Tax Policy for Developing Countries

Vito Tanzi, Howell Zee

© 2001 International Monetary Fund

March 2001

[Preface]  [Tax Policy for Developing Countries] 

[Level of Tax Revenue]  [Composition of Tax Revenue?] 
[Selecting the Right Tax System] 
[Tax Policy Challenges Facing Developing Countries]  [Author Information]

Preface

The Economic Issues series aims to make available to a broad readership of nonspecialists some
of the economic research being produced on topical issues by IMF staff. The series draws mainly
from IMF Working Papers, which are technical papers produced by IMF staff members and
visiting scholars, as well as from policy-related research papers.

This Economic Issue is based on IMF Working Paper 00/35 "Tax Policy for Emerging Markets,"
by Vito Tanzi and Howell Zee. Citations for the research referred to in this shortened version are
provided in the original paper which readers can purchase (at $10.00 a copy) from the IMF
Publication Services or download from www.imf.org. David Driscoll prepared the text for this
pamphlet.

Tax Policy for Developing Countries

Why do we have taxes? The simple answer is that, until someone comes up with a better idea,
taxation is the only practical means of raising the revenue to finance government spending on the
goods and services that most of us demand. Setting up an efficient and fair tax system is,
however, far from simple, particularly for developing countries that want to become integrated in
the international economy. The ideal tax system in these countries should raise essential revenue
without excessive government borrowing, and should do so without discouraging economic
activity and without deviating too much from tax systems in other countries.

Developing countries face formidable challenges when they attempt to establish efficient tax
systems. First, most workers in these countries are typically employed in agriculture or in small,
informal enterprises. As they are seldom paid a regular, fixed wage, their earnings fluctuate, and
many are paid in cash, "off the books." The base for an income tax is therefore hard to calculate.
Nor do workers in these countries typically spend their earnings in large stores that keep accurate
records of sales and inventories. As a result, modern means of raising revenue, such as income
taxes and consumer taxes, play a diminished role in these economies, and the possibility that the
government will achieve high tax levels is virtually excluded.
Second, it is difficult to create an efficient tax administration without a well-educated and well-
trained staff, when money is lacking to pay good wages to tax officials and to computerize the
operation (or even to provide efficient telephone and mail services), and when taxpayers have
limited ability to keep accounts. As a result, governments often take the path of least resistance,
developing tax systems that allow them to exploit whatever options are available rather than
establishing rational, modern, and efficient tax systems.

Third, because of the informal structure of the economy in many developing countries and
because of financial limitations, statistical and tax offices have difficulty in generating reliable
statistics. This lack of data prevents policymakers from assessing the potential impact of major
changes to the tax system. As a result, marginal changes are often preferred over major structural
changes, even when the latter are clearly preferable. This perpetuates inefficient tax structures.

Fourth, income tends to be unevenly distributed within developing countries. Although raising
high tax revenues in this situation ideally calls for the rich to be taxed more heavily than the
poor, the economic and political power of rich taxpayers often allows them to prevent fiscal
reforms that would increase their tax burdens. This explains in part why many developing
countries have not fully exploited personal income and property taxes and why their tax systems
rarely achieve satisfactory progressivity (in other words, where the rich pay proportionately more
taxes).

In conclusion, in developing countries, tax policy is often the art of the possible rather than the
pursuit of the optimal. It is therefore not surprising that economic theory and especially optimal
taxation literature have had relatively little impact on the design of tax systems in these
countries. In discussing tax policy issues facing many developing countries today, the authors of
this pamphlet consequently draw on extensive practical, first-hand experience with the IMF's
provision of tax policy advice to those countries. They consider these issues from both the
macroeconomic (the level and composition of tax revenue) and microeconomic (design aspects
of specific taxes) perspective.

Level of Tax Revenue

What level of public spending is desirable for a developing country at a given level of national
income? Should the government spend one-tenth of national income? A third? Half? Only when
this question has been answered can the next question be addressed of where to set the ideal level
of tax revenue; determining the optimal tax level is conceptually equivalent to determining the
optimal level of government spending. Unfortunately, the vast literature on optimal tax theory
provides little practical guidance on how to integrate the optimal level of tax revenue with the
optimal level of government expenditure.

