Introduction to Tax Policy Design and Development

Richard M. Bird and Eric M. Zolt

April !!"
This is a draft prepared for a course on Practical Issues of Tax Policy in Developing
Countries, World Bank, April 2!"ay #, 2$$%&
2
#ontents
I& Introduction
II& An 'vervie( of the World of Taxes
#& Tax levels
2& Tax structure
%& )ecent trends
*& Conclusion
III& What Can Taxation Do+
#& )aising revenue
2& ,cono-ic efficiency
%& .airness concerns
*& Tax ad-inistration
/& Taxation and gro(th
0& Taxation and decentrali1ation
2& 3sing the tax syste- for non!fiscal o45ectives
I6& Conclusion !! The Political ,cono-y of Taxation
)eferences
%
Introduction to Tax Policy Design and Development
Richard M. Bird and Eric M. Zolt
April !!"
I. Introduction
Taxes -atter& People talk a4out the-, co-plain a4out the-, and try to dodge
the- (hen they can& Businesses also react to taxes, 4oth in ho( they organi1e their
activities and, perhaps, in (here they carry the- out& 7o( people and 4usinesses react in
turn affects the level and structure of taxation& The 8uestion (e consider in this
introductory -odule is ho( developing countries -ay 4est design and develop tax
policies to achieve (hatever their policy o45ectives -ight 4e, given the co-plex
econo-ic and political environ-ents they face&
As the title of this course suggests, its focus is pri-arily on 9practical: issues of
tax policy in developing countries& As ;ohn "aynard <eynes =#>%0, pp& %%!*?
fa-ously said, ho(ever, 9practical -en, (ho 4elieve the-selves to 4e 8uite free fro-
any intellectual influences, are usually the slaves of so-e defunct econo-ist@&&soon or
late, it is ideas, not vested interests, (hich are dangerous for good or evil&: Practical tax
policy is certainly not i--une to the influence of either ideas or vested interests& Aeveral
recent studies de-onstrate the influence of 4oth these factors, as (ell as the specific
political institutions that in turn reflect these factors, in shaping tax policy in countries
such as the 3nited Atates and A(eden =e&g, Atein-o, #>>%?&
Developing countries are no differentB ideas, interests, and institutions play a
central role in shaping tax policy& To set the stage for su4se8uent -odules of this course,
(hich address -any i-portant, 4ut narro(er, aspects of tax policy, this introductory
-odule therefore considers in rather 4road ter-s 4oth so-e i-portant theoretical and
philosophical develop-ents related to tax policy and also so-e e8ually i-portant (ays in
(hich circu-stances in different developing countries -ay call for different tax policy
designs&
We proceed as follo(s& In Part II, (e provide a short overvie( of (hat tax
syste-s look like around the (orld& There are so-e i-portant si-ilarities in the level
and structure of taxation in different countries, 4ut also so-e differences reflecting 4oth
regional and econo-ic factors, such as the level of per capita inco-e& Although there
continues to 4e (ide variations in the tax structures a-ong countries, countries,
regardless of their inco-e level, have generally adopted taxes that are si-ilar in
character, such as personal and corporate inco-e taxes, value!added taxes, and excises
taxes& We conclude this discussion 4y raising a 8uestion =to (hich (e return at the end of
the -odule? a4out the i-plications of the pheno-enon of 9glo4ali1ation: for tax policy
in developing countriesB does still -ore har-oni1ation, at least in the for-al structure of
tax syste-s, lie in the future+
*
Against this 4ackground, (e then discuss in Part III the principal policy
o45ectives that different countries -ay atte-pt to achieve through 4udgetary and
especially tax policy !! such as the need to raise revenue =usually for -ore than one level
of govern-ent?C the desire to raise such revenue e8uita4ly or fairlyC the desira4ility of
-ini-i1ing the costs of raising taxesC the desire to encourage econo-ic gro(th and such
related 8uestions as the desire to encourage =or discourage? particular types of activity or
to help =or penali1e? particular groups or regionsC and the (ish to encourage and facilitate
honest and responsive govern-ent&
.inally, in Part I6, (e sketch 4riefly the 4road political econo-y context (ithin
(hich tax policy design and develop-ent issues -ust 4e considered 4y practical
refor-ers& We do not provide definitive ans(ers to -ost of the 8uestions raised in this
introduction, -any of (hich are considered in -ore depth in later -odules, and so-e of
(hich cannot 4e definitively ans(ered& 'ur ai- is rather si-ply to set out so-e of the
4asic issues facing tax policy designers in developing countries and to suggest at least
so-e of the key ele-ents that -ust 4e considered in designing the 4est feasi4le tax
structure for a particular country at a particular ti-e&
II. An $vervie% o& the 'orld o& Taxes
Do single tax structure can possi4ly -eet the re8uire-ents of every country& The
4est syste- for any country should 4e deter-ined taking into account its econo-ic
structure, its capacity to ad-inister taxes, its pu4lic service needs, and -any other
factors& Donetheless, one (ay to get an idea of (hat -atters in tax policy is to look at
(hat taxes exist around the (orld& The level and structure of taxes, and the (ay in (hich
taxing patterns have changed in recent years are revie(ed here on the 4asis of data
collected for so-e recent years for #0 countries, representing every region of the (orld&
#
#
There are -any pro4le-s in asse-4ling such data& .or exa-ple, although (e shall focus here
largely on national taxes, it should 4e noted that the data coverage in this sa-ple varies& .or //
countries in the sa-ple, only central govern-ent is included, (hile for 0> countries, general
govern-ent, including regional and local govern-ent, is covered& .or #2 countries, the sources
do not -ake it clear (hich govern-ents are included& Data are analy1ed for the -ost recent year
for (hich they are availa4le for each country !! usually #>>& The length of the ti-e series used
to investigate the changes in this pattern also varies 4y country, 4ased on data availa4ility& The
data (ere collected for a period averaging a4out six years, usually in the -id!#>>$Es& The data
reported in this section are 4ased on (ork done 4y Willia- .ox for a 4ackground report for the
3nited Dations& =Ao-e later sections of this -odule also dra( on this report, as yet unreleased,
(hich (as prepared 4y )& Bird, W& .ox, and "& "cIntyre&? FDP data were obtained from
the IMF World Economic Outlook Database at
www.imf.org/external/pubs/ft/weo/!!/ol/data/index.htm. "e#enue data
were obtained from IMF $ountr% "eports at
www.imf.org/external/countr%/index.htm and OE$D "e#enue &tatistics
$D"om' ()*+,!!!' dated !!(.
/
(. Tax levels
'n average, the tax ratio !! taxes as a share of FDP !! (as a 4it less than one!fifth
of FDP =#& percent? for the #0 countries in the sa-ple&
2
This is a si-ple average,
treating each country as a single o4servation, so that a s-all island such as At& Gucia
receives the sa-e (eight as the 3nited Atates or China& In fact, tax ratios in the sa-ple
range fro- (ell under #$ percent in a fe( countries, -ost of (hich are s-all and all of
(hich are lo( inco-e !! for exa-ple, "yan-ar, Chad, Fuate-ala, and Central African
)epu4lic !! to (ell over *$ percent in a fe( high!inco-e countries in (estern ,urope
such as .rance and A(eden& Aurprisingly, ho(ever, so-e lo(er!inco-e countries,
particularly transitional countries, also had high ratios, such as Belarus, 3kraine, Algeria,
and Audan& Ai-ilarly, so-e higher!inco-e countries, such as the 3nited Atates, had
considera4ly lo(er tax ratios than others, (ith 7ong <ong 4eing the extre-e case in this
respect&
Both opportunity and choice appear to affect tax levels& Countries (ith access to
rich natural resource revenues, such as 6ene1uela and A1er4ai5an, tend to have higher tax
ratios than other(ise co-para4le countries, though such revenues -ay also 4e highly
volatile, reflecting co--odity price changes& Tax ratios in higher inco-e countries
appear to reflect -ore choice than chance& Ao-e, such as A(eden and the Detherlands,
have large and centrali1ed govern-ents and others, such as the 3nited Atates and
A(it1erland, have s-aller and -ore decentrali1ed govern-ents&
Broadly, ho(ever, tax ratios do vary 4y inco-e levels& The countries in the
sa-ple for (hich FDP data (ere availa4le (ere divided into three groups 4ased on per
capita FDP& ,ighty!nine countries in (hich per capita FDP (as less than 3AD#,$$$ in
#>>> (ere classified as lo(!inco-e, /# countries (here per capita FDP (as 4et(een
3AD#,$$$ and 3AD#2,$$$ (ere classified as -ediu-!inco-e, and the 2* countries (ith
per capita FDP greater than 3AD#2,$$$ (ere classified as high!inco-e& As earlier
studies =Tan1i, #>2? have sho(n, in general, taxes tend to rise as per capita inco-es rise&
The tax ratio rises fro- a4out #2 percent in the lo(!inco-e group, to 22 percent in the
-ediu-!inco-e group, and 22 percent in the high!inco-e group&
Aeveral factors could explain this relationship& The de-and for pu4lic services
-ay rise faster than inco-e =the inco-e elasticity for services is greater than one?,
particularly in lo(er!inco-e countries& .or instance, ur4ani1ation tends to rise (ith
inco-e, and the de-and for pu4lic services is generally higher in ur4an areas& At the
sa-e ti-e, ho(ever, it is usually easier to collect taxes in ur4ani1ed areas& "ore
generally, the capacity of countries to collect taxes appears to rise as inco-e levels
increase&
2
If social insurance contri4utions are included, the average tax ratio rises to 2#&2 percent& We
shall not discuss social insurance pay-ents, ho(ever, in part 4ecause it is not al(ays clear
(hether they are included in the tax data for so-e countries&
0
"ore detailed analysis confir-s the 4road conclusion that, on average, tax ratios
rise (ith per capita inco-e levelsC ho(ever, the relationship 4et(een rising inco-e levels
and higher taxes is significant only for the poorer countries&
%
As inco-es rise in poor
countries, the si1e of the pu4lic sector al-ost invaria4ly 4eco-es relatively larger& After
so-e point, ho(ever, this 9inco-e deter-inis-: of the tax level declines and the
relationship 4et(een inco-e and tax levels largely disappears& As already -entioned, the
rich countries have -ore choices, and so-e rich countries have chosen to levy -uch
lo(er taxes than others& Perhaps the -ost i-portant conclusion that can 4e derived fro-
these data, ho(ever, is that there is, at 4est, a (eak relationship 4et(een econo-ic
develop-ent and the level of taxation& ,ven the poorest countries, (hile o4viously -ore
constrained than rich countries, appear to have considera4le discretion as to ho( -uch
they raise in taxation&
. Tax structure
The -anner in (hich countries raise taxes differs as (idely as do the a-ounts
they raise& The pattern of taxes found in any country depends upon -any factors such as
its econo-ic structure, its history, and the tax structures found in neigh4oring countries&
Choice also plays a part, as different countries -ay also attach different i-portance to
such co--only accepted characteristics of a good tax syste- as fairness, econo-ic
effects and collection costs& Donetheless, it is again useful to consider 4riefly average
patterns as one approach to tax policy in any one country&
.or the sa-ple as a (hole, consu-ption taxes accounted for al-ost *$ percent of
the total, and inco-e taxes =including special taxes levied on extractive industries? (ere
al-ost e8ually i-portant& Within the consu-ption tax category, value!added taxes =6ATs?
account for a4out *$ percent of the total, (ith excises 4eing al-ost e8ually i-portant&
Personal inco-e taxes are a 4it -ore i-portant than corporate taxes =including the
extraction taxes? (ithin the inco-e tax category& "ost of the re-aining tax revenues
co-e fro- taxes on i-ports and exports&
A countryEs revenue structure appears to depend to so-e extent upon its location
and econo-ic structure& In s-all island countries such as Bar4ados, for instance,
international trade taxes -ay play an unusually i-portant role& "ore generally, and not
surprisingly, trade taxes tend on the (hole to 4e -ore i-portant in the lo(er!inco-e
group, (here they account for 2* percent of tax revenues, co-pared to only # percent in
the higher!inco-e group& Trade taxes =-ainly custo-s duties? appear to decline steadily
as countries 4eco-e -ore developed&
*
An interesting exception are the transitional
countries (hich !! although -any of the- fall (ithin the lo(!inco-e group as defined
%
A si-ple regression of per capita taxes on per capita FDP has an elasticity of only $&0#,
indicating that taxes gro( -ore slo(ly than inco-e, 4ut a -ore appropriate 8uadratic regression
on inco-e sho(s that taxes tend to rise (ith inco-e, 4ut -ore slo(ly as inco-e rises& Indeed,
after per capita inco-e reaches a4out 3AD%/,$$$, the tax ratio actually declines& Ginear
regressions esti-ated separately for each inco-e group yielded a significant coefficient on per
capita FDP only for the lo(!inco-e countries&
2
here !! have traditionally relied little on trade taxes ="artine1!6a18ue1 and "cDa4,
2$$$?& In general, ho(ever, trade taxes clearly decline in i-portance as inco-e rises&
The higher the level of per capita inco-e, the -ore a country relies on direct
taxes, especially those on personal inco-e& Ai-ilarly, although they rise -ore slo(ly,
consu-ption taxes too 4eco-e relatively -ore i-portant in -ore developed countries&
/

