Tanzi TaxPolicyEmerging 2000

Tax Policy for Emerging Markets: Developing Countries
Author(s): Vito Tanzi and Howell H. Zee

Source: National Tax Journal , June, 2000, Vol. 53, No. 2 (June, 2000), pp. 299-322
Published by: National Tax Association
Stable URL: https://www.jstor.org/stable/41789458
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Tax Policy for Emerging Markets :
Developing Countries
Abstract - This paper discusses important tax policy issues facing

developing countries today. It views tax policy from both the mac-
roeconomic perspective, which focuses on broad questions such as
the level and composition of tax revenue, and the microeconomic
perspective, which focuses on certain design aspects of selected major
taxes, such as the personal income tax, the corporate income tax,
the value-added tax, excises, and import tariffs. It provides a re-
view of the role of tax incentives in these countries, and identifies
some policy challenges posed by the globalization of the world
economy.
INTRODUCTION
The tax study

tax system
systemthatof isthat
capable
tax isofpolicy
financing
capabletheisnecessary
concernedlevel
of financing with the necessary the design level of a
of public spending in the most efficient and equitable way
possible. In developing countries with emerging markets, and
especially in those that aim at becoming integrated with the
international economy, tax policy must play a particularly
sensitive role. In these countries, the tax system should: (1)
raise enough revenue to finance essential expenditures with-
out recourse to excessive public sector borrowing; (2) raise
the revenue in ways that are equitable and that minimize its
disincentive effects on economic activities; and (3) do so in
ways that do not deviate substantially from international
norms.
In developing countries, the establishment of ef

efficient tax systems faces some formidable ch
first of these challenges is the structure of the e
makes it difficult to impose and collect certain ta
ond is the limited capacity of the tax administrati
is the paucity, or the poor quality, of basic dat
VitoTanzi & many developing countries the political set up
Howell H. Zee nable to rational tax policy than in advanced c
International Monetary would take too much space to discuss these ch
Fund, Washington , DC
any detail, so a few comments on each of them
suffice.
20431
Developing countries are often characterized
share of agriculture in total output and employ
National Tax Journal informal sector activities and occupations; man
Vol. Llll, No. 2 tablishments; a small share of wages in total nat
299

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NATIONAL TAX JOURNAL
a small share of total consumer spendingrevenue. Given the often precarious fis-
made in large, modern establishments; cal situation of developing countries, this
and so on. All these characteristics reduce uncertainty would expose them to poten-
the possibility of relying on certain mod- tially serious fiscal difficulties. As a con-
ern taxes, such as personal income taxes sequence, marginal changes are often pre-
and, to a much lesser extent, on value- ferred over major structural changes, even
added taxes. They also reduce the possi- when the latter would be clearly prefer-
bility of achieving high tax levels. able. This perpetuates the inefficient tax
In part as a consequence of the struc- structures.
ture of the economy, and in part as the Finally, it is well known that develop-
result of low literacy and low human ing countries tend to have income distri-
capital, it is difficult to combine all the butions that are much less even than
ingredients that make for a good tax ad- industrial countries. In the former, Gini
ministration. When the staff of the tax ad- coefficients that exceed 0.5 are not rare.1
ministration is not well educated and well This highly uneven income distribution
trained, when resources to pay good has two implications: first, that to gener-
wages and to buy necessary equipment ate high tax revenue, the top deciles would
are not there, when the taxpayers have have to be taxed significantly more pro-
limited ability to keep accounts, when the portionally than the low deciles; second,
use of telephones is limited and the mail that economic and often political power
is not reliable, it is difficult to create an is concentrated in the top deciles so that
efficient tax administration. As a conse- richer taxpayers are able to prevent tax
quence, countries often develop tax sys- reforms that would affect them negatively.
tems that allow them to exploit whateverThis partly explains why personal income
options they have rather than develop taxes and property taxes have been very
modern and efficient tax systems. One little exploited in these countries and why
consequence of this situation is that many tax incidence studies of developing coun-
developing countries often end up with tries have found that tax systems rarely
too many small tax sources, too heavy aachieve effective progressivity.
reliance on foreign trade taxes, and a rela- In conclusion, in developing countries,
tively insignificant use of personal incometax policy is often the art of the possible
taxes. rather than the pursuit of the optimal. It
is, thus, not surprising that economic
Because of the large role played by
informal activities; because of limited re-theory, and especially the optimal taxation
porting requirements; because many ac- literature, have had relatively little impact
tivities are not carried out by modern on the formulation of tax systems in de-
establishments; and because of financial veloping countries.2
limitations, statistical and tax offices haveThis paper discusses some of the impor-
difficulties in generating reliable and de-tant tax policy issues facing many devel-
tailed statistics. This paucity of reliableoping countries today. It draws on the
data makes it difficult for policy makers extensive first-hand experience with pro-
to assess the potential impact of major viding tax policy advice to these countries
changes to the statutory tax system. by If the International Monetary Fund
made, such changes are rarely accompa- (IMF), with which both authors of the pa-
nied by easily quantifiable impacts on tax per are affiliated. It is organized along the
1 A new comprehensive data set on income distribution in developing countries has recently been compiled by
Deininger and Squire (1996).
2 For a sympathetic discussion (largely focused on developed countries) of how the optimal taxation literature
could be used as a guide for tax policy formulation, see Heady (1993).
300

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Forum on Tax Policy in Emerging Democracies
given
lines of specific a particular level,
policy whether the ex-
issues, rath
individual country practices
isting composition of tax revenue (usually and
ences.3 Space limitations
in terms of income relative dictate
to consump- th
issues covered tion
are taxation) is desirable.5 This interestsele
necessarily
the selection criteria
stems in part from are guided
the widely-held belief m
that the welfare
the issues' general costs of resource misallo-to the
relevance
oping countries as
cation (bothaintra-
group than by
and intertemporally)
importance to increase
only with increased
some taxation, and
of that, these
in the choice
tries. For example, between taxing
issues income and
related to
assignment and revenue
consumption, the latter is thesharing
lesser evil b
the central andin local
affecting long-rungovernments
growth. However, it
addressed here,alsoeven
originates fromthough
the question of what they
pivotal in tax policy deliberations
level of public spending is desirable for a i
developing country at a given income
developing countries.
level.
For organizational purposes, this
views tax policy from
The vast two
literature on optimal perspe
tax theory
the macroeconomic perspective,
provides little practical guidance on the w
focuses on choice of thequestions
broad overall level of taxation. The such
level and composition of intax
literature is a bit more helpful the choice reve
covered in the next section; and the between income and consumption taxa-
microeconomic perspective, which fo- tion, but even here its value is limited.6
cuses on certain design aspects of selected Following brief reviews of theoretical con-
major taxes, is provided in the third sec- siderations about the tax burden and rev-
tion. The fourth section briefly discusses enue composition, the revenue situation
some policy challenges ahead for devel- in developing countries is assessed
oping countries. This is followed by the against that in developed countries and
conclusion. policy implications are drawn from it.7
LEVEL AND COMPOSITION OF Level of Tax Revenue

TAX REVENUE
Theoretical considerations
From a macroeconomic perspective,
aspects of a tax system that are of particu-The primary reason why optimal tax
lar interest to policy makers in develop- theory has little to say about choosing the
ing countries are (1) whether the existingoverall tax burden for an economy is that
overall tax level (usually expressed as amuch of this theory has been developed
ratio of tax revenue to gross domestic to suggest the optimal structure of taxes
product (GDP) is appropriate, and (2)
in a static context to raise a given tax bur-
3 Much of the material from which the present paper is drawn is contained in confidential IMF technical reports
prepared at the request of country authorities. Most of the country-specific references have, therefore, been
suppressed, except in those few cases involving references to factual information that is readily available in
the public domain.
4 The literature on taxation and development is voluminous. See, for example, Bird (1992); Bird and Oldman
(1990); Newbery and Stern (1987); and Tarizi (1991). For a recent survey of tax issues in developing countries
from a somewhat different perspective from the present paper, see Burgess and Stern (1993).
5 From time to time, policy makers are concerned about tax revenue in relation to short-run budgetary imbal-
ances. Such concerns are country-specific and will not be addressed here.
6 Much of the theoretical and empirical literature in this area has been surveyed recently in Tanzi and Zee (1997).
A detailed comparative study of level and composition of tax revenue between developed and developing
countries can be found in Zee (1996).
301

