51627 The World Bank JUNE PREMnotes 2009 N U M B E R 137 TAX POLICY The Personal Income Tax Richard M. Bird* A recent paper argues persuasively that in developing countries corporate tax the two basic pillars of taxation in most revenues usually substantially exceed PIT countries are the income tax and the VAT revenues.2 As a percentage of GDP, PIT (Barreix and Roca 2007).1 The authors revenues in developed countries average argue that the VAT is excellent as a rev- about 7 percent of GDP as compared to enue raiser and works best if it is applied about 2 percent for developing countries. in the simplest and most neutral fashion Moreover, as Bird and Zolt (2005) note, possible--that is, on as broad a base as pos- in many developing countries personal sible and preferably at a uniform rate. This income taxes often amount to little more conclusion seems well-founded as has been than taxes on labor income. At the same argued at length recently (Bird and Gen- time, although little revenue is received dron 2007). More controversially perhaps, from capital income, income taxes often Barreix and Roca (2007) also argue, with impose high marginal effective rates on in- special reference to Latin America, that vestment and hence discourage growth.3 most countries need to pay more attention PITs like these might seem at first to the potential of the personal income glance to deliver neither equity nor tax (PIT) both as a revenue raiser and as growth. In reality, however, since even an important element of social cohesion. defective PITs are generally applied only PIT plays the second of these roles both to labor income accruing in the modern because revenue raised from this source sector, they are inherently progressive, comes mainly from higher income groups particularly in less developed countries. and because the personal nature of the Studies of tax incidence invariably show tax strengthens the connection between that the only moderately progressive part taxpayers and the state. of the tax system in most countries is the Given the relative unimportance of PIT.4 To achieve both equity and growth, personal income taxes in most developing ideally the PIT would have a significant av- countries this argument is at first sight per- erage rate--thus producing revenue--but haps somewhat surprising. PIT revenues a modest marginal rate in order to avoid are often three to four times corporate distorting economic decisions in unduly tax revenues in developed countries, but costly ways. *The views expressed in this note are the author's and must not be represented as those of The World Bank. This note was reviewed by Milan Brahmbhatt, Tuan Minh Le, and Eduardo Ley. FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK As Barreix and Roca (2007) argue, in and sometimes critical visible symbol of many countries societal disaffection with concern with the inequality usually ac- the inequities accompanying growth often companying growth. Policy makers in most seems to require some degree of visible countries should therefore be concerned fiscal correction if growth-facilitating with how to strengthen the PIT. The key policies are to be politically sustainable. question is whether to retain a compre- There is thus an important continuing hensive income tax approach, to revert role in most fiscal systems for the income to some updated version of the older tax--the mirror of democracy as one fiscal presumptive approach (explained below), historian labeled it (Webber and Wildavsky or to introduce some explicit schedular 1986). A properly designed tax regime can elements into the income tax as in the in most countries generate sufficient rev- dual income tax systems of the Nordic enue to finance needed social and public countries under which a flat rate is applied services in a mildly progressive (or at worst to income from capital and a mildly pro- proportional) way. Much of the revenue in gressive rate to income from labor. developing countries will inevitably come Although all these matters relate to from VATs and other consumption taxes, the proper base of the tax, to many people but most of the progressivity will equally tax rates seem to be the most important inevitably have to come from income taxes. part of the tax system. Certainly the most Most developing countries thus need both striking feature of recent decades has been income and consumption taxes, but they the steady decline in the level and degree need the right kind of each: the details of of progressivity of most PIT rate structures design and administration matter a lot. around the world. In Latin America, for Consumption taxes are discussed briefly example, the average top rate on per- in another note in this series. This note sonal income declined from 51 in 1985 focuses on personal income taxes.5 to 28 percent in 2003 (Lora and Cardenas In the not too distant past, most tax 2006). Similar trends may be found else- policy advisors saw the PIT as the center where in the world. Arguably, the result of the tax universe. The main challenges has been very little, if any, decrease in the in developing countries were considered effective progressivity of tax systems in to be, first, to adopt a good comprehen- most developing countries. Some would sive income tax with adequately progres- like to continue this movement to reduce sive rates and, second, to put into place progressivity by introducing a flat or single a sufficiently effective tax administration PIT tax rate, as has been done in a number to spread the cost of government among of former command economies in recent members of society in accordance with years. Because such taxes continue to be some appropriate concept of ability to pay. applied only to income above a certain The appropriate base for such a tax was threshold limit, they continue to be pro- thought by most to be a comprehensive gressive to a certain extent. Nonetheless, base including all forms of income (the although this note argues for a flat tax on Haig-Simons concept). capital income, there seems little reason to Despite the defects of this model in extend this argument to require flat taxes practice, a PIT remains an important on all income.6 2 PREMNOTE JUNE 2009 Improve the Comprehensive tive to its chance of success. Most studies Income Tax Approach end up recommending that countries For a developing country to have a viable lower (not raise) marginal rates, coupled comprehensive PIT system the principal with broader bases with respect to both need is usually to expand the tax base. labor (informal sector, fringe benefits) and Depending on the country, this might capital (tax incentives, interest, perhaps involve taxing interest on government real estate gains) income; heavier reliance bonds, taxing noncash compensation to on withholding (for example by banks); employees, taxing residents on portfolio and, above all, better administration (tax- income earned outside the country, taxing payer identification numbers, outsourcing capital gains, and eliminating the use of routine data processing, case-tracking tax holidays. A separate paper could be systems, and above all better auditing). In devoted each of these issues.7 Countries effect, what this advice amounts to is that a should also seek to reduce the portion better comprehensive income tax depends of the economy operating outside the almost entirely on significantly improving tax system through such means as devot- tax administration. While better adminis- ing greater administrative resources to tration is certainly needed in most devel- taxpayer registration and compliance; oping countries, this takes us well beyond devising simplified rules for taxing small the scope of the present note.8 businesses, professionals, and agriculture; and increasing the costs of operating in The Presumptive Approach the informal economy while increasing A common administrative stopgap in the benefits of operating in the formal many countries is to impose taxes on economy. In addition, withholding re- bases that are administratively determined gimes could be expanded, for example, by rather than self-assessed by taxpayers. expanding the definition of employee for Presumptive systems may, for example, tax purposes beyond the requirements for calculate taxable income based on key employment law or prohibiting businesses factors that are presumably associated from deducting payments without either with income generation such as sales, turn- withholding or information reporting. over, number of employees, size of firm, All of these approaches have been assets of the taxpayer, and so forth. The tried at various times in different places. estimated tax base typically is calculated In some circumstances, they have worked based on coefficients for different factors fairly well. In others, they have not. The applied to specific taxpayers or specific question is always whether the game is types of taxpayers (such as certain sized worth the candle: would the incremental enterprises in particular industries). The gain in terms of additional tax revenue idea is to use data available to officials to and progressivity justify the political, ad- capture at least some minimum level of tax ministrative, and economic costs? Practical from those taxpayers who are considered experience suggests that in developing to be unreliable sources of information on countries the costs and risks of following their own activities. this strategy are likely to prove high rela- JUNE 2009 PREMNOTE 3 Most presumptive tax systems have De-Link the Taxation of two thresholds. There is a minimum Income from Capital and threshold below which activities are not Income from Labor subject to tax and a maximum threshold On the whole, the simplest and most above which taxpayers no longer qualify promising approach to taxing personal for the presumptive tax regime and are income more effectively in developing subject to tax under the regular tax sys- countries is to establish separate regimes tem.9 Too high an exit threshold under- for the taxation of labor and capital. mines the regular tax system and invites Separate treatment of income from too many participants into the special capital and labor of course has its own dif- regime. An entry threshold that is too low ficulties but the dual income tax approach may discourage small business activity and has two major advantages in developing may impose tax liability on persons who countries: rationalization of the taxation should not be in the tax system. None- of capital income and improved enforce- theless, those subject to presumptive tax ment and compliance. Adopting a single regimes often prefer them because they flat tax rate on capital income provides shelter them from some of the complexity an opportunity to expand the tax base of the tax system and the rapacity of tax to include types of income that were officials. The tax administration may also previously exempt from taxation, such as prefer presumptive regimes because they interest on bonds. It should also improve no longer have to deal with troublesome enforcement and compliance. A uniform small taxpayers and can concentrate on rate should allow for more effective "final" the big taxpayers, where the revenue is. withholding tax taxes.10 Politicians may also prefer presumptive It may seem unfair that capital income regimes, because the small taxpayer com- is subject to lower tax rates than (some) munity is large and vociferous and because income from labor. The issue of fairness they think it costs them little or nothing is more complicated than appears at in terms of revenues or is perhaps even a first examination, however. Sometimes, revenue gainer. separate tax regimes for taxing labor However, those concerned with the and capital income may make everyone equity, efficiency, and long-term develop- better off. Suppose, for example, that ment of sound tax systems should be less under the typically flawed current PIT sanguine about presumptive tax regimes. the tax rate for all income is 30 percent Such systems are seldom well designed and total tax revenue is $100 million, of and almost never well integrated with the which $20 million is from taxes on capital regular tax system. To a limited extent, and $80 million is from taxes on labor presumptive tax approaches may play (including self-employed). If a schedular a useful supporting role in establishing tax on capital income (at, say, 20 percent) and enforcing some form of taxation on that is more effective at taxing capital is self-employment income in developing adopted so that tax revenues from capital countries. From the point of view of the income increase to $30 million and the longer-term development of sustainable revenue requirement remains the same, tax system, however, they are usually a only $70 million is then required from dead end. labor income--allowing a rate reduction 4 PREMNOTE JUNE 2009 to, say, 27 percent. Everyone is better Bird, R.M., and P-P.Gendron (2007). The off. Furthermore, since capital income VAT in Developing and Transitional Coun- comprises a higher proportion of the in- tries. Cambridge University Press. come of the rich than of the middle class Bird, R.M., and S. Wallace (2004). "Is It (the poor in developing countries are not Really so Hard to Tax the Hard-to-Tax? subject to PIT), the resulting income tax The Context and Role of Presumptive is almost certainly more progressive than Taxes." In J. Alm, J. Martinez-Vazquez, the previous comprehensive tax--even and S. Wallace, eds., Taxing the Hard- if that tax had progressive rather than to-Tax: Lessons from Theory and Practice. proportional rates. Amsterdam: North-Holland, pp. A comprehensive progressive income 121­158. tax may still look best to many tax analysts Bird, R.M., and E.M. Zolt (2005). "Redis- from an equity perspective, but as a rule tribution via Taxation: The Limited in developing countries it is considerably Role of the Personal Income Tax in less desirable from both economic and es- Developing Countries." UCLA Law pecially administrative perspectives than a Review 52(6): 1627­95. dual income tax. A consumption tax may Chu, K., H. Davoodi, and S. Gupta (2000). be even better from the latter two perspec- "Income Distribution and Tax and tives, but as argued above it is likely to be Government Social Spending Policies less acceptable politically and perhaps in Developing Countries." Working less desirable from an equity perspective. Papers No. 214, UNU/WIDER, De- The dual income tax--a schedular income tax cember. with a proportional rate on capital income Lora, E., and M. Cardenas (2006). "La close to the lower rate of the wage tax--may reforma de las instituciones fiscales prove an acceptable compromise. A modestly en América Latina." Inter-American progressive tax on wage income and as Development Bank, Research Depart- comprehensive a low-rate tax on capital ment, Documento de Trabajo #559, income as possible is perhaps the best April. one can or should aim for in develop- OECD (2006). Fundamental Reform of Per- ing countries. Certainly such a tax would sonal Income Tax. Paris. constitute a major improvement over the ------ (2006a). Taxation of Capital Gains superficially progressive and superficially of Individuals: Policy Considerations and comprehensive PITs normally found in Approaches. Paris. such countries. Poirson, H. (2006). "The Tax System in India: Could Reforms Spur Growth?" References IMF Working Paper WP/06/93, Wash- Barreix, A., and J. Roca (2007). "Strength- ington, DC, April. ening a Fiscal Pillar: the Uruguayan Saavedra, P. (2007). "Taxation of Labor." Dual Income Tax." CEPAL Review 92 In C. Grey, T. Lane, and A. Varoudakis, (August): 121­40. eds, Fiscal Policy and Economic Growth: Bird, R.M. (2004). "Administrative Dimen- Lessons for Eastern Europe and Central sions of Tax Reform." Asia-Pacific Tax Asia. Washington, DC: World Bank. Bulletin 10(3): 134­50. Tanzi, V., and H. Zee (2000). "Tax Policy for Emerging Markets: Developing JUNE 2009 PREMNOTE 5 Countries." National Tax Journal 53 9. A major flaw of such regimes in many (June): 299­328. countries is that they do not include explicit Webber, C., and A. Wildavsky (1986). A plans for "growing"` taxpayers out of the History of Taxation and Expenditure in special system into the normal system of the Western World. New York: Simon taxation. This serious design flaw increases and Shuster. the potential unintended impacts of spe- cial regimes, especially since the political Notes economy of presumptive systems almost 1. The paper actually says there are three guarantees that the tax burdens enjoyed by pillars--the third being pension contribu- those in such regimes are sufficiently favor- tions--but discussion of this issue is beyond able to make them an attractive place to the scope of the present paper. stay and provide no incentive to graduate. 2. See Tanzi and Zee (2000). These data For further discussion, see Bird and Wallace may be misleading in that some countries (2004). classify income from unincorporated busi- 10. Usually, in the Nordic models of dual ness as corporate (business) rather than income taxes the same rate is applied to personal income. business and capital income. Uruguay, in 3. See Poirson's (2006) description of the contrast, has adopted a dual rate dual in- current Indian tax system for a depressingly come tax with the rate on business income good example of such a PIT. being set at the top rate of the labor income 4. In addition to the studies cited in Bar- tax (25 percent) and the rate on capital reix and Roca (2007) see the broader survey income close (12 percent) to the bottom in Chu et al. (2000). rate of the labor income tax (10 percent) 5. What follows draws in part on Bird and (Barreix and Roca 2007). This system obvi- Zolt (2005). For a detailed recent discussion ously limits the scope for arbitrage between of personal income tax issues in developed labor and business income; Barreix and countries, see OECD (2006). Roca (2007) assert that arbitrage between 6. A good summary of the experience business and capital income is adequately with flat taxes may be found in Saavedra dealt with by such rules as limiting interest (2007). deductions to the ratio between the rates on 7. See, for example, OECD (2006a) on capital and business income (for exmaple, the taxation of capital gains. in Uruguay, 12/25). Obviously, in practice 8. For a recent assessment of administra- the control of all tax arbitrage when rates tive reform needs and possibilities, see Bird differ ultimately depends on the quality of (2004). tax administration. This note series is intended to summarize good practices and key policy findings on PREM-related topics. The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank. PREMnotes are widely distributed to Bank staff and are also available on the PREM Web site (http://www.worldbank.org/prem). If you are interested in writing a PREMnote, email your idea to Madjiguene Seck at mseck@worldbank.org. For additional copies of this PREMnote please contact the PREM Advisory Service at x87736. PREMnotes are edited and laid out by Grammarians, Inc. Prepared for World Bank staff