Nevertheless, an alternative, statistically based approach to assessing whether the overall tax
level in a developing country is appropriate consists of comparing the tax level in a specific
country to the average tax burden of a representative group of both developing and industrial
countries, taking into account some of these countries' similarities and dissimilarities. This
comparison indicates only whether the country's tax level, relative to other countries and taking
into account various characteristics, is above or below the average. This statistical approach has
no theoretical basis and does not indicate the "optimal" tax level for any country. The most
recent data show that the tax level in major industrialized countries (members of the
Organization for Economic Cooperation and Development or OECD) is about double the tax
level in a representative sample of developing countries (38 percent of GDP compared with 18
percent).

Economic development will often generate additional needs for tax revenue to finance a rise in
public spending, but at the same time it increases the countries' ability to raise revenue to meet
these needs. More important than the level of taxation per se is how revenue is used. Given the
complexity of the development process, it is doubtful that the concept of an optimal level of
taxation robustly linked to different stages of economic development could ever be meaningfully
derived for any country.

Composition of Tax Revenue

Turning to the composition of tax revenue, we find ourselves in an area of conflicting theories.
The issues involve the taxation of income relative to that of consumption and under
consumption, the taxation of imports versus the taxation of domestic consumption. Both
efficiency (whether the tax enhances or diminishes the overall welfare of those who are taxed)
and equity (whether the tax is fair to everybody) are central to the analysis.

The conventional belief that taxing income entails a higher welfare (efficiency) cost than taxing
consumption is based in part on the fact that income tax, which contains elements of both a labor
tax and a capital tax, reduces the taxpayer's ability to save. Doubt has been cast on this belief,
however, by considerations of the crucial role of the length of the taxpayer's planning horizon
and the cost of human and physical capital accumulation. The upshot of these theoretical
considerations renders the relative welfare costs of the two taxes (income and consumption)
uncertain.

Another concern in the choice between taxing income and taxing consumption involves their
relative impact on equity. Taxing consumption has traditionally been thought to be inherently
more regressive (that is, harder on the poor than the rich) than taxing income. Doubt has been
cast on this belief as well. Theoretical and practical considerations suggest that the equity
concerns about the traditional form of taxing consumption are probably overstated and that, for
developing countries, attempts to address these concerns by such initiatives as graduated
consumption taxes would be ineffective and administratively impractical.

With regard to taxes on imports, lowering these taxes will lead to more competition from foreign
enterprises. While reducing protection of domestic industries from this foreign competition is an
inevitable consequence, or even the objective, of a trade liberalization program, reduced
budgetary revenue would be an unwelcome by-product of the program. Feasible compensatory
revenue measures under the circumstances almost always involve increasing domestic
consumption taxes. Rarely would increasing income taxes be considered a viable option on the
grounds of both policy (because of their perceived negative impact on investment) and
administration (because their revenue yield is less certain and less timely than that from
consumption tax changes).
Data from industrial and developing countries show that the ratio of income to consumption
taxes in industrial countries has consistently remained more than double the ratio in developing
countries. (That is, compared with developing countries, industrial countries derive
proportionally twice as much revenue from income tax than from consumption tax.) The data
also reveal a notable difference in the ratio of corporate income tax to personal income tax.
Industrial countries raise about four times as much from personal income tax than from corporate
income tax. Differences between the two country groups in wage income, in the sophistication of
the tax administration, and in the political power of the richest segment of the population are the
primary contributors to this disparity. On the other hand, revenue from trade taxes is significantly
higher in developing countries than in industrial countries.

While it is difficult to draw clear-cut normative policy prescriptions from international

comparisons as regards the income-consumption tax mix, a compelling implication revealed by
the comparison is that economic development tends to lead to a relative shift in the composition
of revenue from consumption to personal income taxes. At any given point of time, however, the
important tax policy issue for developing countries is not so much to determine the optimal tax
mix as to spell out clearly the objectives to be achieved by any contemplated shift in the mix, to
assess the economic consequences (for efficiency and equity) of such a shift, and to implement
compensatory measures if the poor are made worse off by the shift.

