It is often said that death and taxes are the only certainties in a world increasingly characterised by uncertainty.
Whether you are an individual or a business, taxes are indeed a definite. Whether it’s personal income tax or Value Added Tax (VAT), so-called ‘sin tax’ on tobacco products and alcohol or import and export duties, individuals are taxed nearly around every corner.
The reason for this is that taxes are still the only practical way to raise the revenue required to finance governments’ spending on the goods and services that these very individuals (us) demand. In developing countries specifically, taxation provides relief from aid dependency while it also provides fiscal reliance and the sustainability that is needed to promote growth. Usually, around 90% of domestic revenue in all countries is derived from tax.
Tax ensures that the state is accountable to its taxpayers; the public can hold governments accountable for their decisions. As tax revenues are fairly predictable, it also assists governments to plan ahead.
Whether looked at from the point of view of an industrial (developed) country or a developing country, tax is a complex economic issue. Without a deep understanding of all the issues that have a bearing on raising tax revenue, also in developing countries, there is a real danger of oversimplifying these issues and their possible solutions. The aim of this article, written by a non-economist, is to give the reader an overview of the facts around tax issues in developing countries, the unique challenges that impact tax collection in these countries as well as some pointers on what experts agree possible suggestions for improvements are.
The bigger question is whether governments worldwide – in particular in developing countries – are spending the tax revenue effectively to invest in development, to relieve poverty and deliver public services or if they are – as the heading suggests – using tax revenue as a ‘gambling fund’. There is no simple answer to this question. The facts contained in several high-level reports point to widespread corruption at various points that result in illicit outflows every year of tax revenue earmarked for investment in desperately needed infrastructure and development.
According to a report from Global Financial Integrity (GFI), based in Washington DC, illicit outflows as described above are worst in sub-Saharan Africa, where countries lost an average of between 5% and 7% of their GDP annually between 2002 and 2011. In 2011, the world’s developing countries lost a total of $946.7 billion to corruption, trade misinvoicing and tax evasion. This is 13.7% more than the amount lost in the same way in 2010. This amount is 10 times the amount that – in the corresponding period – came in as development assistance to these countries. Trade misinvoicing is the leading driver of such losses, accounting for 79.7% of illicit outflows. Such corruption, tax evasion and ‘shady trade practices’ have an ‘outsized impact’ on the African continent, the report says, emphasising that these ‘illicit outflows’ results in less money being available to invest in desperately needed infrastructure and development.
However, these practices – while deeply entrenched in many developing countries - should not be viewed in isolation. Various reports suggest that eliminating corruption should be tackled as part of a much bigger picture, namely much needed reform of the tax systems in developing countries, especially those (developing) countries that want to become integrated in the international economy. For a number of years, this aspect hasn’t received sufficient focus, as various international organisations have focused largely on providing developing countries with technical tax advice with little or no focus on improving the tax systems in or of these countries. The OECD Observer says that a lack of tax structures in a major cause of weak and unresponsive governance in developing countries. This, it says, leads to these countries relying too heavily on aid.
Also according to the OECD Observer, tax administrations in developing countries will have to improve dramatically if these countries are to move beyond poverty. Such improvements will enable the officials to carry out the necessary reforms, including broadening the tax base. Improvements, however, will only succeed when made in an independent revenue service, led by strong tax commissioners who work within an integrated administration and with well-paid officials. It is critical that improvements aimed at improving tax capacity in developing countries are well supported by the relevant institutions, including donor governments, aid agencies and civil society groups.
A fair and effective tax system is one that not only eliminates corruption at every level, but that also boosts voluntary tax compliance. Good governance and voluntary tax compliance are reinforced only if there is trust between taxpayers - use of tax revenue and tax officials’ behaviour - and tax administration - how willing taxpayers are to meet their tax obligations. Taxpayers will have a positive attitude towards tax compliance (and comply voluntarily) only if public services are provided.
A report, compiled in 2011 by the IMF, OECD, UN and World Bank for the G-20 Development Working Group Supporting the Development of More Effective Tax Systems, makes it clear that tax is central to and critical for development. It states that there is an increased realisation that sustainable development and addressing governance issues (also as these relate to tax), are impossible if developing countries don’t have sufficient revenues to invest in physical and social infrastructure. An efficient and fair tax system can enable this.
This, as well as the fact that developing countries have to move towards simpler, more equitable and transparent tax systems and broaden their respective tax bases remain as concerns. In this respect, it is important to note that half of sub-Saharan countries still mobilise less than 17% of their Gross Development Product (GDP) in tax revenues. According to the report, this figure is well below the minimum of 20%, considered by the United Nations as necessary to achieve the Millennium Development Goals.
The same report suggests that there is no ‘one-size-fits-all’ approach to tax for development that will fix the developing world’s tax problems and reform their tax systems overnight. However, what is required is a framework within which such countries try to raise their tax revenue to promote state-building and fair distribution of the tax burden.
According to the International Monetary Fund (IMF), a number of challenges within developing countries complicate the implementation of efficient tax systems in these countries:
Difficulty in calculating the tax base
Many workers in developing countries work in agriculture or in small, informal enterprises. These workers do not earn a regular or fixed wage, which means their earnings fluctuate. They are also usually paid in cash. Adding to the woes of the tax administration in these countries is the fact that these workers don’t necessarily spend their money at large stores that keep an accurate record of sales and inventories. The sheer number of these workers makes it very difficult to calculate the tax base in developing countries. Dealing with these ‘hard-to-tax’ sectors is a challenge in arriving at an efficient tax system.
