Introduction

Effective tax policy design is the foundation of strong economic development. Barriers to tax collection limit governments’ abilities to finance public goods and services, and invest in infrastructure to spur economic growth.

Key Messages

  1. Overcoming barriers to tax policy enforcement requires greater access to information

    Large informal economies with limited digital coverage of financial transactions make monitoring, verifying, and enforcing tax liabilities a challenge in developing countries. Policies must address enforcement gaps and strengthen information trails.

  2. Third-best policies, inefficient in developed countries, may prove efficient in developing countries

    The barriers to information and enforcement that plague developing countries require experimentation and policy innovation. Although taxes of inputs, turnover, and trade, are traditionally considered production inefficient, gains in revenue efficiency may significantly offset losses from production efficiency.

  3. Harnessing social incentives may increase compliance

    Non-monetary incentives affect tax morale and compliance. Harnessing social and non-monetary incentives may provide a cost-effective mechanism for raising compliance.

  4. Motivating tax collectors could bridge wider enforcement gaps

    Effective administration systems are crucial to tax collection. Smart interventions like pay-for-performance can incentivise better performance by tax collectors.

Taxes are a channel of reciprocal exchange between citizens and governments. Taxes increase government accountability, encourage better governance, public service delivery and enforcement of law and order for the protection of citizen rights – essential ingredients for economic growth. Without widespread monitoring and reporting systems to capture and verify financial transactions, many developing country tax systems generate low tax-to-GDP ratios. Effective tax policies must also address tax morale and administration.

Inability to tax is both a symptom and cause of underdevelopment. In countries with large informal economies, tax policies must account for gaps in monitoring, reporting, and administration to overcome barriers to tax enforcement and collection. Developing country governments are often characterised by poor public service delivery. Without the benefits of public goods and services, citizens have few incentives to pay taxes.

This brief presents a rethinking of tax policy. Traditional tax models assume a ‘second-best’ approach where, in the absence of perfect information (‘first-best’ conditions), tax authorities face some informational barriers to tax collection. Our approach, characterised as ‘third-best’, assumes that developing country tax authorities face severe informational barriers and significant enforcement constraints.

Given the central importance of tax revenues to financing public services, there is no viable alternative to building effective tax systems. Third-best measures, addressing information and enforcement challenges, could yield significant revenue gains in developing countries.