Selecting the Right Tax System

In developing countries where market forces are increasingly important in allocating resources,
the design of the tax system should be as neutral as possible so as to minimize interference in the
allocation process. The system should also have simple and transparent administrative
procedures so that it is clear if the system is not being enforced as designed.

Personal Income Tax

Any discussion of personal income tax in developing countries must start with the observation
that this tax has yielded relatively little revenue in most of these countries and that the number of
individuals subject to this tax (especially at the highest marginal rate) is small. The rate structure
of the personal income tax is the most visible policy instrument available to most governments in
developing countries to underscore their commitment to social justice and hence to gain political
support for their policies. Countries frequently attach great importance to maintaining some
degree of nominal progressivity in this tax by applying many rate brackets, and they are reluctant
to adopt reforms that will reduce the number of these brackets.

More often than not, however, the effectiveness of rate progressivity is severely undercut by high
personal exemptions and the plethora of other exemptions and deductions that benefit those with
high incomes (for example, the exemption of capital gains from tax, generous deductions for
medical and educational expenses, the low taxation of financial income). Tax relief through
deductions is particularly egregious because these deductions typically increase in the higher tax
brackets. Experience compellingly suggests that effective rate progressivity could be improved
by reducing the degree of nominal rate progressivity and the number of brackets and reducing
exemptions and deductions. Indeed, any reasonable equity objective would require no more than
 a few nominal rate brackets in the personal income tax structure. If political constraints prevent a
meaningful restructuring of rates, a substantial improvement in equity could still be achieved by
replacing deductions with tax credits, which could deliver the same benefits to taxpayers in all
tax brackets.

The effectiveness of a high marginal tax rate is also much reduced by its often being applied at
such high levels of income (expressed in shares of per capita GDP) that little income is subject to
these rates. In some developing countries, a taxpayer's income must be hundreds of times the per
capita income before it enters the highest rate bracket.

Moreover, in some countries the top marginal personal income tax rate exceeds the corporate
income tax by a significant margin, providing strong incentives for taxpayers to choose the
corporate form of doing business for purely tax reasons. Professionals and small entrepreneurs
can easily siphon off profits through expense deductions over time and escape the highest
personal income tax permanently. A tax delayed is a tax evaded. Good tax policy, therefore,
ensures that the top marginal personal income tax rate does not differ materially from the
corporate income tax rate.

In addition to the problem of exemptions and deductions tending to narrow the tax base and to
negate effective progressivity, the personal income tax structure in many developing countries is
riddled with serious violations of the two basic principles of good tax policy: symmetry and
inclusiveness. (It goes without saying, of course, that tax policy should also be guided by the
general principles of neutrality, equity, and simplicity.) The symmetry principle refers to the
identical treatment for tax purposes of gains and losses of any given source of income. If the
gains are taxable, then the losses should be deductible. The inclusiveness principle relates to
capturing an income stream in the tax net at some point along the path of that stream. For
example, if a payment is exempt from tax for a payee, then it should not be a deductible expense
for the payer. Violating these principles generally leads to distortions and inequities.

The tax treatment of financial income is problematic in all countries. Two issues dealing with the
taxation of interest and dividends in developing countries are relevant:

 In many developing countries, interest income, if taxed at all, is taxed as a final withholding
tax at a rate substantially below both the top marginal personal and corporate income tax rate.
For taxpayers with mainly wage income, this is an acceptable compromise between theoretical
correctness and practical feasibility. For those with business income, however, the low tax rate
on interest income coupled with full deductibility of interest expenditure implies that
significant tax savings could be realized through fairly straightforward arbitrage transactions.
Hence it is important to target carefully the application of final withholding on interest
income: final withholding should not be applied if the taxpayer has business income.
 The tax treatment of dividends raises the well-known double taxation issue. For administrative
simplicity, most developing countries would be well advised either to exempt dividends from
the personal income tax altogether, or to tax them at a relatively low rate, perhaps through a
final withholding tax at the same rate as that imposed on interest income.

