POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise OCTOBER 2010 · Number 36 JUNE 2010 · Number 18 57398 Trade Tax the Competitiveness Agenda Smart and Administration Richard Bird José Guilherme Reis and Thomas Farole The "smartest" development policy needs to be underpinned by "smart" tax policy. However, the best tax policy in the world The global economic crisis has forced a major rethinking of the respective roles of governments and markets in what is worth little if it cannot be implemented effectively. What can be done, to a considerable extent, inevitably determinesthe processes of trade and growth. Indeed, industrial policy seems to be back in fashion--or, at least, talking about into is done. Increasing tax revenues requires an effective tax administration: new taxpayers must be identified and broughtit is. But a renewed new collection techniques developed. Implementing such changes invariably takes return to old-style the tax net, and "activism" by government in the trade and growth agenda need not mean a time. policies of import substitution and "picking winners." Instead, it may mean a stronger focus on competitiveness by unlocking the constraints to private sector­led growth. This note discusses the renewed role of government in trade and growth policy from the competitiveness angle, and it suggests some priorities for the new competitiveness agenda. Three ingredients are essential to effective tax administration: when new tax structures were introduced resulted in very un- political will, a clear strategy, and adequate resources. even tax imposition, widespread tax evasion, and lower than If the political will exists, the blueprint for effective tax ad- anticipated revenue. In some developing countries, corporate ministration is relatively straightforward. The tax administra- tax liabilities are often negotiated rather than calculated as set Export-Led Growth, the Crisis, and the End tion should be given an appropriate institutional form--which out in the law. In some policy environment common trade pacts of the crisis on thecountries, bribery is soregardingthat it of an Era not) mean a separate revenue authority, as dis- may (or may is considered a regular part more apparent. Indeed, in addi- and growth were becomingof the compensation of tax officials. cussed later. It should be adequately staffed with trained offi- tion to raising concerns over the global commitment to trade Such corruption undermines confidence in the tax system, af- The It should expansion in global which usually means an cials. dramaticbe properly organized, trade over recent decades fects willingness crisis taxes, and reduces a country's capacity liberalization, the to payhas also led to some serious rethink- has contributed significantly to diversification, growth, and organizational structure based on function or client groups (for to finance of the conventional wisdom regarding the ing of somegovernment expenditures. How revenue is raised-- poverty large and small taxpayer offices) countries. on a period example, reduction in many developing rather thanThis tax- the effect of revenue-generation effort result of on the is the growth agenda--the most important on equity, which politi- of rapid export growth has been enableduse of modern by-tax basis. Computerization and appropriate by two critical cal fortunes of the government, play a much more activist likelihood that governments willand on the level of economic structural changes in global trade: (1) but these and spatial information technology are important, the verticalimprove- welfare--may in some ways be equally (or principal reasons role in the coming years. There are threemore) important as fragmentation of manufacturing into highly integrated ments must be carefully integrated into the tax administration. how much revenue is likely why governments areraised. to be more actively involved in "global production networks," and (2) the rise of services Putting all this into place takes time, resources, direction, and Tax and trade policy difficult task years. industrial administration is ain the coming even in the best of trade But the growth of "offshoring." as demonstrated turn, effort. and it can be done, and it pays off,Both of these, in by First, and in the has undone faith in markets in developing times the crisis best of places, and conditions and discred- were made possible by to Chile. countries from Singapore major technological revolutions; and ited laissez-faire approaches that rely simply on trade policy countries seldom match these specifications. Assessing the rela- they were supported by multilateral trade policy reforms liberalization. Instead, governments and local markets have tionship between administrative effort and revenue outcome-- and broad Administration Matters Why Tax liberalizations in domestic trade and investment been alone other possible policysense, thesuch as procedural fair- let "rediscovered." In this objectives demand for activist environments worldwide. ness or strengthening go well beyond financial markets and government is likely tostate legitimacy-- is by no means a simple How a tax system is administered affects its yield, its incidence, The global economic crisis came crashing into the middle task. One cannot assess how well a tax administration which regulation, and it will affect the policy environment inis func- and its efficiency. Administration that is unfair and capricious of this long-running export-led growth party during 2008 tioning, let alone suggest