Educated and trained staff; computers essential
For a tax system to be efficient, well-trained and well-educated staff is critical. However, the money required to pay these staff members, as well as to computerise the tax operation, is seriously lacking. The inability of governments just to provide an efficient telephone and mailing system as well as the fact that many taxpayers are unable to hold accounts, often see these countries opting for tax systems that allow them to exploit available opportunities over the establishment of modern, efficient and rational tax systems.
Lack of data and reliable statistics
Inefficient tax systems in developing countries are perpetuated because of the informal structure of the economy as well as the fact that, owing to financial limitations, tax and statistical offices can generally not generate reliable statistics. This lack of data makes it impossible for policy makers to assess the potential impact that major changes to the tax system would have. Despite the fact that major, structural changes are required and preferable, policy makers choose to rather make only marginal changes.
Uneven income distribution
In developing countries, income is usually unevenly distributed, yet in order to raise high taxes (as part of an efficient tax system) the tax burden of the rich should be significantly higher than that of the poor. The significant economic and political power these rich taxpayers have, see them resisting reforms that are likely to increase their tax burden.
Possible vs. optimal
Compared to the optimal tax revenue level in a specific developing country, what is the desirable level of public spending? For developed countries, it is set at around 38% of GDP. Optimal public spending for developing countries is set at around 18%. However, these are indeed just averages, as optimal public spending will differ even between developing countries, as their similarities and dissimilarities have to be taken into account.
The respective countries’ natural resource wealth, geography and history, says the report compiled by the IMF, OECD, UN and World Bank for the G-20 Development Working Group Supporting the Development of More Effective Tax Systems, also play a role in the different revenue performance of these countries.
Many developing countries are not averse to tax reform, increasingly calling for discussions about both domestic and international tax issues from their own ranks. Examples of this are the African Tax Administration Forum, which is managed, driven as well as operationally funded by Africans. In the Americas the Centro Interamericano de Administraciones Tributarias (CIAT) addresses tax concerns in this region. The OECD Observer indicates that the relevant structures within developed countries should support and participate in these and other forums aimed at encouraging tax dialogue between developed and developing countries.
Suggestions for improvement
Common denominators of success
Where efficient tax systems have been successfully implemented in other areas of the world, common elements of success can be found suggests the 2011 report by the IMF, OECD, UN and World Bank for the G-20 Development Working Group Supporting the Development of More Effective Tax Systems. These same common elements, they say, are also likely to attract strong opposition when implemented. These are:
- Sustained political commitment at the highest levels
- Administrative reforms that are closely aligned with political changes
- Strong leadership of the revenue administration system
Remove persisting challenges
The same report indicates that while significant progress with tax reform show promise in some developing countries, persisting challenges that remain and should be removed include weak capacity, corruption and an inability to see that tax, public and social expenditure are inextricably linked. Another challenge is the vicious circle of low tax compliance and morale that impact negatively on funding being available for public services. This ‘vicious cycle’, the report says, has to be broken, while these countries’ reliance on trade tax revenues should also receive attention.
The report further suggests that the political will to reform tax systems and their administrations and to address and tackle broader issues is critical to tax reform in developing countries. In addition, the report suggests, existing capacity should be correctly channelled while an incentive structure will discourage corruption at all levels.
Remove barriers to an efficient and fair tax system
Barriers – in the form of corrupt tax administrations, poorly paid tax officials, informality and non-compliance, weak organisational structures as well as political interference - should be removed, because as long as they remain, establishing an efficient and fair tax system and building trust between the government and citizens is not possible.
Tax high-income earners more effectively!
Another critical factor that the report says should be attended to in terms of tax reform in these countries, is the issue of high-income earners, who they say must be taxed more effectively in the interest of creating a fair tax system to support wider compliance. This can be done in various ways, including removing any opportunities for such individuals to avoid paying tax while at the same time strengthening ways to detect such individuals and enforce tax payment.
Realising the true revenue potential of VAT
Eliminating exemptions from Value Added Tax (VAT), implementing a uniform rate and improvements in compliance will ensure that a broader base of taxpayers contribute to VAT. This will realise the true potential of VAT, which the report suggests has much greater revenue potential than most other tax instruments.
Share – and use - knowledge
While the sharing of tax information between developed (industrial) and developing (third-world) countries is encouraged through IT-based systems for information pooling and access, it will only be effective if the countries that use it do so to adopt better tax policies and improve their tax administration.
The report recommends that developed and developing countries collaborate towards improving transparency and strengthening of financial regulatory systems. “Without concrete action, the drain on the developing world is only going to grow larger,” says Brain LeBlanc, GFI economist and co-author of the report.
According to the OECD Observer, especially within developing countries, recognising the importance of tax is one thing. Improving its impact and operation is quite another, especially bearing in mind aspects such as cultural barriers, institutional weaknesses and corruption, as well as international factors that come into play such as capital flight, aggressive tax planning and trade pressures.
While the OECD Observer is clear that developing countries need and will continue to need aid, it suggests that such aid should also be used to strengthen their tax capacity, increase their autonomy and in so doing, reduce their dependence on external assistance.
There are clearly no easy answers to the question if developing countries’ tax administrations are indeed using their countries’ taxes as a proverbial ‘gambling fund’ as suggested in the heading of this article. Many of these countries’ tax administrations are very old, often dating back to their colonial past. Much more collaboration and knowledge-sharing with the developed world is necessary before corruption and other tax challenges in developing countries can be successfully addressed. At the root of this should be an objective for true and deep seated reform of the tax systems in these countries, also in view of their economies taking their rightful place in the international economic arena.