Corporate Income Tax

 Tax policy issues relating to corporate income tax are numerous and complex, but particularly
relevant for developing countries are the issues of multiple rates based on sectoral differentiation
and the incoherent design of the depreciation system. Developing countries are more prone to
having multiple rates along sectoral lines (including the complete exemption from tax of certain
sectors, especially the parastatal sector) than industrial countries, possibly as a legacy of past
economic regimes that emphasized the state's role in resource allocation. Such practices,
however, are clearly detrimental to the proper functioning of market forces (that is, the sectoral
allocation of resources is distorted by differences in tax rates). They are indefensible if a
government's commitment to a market economy is real. Unifying multiple corporate income tax
rates should thus be a priority.

Allowable depreciation of physical assets for tax purposes is an important structural element in
determining the cost of capital and the profitability of investment. The most common
shortcomings found in the depreciation systems in developing countries include too many asset
categories and depreciation rates, excessively low depreciation rates, and a structure of
depreciation rates that is not in accordance with the relative obsolescence rates of different asset
categories. Rectifying these shortcomings should also receive a high priority in tax policy
deliberations in these countries.

In restructuring their depreciation systems, developing countries could well benefit from certain
guidelines:

 Classifying assets into three or four categories should be more than sufficient—for example,
grouping assets that last a long time, such as buildings, at one end, and fast-depreciating
assets, such as computers, at the other with one or two categories of machinery and equipment
in between.
 Only one depreciation rate should be assigned to each category.
 Depreciation rates should generally be set higher than the actual physical lives of the
underlying assets to compensate for the lack of a comprehensive inflation-compensating
mechanism in most tax systems.
 On administrative grounds, the declining-balance method should be preferred to the straight-
line method. The declining-balance method allows the pooling of all assets in the same asset
category and automatically accounts for capital gains and losses from asset disposals, thus
substantially simplifying bookkeeping requirements.

Value-Added Tax, Excises, and Import Tariffs

While VAT has been adopted in most developing countries, it frequently suffers from being
incomplete in one aspect or another. Many important sectors, most notably services and the
wholesale and retail sector, have been left out of the VAT net, or the credit mechanism is
excessively restrictive (that is, there are denials or delays in providing proper credits for VAT on
inputs), especially when it comes to capital goods. As these features allow a substantial degree of
cascading (increasing the tax burden for the final user), they reduce the benefits from introducing
the VAT in the first place. Rectifying such limitations in the VAT design and administration
should be given priority in developing countries.
Many developing countries (like many OECD countries) have adopted two or more VAT rates.
Multiple rates are politically attractive because they ostensibly—though not necessarily
effectively—serve an equity objective, but the administrative price for addressing equity
concerns through multiple VAT rates may be higher in developing than in industrial countries.
The cost of a multiple-rate system should be carefully scrutinized.

The most notable shortcoming of the excise systems found in many developing countries is their
inappropriately broad coverage of
products—often for revenue reasons. As is well known, the economic rationale for imposing
excises is very different from that for imposing a general consumption tax. While the latter
should be broadly based to maximize revenue with minimum distortion, the former should be
highly selective, narrowly targeting a few goods mainly on the grounds that their consumption
entails negative externalities on society (in other words, society at large pays a price for their use
by individuals). The goods typically deemed to be excisable (tobacco, alcohol, petroleum
products, and motor vehicles, for example) are few and usually inelastic in demand. A good
excise system is invariably one that generates revenue (as a by-product) from a narrow base and
with relatively low administrative costs.

Reducing import tariffs as part of an overall program of trade liberalization is a major policy

challenge currently facing many developing countries. Two concerns should be carefully
addressed. First, tariff reduction should not lead to unintended changes in the relative rates of
effective protection across sectors. One simple way of ensuring that unintended consequences do
not occur would be to reduce all nominal tariff rates by the same proportion whenever such rates
need to be changed. Second, nominal tariff reductions are likely to entail short-term revenue loss.
This loss can be avoided through a clear-cut strategy in which separate compensatory measures
are considered in sequence: first reducing the scope of tariff exemptions in the existing system,
then compensating for the tariff reductions on excisable imports by a commensurate increase in
their excise rates, and finally adjusting the rate of the general consumption tax (such as the VAT)
to meet remaining revenue needs.