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
den. Thus, economythe(measured by the share of im-
theory
integrated ports and exports
the in GDP), theexpen
ratio of
budget in
money toitsGDP, and other analysi
variables. When
sumption solvedin
with data fora meanin
a specific country, the
poses of estimated
normative regression equation provides a p
would necessitate
hypothetical tax ratio for that country. This th
of the tax ratio is then compared with
benefits from the
tures to beactual
country's financed
tax ratio.9
other words, The comparison determin
between the tax ratio
level is estimated from the equation and the ac-
conceptually
mining tual tax level for
the the country indicates
optimal l
expenditure. While
whether, in comparison with other countries , sev
cal attempts
and taking into accounthave
its own characteris- be
this issue in
tics, the country'san integ
tax level is above or be-
expenditurelow the expectedand one. This derivedtaxatax
far have ratio
been has been interpreted to reflect the
rather
model degree of tax effort that the country is The
dependent.
provide making. As noted earlier, such a statisti- pol
practical
cal approach has no theoretical basis and
International comparison
should not be interpreted to indicate the
Lacking"optimal"a tax clear
burden for any country. pre
theory, Nevertheless,
an its use was (and at times still
alternativ
ing whether is) popular and usefulthe
because the derived
leve
level in aratio could be used to convince a reluc-
developing
priate" has
tant ministerbeen
of a low taxed countryto (such co
erage tax asburden
Guatemala), or to provide a justifica-
of a
of both tion for a determined minister, to increase
developing a
tries, his/her country'sinto
taking tax burden. Such an acc
countries' approach
characteristic
has been convenient both in es-
this is atablishing a benchmark by which a
statisticall
which, country's tax level could be popul
though judged against
ful, doesthe not norm of its peershave
and in anticipating a
tion. likely future developments as its economy
This approach became quite fashion- became more advanced. In fact, the regres-
able, especially in the 1960s and 1970s. It sions typically indicated that, ceteris
would correlate the ratio of tax revenue paribus, a higher per capita income was
to GDP (the dependent variable) for aaccompanied by a higher ratio of tax rev-
large group of countries against severalenue to GDP.
independent variables, for the same coun- Table 1 provides some comparative in-
tries, that could be expected to influenceformation, over the most recent decade for
the tax ratio. Variables often used in these which data are available, on the tax levels
studies are per capita income, share of in OECD countries and in a representa-
agriculture output in GDP, share of min- tive sample of developing countries -
eral exports in GDP, the openness of the disaggregated by broad geographical
8 Such attempts have become increasingly fashionable since the advent of the endogenous growth literature. A
particularly well-known example is Barro (1990). Turnovsky (1996) provides a more elaborate model of si-
multaneous determination of optimal tax and expenditure.
9 The literature is very extensive. See, for example, Bahl (1971); Tait, Gratz, and Eichengreen (1979); and Tanzi
(1992) for a more recent example.
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TABLE 1
COMPARATIVE LEVELS OF TAX REVENUE,
foregoing comparative observations are
1985-97 equally applicable to the tax revenue data
(IN PERCENT OF GDP) for the period 1995-97, during which the
average total tax level showed only a mar-
OECD Countries (1) 36.6 37.9 ginal increase for all subcountry groups
America 30.6 32.6
relative to the earlier period.
Pacific 30.7 31.6
Europe 38.2 39.4 As already mentioned, numerous stud-
ies have attempted to identify the deter-
Developing Countries (2) 17.5 18.2 minants of the level of taxation. One of
Africa 19.6 19.8
Asia 16.1 17.4 the most commonly used determinants
Middle East 16.5 18.1 has been per capita income, usually on
Western Hemisphere 17.6 18.0 grounds that economic development
Sources: Revenue Statistics (OECD); and Government
would
bring about both an increased de-
Finance Statistics (IMF).
mand for public expenditure (Tanzi, 1987)
and a larger supply of taxing capacity to
(1) Excludes the Czech Republic, Hungary, Korea,
Mexico, and Poland. meet such demands (Musgrave, 1969).
(2) A sample of 8 African countries; 9 Asian countries;
These considerations suggest - with gen-
7 Middle Eastern countries; and 14 Western
Hemisphere countries. erally strong empirical support - that a
positive correlation exists between tax lev-
regions.10 It shows that, for the period els and economic development. They also
1985-87, the average total tax level in the suggest, in theory, that the direction of cau-
developing countries was about 17.5 per- sation tends to run from development to
cent of GDP. The variation in this average tax levels, and not the other way around.
across geographical regions was fairly This is important because the common
narrow, with countries in Africa exceed- notion that higher tax levels would gen-
ing the sample average by about 2 per- erate larger distortions - and would thus
centage points of GDP (the variation be detrimental to growth - is then not nec-
within each group of countries was much essarily contradicted by the observed cor-
greater). In contrast, the average total tax relation between tax levels and develop-
level in the OECD countries in the same ment.11
period was more than twice as high (36.6 The main policy implication of the
percent of GDP), although there was a sig-above discussion for developing countries
nificant variance across the three OECD is that economic development would
subcountry groups: the average total taxmore often than not generate additional
needs for tax revenue to finance the rise
level in the European subgroup was on
the order of 8 percentage points of GDPin public expenditures while at the same
time increasing the countries' ability to
higher than that in the American and Pa-
cific subgroups. At the same time thereraise revenue to meet those needs. It is
was much less variance within each thus important to focus more on the ways
OECD group than within the group of thethe
revenue is utilized, and perhaps on the
taxthe
developing countries. Essentially all of structure, than on the level of taxation
10 Data for the OECD countries do not include the five recent OECD members: the Czech Republic, Hungar
Korea, Mexico, and Poland. Korea and Mexico are included in the developing country sample, which cover
a total of 38 countries in Africa (8), Asia (9), Middle East (7), and Western Hemisphere (14). In both Table 1 an
Table 2 (shown below), data presented are unweighted. While not shown, weighted average data (usi
country GDP in U.S. dollars as weights) convey broadly the same comparative picture.
11 In any case, much of the available econometric evidence on the relationship between tax levels and per capita
income growth has not been very robust, due largely to the difficulties in disentangling the growth effects o
other relevant variables from taxation. See, for example, Easterly and Rebelo (1993) and Levine and Rene
(1992).
303

