Growth brief: Taxing to develop – When ‘third-best’ is best

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.

See our infographic on ‘third-best’ here.