Tax reforms to support an equitable and pro-poor recovery in developing countries

The COVID-19 pandemic has strained government finances. To address these fiscal challenges and support growth, policymakers will need to mobilise revenue in a way that encourages an inclusive recovery. Tax policy will therefore need to be innovative, efficient and equitable.

Across the globe, pandemic containment efforts and disbursal of economic and health support packages, coupled with sharp contractions in economic activity, have led to growing fiscal deficits. In low-income countries, fiscal deficits are projected to have widened by more than 2 percentage points of GDP in 2020 compared with 2019. Debt servicing costs will exceed 20% of tax revenues in over half of low-income countries in 2020 and 2021, and more than half of low-income developing countries are now in debt distress or at high risk of debt distress.

For developing countries, fallout from the pandemic has impacted both national and sub-national finances. Confronted with shrinking fiscal space, policymakers are in need of mobilising additional revenue without destabilising recovery prospects and equity. We discuss reform options across four types of taxes that can strengthen revenue generation during the economic recovery.

1. Wealth tax

Wealth taxes are underutilised as a policy tool but could be an efficient, engaging, and equitable response to COVID-19.

The key considerations for policy reform are:

• Targeting: Wealth taxes could be designed based on three principles relevant to the COVID-19 context: easy to find, easy to value, and easy to liquidate. Targeting wealth that is more visible (such as cash and non-financial assets) and can be easily valued and liquidated is efficient from a revenue point of view, even if leads to distortions. This approach is an example of a third-best tax policy and is suitable where enforcement capacity is weak.
• Time horizon of reform: The COVID-19 pandemic is a unique shock—time-bound as well as income-, wealth-, and health-focused. An equitable tax policy response should mirror these considerations. Rather than burden future generations with a higher tax burden, policymakers could prioritise redistributing today’s wealth.
• Enforcement: Enforcement of wealth taxes can be done by building voluntary compliance through ring-fencing taxes and punishing non-compliance through criminalisation.

2. Property tax

The pandemic provides an opportunity to reform revenue bases from taxes on land and property that hold promise to be more stable than other taxes, especially during economic downturns. Despite having potential, this remains underutilised in most developing countries, with land and property tax accounting for just 0.5% of GDP across sub-Saharan African countries, compared to around 2% among OECD countries.

The key considerations for policy reform are:

• Addressing liquidity constraints of taxpayers: Liquidity constraints for property owners due to the pandemic can addressed through time-bound tax deferral schemes or exemptions for some households, especially those in lower income quintiles.
• Enforcing collection on the richest: Immediate enforcement can focus on the richest quintile of the population so those with the greatest ability to pay do so in the present period. Identifying the richest can be challenging, but tax administrations have successfully identified wealthier populations by tracking luxury expenditures like purchase of cars or repeated foreign trips.
• Using technology to substitute face-to-face interaction: Valuing and collecting property taxes in-person can be difficult given social distancing rules. However, technology can minimise or even eliminate face-to-face contact by allowing people to pay online or through mobile wallet payments.

3. Consumption tax

VAT remains one of the most popular consumption tax instruments as it can better induce compliance throughout supply chains and can be relatively less distortionary than other general sales taxes. Given that consumption taxes are so important in developing countries, tax authorities should work on strengthening and broadening the base so that it can offer more resilience to revenues during future downturns.

The key considerations for policy reform are:

• Technology can increase compliance: VAT coupled with improvements in ICT provides tax authorities the ability to gather information across the supply chain, which can in turn reinforce compliance among other tax instruments. When tax evasion is high and administration is weak, the information generated by this VAT chain can be used to improve tax administration and increase the revenues obtained from other taxes such as corporate income tax.
• Strategic formalisation can spread: Evidence from India and Chile show that positive compliance shock in a VAT system can create a domino effect of formalisation as firms that are complying have a preference to trade and deal with other firms of the same type, causing formalisation to potentially spread throughout the production network.
• Revisiting exemptions: VAT advocates for uniform rates with minimal exemptions and no domestic zero-ratings. Nevertheless, in almost all tax regimes there are exemptions for essential goods and services for equity considerations. However, recent evidence suggests that the redistributive potential of such exemptions and reduced rates are limited; rather, it may be worthwhile to focus on building capacity for direct transfers and taxes.

4. Corporation tax

Corporate taxation is an important source of revenue for developing countries, accounting for 15.3% of tax revenue on average in Africa compared to 9% among OECD countries.

The key considerations for policy reform are:

• Rationalise tax expenditures: Many corporate tax regimes include expenditures such as allowances, deductions, or preferential rates for certain corporations or industries. The pandemic offers the opportunity to review these as they often benefit higher-income groups and it is unclear how effective they are at encouraging productive investment. Governments could link future tax expenditures to COVID-19 relief packages to support newly-vulnerable firms and wind down incentives utilised solely by profitable and wealthy firms. A positive side effect of such rationalisation could be seen in tax compliance, as citizens see the removal of unequal tax expenditures as creating more equity and trust in the tax system.
• Raising revenue in solidarity: The pandemic’s economic fallout has not been the same across all industries; large multinational supermarkets and pharmaceuticals may have experienced higher profits compared to firms in tourism or aviation. In these cases, policymakers should consider asking successful firms to contribute to a solidarity tax, which should be earmarked towards financing the COVID-19 response. Identifying such firms, likely large and incorporated, should be straightforward as tax receipts in developing countries are often dominated by only a few large taxpayers.
• Rethinking corporate taxation: Many policymakers may consider using the statutory rate on profits as a policy lever to either encourage investment or raise revenue. However, evidence suggests that this tool is often not effective to achieve such objectives. Some tax administrations may consider raising taxes on company turnover rather than profits, though the efficiency of this may depend on the capacity of tax administrations and the extent to which companies are part of transnational groups.

Taxes for the future

The COVID-19 pandemic has strained revenues. It is likely that this decrease in revenue will linger. Tax policies for the post-pandemic recovery period will thus require governments to be resourceful. Effectively targeted tax policy not only raises revenue but can help address long-term challenges, such as wealth inequality, building a more equitable future.

Disclaimer: The views expressed in this post are those of the authors based on their experience and on prior research and do not necessarily reflect the views of the IGC.

This blog summarises the policy brief COVID-19 and taxes: Policies for the post-pandemic recovery.