These differences in tax structure appear to reflect certain 4asic differences 4et(een lo(
and high!inco-e countries& Go(!inco-e countries tend to raise -ore revenues at the
4order, (here relatively fe( collection points need to 4e controlled& .or the sa-e reason,
they are -ore likely to rely -ore heavily on excise taxes on to4acco, alcohol and so on&
In contrast, direct taxes =and 6AT? tend to re8uire 4oth a -ore effective tax
ad-inistration and taxpayers (ho are -ore sophisticated, conditions -ore likely to exist
in developed countries&
". Recent trends
'ver the short ti-e period covered in the data =only five or six years for -ost
countries in the sa-ple?, tax 4urdens have increased only slightly on average, fro- #&$
to #& percent of FDP& Indeed, taxes actually (ent do(n a 4it in Asia in this period&
Taking a longer perspective, Tan1i =#>2? reported for the late #>2$s an average tax ratio
of #2& percent of FDP for the 0 developing countries in his sa-ple& The co-para4le
ratio for the 2/ countries for (hich overlapping data are availa4le (as #&0 percent, again
suggesting a slight increase over ti-e in tax ratios&
'ne (ay to su--ari1e revenue gro(th over ti-e is in ter-s of 9tax 4uoyancy,:
that is, the percent change in tax revenue divided 4y the percent change in FDP&
0
Aince,
as noted a4ove, on average revenues have gro(n -ore 8uickly than FDP, the overall
average 4uoyancy (as #&$*& "oreover, 4uoyancies (ere roughly the sa-e in all three
inco-e categories, although they tended to 4e lo(er in Africa, and especially Asia, than
else(here&
The relative i-portance of different taxes has changed in recent years& The -ost
striking feature has 4een the increase in the share of revenues generated 4y consu-ption
taxes& 'ne reason has 4een the continued -ove to the adoption of 4road!4ased 6ATs,
(hich rose fro- %* to *$ percent of all consu-ption taxes even in the short period
considered in our sa-ple& A4out 2$ percent of the (orldEs population lives in the #2% or
-ore countries that no( levy a 6AT =,4rill et al&, 2$$#?& 'n the other hand, there has
also 4een so-e increase in the share of revenues raised fro- direct taxes, especially
personal inco-e taxes& In contrast, although the change is s-all, corporate taxes are
relatively less i-portant& Taxes on international trade have dropped dra-atically,
decreasing 4y *&% percent of total collections in this short period !! a decline
*
The coefficient in a regression of per capita FDP on international trade taxes as a share of FDP
is negative and statistically significant&
/
The inco-e elasticity of direct taxes is $&$, for consu-ption taxes $&0#, and for trade taxes
$&$>&
0
'n the relation 4et(een 94uoyancy: and 9elasticity:, see the discussion at note 4elo(&

approxi-ately offset 4y the *&# percent rise in consu-ption taxes& The use of trade taxes
has dropped even -ore over the longer ter-& In #>#, for exa-ple, trade taxes accounted
for %$&0 percent of developing country revenues =Tan1i, #>2?, co-pared to only 2*&%
percent for the sa-e countries in #>>&
). #onclusion
This course focuses on developing countries, covering a (ide variety of countries,
(ith very different tax levels and structures& Ao-e countries -ay lack effective
governance structures& Auch countries need to develop and i-ple-ent effective and
efficient tax syste-s if they are to 4e a4le to provide for the needs of their people and to
participate effectively in the (orld econo-y& Another group of countries -ay have -ade
su4stantial progress in -eeting develop-ent goals& There countries -ay still face
significant pro4le-s in tax policy due to glo4ali1ation and other factors& Although even
the less!developed countries -ay face fiscal challenges due to heavy dependence on trade
taxes, those countries (ith a developing econo-y -ust also cope (ith potentially
trou4leso-e and i-portant pro4le-s in the inco-e tax area& While glo4ali1ation and
other factors -ay lead to further convergence of tax syste-s, the evidence to date
suggests that the si1e and structure of taxation in -ost countries (ill continue to 4e
do-inated largely 4y do-estic rather than glo4al factors&
III. 'hat #an Taxation Do*
This Part exa-ines the role of taxes as (ell as so-e criteria that -ay 4e useful in
designing tax regi-es& The -ain purpose of taxation is to generate sufficient revenue to
finance pu4lic sector activities in a non!inflationary (ay& In Part II, (e sho(ed that
countries raise revenue in different (ays& A countryEs choice on ho( to structure its tax
syste- depends upon -any factors, such as the level of develop-ent, the need and desire
for increased pu4lic services, and the capacity to levy taxes effectively& Tax policy
choices also depend on a countryEs preference as to such pu4lic policy goals as attaining a
desired distri4ution of inco-e and (ealth and increasing the rate of national =and perhaps
regional? econo-ic gro(th&
Do one likes taxes& People do not like to pay the-& Fovern-ents do not like to
i-pose the-& But taxes are necessary 4oth to finance desired pu4lic spending in a non!
inflationary (ay and also to ensure that the 4urden of paying for such spending is fairly
distri4uted& While necessary, taxes i-pose real costs on society& Food tax policy seeks to
-ini-i1e those costs&
Tax policy is not 5ust a4out econo-ics& Tax policy also reflects political factors,
including concerns a4out fairness& In -any countries, increased econo-ic gro(th has
increased the disparity 4et(een the rich and the poor& Taxes influence the 4efore!tax
distri4ution of inco-e 4y changing econo-ic incentives& They also influence the after!
tax distri4ution of inco-e through, for exa-ple, progressive inco-e taxation&
>
.inally, regardless of (hat a particular country -ay want to do (ith its tax
syste-, or (hat it should do (ith respect to taxation fro- one perspective or another, it is
al(ays constrained 4y (hat it can do& Tax policy choices are influenced 4y a countryEs
econo-ic structure and its ad-inistrative capacity& These factors reduce the tax policy
options availa4le to developing countries&
,fficiency, e8uity and ad-inistrative feasi4ility are key criteria in designing and
evaluating tax syste-s& This Part provides an overvie( of the role of taxes in part 4y
focusing on these criteria& The first section exa-ines so-e considerations in using taxes
to raise revenue to fund govern-ent operations& The second section revie(s issues of
econo-ic efficiency and different costs of taxation& Dext, fairness concerns are
addressed& The fourth section revie(s the interaction of tax ad-inistration and tax policy&
The fifth section considers taxation and gro(th, and the sixth section touches on such
issues related to decentrali1ation& The final section exa-ines the use of taxes for non!tax
purposes&
(. Raise revenue
Tax syste-s exist pri-arily to raise revenue to fund govern-ent operations& Gack
of sufficient revenue often results in large 4udget deficits& ,xcept (hen short!ter- fiscal
sti-ulus -ay 4e considered appropriate for -acroecono-ic reasons, deficits generally
have undesira4le -acroecono-ic conse8uences such as cro(ding out private invest-ent
and increasing inflation& Preventing deficits re8uires good control over 4oth the
expenditure and revenue sides of govern-ent& The legislated 4udget -ust 4e structured
each year to operate strictly (ithin esti-ates of likely revenue receipts& While this -ay
see- o4vious, even these initial conditions for good tax and 4udgetary policy are not
satisfied in a nu-4er of countries&
Tax refor-s should as a rule 4e undertaken to achieve long!ter- rather than short!
ter- o45ectives&
2
Tax syste-s should not nor-ally 4e altered on a te-porary 4asis to
-eet anticipated current year shortfalls& .re8uent tax changes increase enforce-ent and
co-pliance costs and -ay increase efficiency costs, especially (here 4usinesses -ake
production and location decisions on the 4asis of a particular tax structure&
3nless tax revenues gro( sufficiently 8uickly to finance desired services over the
long ter-, govern-ents -ust reduce expenditures, raise tax rates, or alter other structural
characteristics of the syste-& Thus, a good tax syste- -ust generate sufficient revenue
to fund pro5ected govern-ent expenditures& Although countries differ in the pro5ected
rate of revenue gro(th pri-arily due to differences in pro5ected de-and for pu4lic
services, usually revenue gro(th rate should 4e roughly e8ual to the overall econo-ic
gro(th rate, unless the country (ants to increase =or reduce? the si1e of its govern-ent&
2
The i--ediate revenue effects of a tax policy change need not reflect its long!ter- effects,
o(ing 4oth to transitional aspects of the ne( structure and to the fact that taxpayers often change
their 4ehavior te-porarily to take advantage of higher or lo(er tax 4urdens in the years 4efore or
after the changes&
#$
The rate at (hich revenues increase over ti-e differs depending on the tax
structure, the 8uality of tax ad-inistration, and the pace and nature of econo-ic gro(th&
The 9inco-e elasticity: of a tax syste- -easures ho( fast revenues gro( relative to the
econo-y&

Tax elasticity is defined as the percentage change in tax revenues divided 4y

the percentage change in FDP =or potential tax 4ase, such as personal inco-e?& ,lasticity
e8ual to one, for exa-ple, -eans that tax revenues (ill re-ain a constant share of FDP&
,lasticity greater than one indicates that tax revenues gro( -ore rapidly than inco-e& In
principle, revenues should gro( at the sa-e rate as desired expenditures =that is, the
inco-e!elasticity for revenues and expenditures should 4e the sa-e?& In practice,
ho(ever, -any developing and transitional countries have had great difficulty in
achieving this target& This leads to fre8uent tax 9refor-s: ai-ed pri-arily at closing
short!ter- revenue gaps& Tax policies enacted in such econo-ically and politically
difficult circu-stances often fail to resolve the underlying 4asic pro4le- of inade8uate
revenue elasticity&
The overall elasticity of any tax syste- is si-ply the average of the elasticity of
individual taxes, (eighted 4y the percentage of total taxes raised 4y the tax& The
elasticity of a tax depends on the specific characteristics of its structure& The elasticity of
personal inco-e taxes generally reflects the progressivity of their rate structure and, -ost
i-portantly, the level of the personal exe-ptions =or 1ero 4racket? relative to average
inco-e levels& Consu-ption taxes are -ore elastic if they cover -ore rapidly gro(ing
goods and services rather than 5ust -ore slo(ly gro(ing traditional goods and if they are
levied as a percentage of the price =like a 6AT? rather than on the specific nu-4er of units
purchased =as (ith -any excises?& Property tax revenue increases -ore rapidly (hen
reappraisals occur on a regular 4asis and (hen property is fully valued&
)evenue gro(th generally slo(s during recessions and accelerates during
expansions& )evenue elasticity also tends to rise in expansions and fall in recessions,
thus exacer4ating the volatility of revenue flo(s& The elasticity of the corporate inco-e
tax is particularly volatile 4ecause in a recession corporate profits fall -uch -ore
precipitously than overall econo-ic gro(th& Countries that depend heavily on taxation of
natural resources such as oil or -inerals are especially vulnera4le to cyclical s(ings, (ith
(ide s(ings in co--odity prices changing the level of tax revenues& Fenerally, a
country that relies on a 4alanced set of tax instru-ents rather than a single revenue source
(ill have lo(er tax revenue volatility, 5ust as an individual investor can reduce the
volatility of her invest-ent portfolio 4y adopting a diversified invest-ent strategy&
. Economic e&&iciency
Ao-e -ay contend that econo-ists overe-phasi1e the costs of taxation and the
i-portance of efficient resource allocation& Taxes do, ho(ever, i-pose real econo-ic