how are designed. trade and industrial strategiesto improve it, without taking into may bring the tax system into disrepute and weaken the legiti- and 2009. Between the last quarter of 2007 and the second Second, the crisis has highlighted which it has to function, account not only the environment in the critical importance macy of government. For instance, in many transitional coun- quarter of 2009, global trade contracted by 36 percent. But but also the laws it sectors, products, and trading partners) of diversification (of is supposed to administer and the institu- tries in the 1990s, the failure to improve tax administration as the recovery started to strengthen in 2010 (at least until in reducing the risks of growth volatility. The recent era of the clouds began to form over Europe), the longer-term im- globalization contributed to substantial specialization of 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise tional infrastructure with which it has been equipped. Com- 2. The administration needs a process to determine tax liabilities. plexity and its implications for tax administration have long This may be done administratively (as with most property been a concern even in the most developed countries. Even the taxes) or by some self-assessment procedure (as with most most sophisticated tax administration can easily be overloaded income taxes and value-added taxes [VATs]; see box 1 for with impossible tasks. Such concerns are critical in countries in more information on VATs). Recently, as discussed later, in which inevitably less than perfect administrators are asked to some countries, really "smart" administrations have changed tackle inherently complex tasks in a generally hostile and often the game sustantially by increasingly prefilling tax returns information-poor environment. The life of tax administrators with information obtained from reliable third-party sources. in many countries is made even more complicated by the pro- 3. Taxes must be collected. In many countries, the best solution pensity of governments to alter tax legislation annually, or even is collection through the banking system. It is seldom appro- more frequently. priate for tax officials to handle money directly. Simple exhortations to "do better" are of little use to re- 4. The authorities should provide adequate taxpayer services in source-strapped administrators faced with difficult tasks. Nor the form of information, pamphlets, forms, advice agencies, are the various gimmicks or quick fixes that seem to come easily payment facilities, telephonic and electronic filing, and so to the minds of clever policy designers of much use in resolving on, to make taxpayer compliance as easy as possible. tax administration problems. Experience around the world This approach rests on treating the taxpayer as a client to be demonstrates that the single most important ingredient for ef- served and not a thief to be caught. Unfortunately, the latter fective tax administration is clear recognition of its importance attitude still prevails in many countries. at high political levels and the willingness to support good ad- ministrative practices--even if it is politically difficult to do so. Enforcing compliance Few developing countries have been able to leap this initial Of course, some taxpayers are not honest, so enforcing compli- hurdle. At times, urged by international agencies or simply des- ance and reducing tax evasion are also important tasks. To en- perate to get more revenues, countries have launched frantic force compliance and reduce evasion, the administration efforts to corral defaulters or to rope in new taxpayers without needs to understand the extent and nature of the potential tax hurting politically powerful interests, and without providing base to estimate the tax gap, preferably by sector and type. the time, resources, and the consistent long-term political sup- Without at least some idea of the number and type of individ- port needed to support and administer an effective tax system. uals and firms not complying, no coherent enforcement strat- The widespread reluctance to collect taxes efficiently and effec- egy can be devised. Sometimes the problem is that large groups tively may be understandable in countries that are fragile po- of prospective taxpayers are simply not known to the authori- litically, but without such efforts, no viable long-term tax sys- ties. Or it may be that many taxpayers who are in the system tem can possibly be put into place. If the political will is there, are substantially under-reporting. Without some knowledge of the techniques needed for effective tax administration are not a the unreported base, and its determinants, no administration secret. can properly allocate its resources to improve tax collection and ensure everyone bears at least a roughly fair share of the tax Tax Administration Tasks burden. The three major tasks of an effective tax administration are fa- In addition to exploring the nature of the tax gap and ex- cilitating compliance by ensuring that individuals obligated to tending the reach of the tax system into the informal economy pay taxes are doing so and to try and make compliance easier for to the extent feasible, close attention must also be paid to such the taxpayer; enforcing compliance and reducing tax evasion; simple tasks as ensuring that those who are in the system file on and improving governance to keep tax officials honest and rein- time and pay the amounts due. Immediate follow-up to contact