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
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per se. Given thethecomplexity ofin the d

consumption tax. It turns out that,
opment process and the
the traditional way
neoclassical growththat
model, tax
might impact on the
it,lengthitof the
isconsumer's
doubtful planning that
policy purposes,horizon
the playsconcept
a crucial role in the of
theo- an "
mal" level of taxation
retical ambiguity of thethat is
relative superior- robu
linked to the ity of the consumption
different stages tax. of
If saving
a coun
economic development could
decisions are based on life-cycle consid- eve
meaningfully erations, the optimal
derived for mix ofanyincome and
countr
consumption taxes would depend entirely
on the relevant elasticities, i.e., of labor
Composition of Tax Revenue
supply and savings.12 If, however, the
planning horizon is infinite, then the op-
Theoretical considerations
timal tax on capital would in fact be zero
Important issues in any discussion of in the long run.13
revenue composition involve, first, the The analytical picture would get more
taxation of income relative to that of con- complex and the results more ambiguous
sumption, and, second, under consump- if human capital - the crucial ingredient
tion taxation, the taxation of imports vis- in the new endogenous growth litera-
à-vis domestic consumption. Consider ture - is brought into the analysis. In gen-
first the issue of the optimal income-con- eral, the nature and process of human
sumption tax mix. In evaluating the rela- capital accumulation, i.e., whether its ac-
tive merits of these two tax bases, both quisition is thought to require time (fore-
efficiency and equity considerations are gone wages), physical capital, even hu-
central to the analyses, especially in de- man capital itself, or some combination
veloping countries given their high Gini of all three, will ultimately have a bearing
coefficients. However, the theoretical lit- on the relative welfare costs of income and
erature has tended to focus on the former. consumption taxation. The upshot of the
The conventional belief that taxing in- above theoretical considerations is that,
come entails a higher welfare (efficiency) while taxing (physical) capital may well
cost than taxing consumption is primarily depress (physical) capital accumulation,
based on the observation that the income it, like taxing consumption, could have an
tax consists of two broad components: a impact on human capital accumulation
labor tax and a capital tax. Since the labor and other variables through a web of com-
tax is equivalent to a tax on consumption plex interactions, rendering the relative
in an intertemporal framework, the in- welfare costs of the two taxes a priori un-
come tax gives rise to an additional dis- certain.14 Such considerations also under-
tortion - on savings - that is absent from score the importance in tax policy delib-
12 It is not uncommon to encounter arguments for relatively heavy consumption taxation on the basis that the
elasticity of labor supply - at least for the group of prime male workers - is low. It must be noted, however,
that the cited inelasticity usually refers to the uncompensated labor supply curve. The compensated elastic-
ity - the concept relevant for measuring welfare costs - is typically much higher. Moreover, there is a great
deal of uncertainty about the magnitude of the interest elasticity of savings, even for developed countries. For
developing countries, data limitations have generally hampered empirical investigations on this issue. For
example, the study by Masson, Bayoumi, and Samiei (1998), covering a large sample of developing countries,
has found an insignificant and nonrobust relationship between the real interest rate and the private savings/
GDP ratio.
13 The life-cycle results are established in Atkinson and Sandmo (1980), and results from the infinite-horizon
model are derived in Chamley (1986). It could be optimal to tax capital in the life-cycle model because the
intergenerational excess burden of a tax on capital is not fully captured in such a framework.
14 A survey of the literature on human capital accumulation and growth is beyond the scope of this paper. On a
textbook treatment, see Barro and Sala-i-Martin (1995).
305

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
erations is likely to
of pose tremendous administra-
focusing o
income and
tive difficulties in consum
most developing coun-
equally on human
tries, as net savings during a tax period an
tal accumulation thr
eligible for deduction must be tracked and
design aspects (e.g.,
reported to the tax authorities. Two coun- t
tions targeted
tries that, following Kaldor'sfor
recommen- ex
conducive to
dations, experimented human
with this tax about
In developing
40 years ago (India and Sri countr
Lanka) aban-
taxation doned
on it soon after its introduction. In
physical
has Sweden, a commission (the Lodin Com-
traditionally rece
of attention,
mission) that studiedwhichin detail the possi- in
excessive bility
use of introducing
of a personal
tax expendi- in
motion ture tax concluded that such a tax could
(further disc
Another concern in the choice between not be administered. The upshot of the
taxing income and taxing consumption above discussion is that the equity con-
involves their relative impact on (vertical) cerns of the traditional form of taxing con-
equity. This concern is particularly impor- sumption are probably overstated, and for
tant in view of the uneven income distri- developing countries attempts to address
bution in developing countries. Tradition- such concerns on the consumption tax
ally, it has been thought that taxing side would in any case be either ineffec-
consumption is inherently more regres- tive or administratively infeasible.
sive than taxing income, since it is admin- Turning to the issue of taxes on imports,
istratively infeasible to effectively imple- the traditional heavy reliance on import
ment, on a broad scale, graduated tax rates duties as a convenient tax handle by de-
on consumption.16 Two lines of research veloping countries implies that lowering
have, however, cast doubt on this conclu- tariff rates - necessitated perhaps by their
sion. First, the traditional form of the con- desire to join the World Trade Organiza-
sumption tax, i.e., taxing consumption as tion, to participate in regional trading ar-
it takes place (such as a value-added tax rangements such as the ASEAN in Asia
(VAT) or retail sales tax), has been found and NAFTA or Mercousur in Western
to be far less regressive than commonly Hemisphere, or simply to conclude bilat-
thought when viewed from a life-cycle eral trading agreements with developed
rather than a static perspective.17 Second, countries - could have significant eco-
at least in theory, consumption can be nomic and revenue consequences in these
taxed on the same graduated basis as in- countries. First and foremost, tariff reduc-
come, by allowing unlimited deductions tions, when properly structured (see fur-
from income of savings.18 But such a tax ther discussions below) and not accom-
15 For small, open countries, an additional relevant consideration is clearly the difference in the relative mobili
between capital and labor across national boundaries. In this context, the extent to which capital income
be taxed in these countries is at least partly dependent on how such income is taxed elsewhere in the sam
region of the world.
16 A limited application of differential consumption taxation is certainly feasible and in fact is widely practic
There is, however, compelling evidence suggesting that such a practice is ineffective in achieving equity ob-
jectives, since both the rich and the poor consume (albeit in different proportions) the same goods that
being taxed differentially. For a forceful statement of this point in the context of an actual tax reform progr
in a developing country, see Republic of South Africa (1994).
17 See a series of studies by Metcalf, e.g., Metcalf (1994). These results are, however, generally more relevant f
advanced than developing countries.
18 This is the idea lying behind, for example, the so-called USA (unlimited savings allowance) tax that has b
proposed in the United States recently (see Seidman, 1997). It is also broadly the idea behind Kaldor's (19
expenditure tax.
306

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
panied by othersumption
increasestaxes (with subcategories
in explici of
implicit trade general23, excises,
barriers, and trade taxes24);
would lead andin
eral to lower levels of both nominal and social security taxes. For the entire sample
effective protection. Secondly, tariff reduc- of developing countries, the ratio of in-
tions could also result in a significant losscome to consumption taxes was about 0.5
in budgetary revenue, at least in the shortin 1985-7, compared to 1.2 for OECD
run before the volume of imports has had countries. For either group of countries,
time to respond.19 this ratio showed almost no change a de-
While reducing protection of domesticcade later.
industries from foreign competition is an Another notable difference between
inevitable consequence or even the objec-developed and developing countries is the
tive of any trade liberalization program,ratio of CIT to PIT. Developed countries
reducing budgetary revenue could be anraised about four times as much revenue
unwelcome by-product of the program from the PIT as from the CIT, while the
that needs to be addressed.20 Feasible developing countries raised more revenue
compensatory revenue measures under from the CIT than from the PIT. Undoubt-
the circumstances almost always involve edly, the difference in wage income, in the
increasing domestic consumption taxes;21 sophistication of the tax administration,
rarely would increasing income taxesand be in the political power of the richest
considered as a viable option on grounds deciles between the two country groups
of both policy (on account of their per- are primary contributing factors to the
ceived negative impact on investment) large difference between them in the rela-
and administration (on account of their tive importance of the CIT and the PIT as
revenue effects being less certain and revenue sources. Finally, as expected, rev-
timely than consumption tax changes).22 enue from trade taxes has been signifi-
cantly higher- though falling - in devel-
International comparisons
oping countries (4.2 percent of GDP in
Table 2 provides a breakdown of total 1985-7 and 3.5 percent of GDP in 1995-7)
revenue, for the same countries and over than in developed countries (less than
the same periods as Table 1, into major1 percent of GDP in both periods).
categories of taxes: income taxes (withWhile it is difficult to draw clear-cut
subcategories of corporate income normative
tax policy prescriptions from the
(CIT) and personal income tax (PIT)); con-
above international comparisons as re-
19 In some cases, the revenue impact of tariff reductions, even in the short run, could be moderated to varying
degrees if accompanied by, for example, the tariffication of quotas, or the imposition of some minimum tariff
on imports previously exempted from duties, as part of an overall trade liberalization program. See the de-
tailed study by Ebrill, Stotsky, and Gropp (1999).
20 Some developing countries have taken tariff reductions in a required trade liberalization program as an op-
portunity to lower the overall level of taxation. Such cases are, however, few and far between, since the ability
to do so would typically necessitate a commensurate reduction in expenditures to avoid endangering the
budgetary position.
21 Keen and Ligthart (1999) have recently shown that, if an underlying tariff reform improves production effi-
ciency, replacing the tariffs with domestic consumption taxes would raise welfare in a small open economy.
Increasing income taxes in the form of reducing distortive tax incentives would, however, arguably be a desir-
able policy measure (see discussions below).
23 Included in this subcategory are the VAT; all other VAT-like taxes that sometimes go by different names, such
as goods and services taxes or general sales taxes; and other broad-based single- and multi-stage sales taxes (if
they exist).
24 Trade taxes are mostly import tariffs; export tariffs have become relatively insignificant in recent years. Until
the early 1980s, however, they had been important in some countries and especially in some Latin American
(e.g., Argentina) and African (e.g., Côte d'Ivoire) countries.
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152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
gards thesome of the most important tax policy
income-cons
a compelling
issues encountered in
positive
developing coun-
revealed tries.
by the comp
nomic development te
tive shift in the com
Personal Income Tax
from consumption
taxes. At General
any given
conceptual issues relating to
ever, thethe important
PIT have been comprehensively dis-
developing countries
cussed in Cnossen and Bird (1990), al-
determining
though the focus the
of that study is opti
on OECD
spelling out clearly
countries. In developing countries, the is- t
achieved by any conte
sues of interest are typically narrower in
mix, (2) scope,
assessing
but generally require that more at- th
quences of the shift
tention be paid to their administrative
and equity terms
implications, -
given that administrative in
manner possible,
capabilities are much more binding andin
compensatory
these countries than in - possi
developed coun-
penditure) - measure
tries. Also, the fact that wage income is
being made worse
often a small off
share of national income has b
the poorer deciles.
contributed to the difficulties in render-
ing the PIT as a significant revenue source.
POLICY ISSUES IN SELECTED Rate structure
MAJOR TAXES
Any discussion of the personal income
In developing countries where markets tax in developing countries must start
are taking on an increasingly important with the observation that this tax has
role in allocating resources, the most im-yielded very little revenue in most of these
portant objective of tax policy is to mini-countries and that the number of indi-
mize the interference by the tax system inviduals who are subject to this tax and,
that allocation process, subject, of course,especially, who are subject to the highest
to revenue and redistribution require- marginal tax rate, is very small.
ments. This means not only that the The rate structure of the PIT is often the
tax system should be as neutral in designmost convenient and visible policy instru-
as possible, it should also have simplement for most governments in develop-
and transparent administrative rules ing countries to underscore their commit-
and procedures, so that ex ante neutrality ments to social justice, and hence to gain
is not negated by ex post nonneutralitypolitical support for their policies. It is,
due to the inability of the tax administra-therefore, not surprising to find that many
tion to enforce the tax system as designed. developing countries attach great impor-
The following subsections highlight tance to maintaining some degree of
25 Existing econometric evidence on the relationship between the income-consumption revenue mix on the one
hand, and either the growth or savings rate on the other, has been largely inconclusive. While employing tax
instruments to alter rates of return to savings may have an impact on the composition of savings, there has
been little conclusive international evidence that such measures (unless of a drastic nature) could signifi-
cantly affect either private or national savings as a whole in the long run. For a recent review of tax effects on
household savings in OECD countries, see Normann and Owens (1997). A recent study by Tanzi and Zee
(forthcoming) has found, however, rather strong results, in a sample of OECD countries, that increases in
income taxes reduce household savings more than increases in consumption taxes (for raising the same amount
of revenue).
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152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
nominal PIT rate progressivity by apply- value (in terms of implied tax savings) in-
ing many rate brackets,26 and are reluc- creases with the rate bracket the taxpayer
tant to undertake PIT reforms that would is in. Experiences with PIT reforms in de-
suggest any lessening of such commit- veloping countries (as well as in developed
ments. countries, for that matter) tend to suggest,
More often than not, however, the ef- quite compellingly, that the effective rate
fectiveness of nominal rate progressivityprogressivity could be improved by reduc-
in delivering effective rate progressivity
ing the degree of nominal rate progressivity
and the number of rate brackets, and re-
is severely undercut by the very high per-
sonal exemption which may amount to ducing exemptions and deductions. In-
deed, any reasonable equity objective
several times the country's per capita in-
come (see Table 3 for illustrative cross-
would not require more than a few mod-
country comparative information), and by
erately progressive nominal rates in the PIT
the typical plethora of exemptions andrate structure. If political constraints pre-
deductions commonly found in develop- vent a meaningful restructuring of rates, a
ing countries which benefit those with substantial improvement in equity could
still be achieved by replacing PIT deduc-
high incomes (e.g., the exemption of capi-
tal gains from tax, generous deductions tions with tax credits, which would deliver
for medical and education expenses, the the same benefits to taxpayers in all tax
low taxation of financial income). Tax re-
brackets. The use of tax credits of any sig-
lief provided in the form of deductions nificant
is extent is, however, still very rare
particularly egregious under highly pro-in developing countries (Israel is one coun-
gressive nominal PIT rates because its try that uses tax credits extensively).
TABLE 3
. .. . _ Marginal Tax Rates

Minimum .. . _ Income
Subject to Tax Number Range

(In Multiples of Per (In Percent)
Capita Income
Africa
Kenya 4.1 6 10.0-32.5
South Africa 0.8 7 19.0^5.0
Tanzania 2.1 11 7.5-35.0
Uganda 4.2 3 10.0-30.0
Zambia 1.3 3 10.0-30.0
Zimbabwe 0.5 5 20.0-40.0
Western Hemisphere
Argentina 1.6 7 6.0-33.0
Brazil 3.5 2 15.0-25.0
Chile 0.2 6 5.0-45.0
Costa Rica 1.3 4 10.0-25.0
Mexico 0.1 8 3.0-35.0
Nicaragua 9.3 5 7.0-30.0
Sources: Individual Taxes 1998: Wor
(1) Information generally pertains t
26 It should be noted, however, that

brackets in developing countries
although the latter countries have
ber of rates during the last decad
Messere (1993).
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The progressive nominal rate structure,
effectiveness of as a
rate is noted above,
also much it is common to findreduc
that the
it is often PITs (as well as the CITs, for that matter)
applied at
income, expressed
in developing countries are riddled withas
GDP, that serious violations of theincome
little two basic prin-
rates. In ciples of good tax policy
some at the practical
develop
Honduras), a
level: symmetry taxpayer
and inclusiveness.28 The
hundredssymmetry of times
principle refers to the identical th
before it treatment
enters for tax purposes the
of gains and hi
Another losses of any given source of income, e.g.,
important iss
rate structure if the gains are taxable,
is then the
the losses le
ginal PIT should rate.be deductible. The inclusiveness
In som
tries, this rate
principle exceed
relates to the capturing of an in-
significant come stream
margin,in the tax net (unless it iswh
vides strong explicitly exempt) incentiv
at some point along the
choose the path of corporate
that stream, e.g., if a payment is f
ness purely exempted in forthe hands of thetax payee, then r
tion would exist even if the PIT and the it should not be a deductible expense in
CIT were fully integrated in the taxation the hands of the payer. Violating these
of dividends (see below), because the tax- principles would, in general, lead to dis-
payers who are best situated to abuse the tortions and inequities.
delay in the taxation of accrued income To be sure, there are circumstances un-
by incorporating themselves are precisely der which some (limited) deviation from
those whose sole purpose for incorpora- the symmetry and /or inclusiveness prin-
tion is to evade the PIT rate in the first ciples could be called for, but any such
place. Professionals (e.g., lawyers and ac- deviation should be justified by clear
countants) and small entrepreneurs, for policy objectives.29 Violations of the prin-
example, can easily siphon off profits ciples found in many developing coun-
through expense deductions over time tries are, however, often due simply to
and escape the higher PIT rate perma- inadequacies in the PIT design. Some
nently. For these taxpayers, taxes delayed common examples include the deductibil-
are often taxes evaded. It is, therefore, ity from taxable income on the one hand
good tax policy to ensure that the top of pension/saving contributions, interest
marginal PIT rate does not differ materi- expenditure, capital losses, and (cash and
ally from the CIT rate.27 noncash) perquisites paid by employers
to employees as a business expense; and
Tax base
the exemption from tax on the other hand
In addition to the problem of the highof pension income /saving withdrawals,
levels of exemptions and deductions thatinterest income, capital gains, and perqui-
tends to narrow the tax base and negate sites in the hands of employees. It is easy
much of the effective progressivity of ato see how these tax provisions could be
27 Preferably, these two rates should be equalized if there is full integration of the PIT and the CIT in dividends
taxation (further discussed below). Absent full integration, the top marginal PIT rate should technically be
somewhat lower than the CIT rate.
28 It goes without saying, of course, that tax policy should also be guided by the general principles of neutrality,
equity, and simplicity.
29 For example, to prevent excessive tax avoidance, many countries have found it prudent to place limits on the
deductibility of capital losses in any given year or the number of years losses of any kind can be carried
forward.
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The tax treatment

exploited to varying of dividends raises by tax
degrees
the well-known
ers to evade taxes. Todouble taxation issue. In them
address
most OECD countries,
remedy is invariably the the double taxation
eliminatio
either the deductibility oror the
of dividends is eliminated, exem
at least par-
(but not both), and the through
tially alleviated, choice a varietybetween
of re-
two depends to lief
a measures
large extent
at either the corporate oron
the ad
istrative considerations. shareholder level.31 While such measures
generally entail administrative complica-
Tax treatment of financial income
tions that many developing countries
The tax treatment of financial income is would find difficult to cope with, on eco-
a particularly problematic area in devel- nomic grounds not providing relief at all
oping countries with limited tax adminis- would also not be a particularly desirable
tration capabilities, as alternative forms of course of action to take. For most devel-
such income could be easily disguised, oping countries, a reasonable option
interchanged, and otherwise arbitraged if would be to either exempt dividends from
tax provisions are not carefully written to the PIT altogether, or to tax them at a rela-
deal with them. This is an issue that even tively low rate, perhaps through a final
most developed countries would find dif- withholding tax at the same rate as that
ficult to tackle, and a comprehensive dis- imposed on interest income (if it exists).
cussion of it is clearly beyond the scope of
the present paper. Here, only two particu-
Corporate Income Tax
larly notable issues dealing with the taxa-
tion of interest and dividends are high- Tax policy issues relating to the CIT in
lighted. In many developing countries, developing countries are numerous and
interest income, if taxed at all, is taxed for complex, and are similar to those found
administrative reasons through a final in many developed countries. This paper
withholding tax at a rate that is generally will not attempt to provide a detailed and
substantially below both the top marginal comprehensive discussion of such issues,
PIT rate and the CIT rate. For taxpayers but will instead focus on two problematic
with mainly wage income (usually mak- areas that seem particularly prevalent in
ing up the bulk of PIT taxpayers), this developing countries: multiple CIT rates
seems an acceptable compromise between based on a sectoral differentiation and the
theoretical correctness and practical feasi- incoherent design of the depreciation sys-
bility. For those with business income (and tem.
for companies as taxpayers under the CIT),
however, the low tax rate on interest in- Multiple CIT rates
come coupled with full deductibility of Developing countries (e.g., Egypt, Para-
interest expenditure implies that signifi- guay, Vietnam, Zambia) are more prone
cant tax savings could be realized through to having multiple rates differentiated
fairly straightforward arbitrage transac- along sectoral lines (including the com-
tions. Hence, it is important that the ap- plete exemption from tax of certain sec-
plication of final withholding on interest tors, especially the parastatal sector) than
income be carefully targeted, e.g., final developed countries, possibly as a legacy
withholding not be applied if a taxpayer of past economic regimes that emphasized
has business income.30 the state's role in resource allocation. Such
30 This does not mean that the scope of the withholding itself should be targeted; withholding as a collection
device (but not as a final tax) could still be broadly applied.
31 For a survey of practices in OECD countries, see OECD (1991).
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152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
practices are,
should howev
be more than sufficient, e.g., group-
tal to the proper
ing long-lived assets such as buildings at fu
forces (i.e., sectoral
one end and fast-depreciating assets such a
would be distorted
as commercial vehicles and computers at b
tax rates) and,
the other end, with one or twotheref
categories
the government's of machinery and equipment in between; co
ket economy (2) only one depreciation
is rate should
real. be
rates across attached to eachsectors
asset category; (3) depre- w
important ciation rates outstandi
should generally be set higher
developing than the actual countrie
physical lives of the un-
derlying assets to compensate for the lack
Depreciation
of a comprehensive inflation-compensat-
Allowable ing mechanism
depreciatio
in most tax systems;32 and
for tax (4) on administrative grounds, the declin-
purposes is on
tant structural elements in a CIT in deter- ing-balance method - still not commonly
mining the cost of capital, and thus the used in developing countries - should be
profitability of investment. Designing an preferred to the straight-line method. As
appropriate depreciation system is, there- is well known, the declining-balance
fore, crucial for fostering a favorable invest- method allows the pooling of all assets in
ment climate. Yet, notwithstanding the the same asset category and automatically
great importance they frequently attach to accounts for capital gains and losses from
promoting investment, developing coun- asset disposals, thus substantially simpli-
tries far too often have depreciation systems fying bookkeeping requirements.33
that are complex, incoherent, restrictive,
and in general not investment-friendly.
Value-added Tax , Excises , and
The most common shortcomings found
Import Tariffs
in the depreciation systems in developing
countries include: (1) an excessive num-
Value-added Tax
ber of asset categories and depreciation
rates; (2) excessively low depreciation One of the most visible tax reforms un-
rates; and (3) a structure of depreciation dertaken by developing countries during
rates that is not in accordance with the the past three decades has been the intro-
relative obsolescence rates of different as- duction of the VAT (or a VAT-like tax).
set categories. Rectifying these shortcom- Since the VAT can now be found in an
ings should receive a high priority in tax overwhelming majority of developing
policy deliberations in these countries. countries,34 the outstanding tax policy is-
In restructuring their depreciation sys- sue in the domestic consumption tax area
tems, developing countries could well in these countries is no longer the replace-
benefit from the following guidelines: (1) ment of cascading turnover taxes, but the
under most circumstances, classifying as- proper design of the VAT and the scope
sets into, say, three or four categories of excise taxes.
32 The basis for this is simply that, while inflation increases the replacement costs of assets, depreciation is inevi-
tably computed on their historical costs.
33 A conversion from the straight-line to the declining-balance method would necessitate, of course, an upward
adjustment in depreciation rates on account of the conversion alone to maintain the same depreciation allow-
ances in present-value terms. In a number of OECD countries, a switchover at some point of an asset's life
from the declining-balance to the straight-line method is allowed (see OECD, 1991). For a discussion of the
switching between the depreciation methods, see Messere and Zuckerman (1981).
34 According to a recent study by Ebrill, et al. (forthcoming), the VAT (or a VAT-like tax) can be found in 116
countries around the world as of September 1998.
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While the VAT Excisesthat has been ado
in developing countries is, almost

The most notable shortcoming of the
out exception, implemented throu
credit-invoice mechanism modeled after excise systems found in many developing
countries is their inappropriately broad
the Western European countries, it fre-
coverage of products - often for revenue
quently suffers from the limitation of be-
reasons, but sometimes for reasons diffi-
ing incomplete in its application in one
form or another. It is all too common to cult to discern as the marginal revenue
raised from some excised goods (which
find, for example, that many important
should not have been excisable) could
sectors, most notably services and the
wholesale and retail sector, have been left well be insignificant.
As is well known, the economic ratio-
out of the VAT net; or that the credit
nale from imposing excises is very differ-
mechanism is excessively restrictive (i.e.,
denials or delays in providing proper ent from that for imposing a general con-
sumption tax, such as the VAT. While the
credits for the VAT on inputs), especially
latter should be broad-based so as to maxi-
when it comes to capital goods.35 These
mize revenue with minimum distortion,
features allow a substantial degree of cas-
the former should be highly selective, nar-
cading to remain in the system, and thus
greatly reduce the benefits from introduc-
rowly targeting a few goods mostly on
ing the VAT in the first place. Rectifying
grounds that their consumption entails
negative externalities on society It so hap-
such limitations in the VAT design and
administration should, therefore, be given
pens that the list of goods typically
a high priority in developing countries.
deemed to be excisable on such grounds
Another aspect worthy of attention is (e.g., tobacco, alcoholic, and petroleum
the adoption on the part of many devel- products; as well as motor vehicles) are
oping countries (see Table 4 for illustra- few and usually highly inelastic in de-
tive cross-country comparative informa- mand. Thus, a good excise system is in-
variably characterized by its ability to gen-
tion) of two or more rates (including the
zero rating of certain nonexport supplies).
erate revenue (as a by-product) from a
While multiple rates are likely to compli-
narrow base and with relatively low ad-
ministrative costs.36
cate the administration of the VAT, they
are politically attractive by ostensibly
Import tariffs
serving - though not necessarily effec-
tively - an equity objective. In fact, most As noted earlier, reducing import tar-
OECD countries also have multiple iffs as part of an overall program of trade
rates. Still, the administrative price for ad- liberation is a major policy challenge cur-
dressing equity concerns through having rently facing a large number of develop-
multiple VAT rates is likely to be higher ing countries. From a tax policy perspec-
in developing than in developed coun- tive, this challenge involves two concerns
tries. that need to be carefully addressed. First,
35 If the VAT on capital goods is creditable, the VAT is known as a consumption-type VAT (the standard form
found in developed countries); if not, it is known as a production-type VAT. Even in those developing coun-
tries where the VAT is ostensibly of the consumption-type, credits on capital goods are frequently granted
with a substantial (administrative) delay. For a general discussion of the various variants of a VAT, the various
ways they can be implemented, and their different economic implications, see Zee (1995). Cnossen (1998) and
Ebrill, et al. (forthcoming) contain useful descriptions of VAT features and experiences in a large group of
developing countries.
36 While an extensive excise system with highly differentiated rates set in inverse relationship to demand elas-
ticities could well be a policy implication of the optimal commodity taxation literature, in practice such a
system is rarely if ever administratively feasible - even in developed countries.
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TABLE 4
COMPARATIVE VAT RATES IN SELECTED DEVELOPING COUNTRIES (1)
Standard Rate Significant other Rate(s) (2)
(In Percent)
Africa
Côte d'Ivoire 20.0 11.1
Kenya 16.0 12.0
Mauritius 10.0 -
South Africa 14.0 -
Zambia 17.5 -
Asia
Fiji 10.0 -
Indonesia 10.0 5.0, 20.0, 35.0
Korea 10.0 2.0, 3.5
Philippines 10.0 -
Singapore 3.0 -
Sri Lanka 12.5 -
Thailand 10.0 -
Middle East
Egypt 10.0 5.0, 25.0
Jordan 10.0 20.0
Morocco 20.0 7.0, 10.0, 14.0
Pakistan 15.0 -
Tunisia 18.0 6.0, 10.0, 29.0
Western Hemisphere
Argentina 21.0 10.5, 27.0
Bolivia 14.9 -
Chile 18.0 -
Colombia 16.0 8.0, 10.0, 20.0, 35.0 45.6
Costa Rica 15.0 -
Dominican Republic 8.0 -
El Salvador 13.0 -
Mexico 15.0 10.0
Nicaragua 15.0 5.0, 6.0, 10.0
Panama 5.0 10.0
Peru 18.0 -
Uruguay 23.0 14.0
Venezuela
Source:
(1) Coun
like tax
(2) Excl
it tice the is
attention of a tariff reduction i
nominal tariffs are reduced does not lead program is all too frequently focused on
to unintended changes in the relative rates nominal tariff rates. One simple way of
of effective protection across sectors - ensuring that unintended consequences
which may come about from careless do not occur would be to reduce all
or incoherent differences in the extent nominal tariff rates by the same propor-
to which nominal tariff reductions are tion whenever such rates need to be
effected on inputs and outputs. While changed.37
effective protection is a relatively well- The second concern of nominal tariff
reductions is the likely short-term revenue
established concept in economics, in prac-
37 Note that the point here is on preventing unintended changes to the relative pattern of effective protection
rates. The initial relative pattern of such rates may well be deemed inappropriate, but measures to alter it
would then be intentional.
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loss they may entail.38 Here, the strategy economic and skilled workforce, are usu-
should be relatively clear-cut, and should ally far more decisive than tax consider-
involve three separate compensatory mea- ations in determining suitable investment
sures to be considered in sequence: (1) re- locations. If these factors are favorable,
ducing the scope of tariff exemptions in and the country's tax system is in line with
the existing system;39 (2) compensating for international norms, then tax incentives
the tariff reductions on excisable imports would at best play a role at the margin in
by a commensurate increase in their ex- influencing an investor's decision.43
cise rates;40 and, finally (3) adjusting the Tax incentives could also be of question-
rate of the general consumption tax (such able value to a foreign investor because
as the VAT) to meet remaining revenue the true beneficiary of the incentives may
needs.41 not be the investor concerned, but rather
the treasury of his home country. This
Tax Incentives comes about because any income that is
spared from taxation by the host country
While granting tax incentives to pro- could be taxed by the investor's home
mote investment is common in countries country if the latter 's tax system is based
around the world, available evidence sug-on the residence principle (i.e., the incen-
tives could reduce the amount of foreign
gests that their effectiveness in attracting
incremental investments (above and be- tax credits available to the investor), un-
yond the level that would have taken less a tax sparing clause is included in bi-
lateral double tax treaties. At present,
place if no incentives were given) is often
questionable and that their revenue cost many developed countries are increas-
could well be high (e.g., tax incentives ingly
can reluctant to grant such a clause in
their treaties.44
be abused by existing enterprises dis-
guised as new ones through nominal re- Subject to the above constraints on the
organization).42 For foreign investors -
efficacy of tax incentives, a conceptually
legitimate purpose for granting them in
the primary target of most tax incentives
in most developing countries - the deci-developing countries is to rectify some
sion to enter a country would normally forms of market failure, most notably
those involving externalities. An obvious
depend on a whole host of factors, among
which the availability of tax incentives is
example would be incentives targeted for
promoting certain sectors, such as high-
only one and frequently far from being the
most important one. The existence of natu-
technology industries, the development of
ral resources, political and economic sta-
which is likely to confer significant posi-
tive externalities on the rest of the
bility, transparency of the legal and regu-
latory systems, adequacy of supporting economy. By far the most compelling case
institutions (e.g., banking, transportation,
for granting targeted incentives (if at all)
communication, and other infrastructure is, however, for meeting regional devel-
facilities), ease of profit repatriation, opment
and needs of these countries, such as
38 In the long term, the revenue consequence would obviously depend on import elasticities.
39 Frequently, the most practical way to do this is to impose a low minimum tariff on all imports.
40 If the affected imported excisable is also produced domestically, then the increase in its excise rate sho
apply, of course, to its domestically-produced counterpart.
41 Any reduction in the scope of tax incentives in general (discussed below) should, of course, always
plored as an additional compensatory measure.
42 For a comprehensive treatment of tax incentives in developing countries, see Shah (1995).
43 OECD (1994) reports that, while tax incentives are widely used in Asian countries, country authori
generally skeptical about their effectiveness if the other aforementioned factors are absent.
44 The United States never grants tax sparing.
315

