9002yraurbeF IN PRACTICE investment climate BUSINESS TAXATION 2.on 48314 Linking Business Tax Reform with Governance Max Everest-Phillips How to measure success Richard Sandall Max Everest-Phillips (M-Everest- Phillips@dfid.gov.uk) is the Senior Why should business tax reform aim for better governance? This Governance Adviser of the Growth note highlights the significance of firms' willingness to pay taxes in and Investment Group in the United Kingdom's Department the context of state-building--both as an end in itself and also as an for International Development essential component of sustainable investment climate reform. State (DFID). He leads DFID's Tax Task Team on the importance of taxa- legitimacy, taxpayers' willingness to pay (based on their intrinsic "tax tion for international development. morale" and the translation of taxes into public goods and services), Richard Sandall (R-Sandall@ dfid.gov.uk) is the Private Sector and the effectiveness of tax administration are integral to any tax Adviser in the Investment Climate system. This note suggests diagnostic steps to measure key influences on Section of the Growth and Invest- taxpayers' willingness to pay, offering a baseline for judging progress on ment Group in DFID and is a member of the Tax Task Team. the sustainability of all tax reforms. This note is one in a series on business taxation reform. It was Business taxation as Good governance delivers good tax systems. developed under a joint program governance Revenue collection depends on efficient of DFID and the World Bank administration, trust in government, and Group's Investment Climate Governance and taxation are mutually politicalstability.Withoutthesepre-conditions, Department (CIC) business taxa- reinforcing. Governance shapes tax systems, fair, effective, and efficient tax systems are while how taxes are raised influences the difficult to develop. tion product team, which helps creation of effective state institutions and the governments implement effective dynamics of the investment climate and Better tax systems deliver better governance. tax systems to spur investment economic growth. Investment climate reforms How states obtain revenue affects the quality of and economic growth. of the tax system should aim explicitly at a their governance. Sound and fair domestic virtuous circle: taxation that reinforces both taxation systems promote good governance The IN PRACTICE note series state legitimacy and institutional effectiveness, because raising tax efficiently requires the which in turn improve tax compliance by consent of the tax-paying population. The discusses practical considerations increasing taxpayer consent and reducing the process of political bargaining between and approaches for implement- costs of tax coercion. government leaders and taxpayers legitimizes ing reforms that aim to improve taxes and the state in the eyes of citizens, the business environment. IN The linkages between governance, taxation, increases the state's capacity to collect and PRACTICE is published by the and the investment climate are reflected in administer taxes, and strengthens the Investment Climate Department of three key dynamics: accountability of government to its citizen- the World Bank Group. taxpayers. Governments then have the incentive to Fiscalsocialcontract.Acceptanceoftheobligation promote broad economic prosperity. Negotiation to pay tax empowers parliaments, civil society with taxpayers leads to better public expenditure (including business associations), and the media to policy. play an essential role in scrutinizing government revenues and expenditures. Governance and tax systems shape the invest- ment climate. Developing country governments Accountability. Tax compliance depends on the confidence of the taxpayer that tax revenues Factors in often depend on narrow tax bases and coercive will be used fairly. Confidence is built through Analyzing tax collection. The often small formal sector transparency. Quasi-Voluntary typically bears heavy financial and time burdens Compliance in complying with tax obligations. These burdens create a strong disincentive to investment and Politics. Unless the political process creates participation in the formal economy. Dominant citizens' willingness to pay tax, politicians have no Structural enterprises may be politically powerful vested incentive to broaden the tax base to non-taxpaying Fiscal constitution: interests with the capacity to secure tax exemptions. voters (called the "Devil's Deal"). legitimacy as consent to Micro and small firms can disappear into pay tax. informality. As a result, medium-sized businesses The state also creates an instrumental willingness may emerge as the most politically crucial to pay tax by delivering the services needed by its Trust in government: constituency for fair and effective tax reforms. citizens. Tax compliance is low in many developing perceived justice and Middle-sized companies, in environments where countries where citizens neither believe govern- fairness. they shoulder a disproportionate share of the tax ments act in their interest, nor trust the state to use Cultural and social burden, are potentially most concerned about revenues wisely. In Latin America, for instance, less norms: attitudes to rule effective public services and have the capacity than 25 percent of the population believes taxes are of law. to mobilize politically. However, where they well spent. Such lack of trust perpetuates a vicious suffer the disproportionately