Tax 9elasticity: refers to revenue gro(th in the a4sence of any tax policy changes, (hile tax
94uoyancy: refers to gro(th including the effects of such changes& In principle, elasticity is a
4etter -easure of the gro(th potential of the tax structure& In practice, ho(ever, as in Part II, data
li-itations often force analysts to rely on 4uoyancy data&
##
costs, and all countries should seek to -ini-i1e such 9dead(eight losses,: (hich reduce
the resources availa4le to achieve socially desired o45ectives& Countries (ith scarce
resources need to adopt tax policies to help ensure that those resources are used as
efficiently as possi4le&
Ao-e confusion -ay exist as to (hat is -eant 4y the 9costs: of taxation& Ao-e
people -ay think of such costs solely in ter-s of the taxes collected& 7o(ever, taxes are
si-ply a -eans of transferring resources fro- private to pu4lic use and are not
the-selves a cost in econo-ic ter-s& ,cono-ic costs are incurred only (hen the a-ount
of resources availa4le for societyEs use, (hether for pu4lic or private purposes, is reduced
4y taxes& There are several (ays taxes can reduce the a-ount of econo-ic resources&
The costs of taxation
.irst, taxes cost so-ething to collect& Depending on the types of tax, the actual cost
of collecting taxes in developed countries is roughly # percent of tax revenues& In
developing countries, the costs of tax collection -ay 4e su4stantially higher&
>
Another econo-ic cost is the 9co-pliance costs: that taxpayers incur in -eeting
their tax o4ligations, over and a4ove the actual pay-ent of tax& Tax ad-inistration and
tax co-pliance interact in -any (ays& 'ften, ad-inistration costs are reduced (hen
co-pliance costs are increased, e&g&, (hen taxpayers are re8uired to provide -ore
infor-ation thus increasing co-pliance costs, 4ut -aking tax ad-inistration easier and
less costly& A tradeoff 4et(een ad-inistration and co-pliance costs does not al(ays
exist, ho(ever& Both co-pliance costs and ad-inistration costs -ay increase (hen, for
instance, a -ore sophisticated tax ad-inistration re8uires -ore infor-ation fro-
taxpayers, undertakes -ore audits, and so forth&
Third parties also incur co-pliance costs& .or exa-ple, e-ployers -ay (ithhold
inco-e taxes fro- e-ployees, and 4anks -ay provide taxing authorities infor-ation or
-ay collect and re-it taxes to govern-ent& Co-pliance costs include the financial and
ti-e costs of co-plying (ith the tax la(, such as ac8uiring the kno(ledge and
infor-ation needed to do so, setting up re8uired accounting syste-s, o4taining and
trans-itting the re8uired data, and pay-ents to professional advisors& Although the
-easure-ent of such costs is still in its infancy, there are a fe( studies that esti-ate
co-pliance costs in developed countries =Aandford, #>>/?& These studies conclude that
co-pliance costs are perhaps four to five ti-es larger than the direct ad-inistrative costs
incurred 4y govern-ents& A recent careful study of co-pliance costs (ith respect to the
personal inco-e tax in India =Chattopay and Das Fupta, 2$$2? suggests that co-pliance
costs -ay 4e as -uch or -ore than ten ti-es higher than in developed countries&
Co-pliance costs are generally 8uite regressively distri4uted, and are typically -uch
higher (ith respect to taxes collected fro- s-aller fir-s&
>
A recent study in Fuate-ala, for exa-ple, esti-ated the- at 2&/ percent of collections ="ann,
2$$2?&
#2
.inally, taxes -ay give rise to (hat econo-ists call 9dead(eight: or 9distortion:
costs& Al-ost every tax -ay alter decisions -ade 4y 4usinesses and individuals as the
relative prices they confront are changed&
#$
The resulting changes in 4ehavior likely
reduce the efficiency (ith (hich resources are used and hence lo(er the output and
potential (ell 4eing of the country& Do -atter ho( (ell the govern-ent uses the
resources ac8uired through taxation, govern-ents need to li-it the negative
conse8uences of tax!induced changes in 4ehavior&
Taxes on (ages =personal inco-e taxes, (age taxes, social security taxes, and so
forth? reduce incentives to (ork& .or exa-ple, the higher the tax rate on (ages in the
for-al sector, the less attractive (orking in the for-al sector 4eco-es relative to (orking
in the untaxed infor-al sector& Consu-ption taxes also discourage (ork& Taxes on
spending increase the a-ount of ti-e one -ust (ork to pay for goods and services
through the -arketplace& As taxes are not i-posed on leisure, at the -argin, taxes likely
discourage =taxed? (ork&
Taxes not only alter relative prices =in this case, the net =after!tax? (age?, 4ut also
inco-e& As taxes reduce individualsE after!tax (ages, they -ay choose to (ork -ore to
co-pensate for lost inco-e& The net effect on (ork of any tax change reflects 4oth this
inco-e effect and the effect of the change in relative prices =the su4stitution effect?&
"any studies have exa-ined the i-pact of taxes on (ork, (ith results varying fro-
country to country depending upon the structure of taxes, the nature of the (orkforce, and
the nature of the econo-y&
##
In the present context, it is i-portant to note that the
su4stitution effect =the change in relative prices? (ill cause individuals to change their
(ork decisions and, if those decisions had 4een econo-ically efficient 4efore the tax, to
reduce the potential output of the nation&
Al-ost all taxes affect resource decisions& Consu-ption taxes, such as the value!
added tax, -ay discourage the consu-ption of taxed as opposed to untaxed goods =e&g&
housing in so-e countries?& Taxes on gasoline, alcohol, and cigarettes can reduce the
#$
There are a fe( exceptions& Gu-p!su- taxes, (here the tax 4urden is the sa-e regardless of
any 4ehavioral responses 4y taxpayers, are one exa-ple, -uch favored 4y theorists& "ore
i-portantly in practice, to the extent that taxes fall on econo-ic 9rents: H pay-ents to factors
a4ove those needed to induce the- into the activity concerned !! they too -ay not affect
econo-ic activity& Well!designed taxes on natural resources and land, for exa-ple, -ay thus to
so-e extent produce revenue (ithout econo-ic distortion& .inally, in certain instances, taxes H
again, if properly designed H -ay not only create distortions in econo-ic 4ehavior 4ut -ay even
induce desira4le 4ehavior& Certain environ-ental levies, for exa-ple, or even crude proxies such
as taxes on fuel, -ay to so-e extent have such effects& Auch instances of 9good: taxes H those
(ith no 4ad econo-ic effects H should of course 4e exploited as fully as possi4le, 5ust as (ell!
designed charges should to the extent possi4le, given pu4lic policy o45ectives, 4e used to finance
certain pu4lic sector activities that specifically 4enefit identifia4le individuals& In the end,
ho(ever, -ost of the taxes needed to finance govern-ent (ill have to co-e fro- other sources
and (ill hence give rise to the efficiency costs discussed in the text&
##
.or one such recent study, of Colo-4ia, for exa-ple, see Al- and GIpe1!CastaJo =2$$2?&
#%
consu-ption of these ite-s&
#2
Inco-e taxes, 4ecause they tax the return to savings, -ay
alter the a-ount of savings or the for- in (hich savings are held& .or exa-ple, failure to
tax capital gains until they are reali1ed =(hen the asset is sold? encourages the holding of
assets =a lock!in effect?& Taxes -ay also affect invest-ent, and such effects -ay 4e
especially i-portant (hen econo-ies are -ore open to trade and invest-ent& .oreign
investors -ay choose to locate their activities in a particular country for -any reasons,
such as the relative costs of production, access to -arkets, and sound infrastructure&
Taxes -ay also influence their choice of location& To the extent taxes lo(er the after!tax
return on invest-ents in a country or a region, the level of invest-ent and hence gro(th
-ay 4e lo(er than it (ould other(ise 4e& Corporate inco-e taxes -ay also influence
the co-position of a fir-Es capital structure =use of de4t or e8uity financing? or dividend
policy& .or exa-ple, retained earnings are encouraged (hen dividends are su45ect to tax
at the shareholder level and de4t is preferred over e8uity (here interest on de4t capital is
deducti4le and dividends paid fro- e8uity capital are not&
,xactly ho( i-portant such tax effects are is a -atter of considera4le de4ate
a-ong analysts,
#%
4ut the consensus is that they are -uch -ore i-portant than (as
thought thirty or forty years ago& The efficiency costs of taxation are so-e -ultiple of
the ad-inistrative and co-pliance costs -entioned a4ove& The lo(est esti-ates of the
efficiency costs of taxes for developed countries are at least 2$!%$ percent of revenues
collected, and -uch higher esti-ates are co--on in the literature& If these efficiency
costs are the conse8uence of rational policy decisions =for exa-ple, to redistri4ute
inco-e through the fiscal syste-?, they -ay 4e accepta4le& Atill, it is i-portant to design
taxes to -ini-i1e such possi4le adverse conse8uences, especially in poor countries&
Although the efficiency losses are real, they are not directly visi4le& The efficiency cost
of taxation arises 4ecause so-ething does not happenB so-e activity did not occur or
occurred in so-e other for-& 'utput that is not produced, ho(ever, is still output, and
potential (elfare, lost&
A suggested approach
Food tax policy re8uires -ini-i1ing unnecessary costs of taxation& To -ini-i1e
costs, experience suggests three general rulesB .irst, tax 4ases should 4e as 4road as
possi4le& A 4road!4ased consu-ption tax, for exa-ple, (ill still discourage (ork effort,
4ut such a tax (ill -ini-i1e distortions in the consu-ption of goods if all or -ost goods
and services are su45ect to tax&
#*
A fe( ite-s, such as gasoline, to4acco products and
alcohol, -ay 4e taxed at a relatively higher rate, either 4ecause of regulatory reasons or
#2
As noted earlier, not all such effects need 4e 4adB for instance, if to4acco consu-ption falls,
people -ay live longer, healthier and -ore productive lives&
#%
.or a recent survey of the effects of taxes on saving, for exa-ple, see Bernhei- =2$$2?&
#*
In theory, in order to -ini-i1e efficiency losses different tax rates should 4e i-posed on each
co--odity, (ith higher rates i-posed on those goods and services (here the changes in
4ehavior are the s-allest& To do so, ho(ever, re8uires -uch -ore infor-ation a4out ho( taxes
alter 4ehavior than is availa4le in -ost countries& "oreover, this approach does not take
ad-inistrative and e8uity concerns into account& .or these reasons, in practice it see-s generally
advisa4le to i-pose a unifor- tax rate to the extent possi4le&
#*
4ecause the de-and for these products is relatively unresponsive to taxation&
#/
The tax
4ase for inco-e tax should also 4e as 4road as possi4le, treating all inco-es, no -atter
fro- (hat source, as unifor-ly as possi4le&
Aecond, tax rates should 4e set as lo( as possi4le, given revenue needs to finance
govern-ent operations& The reason is si-ply 4ecause the efficiency cost of taxes arises
fro- their effect on relative prices, and the si1e of this effect is directly related to the tax
rate& The distortionary effect of taxes generally increases proportionally to the s8uare of
the tax rate, so that dou4ling the rate of a tax i-plies a fourfold increase in its efficiency
costs& .ro- an efficiency perspective, it is 4etter to raise revenue 4y i-posing a single
rate on a 4road 4ase rather than dividing that 4ase into seg-ents and i-posing
differential rates on each seg-ent& In practice, the cost of differential treat-ent -ust 4e
4alanced against the e8uity argu-ent for i-posing graduated rate schedules&
Third, fro- an efficiency perspective, it is especially i-portant that careful
attention 4e given to taxes on production& Taxes on production affect the location of
4usinesses, alter the (ays in (hich production takes place, change the for-s in (hich
4usiness is conducted, and so forth& Developing and transitional countries generally need
to i-pose taxes on production for several reasons& .irst, countries (ith li-ited
ad-inistrative capacity find it easier and less expensive to collect excise and sales taxes
at the point of -anufacture& Aecond, to the extent that taxes represent the costs of pu4lic
services provided to 4usinesses, the 4usinesses should 4ear the cost, via taxation, for
those services& .inally, countries need to tax corporate inco-e to prevent tax avoidance
4y individuals (ho (ould avoid shareholder level taxes 4y retaining earnings (ithin a
corporation and to collect taxes fro- foreign!o(ned fir-s&
". +airness concerns
.airness or e8uity is a key issue in designing a tax regi-e& .ro- one perspective,
taxes exist pri-arily to secure e8uity& Dational govern-ents do not need taxes to secure
funds 4ecause they can si-ply print the -oney re8uired to fund operations& The tax
syste- can 4e vie(ed as a -echanis- to take -oney a(ay fro- the private sector in as
efficient, e8uita4le, and ad-inistratively inexpensive (ay as possi4le&
What is fair?
What is considered e8uita4le or fair 4y one person -ay differ fro- the
conceptions held 4y others& Traditionally, tax scholars have defined fairness in ter-s of
hori1ontal and vertical e8uity& 7ori1ontal e8uity re8uires those in si-ilar circu-stances
to pay the sa-e a-ount of taxes& .or apportioning tax lia4ility, hori1ontal e8uity often
e-4races so-e notion of a4ility or capacity to pay& 6ertical e8uity re8uires 9appropriate:
differences a-ong taxpayers in different econo-ic circu-stances&
#/
3nfortunately, in -any instances this i-plies that such taxes (ill 4e highly regressive (ith
respect to inco-e&
#/
'n the surface, 4oth concepts have great intuitive appeal& Those (ho have the
sa-e a4ility to pay should 4ear the sa-e tax lia4ility& Ai-ilarly, it -akes good sense for
there to 4e appropriate differences for taxpayers in different situations& 3nfortunately,
4oth concepts -ay have li-ited usefulness in tax policy de4ates&
The concept of hori1ontal e8uity has 4een challenged as 4eing inco-plete, not
helpful, and derivative& .or exa-ple, an inco-e tax can co-pletely satisfy hori1ontal
e8uity re8uire-ents only if (e assu-e individuals have identical tastes and a single type
of a4ility or inco-e& 'nce (e allo( preferences to vary and provide for different types of
a4ility or inco-e, then only a tax 4ased on an individualEs a4ility to earn inco-e, rather
than actual earnings, can effectively provide for e8ual taxation for those in e8ual
positions& In addition, the concept of hori1ontal e8uity -ay 4e inco-plete to the extent it
focuses only on a short ti-e period, such as one year, or fails to consider the i-pact of all
taxes or ignores the provision of govern-ent services or other 4enefits& The concept of
hori1ontal e8uity also -ay not 4e useful unless (e can deter-ine (hich differences are
i-portant and (hy these differences 5ustify different tax treat-ent&
Ai-ilarly, -uch disagree-ent exists a4out the usefulness of the concept of
vertical e8uity and a4out (hat constitutes appropriate differences in treat-ent& Consider
several possi4le conceptions of fairness& To so-e, fairness could re8uire that all
individuals pay the sa-e a-ount of tax& Thus, one could design a tax syste- that i-poses
a head tax on each individual over the age of # years old& .airness could also re8uire all
taxpayers to pay the sa-e rate of tax on their inco-e& In so-e countries, the 9flat tax: or
9single rate tax: rhetoric en5oys great popularity& While -ost flat rate proposals provide
for a high threshold =1ero rate 4racket? 4efore the i-position of the flat rate, the notion of
one tax rate that fits all strikes -any as an e8uita4le -anner of deter-ining tax lia4ility&
To others, ho(ever, fairness re8uires those taxpayers (ith higher inco-e to pay a higher
percentage of their inco-e in tax& Although the progressive rate structure -ay rest on a
shaky theoretical foundation, it has 4een the -ost co--on inco-e tax rate structure&
"any find a 4asic attraction to assessing tax on the 4asis of 9a4ility to pay: (ith the
result that the rich are 4etter a4le to contri4ute to the financing the govern-ent
operations&
Kuestions -ay also 4e raised a4out the relative fairness of consu-ption taxes
versus inco-e taxes& Consu-ption tax proponents 8uestion (hether any inco-e tax
syste- can 4e fair& There are several, so-e(hat related, strands to their positions& 'ne
approach takes a societal vie(& Inco-e is (hat individuals contri4ute to societyC
consu-ption is (hat they take a(ay fro- the pot& Therefore, if (e (ant a society that
(ill continue to gro( and prosper, (e are 4etter off taxing consu-ption rather than
inco-e& A second approach considers consu-ption as a 4etter -easure of a householdEs
a4ility to pay& Because of the greater variations in inco-e over a personEs or householdEs
lifeti-e, it -ay 4e 4etter to use consu-ption as the 4ase for taxation rather than inco-e&
.inally, inco-e taxes i-pose higher taxes on households (ith higher savings& As such,
the inco-e tax syste- penali1es savers over those (ho consu-e currently&
#0
Proponents of inco-e tax clai- that a personLs net increase in econo-ic (ealth is
a 4etter -easure-ent of a4ility to pay than the use of their inco-e& That is, an inco-e
tax proponent (ould say the person (ho earns M# -illion and spends M#$ has a greater
a4ility to pay than the person (ho earns M#$ and spends M#$& 3nder a consu-ption tax,
4oth (ould 4ear the sa-e tax 4urden (hile under an inco-e tax, the first person (ould
4ear a -uch greater tax 4urden& Ao-e consu-ption tax advocates concede the
consu-ption tax alone (ould not 4e appropriate if it failed to tax a personLs savings as
(ell as consu-ption& It is argued, ho(ever, that the inco-e tax is not an appropriate tool
to tax savings& 'ne alternative (ould 4e to use a consu-ption tax to tax spending and a
(ealth tax to tax savings&

