By Jomo Kwame Sundaram, Coordinator for Economic and Social Development at the Food and Agriculture Organization and received the 2007 Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.
The Addis Ababa Action Agenda is widely seen as a major disappointment for developing countries as well as others hoping for adequate means of implementation to realise national development ambitions and the Sustainable Development Goals (SDGs).
It has become clear that the South, including the least developed countries, should not expect any serious progress to the almost half century old commitment to transfer 0.7 percent of developed countries’ economic output to developing countries. But to add insult to injury, developing countries cannot expect to participate meaningfully in inter-governmental discussions to enhance overall as well as national tax capacities.
While OECD countries agree that taxation is the only viable strategy for developing countries to exit foreign aid dependency in the long run, they have refused to accede to the latter’s desire for a full-fledged inter-governmental body for international tax cooperation under United Nations auspices.
The ability to pursue development policies depends crucially on available fiscal space, which relies mostly on domestic revenues, especially taxes. However, tax revenues in most low- and lower middle-income developing countries are low.
The average tax-GDP ratios in low-income and lower-middle income countries are around 15 and 19 per cent respectively, compared to over 30 percent in high income countries.
Low- and lower-middle-income countries should take steps to increase their revenues; but the main approach in recent decades has been to increase tax rates only if unavoidable. It was presumed that lower rates would ensure better compliance with tax laws, and thus raise revenue.
The prevailing tax wisdom also favoured broadening the tax base, even when taxation capacities are modest. Thus, indirect taxation has tended to increase while direct taxation of corporations and individuals has tended to decline. The latter was supposed to be good for investment and growth although the empirical support for this presumption is dubious.
In the vast majority of countries in sub-Saharan Africa and Latin America, the tax to GDP ratio has actually stagnated or declined as tariffs and export duties, which accounted for the largest share of tax revenue, declined with trade liberalization. Unfortunately, other taxes have not grown to compensate for the lower trade taxes.
There is an urgent need to reverse this trend, with greater commitment to revenue generation in order to improve social protection, create employment and otherwise contribute to sustained economic recovery.
With their different economic circumstances, it does not make sense for developing countries to simply try to emulate developed economies in trying to generate revenue. Even among developing countries, no one size fits all.
And certainly not for all time, as tax systems must evolve with changing economic circumstances. A key question is: which taxes are most likely to meet the requirements of implementability, buoyancy and stability?
Domestic Taxes: Direct or Indirect?
The revenue to GDP ratio can rise in the following ways: the domestic tax base is widened; tax avoidance and evasion are reduced; and new sources of international taxation are found.
There is no reason to be overly pessimistic about direct taxation as tax reform has significantly improved the contribution of direct taxes to overall revenue in many countries. It is certainly possible to enhance tax revenues by increasing the share of direct taxation of the wealthy through more progressive income taxes in developing countries.
However, there should also be a greater effort to ensure better compliance with, and higher collection of existing taxes.
Limiting the discretionary authority of tax officials could also help improve compliance and reduce evasion. Computerisation of tax administration can help limit corruption, as it makes it harder to tamper with records. But government computerisation alone cannot ensure effective introduction of the much-touted value-added tax (VAT), an indirect tax largely responsible for facilitating the shift from direct to indirect taxation.
Improved tax administration can increase the share of personal income taxes in total tax revenue. Expansion of the scope for tax deduction at source has been very effective in taxing those otherwise hard to reach.
Every individual who is a house owner, vehicle owner, club member, credit card holder, passport, driving licence or identity card holder and telephone subscriber can be required to file a tax return.
Excise taxes are another important source of revenue in developing countries as they have a buoyant base and can be administered at low cost. They are typically levied on products such as alcohol, tobacco, petroleum, vehicles and spare parts.
From a revenue perspective, they are convenient, involving few producers, large sales volumes, relatively inelastic demand and easy observability.
Excises may be levied on quantities leaving the factory or arriving at ports, thus simplifying measurement and collection, ensuring coverage, limiting evasion and improving monitoring. Excise taxes currently amount to less than 2 per cent of GDP in low-income countries, compared to about 3 per cent in high-income countries.
Globalisation and Tax Evasion
Revenue losses due to globalisation need to be addressed. There are three main reasons for revenue losses: first, capital movements increase opportunities for tax evasion because of the limited capacity that any tax authority has to check the overseas incomes of its residents; evasion is easier as some governments and financial institutions systematically conceal relevant information.
Where dividends, interest, royalties, and management fees are not taxed in the country in which they are paid, they more easily escape notice in the countries where the beneficiaries live. There have been large non-resident aliens’ bank deposits in some countries like the U.S. that imposes no taxes on interest from such deposits.
Second, avoidance (not evasion) may increase, given international differences in tax rules and rates, because of the choice of tax regime that international-tax-treatment of enterprise income commonly offers. This is more likely for taxation of profits from corporations’ international operations.
Transfer pricing for goods, services and resources – moving among branches or subsidiaries of a company – provides opportunities for shifting income to minimise tax liability.
Third, international competition for inward foreign direct investment has lead governments to reduce tax rates and increase concessions to foreign investors. The tax rates that governments can impose are thus constrained by international competition.
Hence, they are reluctant to raise rates or to tax dividend and interest income for fear of capital flight although it is well known that direct tax concessions have little effect in diverting international investment, let alone in attracting such flows. Hence, such tax concessions constitute an unnecessary loss of revenue.
Not surprisingly, income tax rates, both on corporations and on individuals, have fallen sharply since the 1980s. Beggar-thy-neighbour policies have led to losses of revenue for many developing countries in a larger race-to-the-bottom also involving labour and environmental standards and conditions, which also undermines the possibility of balanced, inclusive and sustainable development.
Finance ministries and tax authorities in developing countries need to cooperate among themselves and with their counterparts in the OECD economies to learn from one another and to close existing loopholes in their mutual interest. With the huge and growing size of public debts as well as the real and imagined fiscal constraints to sustained global economic recovery, such cooperation is more urgent than ever.