Key message 1 – Overcoming barriers to tax policy enforcement requires greater access to information
Tax collection requires effective enforcement mechanisms. For this, governments must have the capacity to monitor and verify taxable financial transactions. This is a particularly vexing problem for developing country governments where a significant proportion of the labour force is engaged in informal employment (Auriol & Warlters, 2005).
The prevalence of informal or unregistered labour within developing countries reduces the proportion of financial transaction data that flows through verifiable channels. Without access to third-party verifiable transaction data, modern tax instruments are much less effective at monitoring and enforcing tax payment.
Modern tax systems rely on comprehensive systems of verifiable information reported by third-party institutions (e.g. employers, banks, and investment or pension funds). These explicit thirdparty verified information trails form the basis of a modern government’s tax enforcement capacity. Explicit information is reinforced through various implicit information trails. Implicit information is typically created through transactions between the taxpayers and third-party agents (e.g. credit card records, mortgages, contracts, etc.) and functions as a supplemental means of monitoring and verifying any self-reported or non-third-party reported income.
Both explicit and implicit information trails rely on widespread coverage of reporting and documentation to generate traceable financial flows – but this is often missing in developing country tax systems. Access to high-quality explicit and implicit information trails allow governments to systematically compare third-party reported information with selfreported tax returns in order to uncover discrepancies or detect tax evasion. This intrinsically raises the costs of non-compliance by taxpayers and, consequently, increases revenues collected.
Figure 1: Tax collection relative to the proportion of self-employed workers
Unwilling or unable to cheat? Evidence from Denmark
The impact of small informational barriers can be seen even in Denmark, which has an exceptionally effective tax enforcement system and the world’s highest tax-to-GDP ratio (48.6%). Evasion in Denmark is very low because most income is in fact third-party reported. In contrast, income in most low-income countries is purely self-reported. With the obvious caveat that Danish estimates do not directly apply to developing countries, we find that evasion rates on total income and on third-party reported income differ due to differences in enforcement. The results suggest that as the fraction of total income that is self-reported increases, evasion rates increase; whereas, the evasion rate for third-party reported income remains close to zero.
Specifically, as the fraction of income that is self-reported approaches 1 (similar to the situation in developing countries) our estimates indicate evasion rates could be as high as 50%. This is likely to be even higher in developing countries where self-reported income evasion is harder to detect (due in part to differences in availability of implicit third-party information trails such as credit cards). In other words, individuals are near-perfect compliers on third-party reported income, and at the same time, large evaders on self-reported income. Hence, tax enforcement is effective whenever third-party reporting is in place, but weak when it is not in place, even in an advanced economy like Denmark.
The structure and composition of labour markets in developing economies tends to be distinct from that of developed economies: developing economies have a higher proportion of self-employed workers (Kleven & Waseem, 2013; Kleven, 2014; Jensen 2016); smaller and less complex firm structures; and a less sophisticated financial sector. Many of these characteristics are interrelated and may partly explain why the scope for tax evasion tends to be greater in developing countries. The result, illustrated in Figure 1 opposite, is that countries where a higher share of the population is self-employed generate lower tax-to-GDP ratios.
The prevalence of these constraints in developing countries has meant that tax policies designed with the assumption of widespread coverage and availability of third-party reported information trails have proven highly ineffectual for tax revenue generation. The challenge for policymakers and researchers remains to develop a better understanding of how to design localised or contextually appropriate policies and systems for tax collection.
As countries develop, both the proportion of tax revenues gathered from third-party reported sources and the tax-to-GDP ratio tends to increase. Increasing sophistication of financial systems and a shift towards more formalised employment may explain why tax compliance improves as countries become richer. Strikingly, in many cases, present-day tax-to-GDP ratios of developing countries are similar to the ratios of developed countries over a century ago.
Both developed and developing country tax systems collect some proportion of their tax revenues from self-reported information such as inheritance taxes, customs duties, excise taxes, or income from self-employment. As a result, all governments face similar enforcement barriers when collecting tax liabilities on self-reported income. Most developed or high-capacity governments use a range of mechanisms for enforcing tax payments on self-reported income such as implicit information trails, social pressures and tax morale.
Developing countries usually have higher percentages of self-employed workers and thus rely much more on self-reporting for income tax revenue generation. As self-reported income is easier to manipulate, tax evaders can report artificially lower earnings to reduce their tax liabilities, which is much harder to do for third-party verified income (Kleven & Waseem, 2013). The introduction of small informational barriers, even in developed countries, reduces the efficacy of tax enforcement systems and impairs revenue collection.
Countries where a greater proportion of the labour force is self-employed rely more heavily on taxing self-reported income. This, coupled with weaker enforcement capacity and fewer incentives for paying taxes, typically results in higher tax evasion rates in developing countries.