into two items: a fixed ad valorem tax (or VAT) and an excise tax. iv. Impact of Proposed Refoms,. 65. It is difficult to estimate the net impact on Government revenues of the above recommendations. Improving incentives for investment in exploration activity will require a smaller take for the Government from downstream activities; no change in fiscal arrangements may, however, mean declining revenues from the sector on account of declining production with no prospect for new discoveries. Proposals regarding upstream activities, on the other hand, should improve resource mobilization for the treasury without increasing consumer prices through efficiency gains at the refinery stage and through the elimination of parafiscal levies. VI. ADMINISTRATION AND IMPLEMENTATION 66. Even with the best tax administration, the current tax system would be near to unadministrable. However, it is doubtful that the kind and magnitude of tax reforms recommended in this report can be absorbed by the present system of administration. Even though these reforms result in simplification, they also result in change, and it seems unlikely that major change can be implemented without a complete overhaul of tax administration. Recommendations for reform, which would also improve the ability of the tax authorities to administer the current tax system in the short term, are summarized below: - a system of unique taxpayer identification numbers should be set up urgently. - a management umbrella over the entire tax function should be instituted, with responsibility for all taxation, oversight and coordination of the several bureaucracies, and leadership in the preparation and implementation of reform. A deputy minister could be nominated with staff responsible for legislation and legal affairs, training, public information and policy analysis. - the Treasury's tax payment records should be integrated with the Tax Department's liability records on a new computer system recommended for the tax authorities; this would enable systematic follow-up of taxpayers, absent from the current system. - codification of the law, regulations and practice should be undertaken urgently and provisions made for continuous updating. - information dissemination and training of the force of inspectors should be among the regular functions of the tax authorities. Special attention should be devoted to these functions during the preparation and implementation of the proposed reforms. - xxii - - the tax authorities should be provided with their own computing facilities rather than having to rely on the central computing department. A few personal computers in key management locations would also ease bottlenecks and make policymaking much more efficient and responsive. - adequate budgetary provisions should be made for the proper functioning of tax administration.