As these 4rief co--ents suggest, discussions of fairness in general, or of
hori1ontal and vertical e8uity in particular, are, 4y the-selves, of li-ited usefulness&
Ai-ply saying (e should accord e8ual treat-ent to e8uals adds little to tax policy
discussions& We need to choose an ethical fra-e(ork 4efore -aking any co-parisonsN
(hether co-paring e8uals or -aking 9appropriate: co-parisons a-ong une8uals&
Without such a funda-ental fra-e(ork one cannot evaluate the relative fairness of
different proposals or different tax regi-es& Perhaps the 4est (e can do nor-atively is to
deter-ine the conse8uences of a proposal or regi-e, and then evaluate the- in the
context of different ethical structures& In the end, only through its political institutions
can any country really define and i-ple-ent its vie( of (hat is an accepta4ly fair tax
syste-&
A possible approach
.airness -ay 4e approached in various (ays& As discussed a4ove, one -ay
consider the relative tax 4urdens i-posed on taxpayers (ho are in the sa-e or in different
econo-ic circu-stances& Alternatively, one -ay consider the overall effects of taxation
on inco-e and level of (ell!4eing& The policy i-plications of these t(o approaches -ay
4e 8uite different& The first approach focuses on the distri4utional conse8uences of a
particular refor- proposal to change a particular provision or series of provisions&
3nfortunately, although proposals to refor- taxes 4ased on such analysis -ay indeed
i-prove particular -easures of hori1ontal and vertical e8uity (ithin the li-ited group
actually su45ect to the full legal 4urden of the tax in 8uestion, they -ay also have
i-plications for others that -ay in so-e instance -ake the syste- as a (hole less fair&
.ro- the perspective of social and econo-ic ine8uality, (hat -atters in the end is
the overall i-pact of the 4udgetary syste- on the distri4ution of (ealth and inco-e&
Both expenditures and taxes should therefore 4e taken into account in considering ho(
govern-ent policy affects the distri4ution of inco-e, as (ell as the overall e8uity
i-plications of any tax change&
Taxes affect e8uity in -any and co-plex (ays& They -ay treat people (ho are in
essentially the sa-e econo-ic position differently =hori1ontal e8uity?& Taxes -ay fall
-ore heavily on those (ho consu-e alcohol than on those (ho consu-e housing, or on
those (ho get their inco-e in the for- of (ages rather than fro- far-s or dividends&
#2
Taxes -ay also differ in their effects on inco-e distri4ution =vertical e8uity?& They -ay
tax the rich relatively -ore =progressivity? or less =regressivity? than the poor&
Ao-e countries -ay (ish to favor cities, other countries -ay favor rural areas&
Ao-e -ay choose to favor rich savers in the na-e of gro(th, others the poor, in the na-e
of redistri4ution& Gike -ost policy instru-ents, tax policy can play -any tunes& What is
critical fro- an e8uity perspective is, first, to 4e a(are of the e8uity i-plications of tax
refor-s for different groups, and, second, to ensure that the actual outco-e of such
refor-s is consistent (ith the intended outco-e&
Consider, for exa-ple, the case of a transitional country like the )ussian
.ederation, in (hich the 4ig 9untaxed: sector is not traditional agriculture =as in -any
lo(!inco-e countries? 4ut rather the relatively large 9shado(: econo-y& The existence
of such a sector -ay have i-portant i-plications for the effects of particular tax policy&
.or exa-ple, to the extent the 6AT functions properly, it (ill to so-e extent serve
essentially the sa-e function as a presu-ptive tax on the infor-al sector =since credits
are only availa4le for fir-s that are registered as taxpayers and those earning inco-e in
the shado( sector are taxed (hen they purchase co--odities through the for-al sector?&
'n the other hand, if -any high!inco-e recipients operate through the shado( econo-y,
the effects on e8uity of increasing the progressivity of the personal inco-e tax are not
al(ays o4vious& Fovern-ent e-ployees and e-ployees of large, for-al -arket fir-s
-ay 4e the pri-ary personal inco-e taxpayers and hence 4ear the 4runt of such changes&
In such circu-stances, it is not inconceiva4le that indirect taxes such as a 6AT and
especially certain excises in 9higher!inco-e: consu-ption goods such as -otor vehicles
-ay 4e -ore progressive than a personal inco-e tax that in reality falls largely on a
li-ited group of (age earners&
#0
In short, it is i-portant in thinking a4out taxation and
e8uity to focus not on preconceived notions a4out la4els !! for exa-ple, that anything
called a personal inco-e tax is, 4y definition, progressive, (hile anything called a 6AT
is, 4y definition, regressive H 4ut rather on the reality of ho( taxes (ork in practice&
Auch argu-ents do not -ean that corporate and personal inco-e taxes do not serve
an i-portant role in developing and transitional countries& Auch taxes are often the
largest tax source for high!inco-e countries, and the sa-e -ay 4eco-e true in other
countries as their econo-ies develop, -ore 4usinesses and individuals 4eco-e part of the
for-al econo-y, and infor-ation and tax ad-inistration i-proves& Currently, ho(ever,
particularly in the least developed countries, revenue syste-s rely heavily on
consu-ption taxes and are likely to continue to do so for so-e years to co-e&
#0
A tax is considered progressive (hen the tax 4urden as a percent of inco-e is greater for higher
inco-e households than for lo(er inco-e households, proportional if the percentage of inco-e
paid in taxes stays constant as inco-e rises, and regressive if the percentage paid in taxes falls as
inco-e rises& A higher inco-e taxpayer (ill nor-ally 4ear a larger a4solute tax lia4ility than a
lo(er inco-e taxpayer, regardless of (hether the tax is progressive, proportional or regressive, so
the difference 4et(een the three concepts is ho( rapidly taxes rise (ith inco-e, not (hether
taxes rise (ith inco-e&
#
Taxes -ay not -ake the poor richer, 4ut they can certainly -ake the- poorer&
#2

.iscal atte-pts at poverty alleviation in developing countries -ust therefore 4e
undertaken pri-arily on the expenditure side of the 4udget& Donetheless, the poor should
not 4e -ade even poorer through taxes& It -ay therefore 4e desira4le to exe-pt certain
94asic needs: ite-s fro- even the 4roadest!4ased consu-ption tax& Certainly, heavy
taxes on ite-s that constitute -a5or consu-ption expenditures for poor people should
generally 4e avoided&
Taxation is one of the fe( (ays in (hich the (ealthy -ay 4e -ade less (ealthy,
short of outright confiscation& But taxes have likely had only -oderate success in
reducing inco-e ine8uality in developed countries and appear to have had even less
success in reducing inco-e ine8uality in developing countries& The -a5or tax instru-ents
for achieving progressivity are the individual inco-e tax and various (ealth taxes =such
as taxes on real property, taxes on personal assets, and inheritance taxes?& Done of these
taxes has 4een particularly effective in developing countries in reducing inco-e
ine8uality&

Although atte-pts to redistri4ute inco-e through taxation have generally not 4een
effective in -ost developing and transitional countries =Chu, Davoodi, and Fupta, 2$$$?,
it -ay often 4e politically necessary and desira4le to tax those (ho gain the -ost fro-
econo-ic develop-ent, 4earing in -ind the need at the sa-e ti-e to -ini-i1e the
efficiency costs of unduly high tax rates& Austaina4le tax policy needs to 4e accepted as
fair 4y those affected& ,ven in the poorest countries, auto-o4iles and other luxury
products are -ore visi4le than inco-e, so that it should 4e feasi4le to collect progressive
taxes on these ite-s&
#

Tax incidence
To deter-ine the fairness of a tax regi-e, one -ust consider the econo-ic
incidence of taxation& It is i-portant to distinguish 4et(een those (ho have the lia4ility
to pay a particular tax and those (ho suffer the econo-ic incidence or 4urden of the tax&
Tax 4urdens fall on individuals in their roles as consu-ers, producers and factor
suppliers, not on corporations or other institutions& .or exa-ple, although the 6AT la(
-ay re8uire fir-s to pay 6AT to the govern-ent, it is likely that the real econo-ic
incidence of the 6AT falls on the ulti-ate consu-er& Ai-ilarly, although -otor fuel taxes
are al-ost al(ays collected high in the distri4ution chain =for exa-ple, at i-port or fro-
-a5or distri4utors?, the cost of the tax is likely 4orne 4y consu-ers& In other instances, it
is unclear (ho actually 4ears the econo-ic costs of taxation& .or exa-ple, the econo-ic
#2
Ao-e developed countries, such as Canada and the 3nited Atates, use their inco-e tax syste-s
to provide inco-e support to certain lo(!inco-e people& 3sing the tax syste- to -ake such
transfers re8uires 4oth that the tax ad-inistration is efficient and that -ost people file tax returns&
Deither condition is satisfied in -ost developing countries&
#
As 7ughes =#>2? notes, taxing fuel correctly can 4e especially difficult in countries
like Indonesia in (hich petroleu- products =in this case, kerosene? are an essential consu-ption
ite- for the poorest people& Bosnia seeks to i-pose differential rates on fuel for ho-e heating
versus for other purposes =such as transportation?, 4ut this has proven to 4e very difficult to
enforce and is su45ect to significant evasion&
#>
incidence of property taxes -ay 4e 4orne either 4y the o(ners of land and capital =(ho
also 4ear the legal incidence? or 4y the users or renters of the property, depending upon
-arket conditions&
Deter-ining tax incidence re8uires a good understanding of ho( various -arkets
operate in an econo-y, particularly the a4ility of different types of taxpayers to shift the
cost of the tax to other econo-ic actors& Who actually 4ears taxes depends on the relative
supply and de-and elasticities of consu-ers and suppliers and other factors& While
econo-ists have -ade i-portant advances in esti-ating tax incidence, -uch (ork
re-ains, particularly in deter-ining tax incidence in developing countries&
.or exa-ple, it is still not clear (ho 4ears the cost of the corporate inco-e tax& As
corporations are 5ust legal constructs, the tax cost -ust fall on individuals& As a result of
the corporate tax, shareholders =or all o(ners of capital? could receive lo(er returns,
consu-ers could pay higher prices, or (orkers could receive lo(er (ages, or so-e
co-4ination thereof& In addition, the tax conse8uences in the short!run could differ fro-
long!run conse8uences& The incidence of a corporate inco-e tax thus depends on such
factors as the openness of the overall econo-y in ter-s of the inflo(s and outflo(s of
capital invest-ent, as (ell as on the extent to (hich capital -oves 4et(een the corporate
and unincorporated sectors, the relative capital!intensity of corporations, and the
elasticity of de-and for goods produced 4y corporations and other 4usinesses& These
factors are not easy to -easure& As econo-ic conditions vary a-ong different countries,
taxes that have the sa-e legal incidence -ay have different econo-ic incidence in
different countries =Ahah and Whalley, #>>$?&
Consider also the payroll tax& ,cono-ists generally assu-e the payroll tax is
actually 4orne 4y (orkers in the long run, regardless of the actual division 4et(een
e-ployers and (orkers on the o4ligation to pay the tax& Again, the incidence depends on
the elasticities of supply and de-and& Because the supply of la4or is relatively inelastic,
-ost or the entire tax 4urden falls on (orkers& In so-e instances, the i-position of a
payroll tax -ay have additional effects& The change in the after!tax (age (ill have 4oth
inco-e and su4stitution effects on (orkers& It is possi4le that the la4or supply could
curve 4ack(ards such that the (age rate could fall 4y -ore than the a-ount of the tax& In
this case, 4ecause of the additional supply response, the e-ployers could actually 4enefit
fro- the i-position of a tax on la4or&
Chu, Davoodi, and Fupta =2$$$? find that for %0 studies of overall tax syste-s in
#> different developing countries, #% studies found the tax syste- progressive, 2 studies
found the tax syste- proportional, 2 studies found the tax syste- regressive, and the
re-ainder of the studies had -ixed findings or insignificant effects& .or inco-e tax
syste-s, #2 of the #* studies (ere progressive, one study (as regressive, and one had a
-ixed finding&