heaviest tax burden, circle--low trust undermines a weak legitimacy Corruption: informal tax middle-sized firms have little incentive to grow the of the state in the eyes of citizens, making tax substitutes for the formal. economy and every incentive to break up and try collection less cost effective, necessitating more Systemic factors: for to disappear. This undermines growth prospects coercive tax collection that further undermines example, high tax rates, and broad-based political mobilization by the trust and reduces the likelihood of the efficient the total amount of the private sector. provision of public goods and public services. tax take, and compliance "Quasi-voluntary tax compliance" extends the costs. State legitimacy matters to the private sector concept of legitimacy from both the intrinsic Individual and instrumental willingness to pay tax to the taxpayer's overall perception of fairness of the Norms and values: these State legitimacy is a fundamental influence on shape the citizen's view of intrinsicwillingnesstopaytax,alsocalled"taxmorale." tax system. Taxpayers will evaluate taxation: i) in providing public goods that benefit the citizen the state. Business-owners as citizens will actively seek to avoid paying tax to a state they do not believe in. The more efficiently (at a reasonable cost); ii) in legitimately Perceived risk of legitimate a state is in the eyes of its citizens, the less and effectively exercising state power; and iii) in detection: cost/benefit a regime requires coercion to raise tax. An increase reflecting legitimacy in the tax authority's powers ratio of evasion. in trust in government increases citizens' tax morale. of enforcement (not unaccountable coercion) and capacity to make all taxpayers shoulder their Skill base: formal Business tax reform programs can too easily focus on employment opportunity. technicalfixes;thatis,theytargetthedetaileddesignof fair burden. The actual level of tax compliance is taxes rather than the political attitudes toward paying the combined outcome of the intrinsic and the Private Sector taxes. These links between legitimacy and business tax instrumental willingness to pay tax, along with taxpayer acceptance of the level of tax burden and Labor market: ease morale matter for the sustainability of any tax reform. of work in informal the effectiveness of enforcement. economy. Tax is at the institutional roots of legitimacy for four key reasons: How to tackle business tax Sector-specific: for reform as state-building instance, degree of Representation. Paying taxes encourages collective competition. participation in and oversight of government through The following six steps address the operational participatory democratic institutions. implications of applying the tax-as-state-building IN PRACTICE BUSINESS TAxATIoN 2 approach to improving governance, growth, and compliance is also shaped by governance capacity the investment climate. in the tax authority's enforcement capability, which has two dimensions: i) taxpayer acceptance 1. Understand the politics of taxation. Tax is of enforcement as a legitimate and effective always highly sensitive, and it draws attention exercise of state power (tax morale), and ii) to the political power of vested interests. Tax perceived fairness and effectiveness of the tax structures represent the outcome of the political authority based on the taxpayer`s experience and process--good technical solutions are not perceptions of the extent of other taxpayers' levels enough. For instance, political choice limits tax of compliance. These factors can create a virtuous simplification; the more advanced democracies circle of mutually reinforcing trends towards have the most complex tax systems. consent and higher effectiveness, or a vicious 2. Analyze quasi-voluntary compliance. This Diagnosing Quasi-Voluntary Compliance analysis should include relevant factors at the structural, individual, and private sector levels (see sample list of factors, opposite page). The Step 1: Assess Instrumental or "Cost-Benefit" Willingness to factors can be based on taxpayer perceptions Pay Taxes (such as trust in government and perceived risk high Limited Effective and consensual of detection), systemic characteristics (such as the consensual compliance tax rate), and actual market dynamics (such as the compliance; degree of competition). Taxpayer ineffectual perceptions of enforcement utility of public 3. Diagnose the potential willingness to pay goods and low No voluntary Effective but coercive tax. How taxpayer attitudes to the state influence services compliance; compliance ineffectual willingness to pay tax is the least understood but enforcement most fundamental dimension of compliance. This dimension emerges from taxpayers' assessment low high of the overall quality of governance at the instrumental and intrinsic levels (see figure). Taxpayer perceptions of costs of evasion/risks of coercion At the instrumental level. Taxpayers assess government capacity to deliver the fiscal social contract--the instrumental side of governance in providing essential public goods such as security Step 2: Measure Intrinsic or Voluntary Willingness to Pay Taxes and core services such as infrastructure, health, (Tax Morale) and education. high Limited High voluntary compliance At the intrinsic level. Taxpayer perceptions of the voluntary Taxpayer compliance legitimacy of the state, called tax morale, combines perceptions of politicalacceptanceofstateauthority,theperceived state legitimacy