Taxation is an important fiscal policy tool that governments can use to raise revenue and encourage economic growth and development. Tax income is used by governments to carry out traditional functions such as providing public goods and services, maintaining law and order, defending against external threats, and regulating commerce and business to preserve social and economic stability. Tax revenue mobilization effectively minimizes an economy’s reliance on foreign flows, which have been found to be very volatile.
Taxation also provides governments with greater flexibility in designing and controlling their development agenda; it encourages states to improve their domestic economic policy environment, thereby creating a favorable environment for much-needed foreign direct investment; and it strengthens the bonds of accountability between governments and citizens.
The global financial and economic crisis of 2008/2009 taught governments a valuable lesson about the importance of directing more attention to internal resource mobilization activities, particularly increased tax revenues and shifting away from over-reliance on external financial flows and export income.
Although tax structures vary considerably across countries, the primary objective of any tax structure is to attain maximum revenue and economic growth with minimum distortions. Different countries have different philosophies about taxation and different methods of tax collection. In the same manner, countries have different uses for their revenue which affect growth differently. Agell et al. have argued that the different uses of total government expenditure affect growth differently and a similar applies to the way tax revenue is raised.
Romer emphasizes factors such as the ‘spill-over effect and learning by doing’ by which firms’ specific decisions to invest in capital and research and development, or investment in human capital, can yield positive external effects that benefit the rest of the economy. Solow was the first to examine how taxation affects growth. He argued that steady-state growth is not affected by tax policy; that is, tax policy, regardless of distortion, has no impact on long-term economic growth rates, even if it reduces the level of economic output in the long term.
On his part, argued that the different uses of total government expenditure affect growth differently and a similar argument applies to the way tax revenue is raised. The economic growth of Singapore for instance can be attributed to low rates of corporate and personal income taxes. Relatedly, argue that there exists a structural difference in taxation in developing countries and developed countries.
For developing countries, they established that roughly two-thirds of tax revenue is derived from indirect taxes while for developed countries two-thirds comes from direct taxes. They suggested however, that tax structure can change over time to maximise the economic growth.
4 Ways Low-income Economies Can Boost Tax Revenue
A substantial increase in investment over the next decade is required to achieve the Sustainable Development Goals – each year, the equivalent of up to 8.2% of national GDP for some poor nations. Even the richest countries will struggle to meet that challenge. It is a potentially crushing burden for low-income countries.
The majority of these countries are already overextended: one-half of the poorest countries eligible to borrow from the World Bank’s International Development Association (IDA) are either at high danger of or already in debt crisis. Many of them recognize that borrowing from foreign lenders will become increasingly difficult in the future and that mobilizing domestic resources in the form of tax revenues will be crucial to economic success.
Today, more than a third of IDA countries—including 70% of unstable and conflict-affected countries—collect taxes equal to less than 15% of national GDP. That is scarcely enough for governments to carry out the most fundamental governmental functions. Simply raising tax rates would be counterproductive, worsening poverty and slowing growth. It demands a more strategic strategy to increase tax collections in a sustainable manner.
Here are four approaches:
Build trust and provide proof
For taxation to work, citizens must trust their governments. They need proof that their hard-earned resources are being used wisely and that in the long run, they will benefit from projects completed using taxpayer funds.
That requires transparency regarding government spending. Governments can start by implementing and publishing a medium-term revenue strategy so that all citizens can be informed about how their tax dollars are being used.
It also requires proof that taxpayers are getting bang for the buck. In countries with a large trust deficit, governments can commit new resources for specific projects that have visible benefits for the average citizen: The building of a new hospital or the construction of a new school can go a long way toward building trust. As trust in a country’s ability to provide good public services grows, governments could then move away from relating new tax revenues to particular projects.
Better public services would enhance people’s trust in government, thus lowering tax evasion and increasing tax revenues further, which would sustain the level of government services, feeding a virtuous circle of trust and government services.
Keep it simple
Complex tax systems foster a culture of evasion and can create opportunities for corruption. Consider the example of Latin America: The average company can expect to spend 547 hours each year making 22 separate tax payments. Not surprisingly, countries in Latin America and the Caribbean lost $340 billion in 2015 to tax evasion.
A 2014 World Bank Group report found that a 10 percent reduction in both the number of payments and the time to comply with tax requirements can lower tax corruption by 9.64 percent. A simpler code can bring more small businesses into the taxable formal sector. It also creates a more predictable environment for international investors, attracting investment and tax revenues in the process.
We are happy that countries see the benefit of making these changes and are taking action. Fifty economies now have just one tax per tax base. Over the past 13 years, 57 economies have merged or eliminated certain taxes.
The simpler a tax system is, the easier it is to enable electronic tax payments. More countries are moving in this direction, although progress is uneven. In Cote d’Ivoire, for example, the time to prepare and file taxes decreased in 2017 from 270 to 205 hours following the introduction of an e-filing system for corporations. However, in Gabon, the time to prepare and file increased in 2017 despite the new availability of an e-filing system.
To make e-filing work across the board, many countries will have to overcome basic IT infrastructure hurdles. But once the basic elements are in place, countries can make progress by pairing digitized taxes with other innovative approaches such as digital identification, digital finance, online tracking of invoices and sales or auto-populating tax returns that citizens simply have to confirm. Kenya, for example, leveraged its ubiquitous money-transfer system, M-Pesa, to allow taxpayers to file and pay their taxes electronically through the platform.
Find new sources of revenue
Property taxes, excise taxes, and carbon taxes are a potentially significant source of revenue in low-income countries—because they apply primarily to wealthier households. They can also deter unwanted behaviors, such as driving cars in already congested areas, smoking, or consuming unhealthy foods.
We are supporting the OECD-led global initiative to rethink how huge – and often digitized – multinational enterprises (MNEs) are taxed, which could have a big impact on developing countries. Currently, governments around the world miss out on anywhere from $100 billion to $600 billion in tax revenues due to legal forms of tax evasion and avoidance. The OECD proposal represents a turning point for international tax rules and, if done right, could reallocate more funds to developing country governments, as explained in a recent World Bank paper, International Tax Reform, Digitalization and Developing Economies.
How Can Developing Countries Learn to Tax?
The ability to raise revenue via taxes, also known as fiscal capacity, is critical to the functioning of any state, particularly in developing countries. This is due to two factors. First, increased fiscal capability is crucial for state development since it is frequently coupled with the establishment of a civilian bureaucracy, which can provide an enabling environment for the consolidation of statehood.
Second, increased fiscal capacity implies more access to the resources required to offer public goods. When compared to wealthy economies, developing countries can only collect a modest fraction of GDP in taxes. They require increased revenues in order to invest in a variety of economic and social areas critical to their success, such as healthcare, education, and infrastructure.
This is also relevant to achieving the Sustainable Development Goals (SDGs) by 2030, a lofty goal that will necessitate significantly more resources. Indeed, SDG 17 specifically mentions the mobilization of government income.
According to a recent study, learning to tax is dependent on the type of political institutions in place. Political systems that set greater limitations on executive power are more likely to result in tax regimes that are more transparent to their population. This is because non-state actors can restrict and limit the elites’ access to resources in such regimes. As a result, people can demand greater accountability from the state in relation to the taxes they pay.
In turn, tax payment and collection methods marked by enhanced openness and accountability of tax authorities make taxation more consensual between states and citizens. This boosts tax morale and has a substantial impact on revenue collection.
Based on a sample of 47 emerging economies, we investigate whether increased executive constraints improve tax transparency. To capture the degree of openness and accountability of tax authorities, we use Polity IV’s popular measure of the efficacy of checks and balances on executive power, as well as a collection of indicators developed by the Public Expenditure and Financial Accountability project.
Tax optimization and tax system integrity in emerging Asia necessitate careful management of special exemptions. Tax expenditures are preferential tax treatments given to specific industries, activities, or groups that result in revenue loss. They include exemptions, deductions, credits, deferrals, and lower tax rates, and are designed to improve social welfare, promote development, and support other policy objectives. Tax breaks, which are a sort of tax expenditure, are frequently used to stimulate investment in specific industries or activities, especially foreign direct investment.
Tax expenditures, unlike direct expenditures, are not always presented in a consistent, comparable, and transparent manner. Furthermore, the costs and benefits of tax expenditures are rarely examined and are frequently unknown. Only a small percentage of the 43 G20 and OECD countries surveyed, including Australia and Korea, released regular, comprehensive, and rigorous tax expenditure reports. Thus, tax expenditures are marked by a lack of transparency and accountability, which may encourage “spending” outside the budget.
Aside from reducing revenue, tax expenditures reduce the efficiency and, depending on their incidence, the equity of the tax system by narrowing the tax base and distorting the rate structure. Concessions favoring certain taxpayers require governments to offset revenue losses by imposing a higher tax burden elsewhere or reducing expenditure.
Tax incentives that focus on certain businesses can create an unlevel playing field, undermine competition, and reduce tax burdens on investments that would have occurred without the incentive. While it is often claimed that tax incentives create a new investment that ultimately boosts revenues, tax incentives are empirically associated with lower overall corporate tax revenues. Finally, tax expenditures are likely to increase enforcement costs, give rise to fraud, and encourage rent-seeking behavior that leads to further tax base erosion.
Many developing Asian economies apply a tax-free threshold or zero tax bracket. By exempting the lowest earners, this threshold promotes progressivity and can reduce potentially high compliance costs. On average in DMCs, the threshold applies above the level of GDP per capita, lower than in Latin America but much higher than in OECD countries.
To expand the tax base, the zero-tax bracket could be lowered, particularly where it is comparatively high and where enforcement capacity and access to third-party information on earnings is stronger. Where it is not currently applied, including in countries with flat taxes, a zero-tax bracket could be added to strengthen progressivity. In some DMCs, there is also potential to expand personal income tax collected through withholding arrangements.