Tax Incentives

While granting tax incentives to promote investment is common in countries around the world,
evidence suggests that their effectiveness in attracting incremental investments—above and
beyond the level that would have been reached had no incentives been granted—is often
questionable. As tax incentives can be abused by existing enterprises disguised as new ones
through nominal reorganization, their revenue costs can be high. Moreover, foreign investors, the
primary target of most tax incentives, base their decision to enter a country on a whole host of
factors (such as natural resources, political stability, transparent regulatory systems,
infrastructure, a skilled workforce), of which tax incentives are frequently far from being the
most important one. Tax incentives could also be of questionable value to a foreign investor
because the true beneficiary of the incentives may not be the investor, but rather the treasury of
his home country. This can come about when any income spared from taxation in the host
country is taxed by the investor's home country.
Tax incentives can be justified if they address some form of market failure, most notably those
involving externalities (economic consequences beyond the specific beneficiary of the tax
incentive). For example, incentives targeted to promote high-technology industries that promise
to confer significant positive externalities on the rest of the economy are usually legitimate. By
far the most compelling case for granting targeted incentives is for meeting regional
development needs of these countries. Nevertheless, not all incentives are equally suited for
achieving such objectives and some are less cost-effective than others. Unfortunately, the most
prevalent forms of incentives found in developing countries tend to be the least meritorious.

Tax Holidays

Of all the forms of tax incentives, tax holidays (exemptions from paying tax for a certain period
of time) are the most popular among developing countries. Though simple to administer, they
have numerous shortcomings. First, by exempting profits irrespective of their amount, tax
holidays tend to benefit an investor who expects high profits and would have made the
investment even if this incentive were not offered. Second, tax holidays provide a strong
incentive for tax avoidance, as taxed enterprises can enter into economic relationships with
exempt ones to shift their profits through transfer pricing (for example, overpaying for goods
from the other enterprise and receiving a kickback). Third, the duration of the tax holiday is
prone to abuse and extension by investors through creative redesignation of existing investment
as new investment (for example, closing down and restarting the same project under a different
name but with the same ownership). Fourth, time-bound tax holidays tend to attract short-run
projects, which are typically not so beneficial to the economy as longer-term ones. Fifth, the
revenue cost of the tax holiday to the budget is seldom transparent, unless enterprises enjoying
the holiday are required to file tax forms. In this case, the government must spend resources on
tax administration that yields no revenue and the enterprise loses the advantage of not having to
deal with tax authorities.

Tax Credits and Investment Allowances

Compared with tax holidays, tax credits and investment allowances have a number of
advantages. They are much better targeted than tax holidays for promoting particular types of
investment and their revenue cost is much more transparent and easier to control. A simple and
effective way of administering a tax credit system is to determine the amount of the credit to a
qualified enterprise and to "deposit" this amount into a special tax account in the form of a
bookkeeping entry. In all other respects the enterprise will be treated like an ordinary taxpayer,
subject to all applicable tax regulations, including the obligation to file tax returns. The only
difference would be that its income tax liabilities would be paid from credits "withdrawn" from
its tax account. In this way information is always available on the budget revenue forgone and on
the amount of tax credits still available to the enterprise. A system of investment allowances
could be administered in much the same way as tax credits, achieving similar results.

There are two notable weaknesses associated with tax credits and investment allowances. First,
these incentives tend to distort choice in favor of short-lived capital assets since further credit or
allowance becomes available each time an asset is replaced. Second, qualified enterprises may
attempt to abuse the system by selling and purchasing the same assets to claim multiple credits or
allowances or by acting as a purchasing agent for enterprises not qualified to receive the
incentive. Safeguards must be built into the system to minimize these dangers.

Accelerated Depreciation

Providing tax incentives in the form of accelerated depreciation has the least of the shortcomings
associated with tax holidays and all of the virtues of tax credits and investment allowances—and
overcomes the latter's weakness to boot. Since merely accelerating the depreciation of an asset
does not increase the depreciation of the asset beyond its original cost, little distortion in favor of
short-term assets is generated. Moreover, accelerated depreciation has two additional merits.
First, it is generally least costly, as the forgone revenue (relative to no acceleration) in the early
years is at least partially recovered in subsequent years of the asset's life. Second, if the
acceleration is made available only temporarily, it could induce a significant short-run surge in
investment.

