Friday, April 25, 2003

Impact of the 2003/2004 Budget on Companies’ Profitability

Now that the new tax package has been announced, it is time for companies to examine its impact on their operations. The question is, “What are the additional costs of operations and how attractive are the investment options?” The measures that will affect most companies are:
· 4% cess on imports;
· 20% GCT on telephone charges;
· Assets tax increase and
· Removal of tax credit on bonus shares

Cess and Telephone Tax
The Minister of Finance in his presentation stated that, “From the perspective of the importer who systematically files returns, this cess would have minimal impact, only so far as it affects his cash flow.” What companies will need to examine are the various effects that this will have on their operations, as the cost of money differs between companies. Whatever the extent of the impact, it is certain to be negative.

The Minister is correct in saying that the measures will affect cash flow. The effect on cash flow and, ultimately, operations could be devastating. The table below shows a typical company, with revenue of $100 per month, a cost of sale of 50% and other costs of 40%. It further assumes that this company invests approximately $200 every quarter in capital goods, imports 80% of cost of sales and has telephone expenses of 2%. The imposition of the 4% cess and additional 5% GCT on telephone charges will reduce this company’s net cash flow position by more than half.

This may be seen as a timing difference as the tax can be recouped in the tax returns at the end of the year and the GCT is reclaimable the following month, but the implications are much greater. Effectively, the company’s cost of capital has increased and a comparison must be made against other investment options. If the company is unable to claim the tax until the following year (for whatever reason) then the additional cost of capital will be approximately 5%. The recent press conference by the Minister suggests that companies will be able to claim this against quarterly filings, which is good, but what of the companies who are carrying forward a tax loss. They will be left with the additional cost of capital and ironically they are the ones who will need the cash flow most.

In our present environment, it would be better to take the additional cash and invest it in bank deposits making 30% before tax. In a rational economic environment, the company would reduce (or eliminate) the quarterly investments in capital goods and place that additional cash in relatively risk-free cash deposits, based on current rates. The implication for the economy is that we may have reducing long-term investments, as companies may only keep cash for working capital purposes. Furthermore, when it comes to retooling, the rational investment decision may be not to reinvest.

The new tax measures, therefore, is not simply a matter of cash flow but becomes a matter of capital and investment decision. What has effectively happened is that the Government will receive a loan to be financed by the private sector, which will be paid back at the time of the tax returns being filed. If we follow the 70:30 ratios, this means that the government will have to raise funds to replace the 70% of tax collections at the time of the returns being made.
The argument put forward by the Minister is that “…of the real economy only 70 per cent of activities are included in the tax net. All are agreed that we must seek to bring this additional 30 per cent into the tax net.” No one will disagree with the intention, but the method seems to create more problems than it will solve. Why stifle the 70% to get at the 30%? What may happen is that the 30% will be brought in at a cost greater than the additional collections, as many companies will not be able to afford an additional 5% on their cost of capital and there will be reduced capital investments.

In addition, new entrants to the market may be even further restricted. It might have been a better solution to increase General Consumption Tax (GCT) and eliminate income tax, as we would achieve the purpose of capturing more of the informal economy and equating the tax burden for the existing taxpayers, as was suggested at the ICAJ forum on April 9th.

These measures are also going to increase the tax burden on the current PAYE taxpayers. Companies may have to increase prices to deal with the increased cost of capital and increased GCT, which will negatively impact consumers. We will, therefore, see a direct impact on inflation from the tax measures announced. The combined factors of reduced investment and increased inflation may in turn have the undesired effect of reducing consumption and economic activity, thereby reducing future tax collections.
It is evident from the reaction of private sector leaders that the confidence needed to drive the economy forward is being eroded. What has been presented are stop-gap measures that cannot be maintained, if we want long-term solutions to the economy. It is similar to a company seeking short-term working capital funding, until revenue inflows become stronger.

The only problem is that we have a “Bridge Financing Budget” without the prospect of the increased revenue flows being outlined. In addition to the above consequences, the following will also have to be considered:

· How are companies that are already making losses or who have tax losses carrying forward, to be compensated? Will this cess increase the tax loss or is a cheque to be reimbursed to companies on a timely basis? It is necessary that this be clarified so that companies can make projections to determine what their options are
· The administration of this cess will no doubt cause the income tax to become an even more inefficient tax. What is the return on the tax dollar from implementing such measures? Will the cost of administering the tax be more or less than the additional revenue collected? What of the increased operational cost to companies of administering this tax?

Tax Credit on Bonus Shares
The removal of the tax credit on bonus shares may also have the effect of reducing investment in capital. Companies may now find it more prudent, in light of lower returns, to pay out profits by way of dividends instead of reinvesting in capital through bonus issues. What this means is that the company who wants to expand may be faced with more expensive funding.

There is no doubt that the new tax measures will have a negative impact on the cash flow, and effectively a company’s cost of capital. This may mean reduced capital investments and profitability. In the long run, this will result in lower economic activity and tax revenues. Companies will have to go back to the drawing board and take another look at their investment options, as the option of business activity is now even less attractive compared to holding cash deposits.

Thursday, April 17, 2003

The Economy’s Performance: An Accountant’s Perspective

Jamaica’s economic performance has been the most hotly debated topic over the past few years. Measurement of economic performance is similar to the way we approach analyzing our own company’s prospects, as many indicators can be compared to the ones utilized by businesses.

