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

The conventional wisdom's reliance on corporate taxes was challenged in a recent article by Margalioth that builds on the conventional wisdom's emphasis on the optimality of consumption taxes in developing countries but criticizes its reliance on corporate income tax. (110) Margalioth argues that developing countries should adopt policies that attract foreign direct investment (FDI). (111) Case studies suggest that substantial technological diffusion takes place in domestically-owned firms, and, according to new growth theories, such spillover effects are the engine of economic growth. (112)

He also argues that as former FDI barriers, like tariffs, currency exchange controls, and the costs of spreading production processes over multiple countries, are reduced or gone, taxes became a more decisive factor, hence offering tax incentives or having a uniform low corporate tax rate may be an effective policy to attract FDI. (113)

Margalioth suggests that:

[T]ax incentives, like any other market intervention, are justified if

they correct market inefficiencies or generate positive

externalities.... FDI generates positive externalities in the form of

productivity spillovers. As with any positive externality, the amount

of FDI absent government intervention is socially sub-optimal because

foreign investors cannot capture the full gains of their

investments. (114)

He describes tax incentives as:

[T]ax provisions that deviate from baseline provisions. If the

baseline is the standard international or regional tax rate, or even

the individual tax rate, then a low corporate tax rate qualifies as a

'tax incentive.' If the motivation behind the low tax rate is

attracting investments, then it is even more appropriate to classify

it as a tax incentive. If the baseline is the corporate tax itself,

then a low corporate tax rate [that does not distinguish between

foreign and domestic investors] is not an incentive since by

definition tax incentives are targeted at specific types of investors

or investments. (115)

He goes on to argue that targeted tax incentives are much more powerful and cost effective policy tools than low across-the-board corporate income tax rates, at least where policymakers know what types of investments involve the greatest positive spillovers at the lowest administrative cost. (116) Therefore, policymakers might prefer to identify good potential investments on a case-by-case basis. (117)

Margalioth points out that there are, however, many disadvantages to such a regime. First, it is harder to make potential investors aware of this type of incentive. Case-by-case review works best with large investments where investors are more likely to shop around. Second, the advantage over the general tax incentives mentioned above is limited. There is no guarantee policymakers can correctly assess potential spillovers, even when they are examining a specific investment. The most acute disadvantage of discretionary tax incentives, especially in developing countries, is that they are susceptible to corruption. In many countries, discretionary application of tax incentives is one of the most important contributors to corruption. (118)

Margalioth maintains that a general corporate income tax rate reduction is a viable possibility to attract growth-promoting FDI. (119) By far the most troubling aspect of using tax incentives or a low corporate tax rate to attract FDI is surrendering the ability to impose corporate income tax on domestic taxpayers. This frequently is a consequence of tax incentives because limiting tax incentives to foreign investors is administratively infeasible. (120)

However, he notes that losing the ability to impose regular corporate income tax rates on domestic taxpayers might not be too harmful, for the following reason. Shifting from an income to a consumption tax usually is considered efficient but regressive. (121) However, as is now the conventional wisdom (which was not that clear at the time the paper was written), consumption taxes are not necessarily regressive. The regressivity is offsetable through a more progressive use of the tax revenue generated from other sources, mostly through the expenditure side of the national budget. (122) Another consideration is the potential difference in tax incidences between developed and developing countries. (123) Margalioth notes that according to Shah and Whalley, the incidence of corporate income tax in developing countries makes it somewhat regressive. (124) Replacing a regressive corporate income tax with greater reliance on a regressive consumption tax probably adds little, if any, to the overall regressivity of the tax system--even without adjusting the expenditure side of the budget. Hence, a shift to a consumption tax is justified if the tax incentives attract FDI that results in growth-promoting spillovers. (125)

Margalioth further suggests that developed countries should replace some of their foreign direct aid with an equity-based tax expenditure policy. (126) They should allow residents who invest in developing countries to fully benefit from the tax incentives offered by exempting or otherwise sparing this foreign income. (127) His proposal transfers revenue from the treasuries of developed countries to developing countries, but it does so indirectly and with targeted money. (128) It is equivalent to giving the governments of developing countries money that can be used only to attract FDI. (129) The underlying assumption is that governments of developing countries lack the capacity to run large industrial and commercial enterprises, so promoting growth through multinationals' activity is more efficient. (130)

According to Margalioth, these revenue transfers would increase if limits were placed on the ability of rich countries, such as Ireland, to engage in tax competition with poor countries. (131) He argues that a special form of tax harmonization with a sharp division based on per-capita GDP is justified as part of an international vertical equity regime for transferring wealth to developing countries. (132)

Margalioth concludes that since developing countries may also engage in harmful tax competition, we can apply similar anti-tax competition rules to them. (133) This leads to the establishment of two different harmonized tax levels, one for developed countries and the other for developing countries. (134)

V. CONCLUDING REMARKS AND SUGGESTIONS FOR FUTURE RESEARCH

The Washington Consensus, articulated in 1990, was meant to synthesize the reforms that most economists in the World Bank, the IMF, the U.S. Treasury, and some of Washington's think tanks believed were necessary for sustained economic growth. The experience of the last two decades has proved the Consensus wrong. (135)

There is no reason to think that things are different in the tax arena. Common sense advice, based on the experience of advisers educated in developed countries, may not necessarily make sense in any specific developing country. A good tax system is one that fits both the social institutions as well as other specific determinants of distribution and economic growth in each country. Searching for one optimal tax system for countries grouped together by a definition based on GDP per capita is problematic. The vast differences, for example, between Latin America, Sub-Saharan Africa, China, and India, should make it impossible to design a generalized tax system, or even to offer useful guidelines, unless we first study each country separately. Therefore, our initial suggestion for future research is the allocation of developing countries into new categories that will better enable some generalization of tax policy advice.

Based on current literature, we tried to portray the conventional wisdom in the field. There seems to be a general agreement that consumption taxation is superior to income taxation in developing countries in terms of both efficiency and redistribution but that corporate income taxes should be withheld.

Moreover, according to conventional wisdom, developing countries should tax as efficiently as possible and rely on the expenditure policy to take care of inequality and poverty. But if that is the advice, then why use consumption tax? Why not impose a head tax, which is by definition even more efficient? The answer is that a head tax plus an expenditure policy is not necessarily easier to implement than income or consumption taxes. But, exactly how and why is yet to be explored.

If the criterion for welfare is income, then there is no difference between an income tax and an expenditure program, which is in fact a negative income tax. If, on the other hand, we use other proxies for ability, targeting individuals according to non-income characteristics, there is a difference between expenditure policy and an income tax, and the former could be easier to implement.

If we believe in universality (providing public and merit goods of decent quality and possibly providing a cash or in-kind transfer to everyone), expenditure policy could be much simpler and less distortive than an income tax (as it imposes zero marginal tax rate).

The conventional wisdom is further challenged by Emran and Stiglitz who argue that trade taxes may be superior to VAT. They suggest that there is a need for empirical work that explicitly incorporates the role of the informal economy to examine the question of whether the proposed move away from trade taxes to domestic consumption taxes is welfare enhancing or not. (136)