Investment Subsidies

While investment subsidies (providing public funds for private investments) have the advantage
of easy targeting, they are generally quite problematic. They involve out-of-pocket expenditure
by the government up front and they benefit nonviable investments as much as profitable ones.
Hence, the use of investment subsidies is seldom advisable.

Indirect Tax Incentives

Indirect tax incentives, such as exempting raw materials and capital goods from the VAT, are
prone to abuse and are of doubtful utility. Exempting from import tariffs raw materials and
capital goods used to produce exports is somewhat more justifiable. The difficulty with this
exemption lies, of course, in ensuring that the exempted purchases will in fact be used as
intended by the incentive. Establishing export production zones whose perimeters are secured by
customs controls is a useful, though not entirely foolproof, remedy for this abuse.

Triggering Mechanisms

The mechanism by which tax incentives can be triggered can be either automatic or
discretionary. An automatic triggering mechanism allows the investment to receive the
incentives automatically once it satisfies clearly specified objective qualifying criteria, such as a
minimum amount of investment in certain sectors of the economy. The relevant authorities have
merely to ensure that the qualifying criteria are met. A discretionary triggering mechanism
involves approving or denying an application for incentives on the basis of subjective value
judgment by the incentive-granting authorities, without formally stated qualifying criteria. A
discretionary triggering mechanism may be seen by the authorities as preferable to an automatic
one because it provides them with more flexibility. This advantage is likely to be outweighed,
however, by a variety of problems associated with discretion, most notably a lack of
transparency in the decision-making process, which could in turn encourage corruption and rent-
seeking activities. If the concern about having an automatic triggering mechanism is the loss of
discretion in handling exceptional cases, the preferred safeguard would be to formulate the
qualifying criteria in as narrow and specific a fashion as possible, so that incentives are granted
only to investments meeting the highest objective and quantifiable standard of merit. On balance,
it is advisable to minimize the discretionary element in the incentive-granting process.

Summing Up

The cost-effectiveness of providing tax incentives to promote investment is generally

questionable. The best strategy for sustained investment promotion is to provide a stable and
transparent legal and regulatory framework and to put in place a tax system in line with
international norms. Some objectives, such as those that encourage regional development, are
more justifiable than others as a basis for granting tax incentives. Not all tax incentives are
equally effective. Accelerated depreciation has the most comparative merits, followed by
investment allowances or tax credits. Tax holidays and investment subsidies are among the least
meritorious. As a general rule, indirect tax incentives should be avoided, and discretion in
granting incentives should be minimized.

Tax Policy Challenges Facing Developing Countries

Developing countries attempting to become fully integrated in the world economy will probably
need a higher tax level if they are to pursue a government role closer to that of industrial
countries, which, on average, enjoy twice the tax revenue. Developing countries will need to
reduce sharply their reliance on foreign trade taxes, without at the same time creating economic
disincentives, especially in raising more revenue from personal income tax. To meet these
challenges, policymakers in these countries will have to get their policy priorities right and have
the political will to implement the necessary reforms. Tax administrations must be strengthened
to accompany the needed policy changes.

As trade barriers come down and capital becomes more mobile, the formulation of sound tax
policy poses significant challenges for developing countries. The need to replace foreign trade
taxes with domestic taxes will be accompanied by growing concerns about profit diversion by
foreign investors, which weak provisions against tax abuse in the tax laws as well as inadequate
technical training of tax auditors in many developing countries are currently unable to deter. A
concerted effort to eliminate these deficiencies is therefore of the utmost urgency.

Tax competition is another policy challenge in a world of liberalized capital movement. The
effectiveness of tax incentives—in the absence of other necessary fundamentals—is highly
questionable. A tax system that is riddled with such incentives will inevitably provide fertile
grounds for rent-seeking activities. To allow their emerging markets to take proper root,
developing countries would be well advised to refrain from reliance on poorly targeted tax
incentives as the main vehicle for investment promotion.