low No voluntary Limited voluntary compliance fairness and effectiveness of state institutions, and compliance trust in public institutions and officials. low high The development of the fiscal social contract Taxpayer perceptions of the fairness of the tax authority depends on the tax relationships with small and medium-sized businesses. How SMEs and For each step, determine a low/high level along each axis in the grid, and then locate the the informal sector develop social responsibility quadrant that reflects the intersection of these scores: to pay taxes will shape their political incentives Step 1 determines the taxpayer cost-benefits of compliance (the likely benefits from the to mobilize around taxation and compliance. resulting provision of public goods) and the possible risks (detection/fines) from an Broadening the tax base means politicians must effective tax authority; tackle the "Devil's Deal." Step 2 measures taxpayer perceptions of the fairness of the tax authority combined with 4. Diagnose quasi-voluntary compliance. general acceptance of the legitimacy of the state. As shown in the figure, the degree of actual The overall outcome (the combined outcome of Steps 1 and 2) is the level of quasi- voluntary tax compliance. IN PRACTICE BUSINESS TAxATIoN 3 Objectives of Tax Reform Design to Strengthen Governance fairness of the tax system. Survey results clarify the Transparency extent of quasi-voluntary compliance, revealing Constrain the discretion of tax collectors and reduce corruption the governance issues underlying tax reform and by publishing consistent and accessible tax regulations, rates, and offering a baseline for measuring progress. procedures. When higher compliance strengthens effective enforcement, a virtuous circle of mutually Foster public-private dialogue on tax through a formal process of reinforcing taxation and governance emerges, private-sector engagement with government on tax policy. enabling tax authorities to focus attention Create visible links between taxes and expenditure; compliance rates efficiently on high-risk categories of taxpayers. increase when citizens and firms know how taxes are used. These types of surveys are well established for Conduct taxpayer education and outreach--including to small Organisation for Economic Co-operation and business and the informal sector--on the benefits of working in the Development countries, but are nascent in formal economy, and strengthen incentives to do so. developing country contexts. However, surveys may be controversial in countries where the Change perceptions through improved outreach, services, and political contest is oppressive and tax authorities public-private dialogue to engage the private sector in the reform are unwilling to invite criticism of their integrity, process from the outset. public acceptance, and effectiveness. Accountability 6. Pay attention to micro and smaller enter- Ask business and taxpayer associations, along with parliament, the prises. Small and medium-sized enterprises are the media, and civil society, to participate in tax policy formulation and missing link from narrow tax bases with widespread implementation. informality and weak citizenship to effective, legitimate democracies constructed on broad-based Make tax administration accountable through a complaints and appeals procedure. tax systems. The development of the fiscal social Fairness contract depends on the tax relationships with smaller firms. How these firms and the informal Broaden the tax base and reduce exemptions to increase sense of sector develop social responsibility to pay taxes will justice. shape their political incentives to mobilize around Effectiveness taxation and compliance. Broadening the tax base means politicians must tackle the "Devil's Deal." Simplify law, regulations, and administration where possible. Conclusion circle of increasing coercion, higher collection The World Bank Group's Investment costs, and declining effectiveness of the tax system. Climate Department (CIC) is the op- Effective, efficient, and equitable business taxation requires the private sector's willingness to pay erational center for IFC's Business En- 5. Conduct taxpayer perception surveys. taxes. Business tax reforms depend on governance abling Environment Advisory Services Understanding attitudes towards the level of tax context and contribute to improving it. Measuring and FIAS, the multi-donor investment morale, the effectiveness of the tax authority, perceptions affecting the governance aspects of climate advisory service. CIC assists the and the resulting extent of compliance provides taxation is an important diagnostic, offering a an essential diagnostic of the political realities governments of developing countries baseline for building a culture of tax compliance. for reform. It also offers a baseline for measuring and transition economies in reform- Based on the diagnostics and survey results, tax progress on all aspects of tax reform success, not reform design should promote transparency, ing their business environments, with least on tax morale and state legitimacy. Attitude accountability, fairness, and effectiveness (see box, emphasis on regulatory simplification and perception surveys of current and potential above left). and investment generation. The find- taxpayers identify perceived weaknesses in the ings, interpretations, and conclusions included in this note are those of the authors and do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. www.FiAS.neT