T(o other considerations add to the difficulty of trying to deter-ine the tax
4urden of 4oth individuals and groups of individuals in different inco-e classes& The first
factor is the necessity to consider the tax incidence of a group of taxes& The -ore
2$
different types of taxes, the harder it is to untangle the tax incidence of a particular tax
and the cu-ulative and interactive effects of the total group of taxes&
Aecond, a co-plete analysis of incidence re8uires consideration of all parts of
govern-ent activities& In exa-ining 4oth so-e specific taxes and tax syste-s as a (hole
it is i-portant to consider 4oth taxes and 4enefits fro- govern-ent expenditure
progra-s& .or exa-ple, a co-plete analysis of the incidence of a social security tax
re8uires esti-ates of the incidence of the tax and the retire-ent 4enefits provided under
the retire-ent syste-& Ai-ilarly, it is useful to co-pare the tax incidence on individuals
in different inco-e classes (ith the 4enefits provided under such govern-ent expenditure
progra-s as education, health and housing assistance&
In all countries, the tax syste- can effectively 4e split into t(o parts& 'ne part of
the tax syste- has relatively high tax co-pliance rates& A su4stantial portion of la4or
inco-e -ay 4e su45ect to final or provisional (ithholding, -any for-s of inco-e fro-
capital -ay 4e su45ect to (ithholding or infor-ation reporting re8uire-ents, and -any,
4ut not all, -ediu- and large corporations are su45ect to pu4lic reporting re8uire-ents
and keep relatively accurate 4ooks and records& Taxpayers operate in the 9for-al:
econo-y and the difference 4et(een esti-ated tax lia4ility and actual tax pay-ents is
relatively s-all&
In contrast, the second part of the tax syste- has relatively lo( co-pliance rates&
This part of the econo-y is co-prised of -any s-all enterprises operating, at least in
part, in the 9infor-al: econo-y& 7ere, tax evasion is 8uite high and efforts to 4ring this
sector into co-pliance are difficult and expensive& The tax ad-inistration lacks the
infor-ation and resources to tax effectively a large infor-al sector of the econo-y&
When govern-ents re8uire additional tax revenue, the co--on approach is to
raise tax rates on the part of the tax syste- (here co-pliance rates are high& This
contri4utes to the actual and perceived unfairness of the tax syste- as refor-s increase
the tax 4urdens on taxpayers (ith high co-pliance rates&
The role of income taxes
Aeveral reasons exist (hy developing countries are less capa4le of using the tax
syste- to redistri4ute inco-e& .irst, inco-e and (ealth taxes play a relatively s-all role
in the tax structure of developing countries as co-pared to developed countries& In those
Gatin A-erican countries for (hich data are availa4le, for exa-ple, personal inco-e
taxes collect -uch less than # percent of FDP&
Aecond, the individual inco-e tax in developing countries is often -erely a (age
(ithholding tax& In -any countries, taxes on la4or in the for-al sector co-prise over >$
percent of the total individual inco-e tax revenue& In so-e countries, the tax la( does
not reach so-e for-s of inco-e fro- capital, such as capital gains& In other countries, the
li-itations of tax ad-inistrations -ay effectively exe-pt certain types of inco-e fro-
tax =for exa-ple, inco-e fro- passive assets held outside the country?& The li-ited
2#
a4ility of the individual inco-e tax to tax effectively inco-e fro- -ost for-s of capital
-eans that it is unlikely that the very rich 4ear significant tax lia4ility&
Third, it -ay of course 4e politically difficult to i-pose effective inco-e tax and
(ealth taxes in -any countries& It -ay 4e accepta4le to pass tax legislation that is in
theory progressive 4ut in practice does not i-pose significant tax lia4ility on the upper
classes& The appearance of progressivity -ay 4e necessary for the tax syste- to 4e
politically accepta4le even if the reality of effective progressivity is not, in the end,
accepta4le&

Taking all these factors into account, (hat can 4e said a4out the role of inco-e
taxes in developing and transitional countries+ .irst, even if a countryEs sole o45ective is
econo-ic gro(th, a clear case exists for taxing corporate inco-e, if only to collect a fair
share of the revenue that -ultinational and large do-estic 4usinesses derive fro-
econo-ic activities in that country& It is of course true that 4y taxing corporations
differently, and usually -ore heavily than other for-s of 4usiness, govern-ents tend to
discourage, at least in principle, the operation of 4usinesses in corporate for-& Atill, the
fact that -ost -a5or 4usinesses all over the (orld operate in corporate for- despite the
prevalence of corporate inco-e taxes suggests that the corporation re-ains in general the
4est availa4le vehicle for -o4ili1ing large a-ounts of capital for 4usiness purposes&
Aince corporations are the engine of develop-ent in all -odern societies, a tax on
corporations is in effect a tax on the -odern, gro(ing sector of the econo-y&
#>
Countries
need to tax that sector 4oth to secure the revenue they need to -eet expanding
expenditure de-ands and also to ensure that those (ho 4enefit -ost fro- develop-ent
pay their fair share& But they -ust also ensure that corporate taxes are not so high as to
discourage gro(th& In general, the 4est approach for developing or transitional countries
is thus to i-pose a -oderate, sta4le tax on all corporations&
Personal inco-e taxes =as distinguished fro- general (age levies such as those
i-posed in -any countries for social security purposes? serve to -itigate, at least to a
-oderate degree, the ine8ualities in inco-e and (ealth that al-ost invaria4ly acco-pany
gro(th& Care -ust, ho(ever, 4e taken not to co-plicate such taxes unduly, thus raising
their costs to too high a level& ,ven if a country could change its individual inco-e taxes
and (ealth taxes to -ake the- -ore effective, it is not clear the 4enefits of increased
progressivity (ould 4e (orth the econo-ic costs& As discussed else(here, it is difficult to
deter-ine the effects of taxes on econo-ic 4ehavior& It is also likely that the
conse8uences are 8uite different in developed versus developing countries& .or exa-ple,
taxes -ay play a lesser role in influencing decisions a4out (ork vs& leisure in developing
countries, 4ut a greater role in influencing decisions regarding operating in the for-al vs&
grey or 4lack econo-y, or in saving at ho-e vs& portfolio invest-ent outside the country&
#>
In -any developing countries, the corporate sector -ay 4e 8uite s-all to 4egin (ith&
Donetheless, corporate taxes -ay have an i-portance 4eyond the revenue they yield& To the
extent a corporate tax falls on foreign!4ased corporations, for exa-ple, it -ay 4oth yield
revenues that are paid in effect 4y foreigners and also provide a useful (indo( to the (ay
4usiness is conducted in developed countries&
22
In principle, it is also desira4le to expand the 4ase of consu-ption tax to
enco-pass -ore services in part to reduce regressivity& 3nfortunately, it has often
proved exceedingly difficult to include -any services, especially those that -ay 4e
consu-ed disproportionately 4y the rich, in the 4ase of taxes such as the 6AT, so that
even the 4est!designed consu-ption taxes are unlikely to 4e very progressive, at least
(ithin the -arket sector of the econo-y&
2$
Progressivity in the personal inco-e tax -ay
thus provide a useful offset to the likely regressive i-pact of the consu-ption taxes on
(hich the revenue syste-s in -ost lo(er and -iddle!inco-e countries depend& In such
countries, for the -ost part personal inco-e taxation should likely have a 9threshold: H
the level of inco-e at (hich the tax 4egins to apply H (ell a4ove average inco-e levels&
"oreover, to check tax avoidance, it (ould likely also 4e (ise to keep the top -arginal
rate of the personal inco-e tax fairly close to the rate of the corporate inco-e tax&
Both corporate and personal inco-e taxes -ay thus play an i-portant role in
developing and transitional countries& 7o(ever, given the current econo-ic context in
-any countries, the -ost i-portant part of the tax regi-e in such countries is likely to 4e
a 4road!4ased value!added tax, pro4a4ly supple-ented 4y a fe( high!rate excise taxes on
selected ite-s&
In the end, the -ost effective (ay to reduce ine8uality in -any countries see-s
likely to 4e through spending progra-s targeted at the poor& .or exa-ple, expenditures
ai-ed at i-proving pri-ary education or pri-ary health services -ay prove -ore
effective at reducing ine8uality than trying to change the tax syste- to tax the rich& 3nder
this approach, it -ay 4e 4etter to use the tax syste- to raise as -uch revenue as possi4le
(ithout regard to distri4utional concerns and use expenditure progra-s to transfer
resources&
). Tax administration
The 4est tax policy in the (orld is (orth little if it cannot 4e i-ple-ented
effectively& Tax policy design -ust take into account the ad-inistrative di-ension of
taxation& What can 4e done -ay to a considera4le extent deter-ine (hat is done in any
country&
Tax design in developing countries is strongly influenced 4y econo-ic structure&
2#

