Tax net and the big fish

Government revenues can be increased by spending more on tax administration, ensuring enforcement and coming down on evasion.

THE importance of increasing public revenues in most developing countries cannot be stressed too much. Given the significance of public investment in enhancing economic growth and meeting other social goals, and the need for fiscal sustainability, it is absolutely critical for governments to focus on methods of raising revenues.

Despite this obvious need, in most developing countries in the recent past, government revenues have been under pressure, and have even decreased in proportion to national income. This is largely because macroeconomic, financial and trade policies have tended to reduce revenues from taxation.

Thus, many countries offer incentives to foreign investors in the form of tax breaks and explicit or implicit subsidies, in order to attract foreign capital into the economy. When there is a demand for a "level playing field" for domestic investors, they are forced to reduce taxes on domestic profits as well, and both of these reduce tax revenues. Trade liberalisation has tended to involve extensive cuts in import tariffs as well as export taxes, thereby reducing an important source of indirect taxation. Once again, for reasons of symmetry, domestic excise duties cannot be raised in consequence.

The shift to a value added tax (VAT) regime in many countries has been accompanied by the reduction or elimination of other indirect taxes, with a net reduction of tax revenues. In addition, cuts in government expenditure as part of fiscal restraint packages tend to make output growth more sluggish, which in turn tends to affect tax collections negatively even at given tax rates. For all these reasons, tax revenues as a share of gross domestic product (GDP) have been on the decline in developing countries as a group.

Greater openness to capital flows and concern with attracting such inflows and avoiding capital flight have entailed major tax concessions to both foreign and domestic investors. This has been compounded by the presence of international tax havens and the flexibilities allowed by double taxation treaties and other loopholes in tax systems, which effectively allow for large-scale tax evasion. As a result, the tax losses of developing countries, because of assets held offshore and the shifting of corporate profits between jurisdictions, have been estimated to be as much as $100 billion a year.

Obviously, only coordinated international action can plug such tax loopholes for capital. This should be a priority on the international policy agenda, but unfortunately it is still not so. However, there are still other possible instruments that can be used by individual countries, many of them with the advantage of relative ease of collection.

Tax policies can be strengthened in terms of direct taxation as well as transactions taxes that do not fall disproportionately upon the poor. It should always be borne in mind that tax policies have direct implications for income distribution - across classes, regions, social groups and gender - and these implications must be borne in mind while formulating policies. In particular, the effects of tax policies on gender are often ignored, even as there is greater recognition of the gender-differentiated effects of public expenditure policies.

In most developing countries, there is a strong case for increasing the share of personal income tax in total revenue - not necessarily by raising marginal tax rates but by stepping up enforcement and eliminating loopholes. Improving tax policy and tax collection should entail diversifying sources of revenue and moving beyond heavy reliance on VAT. This means that governments have to be willing to spend more on tax administration, and concentrate more on enforcement and come down on evasion.

Taxes on capital and foreign trade are not only easier to collect, they are also less regressive than indirect taxes that affect the incomes of the poor. The increasing reliance on domestic indirect taxes of various kinds in budgets of developing country governments generally adds to income inequalities.

Even personal income tax rates in developing countries are often not progressive in practice. Even when the statutory tax rates are high and seem to be progressive, multiple exemptions and other loopholes combined with lax tax administration and enforcement make the actual taxes paid by richer groups effectively much lower. That is why there is a case for expenditure taxes that target the rich. This can be done by increasing rates or levying new taxes on certain types of luxury expenditure relating to both goods and services, such as taxes on foreign travel, on consumption in luxury hotels, on purchases made in high-end shopping malls, on imports of non-necessities, or on purchase of luxury vehicles.

One advantage of such taxes is that they are relatively corruption-resistant, since they are automatic and rule-based rather than involving individual discretion. This makes instruments such as trade taxes and turnover taxes on financial transactions especially attractive, since they can be levied mechanically and, therefore, even-handedly. Expenditure taxes on luxury consumption also share this advantage.

A large number of countries have shifted recently from sales taxes to VAT. The arguments in favour of VAT relate generally to the perception that it leads to greater harmonisation and refunds create more incentives to pay taxes. But harmonisation can make a VAT system more regressive than pure sales taxes. A uniform VAT is regressive because it increases the costs of goods consumed by the poor.

With more than 120 countries using some form of VAT system currently, the evidence on its fiscal and distributive implications is mixed. Since, in theory, VAT is supposed to be a tax to end all taxes, many countries that have adopted VAT do not levy excise duty, entry tax or luxury tax. This may lead to a net decline in tax revenue if the VAT receipts do not offset the losses of other tax revenues. A recent International Monetary Fund (IMF) study found that in low-income countries, on average, VAT has replaced less than 30 per cent of the revenues that were lost through the elimination of trade taxes.

Other problems have emerged with respect to implementing VAT in developing countries, especially those in which the informal sector and the "black economy" are large. VAT is essentially a tax on the formal sector - that is, on factories, companies, banks and so on, that pay regular salaries and whose incomes can be easily traced. It cannot cover informal activities, such as farming and household enterprises, small vendors and petty traders or service providers. Therefore, in a perverse way it can actually impede development by encouraging such activities to stay informal, rather than entering the formal sector where more value addition takes place. In large developing countries with federal systems of government and taxation, there are other issues, such as the problem of sharing the taxing powers on consumption between regions and the Central government, which can create complex issues and make management of tax policy difficult.

A strong case can be made for certain types of taxes on capital that can be imposed in developing countries without damaging prospects of more investment. Moreover, direct taxes on capital are easier to collect than a range of indirect taxes, which are also usually more regressive. Some options include: taxes on foreign exchange transactions (the "Tobin tax"); taxes on all financial transactions, at a very low rate that does not affect transactions of a productive intent; capital gains taxes; taxes on income from assets held abroad; wealth taxes; differential taxes to promote certain types of "more desirable" foreign direct investment.

Another set of options centres on trade taxes. Their role has been greatly reduced in the recent past as reductions in import tariffs and removal of export taxes have been part of the global process of trade liberalisation. This has reduced substantially revenues available to developing country governments. While World Trade Organisation obligations and other constraints have reduced available options for imposing trade taxes for most developing countries, there is still some scope for using these to generate more public revenues and reduce cyclical fluctuations emanating from international economic conditions.

A number of trade taxes are WTO-compatible and would also provide more revenue. Some examples of these are: taxes on imported luxury goods; export taxes on certain important export commodities; a system of variable tariffs on a range of agricultural and industrial goods, operating in a band within the WTO tariff bindings, such that international price volatility is not immediately translated into domestic relative price volatility.

With such a variety of possibilities still open to developing countries, the inability to collect more taxes must reflect political will rather than any real economic constraints.