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NATIONAL TAX JOURNAL
encouraging investment in their less-de- ward beyond the holiday period (if losses
veloped areas, or discouraging invest- are not allowed to be carried forward into
ment in their more congested areas.45 the post-holiday period, tax holidays
Nevertheless, not all incentives are could, under some circumstances, be a
equally suited for achieving such objec-disincentive to investment46); and (5) the
tives, however justifiable they may be;revenue cost to the budget is seldom trans-
some are simply more cost effective thanparent, unless enterprises enjoying the
others on both policy and administrativeholidays are still required to file proper
grounds. Unfortunately, the most preva- tax returns, in which case administrative
lent forms of incentives found in devel- resources must be devoted to activities
oping countries tend also to be the leastthat yield no revenue, and a frequently
meritorious. alleged benefit of tax holidays would be
negated: allowing investors to dispense
Tax holidays and reduced tax rates
with dealing with the tax authorities.
Of all the different forms of tax incen- Since reduced tax rates are simply a
tives, tax holidays are the most popularmilder form of tax holidays, the former
among developing countries. While ad- have the same shortcomings as the latter,
mittedly simple to administer, they haveonly on a lesser scale.
numerous shortcomings which, even
Investment allowances and tax credits
though shared to some degree by other
types of incentives, are particularly pro- Compared with tax holidays, these tax
nounced: (1) by exempting profits irre- incentives have a number of advantages.
spective of their amount, tax holidays tendThey are, for example, a much better tar-
to benefit an investor who expects high geting instrument than tax holidays for
profits and would have undertaken the promoting particular types of investment,
investment even if there were no such in- and their revenue cost is much more trans-
centives; (2) tax holidays provide strongparent and easier to control. A particularly
incentives for tax avoidance, as taxed en-simple and effective way of administer-
terprises could enter into economic rela-ing a tax credit system is the following.
tionships with exempt ones to shift theirOnce the amount of tax credits to be given
profits to the latter through transfer pric-to a qualified enterprise is determined, it
ing; (3) the duration of tax holidays, evenwould be "deposited" into a special tax
if formally time-bound, is prone to abuse account (kept simply in the enterprise's
and extension by investors through cre- tax file) in the form of a bookkeeping en-
ative redesignation of existing investment try. The enterprise qualifying for this in-
as new investment (e.g., closing down andcentive would in all respects be treated
restarting the same project under a differ-like a regular taxpayer and, therefore, be
ent name but with the same ultimate own- subject to all applicable tax provisions and
ership); (4) time-bound tax holidays tendregulations, including the computation of
to attract (if they have an impact at all) taxable profits and the requirement to file
short-run projects, which typically are nottax returns. The only difference would be
as beneficial to the economy as longer- that its income tax liabilities would be
term ones. The latter may become profit- paid from credits "withdrawn" from its
able only toward the end of the holidaystax account until the balance is reduced
and, therefore, can make little use of suchto zero. If desired, such a tax account could
holidays even if losses can be carried for-be closed after a specified period (i.e., a
45 Even under these circumstances, better policy instruments (e.g., increased infrastructure investment in re-
mote areas) than tax incentives could often be found to achieve the stated objectives.
46 See Mintz (1990) for a rigorous demonstration of this result.
316

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
sunset provision is attached

tem to minimize this danger, for example, to t
count), so that by
all unused
specifying tax
a minimum holding cred
period
simply for anto
allowed asset onexpire.
which the incentive has
In thi
information on beentotal revenue
given. Any shortfall in the holding for
because of the period
incentive over
would then require the enterpriseany
period is readilyto remit to the tax authorities
available at a allprorated
time
thermore, as the share of the allowances /credits
amount of it has
taxal- cr
ready claimed
granted to qualified and utilized associated
enterprises is
with certainty with
in theadvance,
asset. it can e
included in the budget as a tax ex
Accelerated depreciation
ture and subject to the same scrut
any other type of expenditure
Providing tax incentives in the form of in th
getary process,accelerated
thus depreciation
achieving has the least of a hi
gree of transparency. Explicit
the shortcomings associated reco
with tax holi-
of tax expenditure
days and all is
of thea practice
virtues associated with th
be found in an investment
increasing allowances /tax credits
number- and
veloped and overcomes the latter 's weaknessescountrie
developing to boot.
can greatly facilitate the
Since merely accelerating reviewi
the depreciation
policy makers of an the
of asset does cost-effectiven
not increase the total
tax incentives. allowable nominal depreciation of the
A system of investment allowancesasset beyond its original cost, little distor-
could be administered in much the same tion in favor of short-lived assets is gen-
way as tax credits, achieving similar re-erated,47 and neither is there much incen-
sults. The only substantive differencetive for an enterprise to engage in the kind
between the two is that, if the CIT has of tax abuse connected with investment
multiple rates, then a given amount of in-allowances /tax credits.
vestment allowances is worth more in ab- Compared with other types of tax in-
solute terms, the higher the tax rate at centives, accelerated depreciation has two
which the allowances are given. In con- additional merits. First, it is generally least
trast, a given amount of tax credits is costly, as the forgone revenue (relative to
worth exactly the same regardless of the no acceleration) in the early years is at
applicable tax rate. least partially recovered in subsequent
There are two notable weaknesses as- years of an asset's life. Second, if the ac-
sociated with investment allowances or celeration is given only temporarily, then
tax credits. First, these incentives tend toit could (all other things equal) induce a
distort the choice of capital assets in fa- significant short-run surge in investment,
vor of short-lived ones, since a further al-as investors are likely to bring forward
lowance or credit becomes available each investments planned for the future to take
time an asset is replaced. Second, quali- advantage of the incentive.
fied enterprises may attempt to abuse the
Investment subsidies
system by selling and purchasing the
same assets to claim multiple allowances While investment subsidies share some
or credits, or by acting as a purchasing of the merits of investment allowances/
agent for enterprises not qualified to re-tax credits, such as ease of targeting, they
ceive the incentive. Hence, safeguardsare generally quite problematic in that
must be built into such an incentive sys-they pose an even more serious revenue
47 It should be noted that, if the underlying structure of depreciation rates for tax purposes deviates systemati-
cally from the assets' true structure of economic depreciation, then any change to the former (e.g., accelerating
the depreciation rates) could induce additional distortions from the standard second-best type of reasoning.
317

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
risk for ing such zonesbudget
the cannot, however, stamp th
involve out all abuse, as zones of this type are
out-of-pocket
government never completely leakage-proof
up (even fron if
nonviable physically controlled).
investment
able ones. In contrast
Triggering mechanism
come tax incentives a
the latter. Hence,
A particularly important issue concern- th
subsidies is seldom advisable. ing the use of tax incentives in develop-
ing countries is the mechanism by which
Indirect tax incentives
they can be triggered. An automatic trig-
Indirect tax incentives are very prone gering mechanism allows the investment
to abuse, as qualified purchases can eas- to receive the incentives automatically
ily be diverted to buyers not intendedonce to it satisfies certain clearly specified
receive the incentives. They are also diffi-objective qualifying criteria, such as a
cult to justify on policy grounds, except minimum amount of investment in cer-
under extremely limited circumstances. tain sectors of the economy. These criteria
Exempting raw materials and capital are usually laid down either in the rel-
goods from the VAT, for example, would evant laws or their implementing regula-
make little difference to the ultimate tax tions. In granting the incentives, the rel-
burden of the enterprise concerned, since evant authorities would only undertake
the VAT on such purchases is usually cred- to ensure that the qualifying criteria are
itable. If the objective of such incentives met. All other aspects of the investment
is simply to relieve the enterprise of its are irrelevant.48
cash flow burden of the VAT, then a bet- A discretionary triggering mechanism
ter solution would definitely lie else- involves approving or denying an appli-
where, most notably in providing it with cation for incentives on the basis of sub-
prompt VAT refunds. jective value judgement of the relevant
Exempting capital goods and raw ma- incentive-granting authorities after taking
terials used to produce exports from im- into account a variety of considerations,
port tariffs is somewhat more justifiable, irrespective of any formally stated quali-
as removing such duties embedded in the fying criteria. If such criteria exist, they
contents of exportable goods through are stated either as minimum conditions
standard duty drawback mechanisms is or in very general terms, thus requiring
invariably complex and imprecise. The subjective interpretation. An extreme form
difficulty with this exemption lies, of of a discretionary triggering mechanism
course, in ensuring that the exempted would be one by which incentives are
purchases would in fact be used as in- granted entirely on an ad hoc, case-by-
tended by the incentive. Many countries case basis.
have attempted to solve this problem by It is sometimes argued that a discretion-
establishing special export production/ ary triggering mechanism is preferable to
processing zones whose perimeters are an automatic one because the former
secured by customs controls. Imports of would provide the incentive-granting au-
capital goods and raw materials into these thorities with more flexibility in determin-
zones are free from import tariffs, but tar- ing the merits of individual incentive ap-
iffs are imposed on all exports from the plications. This advantage is likely to be
zones to the rest of the country. Establish- outweighed in practice, however, by a
48 Note that the approval of investment and the granting of tax incentives to approved investment could be tw
separate processes. Hence, the automatic triggering of the latter (once qualifying criteria are met) does n
necessarily require that the former be implemented also on a similar basis.
318

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
CHALLENGES AHEAD
variety of problems that are inev
associated with discretion, most n
As trade barriers come
a lack of transparency in down theand capi-
dec
making process,tal mobility
whichincreases around in the world,
turn
discourage somethe formulation
potentialof sound and effective tax
investo
policy poses significant
encourage corruption andchallengesrent-seek for
tivities. In fact, developed
incentives and developing countries
have been
tile ground for alike. For the latter countries,
corrupt however, the
practices in
countries. challenges will be particularly acute on
If the concern about having an auto- account of their relatively more limited tax
matic triggering mechanism is the loss ofadministration capabilities and their high
discretion in handling exceptional cases, dependence on foreign trade taxes. With
then the preferred safeguard would be to increased global economic integration, the
formulate the qualifying criteria in as nar- challenge posed by the need to replace
row and specific a fashion as possible, so foreign trade taxes with domestic taxes
that incentives are only granted to invest- will be accompanied by intensified con-
ments which can meet the highest objec- cerns about profit diversion through
tive and quantifiable standard of merit. transfer pricing, and /or profit stripping
Ultimately the question is one of achiev- through thin capitalization, by foreign in-
ing an optimal balance, and on balance it vestors. Yet, anti-tax abuse provisions in
is generally advisable to minimize the dis- the tax laws as well as the technical train-
cretionary element in the incentive-granting of tax auditors in many developing
ing process. countries are generally inadequate to de-
ter and detect such practices. A concerted
Summing up
effort to upgrade these deficiencies is,
The cost effectiveness of providing tax therefore, of the utmost urgency.
incentives for investment promotion is Another tax policy challenge in a world
generally questionable. The first-best of liberalized capital movements is in the
strategy for sustained investment promo- area of tax competition. For most devel-
tion consists invariably of providing stable oping countries, the relevant issue here is
and transparent legal and regulatory their perceived heightening of the pres-
frameworks as well as adequate support- sure as well as the temptation to broaden
ing institutions and facilities, and of put- the scope of general tax incentives to at-
ting in place a tax system that is in line tract and compete for foreign invest-
with international norms. ments - to the neglect of pursuing more
Some objectives, such as those associ- fundamental tax reforms in, for example,
ated with regional development needsthose areas of the tax system that have
of a country, are more justifiable than been identified earlier. The effectiveness
others as a basis for granting tax incen- of tax incentives - in the absence of other
tives. Not all tax incentives are, how- necessary fundamentals - is highly ques-
ever, equally effective. Accelerated depre- tionable, as already noted. Furthermore,
ciation has the most comparative merits, a tax system that is riddled with such in-
followed by investment allowances or tax centives will inevitably provide fertile
credits. Tax holidays and investment sub- grounds for rent-seeking activities. To al-
sidies are among the least meritorious. low their emerging markets to take proper
As a general rule, indirect tax incen- root, developing countries would be well
tives should be avoided, and discretion advised to refrain from relying on tax in-
in granting incentives should be mini- centives - especially of the kind that are
mized. not carefully and narrowly targeted - as
319

152.58.93.28 on Wed, 06 Mar 2024 07:02:35 +00:00
the main vehicle for
particularly important invest
in their attempt to
tion.49 raise more revenue from the personal in-
Finally, as already indicated, personal come tax. To meet these challenges suc-
income taxes have been contributing very cessfully, policy makers in these countries
little to total tax revenue. Apart from the will not only need to get their policy pri-
structural, policy, and administrative orities right, they will also need to have
considerations discussed earlier, the facil- the political will to implement reforms
ity with which income received by indi- that are often difficult but absolutely nec-
viduals can be invested abroad in an en- essary. It is also necessary to comment that
the tax administrations must be strength-
vironment of globally integrated financial
markets and thus escape domestic taxa-ened to accompany the needed policy
tion - or, for that matter, escape taxationchanges.
altogether - also has been a significant
contributing factor of this outcome. In fact,
Acknowledgments
tax havens as well as special arrangements
in several developed countries, such as tax The views expressed are those of
free accounts for non-resident aliens, have the authors and do not necessarily repre-
created situations whereby, for many de- sent those of the IMF. Useful com-
veloping countries, it is difficult to applyments from Michael Keen and John
the concept of the global income tax toYinger, and assistance from Asegedech
personal income taxation. Bringing finan- WoldeMariam for compiling the tax data
cial income adequately to tax is, therefore,used in the paper, are gratefully acknowl-
a daunting challenge for developing coun- edged.
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Tanzi TaxPolicyEmerging 2000

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Tanzi TaxPolicyEmerging 2000

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Tax Policy for Emerging Markets: Developing Countries

Author(s): Vito Tanzi and Howell H. Zee

Stable URL: https://www.jstor.org/stable/41789458

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Abstract - This paper discusses important tax policy issues facing

The tax study

In developing countries, the establishment of ef

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LEVEL AND COMPOSITION OF Level of Tax Revenue

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per se. Given thethecomplexity ofin the d

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26 It should be noted, however, that

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The tax treatment

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While the VAT Excisesthat has been ado

in developing countries is, almost

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sunset provision is attached

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Bird, Richard, Levine, Ross,

eral Equilibrium with Infinite Lives/' Messere, Ken C.

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tems of Developing Countries." In The Zee, Howell H.

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