"any developing countries have a large traditional agricultural sector that is not easily
taxed& "any transitional and developing countries have a significant infor-al =shado(?
econo-y that also is largely outside the for-al tax structure& The potentially reacha4le
tax 4ase thus constitutes a s-aller portion of total econo-ic activity than in developed
2$
Aee the exa-ple cited in note 2/ 4elo(& To the extent the poorest sectors of society re-ain
largely outside the -arket econo-y, a 6AT -ay, of course, nonetheless 4e 4roadly progressive in
its incidence&
2#
A century ago, for exa-ple, the no( developed countries also relied heavily on excises and
trade taxes, in part reflecting the nature of their econo-ies at that ti-e&
2%
countries& The si1e of the untaxed econo-y is in part a function of tax policy& .or
exa-ple, the high social insurance tax rates levied in transition countries such as Croatia
create an incentive for a large infor-al econo-y 4y discouraging e-ployers fro-
treating -any service providers as e-ployees or encouraging the under!reporting of (age
levels&
22
The resulting lo(er tax revenues often lead govern-ents to raise tax rates,
further exacer4ating incentives to evade taxes& I-proving tax ad-inistration is thus
central to the choice of tax structures and to i-proving taxation in developing and
transitional countries&
The resources used in ad-inistering and co-plying (ith taxes =or, for that -atter,
evading the-? are real econo-ic costs, in ter-s of the a4ility of the econo-y to provide
goods and services& Food tax policy re8uires keeping such costs as lo( as possi4le (hile
also achieving revenue, gro(th, and distri4utional goals as effectively as possi4le& This
is no s-all task& Three ingredients see- essential to effective tax ad-inistrationB the
political (ill to ad-inister the tax syste- effectively, a clear strategy for achieving this
goal and ade8uate resources for the task& It helps, of course, if the tax syste- is (ell
designed, appropriate for the country in 8uestion, and relatively si-ple, 4ut even the 4est
designed tax syste- (ill not 4e properly i-ple-ented unless these three conditions are
fulfilled& "ost attention is often paid to the resource pro4le- !! the need to have
sufficient trained officials, ade8uate infor-ation technology and so on& 7o(ever,
(ithout a sound i-ple-entation strategy, even ade8uate resources (ill not ensure
success& And (ithout sufficient political support, even the 4est strategy cannot 4e
effectively i-ple-ented&
3nfortunately, 4ut unsurprisingly, fe( countries at any inco-e level have senior
govern-ent officials (ho are eager to incur the econo-ic and political costs of -a5or tax
policy and tax ad-inistrative refor-s& .re8uently, international agencies re8uire such tax
refor-s as a condition for loans& Countries, desperate for revenues, launch frantic efforts
to raise revenue (ithout hurting politically po(erful interests or (ithout providing the
ti-e, resources and consistent long!ter- political support needed for effective tax
ad-inistration& This reluctance to collect taxes efficiently and effectively (ithout fear or
favor is understanda4le in those countries (ith a fragile political foundation& But no
-agic (ay exists to o4tain a via4le long!ter- tax syste- (ithout -a5or changes in tax
ad-inistration and often in tax policy also&
If the political (ill exists, the 4lueprint for effective tax ad-inistration is relatively
straightfor(ard& The tax ad-inistration -ust 4e given an appropriate institutional for-,
(hich -ay -ean a separate revenue authority& It -ust 4e ade8uately staffed (ith trained
officials& It should 4e properly organi1ed, (hich generally -eans an organi1ational
structure 4ased on a function rather than on a tax!4y!tax 4asis&
2%
Co-puteri1ation and
22
A nu-4er of agencies in addition to the tax ad-inistration, such as social security
ad-inistration and the custo-s ad-inistration and in so-e countries the financial police =for
exa-ple, in the countries of the for-er Ougoslavia?, are often involved in revenue
ad-inistration&&
2%
Alternatively, organi1ation 4y client groups -ay so-eti-es 4e sensi4le& But (hat is
never sensi4le is to assign specific taxpayers to specific officials for prolonged periods of ti-e, a
practice still co--on in so-e countries&
2*
appropriate use of -odern infor-ation technology is i-portant, 4ut technology alone is
not sufficient and these i-prove-ents -ust 4e carefully integrated into the tax
ad-inistration& De( co-puter syste-s have often developed parallel to the existing
structure =in the Philippines, for exa-ple?, 4ut little can 4e gained fro- a syste- that
does not recogni1e the skills and needs of tax officials&
,ffective tax ad-inistration re8uires 8ualified tax officials& Tax authorities -ust
provide for training and retraining staff as needed& The tax authorities need to collect the
infor-ation needed for effective ad-inistration fro- taxpayers, relevant third parties, and
other govern-ent agencies& The infor-ation -ust 4e stored in an accessi4le and useful
fashionC and, -ost i-portantly, it -ust then 4e used to ensure that those (ho should 4e
on the tax rolls, are, that those (ho should file returns, do, that those (ho should pay on
ti-e, do, and that those (ho do not co-ply are identified, prosecuted and punished as
appropriate& All this is easy to say and hard to do !! 4ut it is not an i-possi4le task&
Countries such as Aingapore are -odels of (hat can and should 4e done, and such
-odels should 4e studied closely and, once adapted as necessary, i-ple-ented&
The first task of any tax ad-inistration is to facilitate co-pliance& This re8uires
-aking sure that those (ho should 4e in the syste- are in the syste- and that they
co-ply (ith the rules&
.irst, taxpayers -ust 4e found& If taxpayers are re8uired to register, the registration
process should 4e as easy as possi4le& Ayste-s -ust 4e in place to identify those
(ho do not register voluntarily& Tax authorities should adopt an appropriate uni8ue
taxpayer identification syste- to facilitate co-pliance and enforce-ent&
Aecond, tax authorities need a process for deter-ining tax lia4ilities& This -ay 4e
done ad-inistratively =as (ith -ost property taxes? or 4y so-e self!assess-ent
procedure =as (ith -ost inco-e taxes and 6ATs?&
2*
Third, the taxes due -ust 4e collected& In -any countries, this is 4est done through
the 4anking syste-& It is seldo- appropriate for tax ad-inistration officials to
handle -oney directly&
.inally, tax authorities should provide ade8uate taxpayer service in the for- of
infor-ation, pa-phlets, for-s, advice agencies, pay-ent facilities, telephone and
electronic filing, and so on, to -ake taxpayer co-pliance (ith the syste- as easy
as possi4le&
2*
Flo4ali1ation confronts tax ad-inistrations (ith so-e special pro4le-s& .or exa-ple, tax
ad-inistrations -ust ensure that revenues and expenses are properly calculated in deter-ining
taxa4le profits for the corporate inco-e tax, and that export credits and refunds are properly
handled under the 6AT& A nu-4er of countries =e&g& 3kraine? have failed to provide the ti-ely
re4ates provided 4y the 6AT legislation for exported goods& Taxpayers cannot 4e expected to
respect tax la(s (hen the govern-ent does not&
2/
This approach rests on treating the taxpayer as a client =al4eit not a (illing one? to 4e
served and not a thief to 4e caught& 3nfortunately, the latter attitude see-s to prevail in
-any developing countries&
'f course, so-e taxpayers are not honest, so the second i-portant task of any tax
ad-inistration is to reduce tax evasion& Tax authorities re8uire esti-ates of the extent and
nature of the potential tax 4ase, for exa-ple, 4y esti-ating (hat is so-eti-es called the
9tax gap&: Ao-e esti-ate of the nu-4er and type of individuals and fir-s not registered
(ith tax authorities is needed to devise strategies to 4ring the- into the tax syste-& In
so-e countries the -a5or tax pro4le- -ay 4e that -any taxpayers (ho are in the syste-
are su4stantially under!reporting their tax 4ase& Without so-e kno(ledge of the
unreported 4ase, and its deter-inants, no ad-inistration can properly allocate its
resources to i-prove tax collection and to ensure all parts of society 4ear their fair share
of the tax 4urden&
In addition to exploring the nature of the tax gap and undertaking the often difficult
tasks involved in extending the reach of the tax syste- into the infor-al econo-y to the
extent feasi4le, close attention -ust also 4e paid to the si-ple task of ensuring that those
(ho are in the syste- file on ti-e and pay the a-ounts due& I--ediate follo(!up of
non!filers and those (hose pay-ents do not -atch their lia4ilities is a too often neglected
aspect of good tax ad-inistration& Ade8uate interest charges -ust 4e i-posed on late
pay-ents to ensure that non!pay-ent of taxes does not 4eco-e a cheap source of
finance& Ai-ilarly, an ade8uate penalty structure is needed to ensure that those (ho
should register do so, that those (ho should file do so, and that those (ho under!report
their tax 4ases are sufficiently penali1ed to increase the costs of evading tax&
,nforcing a tax syste- is neither an easy nor a static task in any country& It is
especially difficult in the changing conditions of developing countries& 3nless this task is
tackled (ith seriousness and consistency, ho(ever, even the 4est designed tax syste- (ill
fail to produce good results&
A third -a5or task is keeping the tax ad-inistration honest& Do govern-ent can
expect taxpayers to co-ply (illingly if taxpayers 4elieve the tax structure is unfair or that
the revenue collected is not effectively used& But even a sound tax structure and sound
expenditure policy can 4e vitiated 4y a capricious and corrupt tax ad-inistration&
Developed countries took centuries to develop and i-ple-ent sound tax ad-inistration
practices ai-ed at preventing dishonest tax officials fro- succu-4ing to o4vious
te-ptations =and even then, not (ithout regular e-4arrassing lapses?& 3nfortunately,
-ost developing countries are trying to -aintain large govern-ent operations on a
precarious fiscal foundation (ithout su4stantial ti-e to solve the corruption pro4le-&
Tax officials -ust 4e ade8uately co-pensated, so that they do not need to steal to
live& They should 4e professionally trained, pro-oted on the 4asis of -erit, and 5udged
4y their adherence to the strictest standards of legality and -orality& Tax officials should
have relatively little direct contact (ith taxpayers and even less discretion in deciding
ho( to treat the-&
20
The failure to develop good tax ad-inistration and good tax policy together has
4een a particular pro4le- in so-e transitional countries& In )ussia, for exa-ple, serious
pro4le-s existed (ith 4oth the structure of the 6AT and the lack of ad-inistrative
experience and capacity& A si-ple exa-ple is that under the initial 6AT legislation, no
tax lia4ility (as due (hen loans (ere -ade fro- one 4usiness to another& Thus, a 4uyer
(ould clai- to have -ade a loan that (as never repaid =and (as in fact pay-ent for
goods? to a supplier and no tax (as due& The result (as a significant loss of revenue& A
-ore capa4le ad-inistration (ould have foiled this si-ple evasion techni8ue, 4ut 4etter
legislation (as also needed&
,ven if policies are good, the (ay in (hich they are ad-inistered can yield very
different outco-es than those intended& Ad-inistration that is seen as unfair and
capricious -ay 4ring the tax syste- as a (hole into disrepute& The initial failure of
transitional countries to develop their tax ad-inistrations (hen introducing ne( tax
structures resulted in very uneven tax i-position, lo(er than anticipated revenue, and
(idespread tax evasion& Ai-ilarly, in so-e developing countries, corporate tax lia4ilities
are often negotiated rather than calculated as set out in the la(& Bri4ery is so-eti-es so
co--on that it is considered a regular part of the co-pensation of tax officials& Auch
corruption under-ines confidence in the tax syste-, negatively affects (illingness to pay
taxes, and reduces a countryEs capacity to finance govern-ent expenditures&
.inally, so-e have argued that i-proved tax ad-inistration alone can generate the
revenues re8uired to 4alance the 4udget or to finance tax policy changes that (ill narro(
the tax 4ase through concessions or lo(er tax rates& Although 4etter tax ad-inistration
(ill generally enhance tax collection, increased revenue -ay not 4e the only goal of
i-proved ad-inistration, (hich is needed also to i-prove fairness, for exa-ple&
"oreover, since i-proving ad-inistration takes ti-e, any additional revenues -ay only
accrue over a nu-4er of years& Cutting tax rates or granting additional concessions in the
hope that i-proved ad-inistration (ill 8uickly -ake up any revenue losses is never a
good idea&
,. Taxation and gro%th
"uch has 4een (ritten a4out the effects of taxation on gro(th and e8uity&
7o(ever, even in developed countries (ith sta4le, long!esta4lished tax syste-s and
excellent data, there is still -uch (e do not understand a4out this co-plex su45ect& 'ur
understanding of the relationship of tax on gro(th in developing countries is even less
co-plete& Consider, for exa-ple, the trade!off 4et(een gro(th and e8uity& "ost
societies (ant to 4e richer& "ost also (ant the increased (ealth to 4e distri4uted fairly&
Are these o45ectives co-pati4le+ Despite -uch theoretical and e-pirical in8uiry as (ell
as political and policy controversy, no si-ple ans(er exists&
Ao-e contend that 4ecause gro(th never occurs across econo-ic sectors evenly, it
is inevita4le that increased ine8uality (ill result& 'thers contend that societies in (hich
22
resources are distri4uted -ore e8ually (ill do 4etter in the long ter-& Atill others suggest
that, (hatever the ans(er -ay 4e, countries can devise policy -easures that are fully
co-pati4le (ith achieving 4oth -ore gro(th and -ore e8uity& While the ans(er likely
depends on a countryEs specific circu-stances, the current situation in -any developing
countries offers !! at least in principle !! so -any opportunities for i-prove-ent that
so-e countries -ay 4e a4le to have their fiscal cake =gro(th? and eat it too
=redistri4ution?&
'ver the past /$ years, there have 4een -any policy prescriptions for econo-ic
gro(th =,asterly 2$$2?& Policy advisors have, in rough chronological order, called in turn
for increased capital invest-ent, i-prove-ents in education, population control,
reduction of govern-ent controls on -arket activities, and loan forgiveness progra-s as
9silver 4ullets: that (ould result in i-proved econo-ic perfor-ance in developing
countries& 3nfortunately, none of these cures (orked as advertised&
Ai-ilarly, there is no -agic tax strategy to encourage econo-ic gro(th& Ao-e
countries (ith high tax 4urdens have high gro(th rates and so-e countries (ith lo( tax
4urdens have lo( gro(th rates& Gooking at the relationship 4et(een gro(th rates and tax
rates in the 3nited Atates over the last /$ years reveals that the 3&A& has had its greatest
periods of econo-ic gro(th during those years (here the tax rates (ere the highest
=Ale-rod and Baki5a #>>0?& 'f course, this does not -ean that high tax rates are the key
to econo-ic gro(th& It -ay 4e that gro(th rates in the 3&A& -ight have 4een even higher
in those years (ith high tax rates if the rates had 4een lo(er& The point is that the
relationship 4et(een taxes and gro(th is co-plex& ;ust looking at the no-inal tax rates
provides little infor-ation as to the real effective tax rates on different individuals and
different activities, the level of govern-ent infrastructure and services that are
9purchased: (ith those tax dollars, and other govern-ent policies that -ay help or hinder
econo-ic activity&
Tax incentives
"any countries have sought to i-prove their econo-y 4y introducing a variety of
tax incentives for invest-ent, for savings, for exports, for e-ploy-ent, for regional
develop-ent, and so on =Ahah, #>>/?& 'ften, such incentives are redundant and
ineffective, giving up revenue and co-plicating the fiscal syste- (ithout achieving their
stated o45ectives& ,ven to the extent that incentives -ay 4e effective in inducing
investors to 4ehave differently than they (ould have done in response to -arket signals,
the result is often distorting and inefficient, diverting scarce resources into less than
opti-al uses& ,ssentially, tax incentives i-prove econo-ic perfor-ance only if
govern-ent officials are 4etter a4le to decide the 4est types and -eans of production than
are private investors& Tax incentives also result in very uneven tax 4urdens, (ith
do-estic co-panies often su45ect to full taxation =at least in theory?, (hile other fir-s,
often foreign investors, 4enefit fro- tax incentives that reduce their effective tax rates&
Despite such strictures, -any developing and transitional countries continue to
introduce and extend a variety of special tax incentives, partly in co-petition (ith one
2
another for increased foreign direct invest-ent& ,xperience suggests, ho(ever, that non!
tax factors, such as a sound -acroecono-ic policy, good infrastructure and a sta4le
governance syste- are -ore i-portant factors in locational decision than tax 4enefits&
Although a li-ited role for certain si-ple incentives -ay exist as part of a gro(th!
oriented fiscal policy, as so-e ,ast Asian experience suggests, tax incentives cannot
co-pensate for the a4sence of such critical factors& Ahould a country decide to introduce
a fe( li-ited incentives, these tax incentives should 4e (ell!designed, properly
i-ple-ented, and periodically evaluated if they are to do -ore good than har-&
It is i-portant to understand ho( particular tax instru-ents (ork in particular
environ-ents& Ao-e taxes that appear to 4e anti!gro(th and pro!redistri4ution =such as
personal inco-e taxes (ith highly progressive no-inal rate structures? -ay, at ti-es,
have neither of these characteristics, (hile other taxes, such as the 6AT, -ay see-
regressive co-pared to other tax alternatives, 4ut actually -ay 4e -ildly progressive =at
least 4et(een lo(er and -iddle inco-e groups?& As noted earlier, ho(ever, one cannot
5udge the effects of a tax 4y its na-e, 4ut only 4y close exa-ination of the details of its
design, i-ple-entation and econo-ic conse8uences&
A pro-growth (and nothing else! tax s!stem
Consider a country that (as concerned only (ith econo-ic gro(th and therefore
(ishes to design a 9pro!gro(th: tax syste-& What -ight such a syste- look like+
Aeveral characteristics co-e to -ind&
.irst, there (ould 4e little or no taxation of profits, to avoid discouraging
entrepreneurship and risk!taking& Taxing profits reduces the return fro- entrepreneurship
and risk!taking& Conse8uently, under a pro!gro(th tax syste-, no good case exists for
taxing nor-al profits&
2/
"ost countries, ho(ever, do tax profits, and properly so H for
exa-ple, to prevent people fro- placing assets in a corporation to avoid personal inco-e
taxes and to o4tain a share for the host country of profits earned 4y foreign investors&
Donetheless, high taxes on profits are unlikely to for- part of a gro(th!oriented tax
strategy& Instead, at -ost a reasona4ly lo( and sta4le 4road!4ased profits tax see-s
called for&
A purely gro(th!oriented tax strategy (ould also likely tax consu-ption -ore than
inco-e& The difference 4et(een consu-ption and inco-e is saving, and fro- a strict
gro(th perspective, -ore saving is 4etter than less& Ao if do-estic savings are essential
to financing do-estic invest-ent, there is a 9gro(th: argu-ent for taxing inco-e fro-
savings -ore lightly&
,ven in the -ost gro(th!oriented tax syste-, ho(ever, taxes should kept 4e as lo(
as possi4le on the poorest people si-ply 4ecause they -ust consu-e to 4e productive&
;ust as so-e so!called 9invest-ent: =for exa-ple, in luxury ho-es or ela4orate office
2/
'n the other hand, there is an excellent case for taxing so!called supra!nor-al profits
=econo-ic rent? as heavily as possi4le& 3nfortunately, it is not easy in practice to tell 9nor-al:
fro- an 9excess: profit&
2>
4uildings? -ay not 4e conducive to productivity, so so-e 9consu-ption: is productive&
If people lack food to eat or lack 4asic clothing and shelter, or if they are not healthy and
sufficiently educated to engage in -eaningful (ork, they are unlikely to 4e econo-ically
productive& ,8uity =in the sense of not taxing the poor? and gro(th =in the sense of
enhancing the productivity of the la4or force? are thus 8uite co-pati4le o45ectives& A
9good: 6AT in such a syste-, for exa-ple, -ight exe-pt certain specific ite-s that
constituted a significant fraction of the consu-ption of poor people&
20
.inally, a gro(th!oriented tax syste- in developing countries -ay seek to increase
the cost of operating in the non!-oneti1ed traditional sector =through tax or other
-easures? to encourage -ove-ent into the -onetary =-odern? sector& I-posing higher
taxes on traditional agriculture -ay 4e difficulty politically and ad-inistratively, and it
-ay not necessarily 4e e8uita4le, 4ut it is likely conducive to gro(th 4y shifting
resources a(ay fro- the traditional agriculture sector& Taxation of the -odern sector
through levies such as 6AT and inco-e taxes thus often needs to 4e supple-ented 4y
taxes on agricultural land and =especially (ith respect to the 9infor-al: or 9shado(:
sector of the econo-y? presu-ptive taxes&
22

In short, a purely gro(th!oriented tax syste- (ould see- to 4e one that has a
relatively lo( and sta4le tax on profits and so-e taxation of the traditional agricultural
and infor-al sectors, 4ut (ith -a5or fiscal reliance 4eing placed on a 4road!4ased
consu-ption tax that -akes so-e allo(ance for exe-ptions of necessary consu-ption&
What is conspicuously -issing in this picture, of course, is any explicit -ention of a
personal inco-e tax or any concern for fairness in taxation& As noted in section % a4ove,
and reiterated in Part I6, ho(ever, one si-ply cannot leave this issue out of account in
designing and i-ple-enting a tax syste-&
-. Taxation and Decentrali.ation
20
In the case of ;a-aica, for exa-ple, one study found that exe-pting only five narro(ly!defined
ite-s (ould cut the 6AT 4urden on the lo(est *$ percent of the inco-e distri4ution in half =Bird
and "iller, #>>?& 'f course, since all such exe-ptions 4oth co-plicate ad-inistration and are
al-ost inevita4ly poorly targeted =in the sense that -uch of the 4enefit goes to the non!poor? they
should 4e kept to a -ini-u-&
22
Presu-ptive taxes are taxes that 9presu-e: a certain taxa4le capacity 4ased on o45ective
=-easura4le, visi4le? indicators of production or consu-ption such as land, electricity used,
e-ployees, -achines, vehicles, and so on& Auch taxes, in -any different for-s, have a long
history in -any countries& They seldo- produce -uch revenue and often suffer fro- -any
defects of design and ad-inistration& Donetheless, despite such pro4le-s, presu-ptive taxes -ay
in principle play t(o vitally i-portant roles in developing countries& .irst, such taxes are often
the only levies effectively i-posed on the often large non!-odern =or at least 9non!official:?
sector of the econo-y& Aecondly, presu-ptive taxes can so-eti-es serve as a 4ackstop for
9nor-al: taxes in the for-al sector& .or exa-ple, "exico i-poses a -ini-u- tax on the gross
assets of a 4usinessB if the profits reported for tax purposes exceed a certain -ini-u- rate of
return on the assets, the profits tax is applied as usual, 4ut if the reported rate of profits is 4elo(
the -ini-al return, the 4usiness is instead su45ect to a tax 4ased on assets&
%$
)efor-ing tax structures is generally difficult in any country& )efor-ing tax
ad-inistrations is often even -ore difficult, and certainly takes longer& ,ven countries
that succeed in refor-ing tax structures and ad-inistrations -ay still fail to reap the
expected 4enefits unless they pay close attention to the often trou4ling pro4le-s arising
fro- the finance of state and local govern-ents& Auch pro4le-s are 4y no -eans
restricted to the relatively fe( =though i-portant? federal countries such as Bra1il, India,
and Digeria& )ather, they are arising (ith increasing fre8uency around the (orld in
countries as diverse as China, Colo-4ia, and 3ganda&
'ne reason for the increased i-portance of intergovern-ental fiscal relations is
si-ply 4ecause decentrali1ation is increasingly i-portant in -any countries, not least in
fiscal ter-s =Gitvack, Ah-ad, and Bird, #>>?& Decentrali1ation is occurring in -any
countries around the (orld, (ith the expected 4enefits varying to so-e extent& Ao-e
countries anticipate that 4etter service delivery (ill result 4ecause the diverse de-ands
and needs of the population can 4e served -ore effectively 4y local officials (ho have
4etter infor-ation on (hat people (ant& Gocal officials often can 4e held -ore
accounta4le than national officials, and particularly 4y the local population (ho have
4etter access to the -ayor than to -e-4ers of parlia-ent& This allo(s i-proved local
voice in deciding the level and 8uality of services and in de-anding i-prove-ents (here
they are needed& Decentrali1ation -ay 4e seen as a -eans of acco--odating the varying
interests of different ethnic groups 4y reducing the potential nu-4er of points of friction&
This has the potential to allo( nation 4uilding& There -ay also 4e disecono-ies of
delivering so-e services at the national or even regional level, (hich -eans that local
service delivery can 4e less expensive& The capacity to generate sufficient revenues is
often a disadvantage of decentrali1ation& The difficulties of taxing econo-ic activity that
can flee or 4e easily hidden is one of the reasons for pro4le-s in collecting tax revenues
at the local level& While there are =as usual? considera4le variations fro- country to
country, in -any developing and transitional countries, it is 4eco-ing increasingly
i-portant to ensure that local and regional govern-ents, like national govern-ents, have
an ade8uate resource 4ase& 3nfortunately, this again is an area in (hich practice falls far
short of (hat is needed, particularly (hen countries are really atte-pting to devolve
significant pu4lic sector responsi4ilities to su4!national levels of govern-ent&
There is no single definition of decentrali1ation of tax revenues& The extent of
decentrali1ation can 4e su--ari1ed in ter-s of the degree of local =or regional? control
over four factorsB o(nership of tax revenue, choice of tax 4ase, choice of tax rate, and tax
ad-inistration& )evenue o(nership is re8uired if tax revenues are to 4e seen as
decentrali1ed, 4ut o(nership is nor-ally not sufficient to vie( taxes as decentrali1ed&
The revenues are 4est seen as a grant if local govern-ents only have revenue o(nership,
since the rate, 4ase and ad-inistration are at the national level& In this case local
govern-ents cannot control the a-ount of revenues raised or the -eans through (hich
the revenues are raised& "any of the local revenues in "iddle ,astern countries like
,gypt are 4est thought of as part of a grant syste- rather than as local taxes& Transfers
fro- higher!level govern-ents -ay in -any instances 4e sensi4le 4oth to close the gap
4et(een (hat reasona4le tax rates can raise fro- a regionEs tax 4ase and to further
national interests in the provision of services (ith inter5urisdictional spillovers& But
%#
grants should nor-ally provide only part of local revenue 4ecause govern-ents are
nor-ally -ore accounta4le for revenues that they raise directly and 4ecause taxpayers are
4etter a4le to link the receipt of pu4lic services and the pay-ent of the taxes if 4oth are
housed (ithin a single govern-ent&
.ro- the perspective of econo-ic and political accounta4ility, the -ost essential
ele-ent of fiscal decentrali1ation is that local or regional govern-ents are allo(ed to
deter-ine the rates of taxes for (hich they are politically responsi4le, and that these taxes
are sufficiently i-portant in ter-s of the revenues generated to ensure that the setting of
rates can affect expenditures in so-e noticea4le (ays& Control over the tax rate gives
local officials the a4ility to influence the level of services provided =(hich is necessary if
govern-ents are to 4e devolved? and -akes the- -ore accounta4le to local citi1ens (ho
are 4etter a4le to see the extent of revenues going to the local govern-ents& Thus, it is
i-portant that so-e taxes, and hopefully representing a significant a-ount of revenue, 4e
decentrali1ed to every devolved local govern-ent& But, decentrali1ation of taxes does not
necessarily re8uire that local govern-ents -ust finance all their expenditures, and a large
role for grants and intergovern-ental transfers (ill exist in -ost developing and
transition countries&
Gocal control over tax 4ases is inappropriate in -any cases 4ecause
ad-inistration and co-pliance costs can often 4e reduced if the sa-e tax 4ases exist
across the country& A constant 4ase -eans that 4usinesses operating across the country are
not su45ected to -ultiple tax structures& There are also lo(er ad-inistration costs if the
taxes are ad-inistered at the national level& 7o(ever, the political incentive exists for
higher!level govern-ents to give a(ay the tax 4ase of a lo(er govern-ent =for (hich the
higher govern-ent gets no revenue?, as has occurred in Bosnia and 7er1egovina, 4ecause
the higher govern-ent receives all of the political 4enefits fro- the tax incentives
(ithout confronting the lost revenues& The perverse incentives are a disadvantage of local
officials not having control over their 4ase& An in!4et(een ground can 4e found 4y
having national control over tax 4ases, 4ut (ith significant local input =even to the point
of re8uiring local agree-ent for any changes?, as exists to varying degrees in Canada,
Australia, and Papua De( Fuinea&
Gocal control over the tax ad-inistration is often not necessary 4ecause in -any
instances national collection of local and regional taxes -ay 4e -ore efficient than
esta4lishing nu-erous s-all and likely inefficient local collection agencies& There can 4e
econo-ies of scale in a single ad-inistration& Co-panies operating across the country
are 4etter controlled 4y a national ad-inistration& Also, a national tax ad-inistration
allo(s for the a4ility to -ove revenue agents fro- ti-e to ti-e in order to li-it the
likelihood of fraud& Again, the potential pro4le- is that national tax ad-inistrations -ay
do a poor 5o4 of collecting local taxes& The national tax ad-inistration does not have the
sa-e incentives to collect local taxes and to respond to local officials as it does to the
Parlia-ent and the Pri-e "inister& The result can 4e that the ad-inistration puts very
little effort into ensuring that local taxes are collected (ell& Food incentives for effective
collection of local taxes -ust 4e esta4lished if the national ad-inistration is to collect
%2
local taxes& A regional tax ad-inistration -ay 4e a4le to collect so-e local taxes as (ell,
given the sa-e caveats&
While the design of a good su4!national tax syste- is even -ore country!specific
than the design of a good tax ad-inistration, like the latter this task lends itself to so-e
generali1ations& .irst, at the local level, in al-ost all countries -ore use can and should
4e -ade 4oth of user charges and especially of a si-ple property tax& 3ser fees should
4e i-posed (herever possi4le to finance services& They can nor-ally 4e effectively
i-posed (hen the recipients of services are easily identifia4le and receipt of the service
can 4e separately identified for individuals or households& '4vious exa-ples include
utility services, (hich should 4e fully priced, and any su4sidies desired for e8uity reasons
-ade explicit as pu4lic expenditures& Aervices such as utilities should 4e considered for
privati1ation as (ell& Gocal property taxes should also provide a significant revenue
source& Central or regional govern-ents -ay play an i-portant role in setting up a
standard tax la( and in undertaking the technical tasks of valuing property and training
staff, 4ut collection and enforce-ent of property taxes should likely 4e at the local level
-aking this an exa-ple of a tax that is 4est ad-inistered at the local level& In all cases,
the deter-ination of the tax rate should definitely 4e at the local level, al4eit (ithin so-e
specified range that could 4e esta4lished 4y either the national or regional govern-ent&
"axi-u- rates are particularly i-portant for non!residential property, to cur4 9tax
exporting: and si-ilar (ays of 4reaking the essential connection 4et(een those (ho
-ake the policy decision (ith respect to rates and those (ho 4enefit fro- the expenditure
of the revenues collected& The property tax, like user fees, can often 4e a good 4enefit
tax, 4ut only if local incentives to i-pose taxes on so-e captive industries are li-ited&
"ini-u- rates -ay also 4e useful to li-it the degree of tax co-petition that can arise
4et(een local or regional govern-ents& .e( developing or transitional countries
currently give local govern-ents sufficient discretion H or responsi4ility H (ith respect to
property taxes&
Aecondly, if regional govern-ents are expected to play an i-portant role in
providing nationally critical services such as education and health, they (ill usually need
access to so-e -ore i-portant tax 4ase such as a payroll tax or a personal inco-e tax
=(hich in practice in -ost countries is little -ore than a payroll tax?& The -ost efficient
(ay to i-pose such regional taxes is usually as a 9surcharge: on existing national taxes,
(ith the regional taxes 4eing collected together (ith the national tax H 4ut 4eing clearly
sho(n to taxpayers as separate H and re-itted to the appropriate regional govern-ent&
Auch a syste- superficially -ay appear si-ilar to the (idespread syste- of 9revenue!
sharing: or 9tax sharing: found in al-ost all transitional countries =such as 7ungary and
Croatia? and in a nu-4er of developing countries as (ell, 4ut it is conceptually and
practically totally different& The usual 9tax sharing: syste- is no -ore than a disguised
intergovern-ental transfer (ith the recipient govern-ents 4earing no responsi4ility at all
for the tax rate or the a-ount they receive& Tax sharing is often the antithesis of sound
decentrali1ation policy and is conducive to irresponsi4le spending 4y su4!national
govern-ents =Bird and A-art, 2$$2?&
/. 0sing the tax system &or non1tax o23ectives.
%%
The tax syste- can 4e used to encourage or discourage certain activities& .or
exa-ple, taxes can 4e used to correct -arket failures, such as positive or negative
externalities& ,xternalities exist (hen -arket prices fail to reflect all the 4enefits or costs
associated (ith an activity& The classic negative externality is pollution& .ir-s that
pollute affect the (elfare of others, often in a (ay that is outside the -arket -echanis-&
The presence of externalities could pro-pt different types of govern-ent action&
The govern-ent could regulate the activity 4y providing rules of conduct and penalties
for failure to co-ply& It could esta4lish clear property rights, such that all affected parties
(ould 4e 4rought together and 4argain in a -anner that could result in the parties
accounting for the costs and 4enefits of their activities& Another alternative (ould 4e to
use the tax syste- as a tool to correct for externalities& A tax on pollution -ay correct for
-arket failure 4y re8uiring polluting fir-s to 4ear the cost of pollution& In addition,
excise taxes on to4acco, alcohol, and gasoline for -otor vehicles -ay seek to reduce the
use of these products 4y i-posing additional costs that reflect so-e or all of the negative
externalities generated 4y these products&
,ven apart fro- -arket failures, policy-akers could use the tax syste- to
encourage or discourage certain activities& Countries use tax provisions to encourage
larger fa-ilies, retire-ent savings, capital invest-ent, ho-e o(nership, and a host of
other activities that -ay or -ay not have ele-ents of -arket failures&
Policy-akers can often choose 4et(een su4sidi1ing the activity directly though
grants and other progra-s or indirectly through the tax syste-& "any countries use a 9tax
expenditure: 4udget to account for the costs of tax provisions that are used to pro-ote
non!tax o45ectives& )e8uiring esti-ates of the costs in ter- of foregone revenue helps
i-prove the accounta4ility of legislatures fro- granting tax 4enefits&
I4. #onclusion 11 The Political Economy o& Taxation
This -odule has covered a very (ide range of issues, for the -ost part at a rather
general level of discussion& A truly 9practical: exa-ination of ho( to design and
i-ple-ent any specific tax change in any particular developing country (ould of course
re8uire a -uch -ore detailed and specific exa-ination of -any co-plex issues&
2
Auch
(as not possi4le in the 4rief ti-e availa4le& Instead, (e have atte-pted to survey a 4road
range of relevant issues related to tax policy design in developing countries in general&
Au4se8uent -odules (ill develop -any of the points raised in -ore detail&
In the econo-ic and ad-inistrative perspectives e-phasi1ed in this -odule,
developing countries face a very difficult task in designing and i-ple-enting suita4le tax
syste-s& "any such countries have large traditional agriculture sectors& 'ther
significant co-ponents of the potential tax 4ase are often in other e8ually 9hard!to!tax:
2
To get the flavor of such an exercise, consider t(o recent =useful? tools prepared for the World Bank !!
the 9diagnostic: for tax ad-inistration refor- =availa4le at (orld4ank&orgPpu4licsectorPtaxPToolkit&doc? and
the 9design tool: for to4acco taxes =availa4le at (orld4ank&orgPto4accoPpdP*Q2$to4accoTaxesQ2$&doc?&
%*
sectors such as s-all 4usiness and the infor-al or shado( econo-y& Auch countries in
practice have often relied heavily on taxes on international trade, 4ut this tax 4ase too is
4eco-ing increasingly hard to tax in the face of pressures for trade li4erali1ation& As
countries develop, the -ass -odern production and consu-ption activities on (hich the
tax syste-s of developed countries rest !! taxes on (ages and personal inco-e, on
corporate profits, on value!added !! expand and need to 4e 4rought into the tax 4ase
(ithout overstraining ad-inistrative capacity or unduly discouraging the expansion of
such activities& ,cono-ic gro(th is often encouraged 4y, and results in, closer
involve-ent (ith the international econo-y, 4ut such 9glo4ali1ation: si-ultaneously
-ay cause fiscal pro4le-s& The 9leading edge: of gro(th -ay 4eco-e the 94leeding
edge: of the fiscal syste- as it 4eco-es difficult to levy taxes effectively on capital
inco-e, thus potentially exacer4ating internal ine8ualities& Gife is not easy for tax people
in developing countries, and is not 4eco-ing any easier&
All these pro4le-s are potentially greatly exacer4ated 4y the political econo-y
context (ithin (hich taxation -ust 4e designed and i-ple-ented& While detailed
exploration of this su45ect is not only 4eyond the scope of this course 4ut, as yet, not very
(ell understood, it -ay 4e useful to conclude this introductory overvie( of the issues 4y
si-ply noting so-e salient considerations that e-erge fro- exploration of taxation as not
5ust an econo-ic 4ut very -uch a political pheno-enon& Tax policy decisions are not
-ade in a vacuu-& Dor are they -ade, as is often assu-ed in econo-ic discussion, 4y a
94enevolent: govern-ent& )ather, they reflect a set of co-plex social and political
interactions 4et(een different groups in society in a context esta4lished 4y history and
state ad-inistrative capacity&
Taxation is not si-ply a -eans of financing govern-ent 4ut one of the -ost
visi4le parts of the social contract underlying the state& Why do citi1ens co-ply (ith tax
la(s, at least to so-e extent+ 'ne key reason is 4ecause they accept the state as
legiti-ate and credi4le and are thus 4oth, to so-e extent, (illing to support it and, to
so-e extent, afraid of (hat (ill happen to the- if they donEt& 3nless states are accepted
as legiti-ate in this sense, they (ill not 4e capa4le of securing sufficient resources to
govern or to develop& In this context, the success of tax refor- clearly depends upon the
(ay in (hich different political groups perceive the refor- and ho( they react to their
perception& To an i-portant extent, then, tax refor- is 9an exercise in political
legiti-ation: =Gledo, Achneider, and "oore, 2$$%?& Those (ho (ill have to pay -ore
-ust 4e convinced that they (ill, so to speak, get so-ething (orth(hile for their -oney&
Those (ho (ill not pay -ore -ust also get 4ehind a refor- if it is to succeed& The
4ureaucracy, those (ho (ill have to i-ple-ent the refor-, -ust also support it, or at
least not actively oppose it&
Ao-e see the inevita4le political processes underlying refor- as 9statist: in the
sense that the state can 4e vie(ed as an institution in its o(n right that seeks to -aintain
and increase its capacity, including its capacity to collect taxes& 'thers see acceptance of
increased tax 4urdens as inextrica4ly ent(ined (ith the expansion of a -ore de-ocratic
polity and a -ore inclusive society& .or citi1ens to pay -ore, they -ust get -ore of (hat
they (ant and the pu4lic finances -ust 4e 4oth transparent and accounta4le& ,ar-arking
%/
revenues to favored o45ectives, for exa-ple, a practice usually disliked 4y 4udgetary and
pu4lic finance experts, -ay prove an essential ingredient of a successful tax refor- fro-
this perspective&
Whether one vie(s tax policy fro- the traditional pu4lic econo-ics, -acro, and
ad-inistrative perspectives discussed in Part III or the -ore explicitly political
perspectives touched on here, ho(ever, one conclusion is inescapa4leB taxation is fro-
any perspective co-plex and difficult, 4ut it is i-portant to get it as right as (e can&
.inally, as if this (ere not hard enough, tax life is getting even -ore co-plicated o(ing
to 9glo4ali1ation&:
Taxation and globali"ation
Countries no longer have the luxury to design their tax syste-s in isolation&
Co--entators use the ter- 9glo4ali1ation: to -ean anything fro- an increase in
-o4ility of 4usiness inputs, pri-arily capital, across regions, to changes in consu-ption
and production patterns so that national 4orders have reduced significance& The result is a
loss of tax sovereignty 4y individual countries&
With the dra-atic reduction in trade 4arriers over the last decade, taxes have
4eco-e a -ore i-portant factor in location decisions& There is increased tax co-petition
for portfolio invest-ent, 8ualified la4or, financial services, 4usiness head8uarters, and,
-ost i-portantly for developed countries, foreign direct invest-ent& This -eans that
taxes do -atter, and a country (ith a tax syste- that differs su4stantially fro- other
countries, particularly its neigh4oring countries, -ay suffer =4enefit?& In addition, (ith
increased financial innovation, la4els are losing their -eanings& Ga(yers and invest-ent
4ankers can (ith relative ease convert e8uity to de4t, 4usiness profits to royalties, leases
to sales, and ordinary inco-e to capital gains !! or the other (ay around&
"uch of the traditional tax regi-e for taxing cross!4order transactions rests on a
styli1ed set of factsB =i? s-all flo(s of cross 4order invest-entsC =ii? relatively s-all
nu-4ers of co-panies engaged in international operationsC =iii? heavy reliance on fixed
assets for productionC =iv? relatively s-all a-ounts of cross!4order portfolio invest-ents
4y individualsC and =v? -inor concerns (ith international -o4ility of tax 4ases and
international tax evasions& But all this has changed in recent years&
What do these changes -ean for tax syste-s of developing countries+ .irst, there
is increased pressure to reduce trade taxes& WT' -e-4ership re8uires significant
reductions in i-port and export taxes& This has different conse8uences in different parts
of the (orld& Trade taxes in ',CD countries account for a4out 2!%Q of total tax revenue&
In contrast, trade taxes in African countries often account for 2/!%$Q of tax revenue& In
addition, African countries have less capacity to -ake up lost revenue 4y increasing other
taxes&
Aecond, there (ill 4e increased pressure on corporate inco-e tax revenues !!
again (ith different conse8uences in different regions& Corporate tax revenues are a
%0
larger portion of tax revenues for developing countries as co-pared to developed
countries& In the last #$ years there has 4een a -a5or change in 4usiness operations (ith
the disaggregation of production resulting in different operations in different countries&
There has also 4een an increase in value!added due to services and intangi4les (hich
-akes it harder to locate the source of corporate inco-e and thus harder for countries to
tax corporate inco-e& Also, increased intra!co-pany trade -akes it easier to avoid or
evade taxes&
Third, there (ill 4e increased pressure on individual tax revenues& Increased
-o4ility of capital -akes it harder to tax inco-e, especially as it 4eco-es easier for
individuals to earn inco-e outside of their country of residence& It -ay also 4e harder to
tax la4or inco-e, as la4or 4eco-es -ore -o4ile, as traditional e-ployer!e-ployee
relationships evolve into independent contractor status, and as o(ner!-anagers convert
la4or inco-e into capital inco-e&
.inally, there (ill also 4e pressure on 6AT revenues& "uch has 4een (ritten a4out
the challenges posed 4y electronic co--erce on 4oth the inco-e tax and 6AT 4ase&
I-prove-ents in technology allo( increased sales (ithout the seller having a physical
presence in a country, as (ell as increased use of digiti1ed products that -ake collecting
taxes on such products -ore difficult&
In these and other (ays, the eternal pro4le-s of designing and i-ple-enting a
good tax syste- continue to 4e co-plicated 4y the changing (orld (ithin (hich such
decisions -ust 4e -ade&
%2
Re&erences
Al-, ;a-es and 7ugo GIpe1!CastaJo, 2$$2& 9Payroll Taxes in Colo-4ia&: )eport
prepared for "isiIn de .inan1as PR4licas, BogotS, Colo-4ia, Dece-4er&
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.eldstein, eds&, Handbook of Public Economics, vol& % =A-sterda-B Dorth!7olland?&
Bird, )ichard "& and Bar4ara D& "iller, #>>& 9The Incidence of Indirect Taxation on
Go(!inco-e 7ouseholds in ;a-aica,: Economic Development and Cultural Change, %2
=;anuary?B %>%!*$>&
Bird, )ichard "& and "ichael A-art, 2$$2& 9Intergovern-ental .iscal TransfersB Gessons
fro- International ,xperience,: World Development,
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Policy, De( Delhi&
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Tax and Fovern-ent Apending Policies in Developing Countries,: I". Working Paper
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Countries,: in David De(4ery and Dicolas Atern, eds&, The Theory of Ta$ation for
Developing Countries =Pu4lished for the World Bank 4y 'xford 3niversity Press?&
<eynes, ;&"&, #>%0& The eneral Theory of Employment% &nterest% and !oney =GondonB
"ac-illan?&
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=WashingtonB World Bank?&
Gledo, 6ictor, Aaron Achneider, and "ick "oore, 2$$%& 9Pro!poor Tax )efor- in Gatin
A-ericaB A Critical Aurvey and Policy )eco--endations,: Institute of Develop-ent
Atudies, 3niversity of Aussex, "arch&
"ann, Arthur ;&, 2$$2& 9,sti-ating the Ad-inistrative Costs of TaxationB A
"ethodology (ith Application to the Case of Fuate-ala,: DevTech Ayste-s, Arlington,
6A, August&
%
"artine1!6a18ue1, ;orge and )o4ert "& "cDa4, 2$$$& 9The Tax )efor- ,xperi-ent in
Transitional Countries,: )ational Ta$ *ournal, /%B 22%!>&
Aanford, Cedric, ed& #>>/& Ta$ Compliance Costs+ !easurement and Policy =Bath, 3<B
.iscal Pu4lications?&
Ahah, An(ar, ed&,#>>/& ,iscal &ncentives for &nvestment and &nnovation =Pu4lished for
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Ahah, An(ar and ;ohn Whalley, #>>$& 9Tax Incidence Analysis of Developing CountriesB
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Ale-rod, ;oel and ;on Baki5a, #>>0& Ta$ing .urselves+ # Citi(en/s uide to the reat
Debate .ver Ta$ 'eform =Ca-4ridge, "assachusettsB "IT Press?&
Atein-o, Aven, #>>%& Ta$ation and Democracy+ 0wedish% -ritish% and #merican
#pproaches to ,inancing the !odern 0tate =De( 7avenB Oale 3niversity Press?&
Tan1i, 6ito, #>2& 9Kuantitative Characteristics of the Tax Ayste-s of Developing
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%>