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

Instead, they assert that "[i]n an economy with both formal and informal sectors, the best one can do is to select the commodity enjoying the lowest indirect tax burden among the subset of formal commodities as the candidate for VAT increase." (77) In light of this restriction, they then prove "that there are plausible (sufficient) conditions under which such a selective reform of VAT and import tariff reduces welfare." (78) They also provide plausible, sufficient conditions for "worsening of welfare from a reduction in import tariff with a revenue-neutral VAT base broadening." (79)

Emran and Stiglitz also criticize the fact that "the extant literature exclusively deals with the coordinated reform of import tariffs and consumption taxes, and ignores the case of a coordinated reform of export taxes and consumption taxes, although such reforms are frequently prescribed by the policy advisors." (80) They argue:

Our results on export tax reform in the absence of an informal sector

show that the conditions required for a welfare improvement from the

reduction in export tax on one commodity combined with a revenue

neutral increase in VAT on another are much more stringent than the

case of an import tariff reform. Unlike the case of an import tariff

reform, the selective revenue-neutral reform of VAT and export tax can

reduce welfare in an economy without an informal sector, even when all

commodities are ... substitutable. The results of this paper thus

complement and strengthen the conclusions reached by [our earlier

article]. (81)

In addition, Emran and Stiglitz argue that "trade taxes enjoy a clear advantage over VAT" due to administrative costs, which is "the usual explanation for the pervasive use of trade taxes in early stages of development." (82) This primarily stems from the fact that "[t]he informational and compliance costs of VAT are likely to be high, especially in developing countries, because of high rates of illiteracy and scant written record-keeping." (83)

Lastly, they argue that trade taxes are not more vulnerable to smuggling than VAT. They assert that:

[A]n increase in import taxes increases the returns to both domestic

production and smuggling, so that the extent of smuggling is

constrained by the higher domestic supply of a commodity. A higher

VAT, on the other hand, increases the consumer price but leaves the

returns to the domestic producers unchanged. This implies a higher

return to smuggling relative to domestic production, assuming that the

commodity in question is an importable. (84)

Other authors have also questioned the wisdom of eliminating trade taxes. Baunsgaard and Keen analyzed panel data for 111 countries over 25 years--from 1975 to 2000. (85) They show that developing countries find it very difficult to replace the revenue lost by trade liberalization with revenue from domestic sources. This reality is especially troubling since "revenue recovery has been extremely weak in low-income countries (which are those most dependent on trade tax revenues)." (86) These countries have recovered, at best, no more than about 30 cents of each lost dollar. (87) Moreover the presence of a VAT has not in itself made it easier to cope with the revenue effects of trade liberalization. (88)

Baunsgaard and Keen seem to present another challenge to the conventional wisdom that eliminating trade taxes is necessarily good. They also argue, however, that "it is perfectly possible for trade reform to be socially beneficial even when accompanied by a reduction in total revenue...." (89) There is no support for this argument in their paper, though, as the paper focuses on income, not welfare measurement, and there is no explanation as to why Emran and Stiglitz, who reach the opposite conclusion, (90) may be wrong.

Two other authors, Gordon and Li, criticize the conventional wisdom indirectly by suggesting a rationale for the distinct structure of tax systems in developing countries that is fundamentally different from the rationale offered by the IMF and World Bank staff. (91)

Gordon and Li describe the characteristics of the tax systems in developing countries in the following way:

[R]evenue/GDP is surprisingly small compared with that in developed

economies. Taxes on labor income play a minor role. Taxes on

consumption are important, but effective tax rates vary dramatically

by firm, with many firms avoiding taxes entirely by operating through

cash in the informal economy and others facing very high

liabilities. (92)

In this model, corporate tax is also significant, as are tariffs and seignorage (printing money). (93) This description runs counter to mainstream theoretical literature analyzing tax policy in developed countries. (94)

The description suggests that all of these aspects of policy (high corporate tax rates, tariffs, and seignorage) may be explained as a reaction to major tax enforcement difficulties. (95) The key assumption in this theory is that firms in developing countries can evade taxes completely "by shifting entirely to cash transactions and not using the financial sector...." (96)

Gordon and Li's model provides that:

When firms make use of the financial sector ... the government can

gain access to their bank records and use this information in

enforcing the tax law. Firms then have to choose whether the economic

benefits from use of the financial sector are greater or less than the

resulting tax liabilities. Poorer countries differ from richer

countries under [this] hypothesis simply because the value firms

receive from using the financial sector is much more modest. When the

value from using the financial sector is low, the government needs to

worry about possible disintermediation and the resulting loss of its

tax base when choosing its tax structure. This threat of

disintermediation not only can keep tax rates low, but can also have

important effects on the design of the tax structure, and on

government policies more generally. (97)

Taxes can most easily be collected from the firms most dependent on the financial sector, presumably capital-intensive firms. (98) Gordon and Li state that "[r]elying more heavily on corporate income taxes is one means of focusing tax collection on the firms that are most dependent on the financial sector." (99)

Given the resulting differential tax rates by sector, other policies would sensibly be used to offset these tax distortions. Tariff protection for capital-intensive firms makes sense since the government wishes to protect its tax base. (100) Another policy is inflation, which is relatively prevalent in developing countries and enhanced by seignorage. Firms that use the financial sector are largely protected from inflation, since in equilibrium their bank deposits should earn a higher nominal interest rate, reflecting expected inflation, whereas those firms that rely on cash transactions so as to evade tax are thereby vulnerable to inflation. (101)

Gordon and Li argue that "[p]olicies may sensibly encourage or hinder investments by multinationals, depending on the government's ability to tax multinationals vs. competing domestic firms. There may even be an efficiency gain from introducing red tape hindering activity in the untaxed sector." (102)

In the tax scheme proposed by Gordon and Li, the financial sector has an essential role in ensuring a functioning tax structure. (103) The government must be able to act to ensure access to bank records on each firm in order to use this information in enforcing the tax law. (104) Gordon and Li contend that "[s]tate ownership of the banks is one extreme policy that can in principle assure that banks make information available to the government. Another approach is use of bank regulations, whereby any bank that refuses to cooperate with the tax authorities loses its license to function as a bank." (105) Entry of foreign banks will be particularly discouraged in this model, given the ease with which foreign banks can facilitate tax evasion by domestic firms. (106)

The policy implications of accepting the hypothesis suggested by Gordon and Li are quite different from those offered by the conventional wisdom analysis. (107) For example, reducing tariffs or inflation may not be optimal, as doing so would reduce tax revenue. The key policy focus in this model would be reform of the domestic financial sector. (108) This system provides that:

Any policies that raise the value of the services provided by

financial intermediaries will increase the usage of the financial

sector, raising efficiency and allowing the government to collect more

revenue. Conversely, anything that undercuts the perceived value of

the services provided by the financial sector, e.g. a bank failure,

can undermine the fraction of GDP collected in tax revenue, in

addition to any direct effects on GDP through loss of financial

intermediation. (109)