Economic Indicators Equivalent Company Indicators
Balance of Payments (BOP) & Trade Financial Statements
Money Cash Flow
GDP and Income Sales
CPI Cost Structure
Labour Human Resources
Debt Ratio Debt/Equity

It is necessary to find objective measurements to arrive at consensus re the underlying problems, which is the first step to finding solutions. Over the years there have been too many emotive analyses of our economic situation and what needs to be done.

I will attempt to do an analysis from an accountant’s perspective. I am not able to reason based on the complicated models our economic commentators use frequently, as the only higher economics learning I have had is from my sixth form teacher, Mark Figueroa (UWI) and Richard G. Lipsey.

The web sites of the PIOJ ( and STATIN ( carries statistics of various aspects of the economy (1997 – 2001), which can be used to examine historical trends and give an indication of where we are heading.

Trade and Revenue
A look at our Trade account shows that between 1997 and 2001 total imports increased by 7.6%, of which consumer goods increased 10.5%, raw materials increased 15.1% and capital imports declined 14.2%. On the other side traditional exports declined 5.1% and non-traditional exports declined 26.3%. The fiscal side shows total revenues increasing by 13.6% (recurrent by 5.9%) and total expenditure increases of 11.2% (recurrent up 21.6%, capital down 3.6% and debt servicing up 76.6%). During this same period increases occurred in the CPI by 38.7%, current prices GDP by 39.1% (constant prices by 1.6%) and GNP by 32.4%.

The above statistics reveal that production and growth increases are fueled by debt. It is also worrying that the increase in GDP, caused by increasing production, does not have at least a corresponding increase in recurrent revenues. One implication of this is that although earnings are higher, there may be no corresponding increases in recurrent revenues as companies are much less profitable. This results in lower tax collections. Additionally, higher revenues are being driven by inflation and not increased productivity or consumption. The country is experiencing what companies saw in the mid 1990s, that is the cost of debt exceeds returns. The declining capital imports imply that retooling is not taking place thus making us even more uncompetitive. The increased raw material import suggests an increasing make up of imported raw materials in production. It would be very interesting to see what portion of exports comes from local value added.

Money Supply and Inflation
The money supply indicators shows increases (1997 – 2001) in M1 by 58.4% (1999 -39.5%) and M2 by 52.7% (1999 – 20.4%). There is, however, no higher productivity to back these increases. In fact money supply increase has surpassed inflation. A look at the numbers reveals that this may have been one of the fundamental drivers of inflation as is shown in the following table.

The table shows that money supply increase always exceeds the inflation rate, with the exception of 2000, when this was preceded in 1999 by significant increases in money supply. Additionally, the 11.48% increase in the exchange rate in 2000 was preceded by the 39.5% and 20.4% increases in M1 and M2 in 1999 and coincided with a sizeable increase in the NIR. What’s more, money supply has increased by rates way in excess of real GDP growth. The implication is that we have created money, with no productive backing, and in fact the exchange rate and inflation changes are caused primarily by increases in money supply. This increase in money supply has been affected by the high interest rates that we have entertained, which in itself creates money, without any corresponding increases in goods and services. The question then is, is inflation and exchange rate movements not caused primarily by money supply increases and not inflation caused by exchange rate movements?

As a country we have had a preoccupation with inflation, coming out of the regime in the 80’s and early 90’s. Inflation is not necessarily an indication that the economy is deteriorating, but may also indicate that the economy is growing rapidly. What we need to determine is the type of inflation we are having. If inflation is caused by productive earnings increases outpacing the availability of goods then it may mean that we are having significant growth, which needs to be controlled. On the other hand, we have inflation caused by increased money chasing lower output. In fact, we could even have deflation caused by reducing income levels (productivity), which would be a bad thing. What is of great importance is stability, wherever that level resides.

Labour and Population
Over the same period, constant prices per capita income has been stable. This means that there has been no real increase in income levels earned by people, and in fact is somewhat consistent with our relative stability in GDP. The education statistics show that between 1997 and 2001, enrolment in primary institutions increased 9% and secondary institutions increased 4%. Over the same period, enrolment in tertiary ones increased 195%. This means that fewer people are able to access secondary education, even though more persons leaving secondary levels are entering tertiary education. This is supported by the increase in training output at the technical and managerial level and decreases in the skilled and semi-skilled categories. This will negatively affected labour productivity, as secondary education is crucial to productivity of our labour force. It is important to factor these numbers into any industrial plan we develop.

Any company in our economic position would not have favourable prospects. Serious analysis and planning would be imperative to address the underlying problems. Businesses, faced with inflationary pressures, have had to increase prices so as not to be overwhelmed by an increasing cost structure. This has resulted in more expensive produce, without any value-added increase.

The reality is that even if we are to experience real growth in all sectors over the next five years, we may find ourselves in the position we were five years ago. This while our international competitors have been experiencing real growth. Before we can solve the problems we first have to agree what they are. I am not sure what the best solutions to our economic problems are, as I am not a trained economist, but from a layman’s perspective I know that we cannot continue to spend more than we earn. Maybe we need to ask the real economists to stand up and not be detracted by the village economists. For too long we have treated symptoms and ignored the illness. Our first priority then remains the need to admit the problems before we can agree on a strategy to address them.