force the legitimacy of the tax system. nonfilers and taxpayers whose payments did not match their Facilitating compliance liabilities is often neglected. Adequate interest charges must be imposed on late payments to ensure that nonpayment of taxes The first task of any tax administration is to facilitate compli- does not become a cheap source of finance. Similarly, an ade- ance: ensure that those who should be in the system are in the quate penalty structure is needed to ensure that those who system, and that they comply with the rules. To do so: should register do so, that those who should file do so, and that 1. Taxpayers must be found. If they are required to register, the those who under-report their tax bases are sufficiently penal- registration process should be as easy as possible. Systems ized to deter tax evasion. must be in place to identify those who do not register volun- tarily. Tax authorities should adopt an appropriate unique Improving governance taxpayer identification system to facilitate compliance and A third major task is to also keep the tax collectors honest. No enforcement. government can expect taxpayers to comply willingly if tax- 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Box 1. An Example: VAT as a Self-Assessed Tax The VAT is often described as a self-assessed tax because To get to this happy position, however, some very once established, it becomes part of standard business fundamental changes in underlying economic and political operations and runs itself. The task of the tax administration conditions may first be necessary--and perhaps unlikely, at is thus not to assess who owes what, but instead to guard the least in the short run. Nonetheless, even with a relatively weak "borders" of the system and verify that those who should be administration in an unfavorable environment, with the right self-assessing are behaving responsibly. VAT, a country may be better off. Almost every country needs a For such a self-assessed tax to function properly, seven general consumption tax, and since the VAT is the best form of preconditions must be in place: such a tax--the one with the fewest bad effects--the case for 1. a simple, clear, stable law, a VAT is strong almost everywhere on administrative grounds. 2. a good taxpayer service, For example, in a poor country with a high import component 3. simple procedures, in its taxable consumption tax base, the tax office no longer 4. effective enforcement, has to prove that a duty-free import had been improperly 5. reasonable audit, claimed. Instead, taxpayers have to demonstrate, by filing 6. strict penalties, and returns, that they were entitled to offset the VAT on imports 7. a good administrative review system. against the VAT on sales. In reality, of course, many developing countries that Because in many countries the informal sector is have VATs do not satisfy many--or sometimes any--of these "fed" largely by the diversion of tax-free imports, stopping preconditions. One cannot take a tax administration out of its this leakage would constitute a major step toward restoring environment, and such factors as the level and distribution the competitive balance between formal and informal of income and wealth, the importance and pattern of sectors. So long as it can identify and track VAT registrants, international trade, the relative size and nature of the informal the country thus can both have more revenue and at the sector, the relative importance of final and intermediate sales, same time stimulate a sounder pattern of development. the prevailing level of trust in government, and taxpayer morale Tax administration can often be a serious constraint on all enter into understanding both the present administrative tax reform, and countries should be both encouraged situation and the prospects of improving its outcomes. To and helped to improve their administrations as much as implement a modern VAT successfully, a country needs not reasonably possible. With just minor changes in tax structure only the right tax structure, it also needs both the right tax and administration, significant improvements in outcomes administration and the right clientele (taxpayers). may be achieved even in very poor countries. payers believe the tax structure is unfair or that the revenue Lessons from International Experience collected is not effectively used. But even a sound tax struc- ture and sound expenditure policy can be tarnished by a capri- There is no single prescription--no secret recipe--that, once in- cious and corrupt tax administration. Developed countries troduced, will ensure improved tax administration in any took centuries to develop and implement systems to prevent country. Countries exhibit a wide variety of tax compliance dishonest tax officials from corrupt practices. One key factor levels, reflecting not only the effectiveness of their tax adminis- to reduce corruption is to adequately compensate tax officials trations, but also taxpayer attitudes toward taxation and gov- so that they do not need to steal to live. Ideally, tax officials ernment in general. Attitudes affect intentions and intentions should be professionally trained, promoted on the basis of affect behavior. Attitudes are formed in a social context by such merit, and judged by their adherence to the strictest standards factors as the perceived level of evasion, the perceived fairness of legality and morality. Temptation should be reduced by of the tax structure, its complexity and stability, how it is ad- limiting direct contact between officials and taxpayers and in- ministered, the value attached to government activities, and creasing supervision when there is direct contact. Developing the legitimacy of government. Government policies affecting countries trying to sustain relatively large governments on any of these factors may influence taxpayer attitudes and hence precarious fiscal foundations find it hard to deal with these the observed level of taxpayer compliance. Countries and cir- various issues. cumstances differ, but some basic points seem universal. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Keep it simple formation among citizens about their obligations under the tax One important lesson suggested by experience is that before re- laws are often as or more cost-effective in securing compliance forming the tax administration, simplify the tax system so that than measures such as auditing and penalties, which are more it can be applied effectively in a low-compliance context. It sel- directly designed to counter noncompliance. The taxpayer ser- dom makes sense to reform tax administration without simul- vice perspective emphasizes reducing taxpayer uncertainty by taneously reforming tax structure to be both sensible and ad- clarifying legal ambiguities, often about issues as simple as the ministrable. Considerable improvements can often be made in tax rate applicable to certain transactions, communicating administration by small simplifications in tax policy. Reducing clearly what the law is, and ceasing to change it so often that no the number of income tax deductions, for instance, may permit one quite knows what it is. Taxpayer compliance costs and con- countries to eliminate filing requirements for most wage earn- venience should also be taken into account in designing legal ers. In addition to giving the administration simpler and more and administrative procedures: for example, some countries enforceable laws to administer, it is equally important to sim- require excessive numbers of tax payments to be made in in- plify procedures for taxpayers, for example, by eliminating de- convenient places. mands for unnecessary information in tax returns and consoli- Taxpayers do not always view the decision to pay or not as a dating return and payment forms. Once procedures are simple gamble. Some always pay; some always cheat; and some simplified, the tax administration can then concentrate on its cheat when they think they can get away with it. An important main tasks: facilitating compliance, monitoring compliance, task of tax administration is to prevent the mix from tipping in and dealing with noncompliance. the direction of pervasive noncompliance. Optimal enforce- ment strategy anywhere is likely to include both rewards for The taxpayer as client compliers and penalties for noncompliers. But the correct mix The prevalent attitude in many tax administrations appears to depends on many context-specific factors such as the value at- be that all taxpayers are potential criminals. The key adminis- tached to "fairness," and its meaning; the degree of deference to trative problems are then identifying and controlling taxpay- authority, and the legitimacy attached to that authority; and ers and catching those who cheat. These tasks are indeed im- the extent to which contributing to the finance of government portant, and this emphasis is understandable in a country activities is seen to be socially desirable. This picture is not as undergoing rapid transition, but problems of tax enforcement simple as the conventional economic model of tax evasion, cannot be solved simply by calling in the "tax police." Exten- where penalties and probabilities of detecting evasion are seen sive research in a number of countries shows that there is as driving taxpayer compliance decisions. Increased enforce- much to be gained from viewing taxpayers more as clients-- ment actions, or lessened enforcement such as an amnesty, may perhaps not very willing clients, but still clients--than as have quite different results on compliers than on noncompli- would-be criminals. ers, as may increased efforts at public education about taxpayer As mentioned earlier, facilitating compliance requires im- rights and obligations or increased efforts by tax authorities to proving services to taxpayers by providing them clear instruc- provide improved service to taxpayers. tions, understandable forms, and assistance and information as necessary. Monitoring compliance requires the establishment Salvation through reorganization? and maintenance of taxpayer current accounts, management Despite the high potential payoff in terms of increased revenue, information systems that cover both ultimate taxpayers and it is usually difficult, and often impossible, for tax departments third-party agents (such as banks) involved in the tax system, to obtain and retain qualified staff or even to meet such basic and appropriate and prompt procedures to detect and follow up material needs as office space and computers. Tax administra- on nonfilers and late payments. Improving compliance requires tors are civil servants and hence subject to all the constraints a judicious mix of both these approaches as well as additional affecting civil services. Reform strategies that require substan- measures to deter noncompliance, such as establishing a reason- tial additional administrative resources--particularly staff--are able risk of detection and the effective application of penalties. hence usually doomed to