Ideas Matter: What is stopping developing countries from taxing more?

Blog State, State Effectiveness, Tax revenue, incentives, information, Income taxes, VAT, Profit and Tax treaties

Public finance – government revenue and expenditure – is crucial for redistribution and inclusive growth. The information scarce environment and a large informal sector make it difficult for developing countries to raise revenue through taxation.

Virtually every country in the world taxes their populations. But, some do so more successfully than others. Most developing countries raise tax revenue equivalent to between 10% to 20% of their GDPs, some even less. Rich countries raise much more, on average 34%. If Pakistan distributed all its annual tax revenue equally among its 200 million citizens, each would get less than 1% of the country’s legal minimum wage. The result of this is considerable differences between the abilities of governments to fund public services, explaining why India spends $62 per citizen on healthcare, while Germany spends over $4,000.[1]

The mother of all information

Developing countries are information-scarce environments -  governments typically do not know who owes how much. This is why when developing countries do tax, they focus on taxing consumption and trade instead of labour, as the former are easier to target.[2]

In most developed countries, this information is largely created by third-party reporting of income. Typically, firms report how much they pay their employees, making it harder for people to cheat. In most developing countries, large informal sectors make this nearly impossible to achieve. Even in China, where formal employment is more widespread, only 28 million people pay direct income taxes, as of 2015. In Pakistan, it is about one million people.

Increasing income taxation is hard without widespread formal employment. In a 2019 working paper, Anders Jensen, of Harvard University, uses data from the United States to show that as people moved away from self-employment to wage labour, this was associated with increased usage of income taxation.  In a similar vein, research from Denmark shows that tax evasion is significantly higher among people who self-report their income than those whose income is reported by employers.

Some developing countries have made some progress on this front by targeting albeit a small number of people who work in formal firms. This is largely done using withholding taxes, in which businesses deduct the tax before giving paychecks to their employees. But this risks pushing the administrative burden on formal private firms, a bad precedent to set especially when so few exist.

The expansion of value-added taxation (VAT), under which the government levy tax on each firm across a supply chain, is also in-part motivated by the desire to create more information. To calculate the value, each firm needs to subtract the difference between its output and its input. By doing so they create an information trail that can be used to verify the tax liabilities of other firms in that chain. 8 out of 10 countries in sub-Saharan Africa levy the VAT today.

It is ingenious, on paper. In practice, it has led to mixed results. In Chile, third-party reporting due to the VAT has strongly disincentivised tax evasion. While researchers in Uganda have found widespread discrepancies in amounts reported by sellers and buyers, despite the paper trail created by the VAT.

Acting on the information

The secret might be how much enforcement capacity a given state has. Firms may eventually realise that the state does not do anything if they do not accurately report their profits. After all, information is worth only if someone acts upon it. But, capacity is a whole other beast: you need the capacity to raise revenue, and revenue to raise capacity.

One way to address this problem is to motivate tax bureaucrats to perform better. When researchers in Pakistan provided property tax collectors with performance pay schemes, revenue jumped by as much as 46%. But, incentives can be tricky to tweak. Some of them can also be costly: in Ghana, one out of five revenue collectors earns a monthly salary that is greater than the revenues they collect, giving them bonuses might not help.

With limited capacity and lack of information, developing countries may need tax policies that we may find unwise for developed countries. Economists Adnan Khan and Henrik Kleven term such policies as ‘third-best’.

One policy they consider is taxing full firm revenue instead of profit. Doing so is inefficient because it does not allow firms to deduct the costs of input and may distort a firm’s production decisions. But some inefficiency maybe tolerable if it raises enough revenue. Researchers estimate that in Pakistan’s case this could raise as much as 74% more tax revenue.

The problem beyond the border

There are other factors: less technocrat, more political. An important one is the prevalence of double tax treaties between countries. Signed to prevent taxing the same income twice, they have undermined the tax capacity of several developing countries. Firms can base their operations in one country, usually that has a treaty with another country and very low taxes, evading taxes in the latter because they pay in the former.

In a 2018 paper, IMF Economists Sebastian Beer and Jan Loeprick have used the fact 11 African countries have such treaties with Mauritius, where firms are effectively taxed at a rate of just 3%. They find that these treaties have not only not led to increased foreign investment in countries that sign these treaties with Mauritius but also lead to significant revenue losses. Zambia has just torn up its tax treaty with Mauritius.

The cross broader implications do not end here. The elite in many developing countries evade taxes by moving their wealth abroad, supported by a network of financial and legal firms. African governments collectively lose about $15 billion a year because of offshore wealth, calculations by economist Gabriel Zucman show. It is hard to tax when much of the tax base is signed away, or hidden in Swiss bank accounts.

This blog is part of the IGC’s Ideas Matter campaign to celebrate the launch of the Little Book of Growth Ideas.

End notes:

[1] Data by World Bank’s WDI database. PPP dollars.

[2] This moves the tax burden to lower-income groups. However, in new research, Bachas et al. (2020) argue that consumption taxes might be more progressive in countries with large informal sectors, because people in the bottom decile tend to rely more on informal transactions which are not taxed.