56944 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise OCTOBER 2010 · Number 34 Taxation and Development Richard Bird For more than half a century, scholars and international agencies have been making recommendations about taxation in developing countries. The advice economists have offered to developing countries has changed over time, particularly regarding income and consumption taxes. Why? What do we know now about taxes and developing countries that we did not know 50 years ago? What do we still not know that we really should know? What should scholars and international agencies do if they wish to make tax policy recommendations that are economically sensible and likely to prove feasible, acceptable, and helpful in practice? This brief note offers some tentative answers to these complex questions. The Changing Consensus rect foreign investment. Moreover, as discussed in PREM Note 157, subnational tax issues also are of concern in many What did we say in the 1960s and 1970s? The advice was countries. usually to tax more and tax better, with "better" often being One reason that the policy advice changed is the optimal defined as coming closer to a comprehensive income tax.1 Tax- taxation approach developed in the 1970s.2 Around the es on trade and on domestic consumption were seen simply same time, new empirical evidence began to emerge about as necessary evils to generate the needed revenues. In most the sensitivity of savings and, especially, capital inflows to cases, neither international nor subnational issues were taken taxation. The combination of new theory and better empir- into account when determining appropriate tax policy. ical work led most tax experts to retreat from the previous In contrast, although the basic message currently is often emphasis on imposing high marginal-rate income taxes and the same as it was in those earlier years--more and better-- to embrace taxing capital income at the same rates as labor both "more" and "better" now usually mean the value added income. Experience with the serious administrative (and po- tax (VAT). Comprehensive income taxation is no longer an litical) constraints that have persistently hampered attempts ideal. To a considerable extent, both substantial tax progres- in most countries to tax income--for example, in the form sivity and, in particular, income taxes on capital are consid- of capital gains--has generally pointed in the same direction. ered (1) undesirable on economic grounds (such as efficien- It is fortunate from a revenue perspective that VAT came cy and competitiveness) and (2) usually unattainable in along to save the day. In most countries, however, VAT large- practice (for example, because of political and administrative ly replaced excises and taxes on trade, with the latter partic- constraints). Capital taxation is particularly out of favor as a ularly declining as trade became more liberalized. Although result of such international concerns as competition for di- income taxes generally continue to be significant in revenue 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise terms, both personal and corporate income tax rates have developing countries, creeping up from 16.2 percent in the declined around the world, not least because of the growing 1970s to only 17.0 percent by 2000 (Bahl and Bird 2008, p. influence of international factors. 280). Moreover, despite the marked rise of the VAT during Tax policy recommendations and, to some extent, tax this period, the balance between income and consumption policy realities thus have changed over the last 20 years. taxes in developing countries has hardly changed in recent Nonetheless, what might be called the fiscal component of decades as both excise and import tax revenues have de- the "Washington consensus" has proved to be surprisingly re- clined sharply.4 silient in that the tax policies recommended to developing Many studies have attempted to explain the marked dif- countries still largely follow the "broad-based, low-rate" ferences in tax levels between rich and poor countries. Prob- (BBLR) approach3--although now generally in the form of ably the most obvious explanation is the marked difference a broad-based, uniform VAT and a flatter and more uniform in the capacity to tax among countries at different levels of income tax (especially on capital income). economic development. As countries become richer, their Why so many countries adopted this approach is a puzzle increasing wealth generally is accompanied both by exten- in some ways. It is possible, but not likely, that they were sive development of the financial structure and by increased persuaded to do so by the arguments of economists. Because dependence on large, formal organizations as sources of em- there is little evidence that anyone (other than economists) ployment and income for an increasingly large fraction of involved in tax policy cares much about efficiency, a more the population.5 These developments make it easier for gov- likely reason may be that this type of system fits better with ernments to track, measure, and tax growing income and such policy objectives as growth and trade expansion than wealth. In contrast, a much greater fraction of economic ac- did the previous expert consensus view favoring comprehen- tivity in developing countries takes place in small-scale ac- sive income taxes. Or perhaps the explanation is simply that tivities that often are in the so-called informal sector-- politically powerful interest groups now are more likely to hence, outside the organized financial sector and inherently support--or at least to contest less vigorously--such policies difficult to tax. than they did comprehensive income taxation. The main lesson suggested by this line of analysis is that in order to tax more, a country must be more developed. Do Taxes Come with Growth? Such news is unlikely to be very helpful to developing coun- tries--not least because they often are simultaneously told Although it is not clear that a better tax system will increase that if they impose higher taxes at the margin on growing economic growth, it does seem clear that a bad tax system sectors of their economies, they will discourage growth. Tax- may stifle it. For example, a summary of a report exploring es may come with growth, but even the best tax policy is un- Latin America's less-than-outstanding growth performance likely to yield much revenue in the absence of growth. Of in recent decades concludes that "Latin American tax course, if foreign donors step in (or natural-resource bonan- regimes encourage the survival of unproductive firms, ob- zas occur), countries may be able to grow without taxing struct the growth of small and large enterprises alike, and themselves--and politicians sensitive to their own political foster a deeply unequal and segmented business universe" futures usually will be happy to follow such easier paths to (IDB 2010, p. 5). Indeed, if bad taxes discourage growth, an expanded public sector. perhaps one inference from the fact that the average tax ra- Some writers have suggested that this dilemma is more tio for central governments in less-developed countries had apparent than real--that if they choose to do so, even the increased by about 24 percent (from 11.3 percent of GDP poorest countries can tax more than they now do simply by in 1953­55 to 13.8 percent of GDP in 1966­68) might be improving administration and by getting the "politics of tax- that their tax systems have improved over this period (Chel- ation" right.6 This advice surely is correct in some ways. liah 1971, p. 263). However, it is unlikely to be either easy or simple to imple- However, a more plausible inference is that richer coun- ment. It is not helpful to tell countries wishing to have bigger tries tend to have higher taxes. At the beginning of this cen- (and, one hopes, better) tax systems that they first must be tury, for example, average tax levels were twice as high in de- better countries. A related (though perhaps a bit more en- veloped countries (35 percent of GDP) than in developing couraging) approach in the literature emphasizes not so countries (17 percent of GDP). Moreover, although the level much the capacity to tax (that is, the level or structure of of income in developing countries as a whole has continued GDP) or the ability to tax (that is, the level of financial de- to rise in recent decades, tax levels in such countries have not velopment) as the willingness to tax (what might be called increased similarly. For example, whereas the average tax the demand side of the fiscal equation). If people want more level in Organisation for Economic Co-operation and Devel- public services and trust that their government will try to opment countries rose from 30.1 percent to 35.5 percent deliver such services as effectively and efficiently as possible, between 1970 and 2000, the similar ratio hardly altered for they are more likely to support efforts to raise taxes than 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise they are when experience has taught them to expect little in it is bad to tax intermediate goods used in production be- the way of benefits from increased government activity (as cause it distorts resource allocation--one reason most econ- has happened in too many countries).7 This view implies omists generally have favored value added taxation. It is un- that taxes imposed without adequately representing the in- fortunate that this important point has proved hard to terests of the people being taxed are unlikely to be collected market to citizens and to politicians focused much more on easily (and will not be productively spent). Again, the infer- the immediate distributional impact of policy changes than ence is that better governments can collect more--and, on their long-run implications for efficiency, investment, and again one hopes, better--taxes. Although this seems plausi- growth. ble, and some evidence suggests that it may even be right, In practice, policy advisers probably rely less on theory once again it is all too clear that there is no simple road to than on rules of thumb closer to Adam Smith's famous better (or bigger) taxation in developing countries. canons of taxation--certainty, simplicity and convenience, However one interprets either the empirical story of the and economy. For example, last 50 years or the ideas sketched above, it is clear that the · The BBLR approach mentioned earlier is such a rule links between taxation and economic efficiency--like those of thumb: taxes should have broad bases and low rates between economic efficiency and economic growth--are to minimize negative economic effects on prices and difficult to tease out and to understand either in general or to reduce the potential for administrative corruption for any particular country. Thus, it seldom is easy to draw and tax evasion. clear policy implications from the literature for any particu- · An important corollary of the BBLR proposition is to lar country at any particular time. To illustrate, it is rare that minimize tax concessions--although this advice often much policy discussion of taxation adequately considers the seems to be more honored in the breach than in the distributional or stabilization dimensions of the fiscal prob- observance (perhaps because of the enduring political lem; instead, discussion focuses mainly on efficiency con- attractiveness of tax favoritism). cerns, even though policy makers almost invariably operate · Another common prescription intended largely to dis- in environments in which distributional, stabilization, and courage corruption and evasion is for fewer rates of tax political considerations dominate. to reduce the problems arising with differentiated tax Even leaving such considerations aside, perhaps the rates. strongest and most relevant policy conclusion one can draw · Yet another prescription intended to improve the con- from an examination of the extensive empirical and theoret- venience and simplicity of the taxes facing unsophisticat- ical literature on the links between taxation and economic ed or poorly educated taxpayers is the use of simple development is simply that we do not yet understand much and often "presumptive" (estimated) taxes--although about this issue in general.8 Nonetheless, the literature does this approach needs to be handled with great care to support a number of specific policy suggestions (discussed avoid doing harm. below) that many developing countries would do well to · Taxes on international trade should be reduced because take into account in designing and implementing their tax they distort allocation of resources in line with com- systems. parative advantage. A possible exception to this rule might apply for some least-developed countries where Lessons for Developing Countries ease of collecting taxes at the border may dominate. · Revenues from income taxes are buoyant; indeed, two Optimal tax theory is a useful and clarifying approach in reasons that countries traditionally were advised to rely many ways; but, for a number of reasons, it seldom offers more on income tax with economic development clear lessons for tax policy makers. As an example, it is often were that taxes would more closely reflect citizens' true that only a small subset of available taxes is considered, ability to pay and that revenue would be more income and such important real-world phenomena as market fail- elastic. Even those people who think that distribution ures and regulatory policy are left out of account. Moreover, is primarily the task of the expenditure rather than the the revenue requirement usually is taken as given (ignoring revenue side of the budget would do well to keep in what it is to be spent on), administrative constraints and mind the elastic nature of the income tax. Indeed, gov- transaction costs typically are left out of account, and most ernments presumably should be interested in both the potentially relevant nonrevenue objectives and the effects of elastic and the progressive characteristics of the in- differences between the public interest and the private in- come tax--the first to finance expanding expenditures terests of those charged with carrying out public policy are and the second to increase the degree of perceived fair- ignored. ness and trust in government. Perhaps the main practical policy implication of optimal No doubt many other useful lessons may be derived in tax theory is that production efficiency matters: in particular, principle from the substantial literature on tax theory and 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise tax economics. In practice, however, surprisingly few such distributional effect. In addition to considering in more lessons have been tested in the context of developing coun- detail how tax policy and administration may affect tries, partly because most critical issues depend on elasticities the building of social capital (for good or ill), more at- about which we usually know far less than we need to design tention needs to be paid to other "political" aspects of good tax policy. Consider some common tax policy design tax policy in developing countries--for example, how issues that come up again and again in developing countries: to sell taxes to an always-unwilling public. Good mar- · Should income taxes be progressive, flat, dual (or keting is at least as important for successful tax reform schedular), or nonexistent? as is good policy design. For example, one way to mar- · Should foreign source income be taxed--and if so, ket policy changes may be to use fiscal illusion to fool how? people about what really is being done. An opposite · Should indirect taxes be imposed at uniform or at dif- tack may be to stress the increased visibility and ac- ferentiated rates? countability of policy actions. (As discussed in PREM · If differentiated, how should externalities (and regula- Note 157, this may be one reason to support a degree tory policies) be taken into account? of taxation decentralization in some countries.) Anoth- · Should small businesses be taxed differently from large er possible marketing approach may be to explore or businesses--and if so, how? exploit to an extent the "sales potential" of earmark- · What taxes should be assigned to different levels of ing--that is, the real or symbolic establishment of links government? between taxes and expenditures. Again, decentraliza- · Should taxes be lighter or heavier on "growing" sectors tion may provide an example in some circumstances. of the economy? To mention such approaches is certainly not to recom- · How should (and can) the "informal" sector be taxed mend them. Nonetheless, such ideas call for more attention more effectively? in the literature on "taxing for development" than they have No simple or general applicable answers to any of these received. Similarly, politicians matter, as does the immediate questions are available-or, in some cases, even conceivable. political environment. There is not, probably cannot, and Nonetheless, as implied by the earlier list of rules of thumb, perhaps should not be anything like a "politician-proof pol- experience and the literature do suggest a number of ways icy." Tax policy reform requires a viable and politically rele- in which these and other policy issues can be (and have vant champion who owns the reform and can sell it. Packag- been) explored in detail in the circumstances of particular ing also matters. Selling reform depends not only on the countries. contents of the policy package, but also on how it is present- ed. This is true because perception is reality to a considerable Keys to Successful Tax Reform extent in the world of politics. Without visible benefits to offset the visible costs of taxation, new tax policies are un- The economic literature on taxation and development fo- likely to be accepted (even if they are technically better than cuses on taxation as a policy instrument. However, it seldom the policies they replace). Finally, details matter. The fate of does so in the context of the policy process. In practice, the a policy may turn on how some particular group perceives process may largely determine the product in two important its interests to be affected or on the precise sequencing and senses9: scope of reform. 1. Tax administration matters--a lot! The best tax policy ineffectively administered amounts to nothing (see Conclusion PREM Note 156). Conversely, the revenue administra- tion will, in effect, produce its own "policy product," From the perspective of international institutions concerned even if there is no coherent or "designed" policy, In with improving tax outcomes in developing countries, this short, policy outcomes depend very much on how poli- note suggests two general conclusions: cies are administered. Thus, critical aspects of tax ad- 1. One must know the context well to be sure that one is ministration need more research and must be integrated recommending the right product and that one under- more closely with tax policy work, Among the ques- stands the right way to get to "there" from "here." Do- tions to be studied are these: How much should be ing so requires a clear analytical model, and demands spent on administration? How should tax administra- that the issues in each country be approached in light tion be organized and run? How can countries deal with of a thorough understanding of the path-dependent the "hard-to-tax" populations (both rich and poor)? and context-specific conditions within which policy 2. More important, taxation is about politics, just as pol- initiatives are introduced and implemented. It also re- itics is partly about taxation--especially its perceived quires one to pay close attention to relevant local con- 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise ditions and evidence--microdata, heterogeneity, per- 7. A useful and concise statement of this argument is pro- ceived norms, and so forth; and to be able and willing vided by Moore (2007). Its empirical basis is explored to to produce fact- and logic-based analysis in a form that some extent in Bird, Martinez-Vazquez, and Torgler (2008). can enter the relevant political-bureaucratic discus- 8. For extensive reviews of the empirical and theoretical sion. In many instances, what this suggests is that inter- underpinnings of this statement (in developed countries), national institutions should support both official and see Johansson et al. (2008) and Myles (2009). (perhaps especially) nonofficial local research and dis- 9. A stimulating discussion of this issue in the context of semination efforts rather than attempting to do the Latin America may be found in IDB (2006). work themselves. 2. Always be mindful of the no-one-size-fits-all principle. About the Author There is no magic blueprint--no tax system, structure, or particular policy that makes sense for all countries Richard Bird, a longtime World Bank consultant, is professor at all times. Realizing that, from the government's per- emeritus of economics at the University of Toronto; associate of spective, taxes are only one of a set of "governing in- the International Institute of Business, Rotman School of Man- struments," it is critical in designing and evaluating tax agement; and adjunct professor at the Munk School of Global policy to take carefully into account the design, admin- Affairs, University of Toronto, Canada. istration, and consequences of such other government Comments from Raúl Junquera-Varela and Eduardo Ley activities as those related to nontax revenues, expendi- are gratefully acknowledged. tures, and regulations. Designing and implementing a viable and sustainable tax References strategy for development in a developing country is a diffi- Auerbach, Alan J., and Martin Feldstein, eds. 1985. Handbook of Public Eco- cult and time-consuming task. But it can be done--and has nomics, vol. 1. Amsterdam: North-Holland. been done, as countries from Chile to Singapore have Bahl, Roy W., and Richard M. Bird. 2008. "Tax Policy in Developing Coun- shown--when countries really want to do so; take the lead tries: Looking Back--and Forward." National Tax Journal 61 (2): 279­ themselves; and obtain the technical, institutional, and per- 301. haps even financial support that may be required. Bird, Richard M., Jorge Martinez-Vazquez and Benno Torgler. 2008. "Tax Effort in Developing Countries and High Income Countries: The Im- pact of Corruption, Voice and Accountability." Economic Analysis and Notes Policy 38 (1): 55­71. Chelliah, Raja. 1971. "Trends in Taxation in Developing Countries." IMF 1. A comprehensive income tax is levied on net income Staff Papers 18: 254­331. from all sources according to the same rate schedule. Gordon, Roger, and Wei Li. 2009. "Tax Structures in Developing Countries: 2. For a review of both the basic theory of optimal taxa- Many Puzzles and a Possible Explanation." Journal of Public Economics tion and the earlier empirical evidence mentioned, see Auer- 93 (7­8): 855­66. IDB (Inter-American Development Bank). 2006. The Politics of Policies: Eco- bach and Feldstein (1985). nomic and Social Progress in Latin America. Washington, DC. 3. For example, policies recommended in World Bank ------. 2010. "Taxes and Productivity." IDEA: Ideas for Development in the (1991). Americas 21 (January­April): 5. 4. For a detailed examination of the effects of VAT on rev- Johansson, Asa, Christopher Heady, Jens Matthias Arnold, Robert Brys, and enue, see Keen and Lockwood (2010). Laura Vartia. 2008. "Taxation and Economic Growth." Working Paper 5. Gordon and Li (2009) provide a useful exploration of 620. Economics Department, Organisation for Economic Co-operation and Development, Paris. this issue. Keen, Michael, and Ben Lockwood. 2010. "The Value Added Tax: Its Causes 6. As an example, the UN Millennium Project (2005) and Consequences." Journal of Development Economics 92 (2): 138­51. notes that, on average, developing countries needed to mo- Moore, Mick. 2007. "How Does Taxation Affect the Quality of Gover- bilize "only" an additional 4 percent of GDP in tax revenue nance?" Tax Notes International June 2: 79­98. to obtain the revenues needed to achieve the Millennium Myles, Gareth D. 2009. "Economic Growth and the Role of Taxation­The- ory," Working Paper 713. Economics Department, Organisation for Eco- Development Goals. It appears to assume that any develop- nomic Co-operation and Development, Paris. ing country worth its salt reasonably could be expected to United Nations Millennium Project. 2005. Investing in Development: A Prac- increase its current tax take by the required 22 percent--or tical Plan to Achieve the Millennium Development Goals. New York. almost three times more than such countries had managed World Bank. 1991. Lessons of Tax Reform. Washington, DC. over the previous three decades. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. It is produced by the Poverty Reduction 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.