failure, because the needed resources Successful reform strategies require an appropriate mix of all will not materialize fully or in a timely fashion. these approaches. One way around this problem is to set up independent rev- Of course, rewriting reality so that citizens are induced to enue authorities that are to some extent freed from civil service comply with tax laws voluntarily is difficult in countries that restrictions on hiring and pay and may also be given access to face severe institutional limitations arising from large informal some earmarked source of revenue. Experience with this ap- sectors, poor salary structures for public servants, ineffective proach has been mixed. In some instances, the result appears to and uncertain legal systems, and an entrenched distrust of gov- have been to provide an institutional structure that provides a ernment. Nonetheless, services to taxpayers that facilitate re- useful catalyst for deeper administrative reform. In other in- porting, filing and paying taxes, or that impart education or in- stances, however, the result looks more like yet another dys- 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise functional bureacracy. A tentative conclusion is perhaps that service salary structure and procedural hurdles in acquiring any country that has the will, strategy, and resources to reform the necessary expertise, hardware, and software. tax administration probably does not need an independent rev- ·. Considerable organizational reengineering, such as consoli- enue authority--and a country in which these critical ingredi- dating return and payment forms, eliminating unnecessary ents are lacking is unlikely to be successful even if it creates such and unused information required from taxpayers, and so an authority. on, is usually needed to prepare the tax administration for a Whether there is a semiautonomous authority or not, suc- computerized environment. cessful administrative reform strategies must usually be carried ·. Equipment and software should be standardized and out without major additional resources. One approach may be bought off the shelf whenever possible to facilitate opera- simply to eliminate unproductive activities such as the auditing tion, networking, and maintenance. the returns of most wage earners; another may be to consider ·. The pace of change and the success of any modernization program depend ultimately on the training and skills of the outsourcing some of the activities traditionally carried on with- people who are expected to use the technology. Appropriate in the administration; and yet another may be to focus efforts incentives and accountability measures are also needed. more on the larger business taxpayers, who not only pay taxes ·. As mentioned earlier, for IT to work at all, a unique identifi- themselves (for example, on imports and profits), but also col- cation number must be assigned to each taxpayer. lect much of the revenue in every country through payroll, in- Perhaps the ultimate example of an automated, Web-based, come, sales, and excise taxes and thus serve a critical function in IT-driven tax system is one like that introduced by Denmark in providing information on their owners, employees, suppliers, 2004. Under the "no touch" system now in place in Denmark, and customers. None of these approaches is without its own which provides extensively prefilled returns online, most tax- complications, but all may, if properly employed, improve out- payers--over 90 percent--no longer need to file returns or to comes without incurring serious revenue risks. have any direct contact with the administration, thus reducing The IT solution compliance costs and freeing substantial administrative re- sources to deal with more complex administrative problems No modern tax administration can perform its tasks efficiently such as auditing complex or questionable returns. The future without using modern information techology (IT). Among the of smart tax administration seems increasingly to lie in this di- areas that may be computerized are: (1) taxpayer records and rection. For many poor countries, that future may still lie some tax collection; (2) internal management and control over re- distance ahead. However, countries such as the Slovak Repub- sources; (3) legal structure and procedures; and (4) systems to lic, Singapore, and Chile have already moved in this direction to lower taxpayer compliance costs. a considerable extent, and other middle-income countries may Tax administrations increasingly need IT expertise because do so in the near future. some of their most important clients--multinational compa- Acknowledgment nies and, increasingly, large domestic firms--employ sophisti- cated computer systems that are beyond the investigative capac- This version has been considerably improved by comments ity of technologically backward tax administrations. from Raúl Junquera-Varela and Eduardo Ley. Experience provides a number of lessons for the successful About the Author application of IT in tax administration: ·. Most importantly, an appropriate strategy must be devel- Richard Bird, a long-time Bank consultant, is Professor Emeritus oped that takes into account the obstacles and the con- of Economics, University of Toronto and Adjunct Professor, School straints arising from organizational rigidities such as civil of Global Affairs, University of Toronto. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduc- tion and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise