ROME – An effective tax policy that ensures adequate domestic revenue is a crucial determinant of a country’s ability to pursue development policies. But tax revenues in most developing countries are low, impeding progress toward more balanced, inclusive, and sustainable economic development that can improve public health and raise standards of living.
Although non-tax revenue may contribute significantly to some countries’ total GDP, the average tax/GDP ratios in low-income and lower-middle-income countries are roughly 15% and 19%, respectively – significantly lower than the OECD average of more than 35%. To finance development projects, poor and lower-middle-income countries must devise and implement tax strategies to increase domestic revenue.
This entails abandoning the prevailing dogma that taxes should only be increased when absolutely necessary. This stance assumes that lower tax rates raise the tax/GDP ratio by ensuring better compliance with tax laws, and favors indirect taxation (such as value-added taxes) in order to broaden the tax base to include those with modest incomes.
Meanwhile, direct taxation of corporations and individuals has tended to decline – despite the moot claim that lower direct taxation ensures investment and growth. As a result, the tax/GDP ratio in most countries in Sub-Saharan Africa and Latin America has stagnated or even fallen.
In many developing countries, total tax revenue is derived from three main sources: domestic taxes on goods and services (sales and excise taxes), direct taxes (primarily on corporations), and, most important, taxes on foreign trade (import duties). But, as trade liberalization has lowered tariffs and duties, the share of trade taxes has declined, while other sources have not compensated for falling trade revenue.
By contrast, in high-income countries, income taxes (primarily on individuals) comprise the largest proportion of tax revenue (roughly 36%), while domestic taxes on goods and services and social-security contributions each account for slightly more than one-quarter. Moreover, the share of trade taxes is typically low.
Of course, developing countries should not simply mimic developed economies’ tax systems. After all, no one-size-fits-all approach exists, even among developing countries. And tax policy must evolve with changing economic circumstances.
Instead, developing-country leaders must draw on the experiences of both developed countries and their peers to design tax policies that meet the basic requirements of operability, buoyancy, and stability. This can include broadening the tax base, reducing tax avoidance and evasion, improving tax collection, and developing new, cooperative international taxation strategies.
In many countries, tax reform has already significantly increased the share of direct taxes in overall revenue. Raising tax rates for the wealthiest citizens in developing a more progressive income tax framework would bolster this progress.
Governments should also work to improve tax compliance and reduce evasion, which requires limiting tax officials’ discretionary authority. Computerizing tax administration, for example, could help to limit corruption by making it more difficult to tamper with records.
In order to increase personal-income taxes’ share of total revenue, developing countries are already improving their tax administrations in innovative ways, particularly to reach hard-to-tax citizens. More can be done: Every individual who owns a house or a vehicle, is a member of a club, holds a credit card, passport, driver’s license, or other identity card, or subscribes to a telephone service can be required to file a tax return.
Moreover, excise taxes are a convenient source of revenue in developing countries, as they are primarily levied on products such as alcohol, tobacco, gas, vehicles, and spare parts, which involve few producers, large sales volumes, relatively inelastic demand, and easy observability. Excise taxes may be levied when goods leave a factory or arrive at a port, simplifying measurement, collection, and monitoring, while ensuring coverage and limiting evasion. But, despite their robust base and low administrative costs, excise taxes currently amount to less than 2% of low-income countries’ GDP, compared to roughly 3% in high-income countries.
Developing countries must also aim to offset the consequences of globalization. For example, capital mobility increases opportunities for tax evasion, given that tax authorities’ capacity to monitor their citizens’ overseas incomes is limited, and some governments and financial institutions systematically conceal relevant information. If dividends, interest, royalties, and management fees are not taxed in the country in which they are paid, they more easily escape notice in the country of residence. Indeed, some countries – including the United States – impose no taxes on interest from large bank deposits by non-resident aliens.
Globalization may also facilitate legal tax avoidance. For example, multinational corporations use methods like transfer pricing (book-keeping of goods, services, and resources transferred between a single company’s branches or subsidiaries) to minimize tax liability on their profits from international operations. Corporate taxpayers take advantage of discrepancies in rules and rates, choosing to do business in countries with more favorable – or lax – tax regimes.
Finally, international competition for inward foreign direct investment may lead governments to reduce tax rates and increase concessions for foreign investors. With evidence of sudden capital outflows in response to certain tax-policy changes, governments are reluctant to raise income-tax rates – which have fallen sharply since the late 1970’s – or to tax dividend and interest income, for fear of capital flight. But, as direct-tax concessions have little or no effect in diverting international investment, let alone in attracting such flows, they constitute an unnecessary loss of revenue.
Beggar-thy-neighbor policies will lead to revenue losses for all developing countries, while undermining the possibility of balanced, inclusive, and sustainable development. Developing-country finance ministries and tax authorities must cooperate with one another and with their OECD counterparts to close existing loopholes and establish effective tax policies that support their shared interests. With rising public debt worldwide placing fiscal constraints (real and imagined) on global economic recovery, such cooperation is more urgent than ever.