A comprehensive tax reform program is needed to secure long-term fiscal sustainability and encourage growth in the private sector, the IMF report states. The reform of the territory's tax system will allow the government to gain additional revenues whilst improving the fairness of its tax regime.

The island's budget surplus will be deposited into the Compact Trust Fund (CTF). Income derived from the trust fund will replace the financial support currently received annually from the US government agreement. The mission projects that, in order to accumulate adequate funding in the CTF, the government will have to progressively build up a fiscal surplus of USD9m per year by 2014 (5% of GDP). This surplus would need to be maintained until 2023 and the savings placed into the CTF. The cumulative savings would generate a large enough asset base to close the projected revenue gap in 2024.

Under the current system, it is anticipated that the Marshall Islands will post a budgetary deficit of USD0.2m in 2009, roughly unchanged from 2008.

In discussions with the IMF, the Marshall Islands government has recognized the need for reform and has undertaken important steps to identify necessary policy measures. Two reform commissions, the Comprehensive Adjustment Program (CAP) group, tasked with identifying expenditure reforms, and the Tax and Revenue Reform and Modernization Commission (TRRMC), have prepared draft reports for the government.

On tax reform – the major segment of the necessary reforms – the IMF has observed that the current system has little potential for the generation of additional revenues. “The annual revenue yield of 18% of GDP is much below economies which have introduced more internationally accepted tax regimes (26% of GDP in Samoa and Tonga in 2007). The lower revenue yield potential is the result of the outdated tax system design and low compliance," the Fund observed.

The IMF statement continued:

“[To this end] the tax system should be modernized to increase revenues and enhance efficiency. The existing tax system lacks the ability to raise additional revenue, fails to encourage private investment, and is inequitable. The gross revenue tax (GRT) taxes exports and has a cascading effect. There is a proliferation of small taxes complicating tax administration, and many sources of income are exempt, generating inequity.”

“A comprehensive tax reform program should be adopted. The TRRMC’s proposal should lay the foundation for a modern tax system. The mission recommends that the government adopt a [Pacific Financial Technical Assistance Center]-based proposal guided by two principles: (i) the proposal should be accepted as a uniform package, and (ii) tax rates and thresholds should be chosen to generate additional revenue. Given the amount of preparatory work and time required for implementation (up to 36 months), the mission recommends that new legislation be passed swiftly.”

The reform strategy, agreed by both parties, is centered around four basic changes aimed at raising efficiency, removing distortions, and raising revenue whilst attempting to keep rates low:

• Replacing the GRT and a number of specific business taxes and duties with a broad-based consumption tax, to eliminate cascading, strengthen compliance, and simplify the tax system;
• Introducing a net profits tax for large businesses while retaining the GRT for small businesses. The net profit tax would eliminate tax cascading, remove disincentives for investment, and lead to more equal taxation across different types of businesses; only the largest 25% of businesses would fall under the new net-profit tax;
• Replacing the existing import duties and local government taxes on alcohol, tobacco, motor vehicles and fuel with similar excises, which would make them acceptable revenue sources for regional trade agreements; and
• Taxes on wages and salaries should be modified by broadening the tax base to include items which are currently exempt, modifying and expanding the current tax-free threshold so that it is available to all taxpayers, and introducing a higher tax rate for high income earners.

Concluding, the report also advocated improvements to the tax administration system in place in the country. “Enforcement has been stepped up, but improved capabilities are needed to support the tax reform. Improved audit activities at the social security administration have led to a sizeable reduction in unpaid contributions and improved compliance. Since there are significant gains from harmonizing collection processes and information sharing, the mission supports the establishment of a unified revenue administration as part of the proposed tax reform.”

In the coming year, the IMF estimates the Marshall Islands’ economy will grow by 0.5%. It anticipates that revenues will fall as a result of falling economy activity, but, according to the Fund, this will be largely offset by increased fees from its shipping registry.

The mission has welcomed the government’s commitment to transferring USD2m to the CTF in 2010, but has warned that achieving this goal will be challenging.