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

poor, but [kerosene can be exempted] from more general fuel taxes to

improve equity without encouraging inefficient substitutions between

fuel types. (37)

On the other hand, it is not entirely clear that taxing gas for cars has a low social cost. (38) Gemmell and Morrissey argue that "taxes on intermediates such as fuel are often thought to be regressive because they affect transport costs (thus increasing prices of goods consumed by the poor)." (39) They suggest that "[t]he important implication for tax policy is that, on distribution and poverty grounds, taxes on goods that are most important in the consumption bundles of the poor should be kept as low as possible." (40)

The distributive consequences of conventional reliance on consumption taxes may seem especially grim when considering Latin America in general, especially Central America, where poverty and inequality rates are exceptionally high. (41) Bird acknowledges such inequality is "[t]he central social and economic problem in many Latin American countries." (42) He argues, however, that this is primarily a political problem. (43) The rich elite in Latin America have a great deal of political power, but they refuse to reduce inequality. (44) Bird notes that a positive correlation exists between inequality in Latin America and the extremely unequal distribution of land ownership. (45) He therefore suggests increasing the very low property tax rates now in force and improving tax administration through "more comprehensive coverage, better assessments, more frequent assessment revaluations, and enforced penalties for late payment." (46)

Bird goes on to advocate "[r]eforms that link taxes and benefits more tightly ..., such as decentralization and more reliance on user charges." (47) He argues that, "contrary to popular rhetoric, most user charges are progressive in their incidence. The property tax, and some local business taxation, may be considered to be 'generalized user charges' if properly designed and implemented." (48)

In addition, Bird argues that pro-poor spending programs are more effective in reducing poverty than the tax system. Nonetheless, at the same time, it is important to "untax" the poor by "setting higher thresholds for certain taxes or charges (e.g. lifeline [utilities]) or granting certain exemptions from the VAT." (49)

In addition to taxing land, Bird suggests imposing taxes on estates. Imposing a wealth tax on the top 1-2% of society, even if badly administered, "may sometimes be worthwhile not only in symbolic but also in actual terms." (50) For example, a 1% annual wealth tax for property yielding a 5% average annual return has the same effect as taxing that return at 20%. (51)

Bird supports the conventional view of tax reform in developing countries by stressing that, despite the extreme inequality in Latin America countries, "the best tax system [for them] is the one that produces the most revenue in the least costly and distorting way." (52) Such a system is "[a] broad-based VAT, and not a steeply progressive income tax." (53) Bird does note, however, that this system should be supplemented with taxes on land and other property, good user charges, and taxes on motor vehicles and fuel. (54)

These ideas are further developed by Bird and Zolt. (55) Bird and Zolt stress that, in developing countries, expenditure policy is much more important for redistribution purposes than income tax policy and consumption taxes can be progressive and should be supplemented with user charges. They further emphasize that "[g]reater fiscal decentralization (moving tax and expenditure authority to lower levels of governments) may allow for better matching of those who benefit and those who pay for government activity," Bird and Zolt then add a series of suggestions on methods to improve income tax enforcement. (56) In addition to the standard administrative advice detailed below, they suggest greater reliance on presumptive taxation and the adoption of the Nordic dual income tax system. (57) They also propose that "[t]ax authorities could try to increase the number and types of individuals subject to withholding [taxes] on labor income, for example, by expanding the definition of employee for tax purposes beyond [that required by] employment law." (58)

Bird and Zolt further recommend "heavier reliance on withholding (for example, by banks) and [on] third-party information." (59) Taxpayers who fail to withhold or report information on payments they have made should not be allowed to deduct those payments for income tax purposes. Bird and Zolt describe a range of options for tax authorities, including "using taxpayer identification numbers, outsourcing routine data processing, adopting case-tracking systems, and improving and expanding audit systems." (60)

Bird and Zolt contend that the use of presumptive taxes "is surprisingly widespread in taxation around the world, though [such taxes appear] under many names." (61) Taxable income is estimated by the authorities on the basis of "coefficients for different factors applied to specific taxpayers, specific types of taxpayers [for example, the location as well as the number of chairs in a restaurant], or in some cases on more aggregate indicators, such as industry and region, or external indicators of income." (62) The authors indicate that "[s]uch taxes are intended to capture at least some minimum level of tax from entities, regardless of either their reported or their true net income." (63) Usually, the taxpayer is allowed to rebut the presumption by proving his or her true income.

A dual income tax system imposes a flat tax on income from capital. In developing countries, this has the advantage of including in the tax base capital income that was previously exempt, and improving enforcement and compliance by allowing the fixed withholding tax rate to be the final tax. (64)

The income tax proposed by Bird and Zolt is designed to be modest reform (justified in whole or in part on symbolic grounds) designed to complement "a broad-based VAT, appropriate excise taxes, more use of local and benefit financing, and above all, an improved expenditure policy." (65)

IV. RECENT LITERATURE CRITICIZING THE CONVENTIONAL WISDOM

In a 2005 article, Emran and Stiglitz challenged "the current consensus that favors a reduction and eventual elimination of trade taxes, and almost exclusively relies on VAT as the instrument of indirect taxation in developing countries." (66) In their 2005 article, they argue that the consensus "is built on fragile results derived from a partial model that ignores the existence of an informal sector." (67) Instead, they contend that "the results from a more complete model demonstrate[] [that replacing trade taxes with VAT] can reduce welfare under plausible assumptions" (68) and conclude that "[t]he results raise serious doubts about the wisdom of the indirect tax reform policies pursued by a large number of developing countries." (69)

In an earlier version of the article, Emran and Stiglitz asserted "that while a radial (across the board) uniform reduction in trade taxes reduces the production distortions and the distortions between tradable and nontradable sectors, a revenue-neutral radial increase in VAT increases the inter-sectoral distortions between formal and informal sectors." (70) That is, goods may be produced and sold in both the formal and informal sectors, but the consumption tax is only paid by the formal sector and creates a distortion between formal and informal sectors, resulting in a potential reduction in aggregate welfare.

In their 2005 article, Emran and Stiglitz "extend[ed their] analysis to the case of a selective reform of trade tax and VAT in an economy with an informal sector." (71) The term selective reform refers to tax changes that apply only to a subset of the commodities falling under the tax net. (72) In such a context, they state:

Michael et al .... show that, in a tradables-only economy with no

informal sector, a reduction in the import tariff on the commodity

bearing the highest tariff and also the highest total indirect tax

burden increases welfare under suitable assumptions of

substitutability, when the lost revenue is compensated for by an

increase in the consumption tax on the commodity bearing the lowest

indirect tax burden. (73)

In their view, however, "[t]he extant literature ... completely ignores the implications of an informal economy for the efficiency of consumption tax (VAT) as an instrument of revenue-raising, which can be especially important in the developing countries." (74)

According to Emran and Stiglitz, for the existing results on "revenue-neutral selective reform of tariffs and consumption taxes" to be valid and applicable, it is necessary to make the assumption "that it is feasible to impose and collect consumption tax (VAT) on the commodity bearing the lowest indirect tax on consumption." (75) This assumption is problematic, for "[w]hile [it] is automatically satisfied when an economy consists of only the formal sector, it is not a plausible assumption in the presence of a large informal segment in the economy that, by definition, escapes VAT coverage." (76)