Taxation

This VoxDevLit has reviewed the literature on taxation and development. Countries at different levels of development differ significantly in their ability to extract a share of national income in taxation. What can current 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? Our review has been organised around three important dimensions of taxation in low- and middle-income countries.

The first dimension is constraints on effective taxation and enforcement. Enforcement depends on the extent to which tax authorities can observe the activities of firms and individuals. Enforcement is strengthened when third-party reporting creates such information trails, though these sources of information must be accompanied by administrative investments. When effective enforcement is constrained, optimal tax policy in low- and middle-income countries may deviate from ‘second best’ policies and instead implement ‘third-best’ policies that distort economic choices more but yield higher revenue collection. In the area of enforcement, there are important areas of future research. More work is needed to understand, both conceptually and empirically, how the optimal tax design combines enforcement interventions and reforms to the statutory schedule. In addition, the emergence of new technologies and digitisation may represent opportunities for low- and middle-income countries to enhance enforcement, but these opportunities will crucially depend on the underlying data-quality and the extent to which the digital data-sources are concentrated amongst large firms or cover the large segment of smaller, initially informal firms. Finally, there is relatively little empirical work which directly establishes the real effects of taxation. What are the real efficiency costs of commonly implemented tax instruments, and how do the costs depend on constrained administrative capacity?

The second dimension is 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. Tax authorities in even the most resource-constrained settings can reform their personnel in ways that are cost-effective yet deliver significant impacts to the taxation process. Moreover, tax authorities can make low-cost investments to systematise the collection process and to render citizens and firms more legible to the state, with positive impacts on revenue that may be mediated through quasi-voluntary compliance. Most tax authorities attempt to communicate with citizens and firms in various ways. These communication interventions may backfire if the local context and priors of taxpayers are not fully taken into account. In this area, there are many interesting areas of future research. Systematisation holds promise, but also presents challenges: while systematising the collection process, local officials are likely to gain more information and knowledge on existing and potential taxpayers. This information can be co-opted or abused by officials, and it is important to know how policies can be designed to minimise these adverse effects. Moreover, communication strategies can enhance perceptions of both redistributive and procedural fairness. Understanding when and how these improvements are perceived by taxpayers, thereby boosting compliance, remains a crucial area for investigation.

The third dimension is equity. De facto incidence is a key channel through which the equity of a tax system is determined. For direct taxes, the existence of a large set of self-employed individuals, for whom effective income taxation is challenging, leads to a narrow personal income tax base in low- and middle-income countries. For indirect taxes, the existence of a large informal consumption sector causes the VAT to be naturally progressive. Taxing the top of the income distribution is challenging in low- and middle-income countries, and it is likely that globalisation further exacerbates these challenges. In this domain, there are many important areas of future work. In principle, the co-existence of formal and informal sectors means that some agents in the economy may benefit from tax increases; this is true not only in retail, but also in other areas such as labour markets. Understanding who benefits from the existence of an informal sector is an understudied area of research. Moreover, the equity effects of any tax change ultimately depend in part on the economic incidence, yet there is very little empirical work on this front. The economic incidence of any tax reform will depend on many factors, including the market structure and relative market-power of the different relevant agents; as these factors will vary across settings, there is a strong need to build evidence on economic incidence ‘from the bottom up’, across a variety of environments.