Taxation

Abstract

Why are there such significant differences across countries in governments’ ability to extract a share of national income in taxation? What can low- and middle-income countries do to improve their ability to tax? How does the pursuit of tax collection depend upon and influence other objectives of a tax system such as equity, growth and the building of a strong state? This VoxDevLit summarises findings from the growing body of research on taxation and development that speaks to these questions. The review is organised along three important dimensions of taxation in low- and middle-income countries: constraints on effective taxation and enforcement; administrative reforms and communication; and equity.

Policy Summary: Taxation and Development

This VoxDevLit summarises findings from the growing body of research on taxation and development. The review is organised along three important dimensions of taxation in low- and middle-income countries: constraints on effective taxation and enforcement; administrative reforms and communication; and equity. 

In the domain of effective taxation and enforcement, there are three main lessons. The first is that the existence of third-party reporting improves enforcement by creating paper trails on the activities of firms and citizens. There are, however, important qualifications: the paper trail ‘breaks down’ at the final consumer stage if the consumers have no incentive to ask for receipts; there are limits to the effectiveness of third-party reporting when firms and individuals can make offsetting adjustments on margins of activity that are less verifiable; the success of third-party reporting relies on the assumption that the tax authority has a certain capacity to cross-check information reported across parties and, perhaps more importantly, that taxpayers believe in this capacity. The second insight is that the lower third-party coverage in low- and middle-income countries can lead optimal tax policies to look very different than they do in high-income countries. For example, once we account for enforcement constraints, it may be desirable for optimal tax policy to implement policies that distort firms’ and households’ economic choices relatively more if they lead to less evasion and therefore greater revenue collection. The third insight is that tax authorities must use evidence to balance between statutory reforms (e.g. changing the tax rate) on the one hand, and direct investments in enforcement, on the other hand. 

A promising domain to improve taxation in low- and middle-income countries lies within the tax authority itself. We emphasise administrative reforms and communication strategies with taxpayers as two ‘building blocks’ of a well functioning tax authority that are feasible policy levers for governments in most settings, including those with lowest levels of initial capacity, and that have potentially beneficial impacts beyond immediate improvements in enforcement. A critical focus area is personnel, where rationalising and professionalising personnel remains paramount. An important policy tool involves optimising the staff-to-taxpayer ratio, perhaps in particular for large firms and high-net-worth individuals. Furthermore, enhancing recruitment practices to attract and retain high-calibre personnel within tax authorities is crucial. Another critical area is that tax authorities can significantly enhance their effectiveness by improving communication with taxpayers. Beyond merely conveying tax liabilities, transparent and clear communication can play a crucial role in shaping taxpayers' perceptions of the state. It can influence their beliefs about the state's ability to detect noncompliance, its commitment to investing tax revenues in public goods rather than rent-seeking, and the fairness of tax burden distribution. These perceptions, in turn, may positively impact taxpayers’ compliance but also their engagement with the state more broadly. 

Finally, in the domain of equity, there are three main lessons. First, due to both structural factors and limited enforcement capacity, the effective distributional impacts of taxes often deviate from their 'statutory' objectives, in ways that are hard to predict based on evidence from high-income countries. Second, administrative reforms which are meant to be distributionally neutral may end up having significant equity impacts because of the practical realities of implementation. Third, the global challenges which tax authorities face to tax the very top of the income distribution appear to be even more pronounced in low- and middle-income countries.

Taxation and Economic Development: Presentation of key takeaways

For our launch event, Senior Editor Anders Jensen presented the key takeaways from this VoxDevLit, highlighting policy relevant results from recent economic research on taxation and development.

This VoxDevLit was supported by Tax for Growth, an IGC initiative that supports tax administrators and policymakers in generating effective approaches to make taxation work for development.