Taxation in developing countries: some recent support and challenges to the conventional view.

The general advice given by international institutions such as the International Monetary Fund (IMF) and the World Bank to developing countries over the past few decades has been to replace trade taxes with domestic consumption taxes, particularly value-added taxes (VAT), and to maintain relatively high corporate income tax rates. This article reviews recent literature that supports and challenges this conventional view.

I. INTRODUCTION

The seminal work on the subject of taxation and development was done by Burgess and Stern, who reviewed previous literature and presented what is still, thirteen years later, regarded as one of the most important works in the field. (1)

According to their view, developing countries should have an indirect tax system based on the following elements:

(i) a VAT with one or two rates and some exemptions; (ii) excises on

alcohol, tobacco, petroleum products, and some luxury goods; and (iii)

direct support for certain groups, possibly through subsidized

rations.... [Such a system] may be supplemented by temporary tariffs

to maintain revenue or where infant industry arguments have genuine

empirical support.... (2)

Burgess and Stern strongly support the now common movement away from trade taxes to sales tax in general, and to value-added taxes (VAT) in particular. (3)

The role of direct taxation in developing countries is much more limited. In contrast to developed countries where taxation on personal income and social security contributions raises two-thirds of the total tax revenue, a narrow tax base and high enforcement costs in developing countries render direct taxation impractical. (4) The income tax base in developing countries is mostly comprised of the wages of public sector employees because most other taxpayers are self-employed or small businesses who evade paying all, or most, of the income tax. (5) In addition, taxation of personal capital income is easily evaded. (6)

Taxing the income of corporations, on the other hand, provides developing countries with a large portion of their total tax revenue (estimated in 1993 to be close to one-third), compared to only a small portion (less than one-tenth) in developed countries. (7) Taxing large corporations does not involve significant administrative and compliance costs because the companies are already forced to comply with statutory accounting requirements. (8)

Following this conventional wisdom, the general advice given to developing countries over the past few decades by international institutions such as the International Monetary Fund (IMF) and the World Bank has been to replace trade taxes with domestic consumption taxes, particularly VATs, (9) and to maintain relatively high corporate income tax rates. (10)

Some recent literature challenges this conventional view, arguing that the relatively large informal sector in developing countries may justify a different tax policy design. (11) In a previous article, Margalioth suggests that maintaining high corporate income tax rates may come at a high cost in terms of economic growth as corporate tax rates affect foreign direct investment (FDI) location, and may cause significant spillover effects. (12)

This article is structured as follows. Part II provides some general background information. Part III reviews some recent papers that support the conventional wisdom. Part IV reviews some recent criticisms of the conventional wisdom. Finally, Part V draws upon this body of recent research to raise a few questions and offer suggestions for future study.

II. BACKGROUND

Taxes are necessary to overcome the free riding inherent in the financing of public goods, to control market imperfections, and to achieve social justice through redistribution. Economic growth (efficiency) is promoted by the first set of goals, whereas social justice (equity) is promoted by redistribution and the provision of public and merit goods, most notably health and education.

Literature on the subject generally assumes that the goals of promoting economic growth and social justice are shared by developed and developing countries; however, a number of major differences between developed and developing countries may call for different tax designs. These differences include variations in industry type (primarily the relatively high shares of agricultural and small businesses in developing countries), in the size of administrative and compliance costs, in the levels of corruption, in the levels of monetization in the economy, in political constraints, and in the relative size of the informal economy.

The overall proportion of government expenditure of the gross domestic product (GDP) is higher in developed than developing countries. (13) This situation is not necessarily optimal, because a greater need exists for government intervention in developing countries (e.g., for building infrastructure and education) than in developed countries. On the other hand, the costs of corruption, administration, and compliance are much greater in developing countries, making the outcome of this trade-off unclear.

The portion of total revenue comprised of non-tax revenue is, on average, larger for developing countries than developed countries. (14) Nevertheless, the main source of government revenue in developing countries, taken as a whole, is the tax system. (15)

The structure of taxation in developing countries is radically different from the structure of taxation in developed countries. About two-thirds of the tax revenue in developed countries is obtained from direct taxes, mostly personal income tax and social security contributions. (16) The remaining one-third comes primarily from the domestic sales tax. (17) The situation is exactly reversed in developing countries, in which about two-thirds of the tax revenue comes from indirect taxes. (18) These indirect taxes include the VAT, the sales tax, and excises and taxes on trade. (19) The remaining one-third comes primarily from the corporate income tax. (20)

Since the 1980s, developing countries have undergone frequent tax reforms, gradually replacing trade taxes with domestic consumption taxes, particularly the VAT. (21) These reforms were part of two world-wide trends that affected developed countries as well. The first trend was economic liberalization and adherence to the World Trade Organization (WTO) requirements, which called for the elimination of all barriers to free trade. (22) The second trend was the rapidly increasing popularity of the VAT all over the world. (23)

The purpose of replacing trade taxes with domestic consumption taxes was principally to improve macroeconomic stability and to introduce the benefits of free trade to developing economies. (24) Export taxes are seen as inefficient because they put the local producers who export their goods at a disadvantage compared with foreign producers. The VAT was viewed as more efficient than import taxes because it does not discriminate between domestic and imported goods. By eliminating import taxes, local consumers benefit from the lower prices created by the competition between domestic and foreign producers. (25) Additionally, eliminating import taxes forces local producers to become more efficient and concentrate their efforts on their comparative advantage. (26)

Equity considerations, namely reducing poverty and inequality, have been of secondary importance, when considered at all, in the tax reforms of developing countries. Focusing only on efficiency can result in the adoption of regressive tax policies. (27) For example, taxes on goods with low price elasticities of demand, such as some cereals and domestic fuel, are efficient in that they do not distort behavior. (28) However, since the poor consume these goods disproportionately, equity considerations will weigh against the adoption of such regressive tax policies. (29)

III. RECENT LITERATURE SUPPORTING THE CONVENTIONAL WISDOM

Gemmell and Morrissey have analyzed the distributional impact of tax reforms in developing countries. (30) They conclude that "[t]he available evidence suggests that sales taxes are slightly more progressive, or less regressive, than taxes on imports." (31) Additionally, Gemmell and Morrissey have found that, in most developing countries, "export taxes were regressive, typically incident on smallholder agricultural producers (who, if not actually poor, were relatively low income). The removal of such taxes, combined with the reduction of other implicit taxes on agriculture, should have had a favourable impact on distribution and the poor." (32) As a result, Gemmell and Morrissey conclude further that "it seems likely that the reforms will not have worsened the effects of the tax structure on distribution and the poor." (33)

Gemmell and Morrissey add to the conventional wisdom an emphasis on the distributive effects of consumption taxes. They argue that no conclusive evidence exists "regarding the impact of generally replacing tariffs with sales taxes, largely because we do not know enough about economic incidence and the implications of a large informal sector," such as those prevalent in developing countries. (34)

They cite the example of excise taxes on fuel as a particularly troublesome manifestation of this problem. (35) Gemmell and Morrissey assert that a tax on kerosene (or paraffin) may have high social costs (36):

Kerosene (or paraffin) is often important within poor household[s,

where it is used for heating, lighting, and cooking] but is not widely

used by the rich. Thus, not only will kerosene taxes be harmful to the