Finally, personal income taxes have been contributing very little to total tax revenue in many
developing countries. Apart from structural, policy, and administrative considerations, the ease
with which income received by individuals can be invested abroad significantly contributes to
this outcome. Taxing this income is therefore a daunting challenge for developing countries. This
has been particularly problematic in several Latin American countries that have largely stopped
taxing financial income to encourage financial capital to remain in the country.

Author Information

Vito Tanzi was the Director

of the Fiscal Affairs
Department of the IMF from
1981 to 2000. He retired from
the IMF on December 1, 2000.
He holds a Ph.D. from
Harvard University and is the
author of many books and
articles in professional
journals.
 
Howell Zee is the Chief of the
Tax Policy Division in the
IMF's Fiscal Affairs
Department. He holds a Ph.D.
from the University of
Maryland (College Park) and
is the author of many articles
in professional journals.
A good tax system raises the revenues needed to finance government spending in a manner that
is as simple, equitable, and growth-friendly as possible. The United States does not have a good
tax system. This chapter highlights five areas where tax policy could be improved: raising long-
term revenue; increasing environmental taxes; reforming the corporate tax; treating low- and
middle-income earners equitably and efficiently; and ensuring appropriate taxation of high-
income households.

RAISING LONG-TERM REVENUE

Under current law projections, public debt as a share of the economy will rise from 77 percent
currently—the highest level ever except for a few years around World War II—to about 129
percent by 2046.[1] Revenues will rise slightly, but spending will rise much faster, due to
increases in net interest, Social Security, and health programs. Under reasonable policy
alternatives, the debt figures will rise even higher. High and growing levels of debt will crowd
out future investment and stymie growth. They will also reduce fiscal flexibility, or the ability to
respond to future recessions.
High and growing levels of debt will crowd out future investment and stymie growth. They
will also reduce fiscal flexibility, or the ability to respond to future recessions.
Alan Auerbach of the University of California at Berkeley and William Gale estimate that in
order to return the debt level to its 1957–2007 average of 36 percent of GDP by 2046 immediate
and permanent (through 2046) spending cuts and/or tax increases equal to 4.2 percent of GDP
will need to be implemented. Just to maintain the 2046 debt at its current share of GDP would
require adjustments, starting in 2017, of 2.7 percent of GDP.[2] It seems unlikely that changes of
this magnitude could be managed on the spending side. Entitlements have proven difficult to
reform, especially Social Security, as there is significant public and political backlash against
cutting benefits. Moreover, any Social Security changes would likely be phased in slowly, and
reasonable changes in the program would not affect the overall fiscal balance that much. In
addition, discretionary spending has already been cut dramatically and is already slated to fall to
historically low shares of GDP over the next 25 years. As a result, tax increases need to be part
of a long-term fiscal solution.
One way to raise revenue is to broaden the tax base by reducing the number of specialized
credits and deductions in the tax code.[3] For example, under current law, a dollar’s worth of
deduction reduces taxable income by a dollar and hence reduces the tax burden in proportion to
the marginal tax rate. A high-income household saves 39.6 cents for a given dollar of deduction,
whereas a low-income household saves only 10 cents or nothing at all. Setting the tax benefit of
each dollar of itemized deductions to 15 cents would affect mostly high-income households and
raise, on average, about 0.6 percent of GDP per year over a decade, or roughly a cumulative $1.4
trillion over the next 10 years. Current itemized deductions are expensive, regressive, and often
ineffective in achieving their goals. The mortgage interest deduction, for example, does not seem
to raise home ownership rates, yet it will cost the federal government around $70 billion in 2017.
Limiting the benefits of the deductions for high-income households is a way of reducing the
distortions created by the tax code, making taxes more progressive, and increasing revenue.
Alternatively, the United States could cap the total amount of tax expenditures that an individual
can claim.[4]
An alternative way to raise revenue is through the creation of a federal value-added tax (VAT),
as a supplement to the current income tax system, rather than as a replacement.[5] A VAT is
essentially a flat-rate consumption tax with administrative advantages over a national retail sales
tax. Although it would be new to the U.S., the VAT is in place in about 160 countries worldwide
and in every OECD country other than the United States. Experience in these countries suggests
that the VAT can raise substantial revenue, is administrable, and is minimally harmful to
economic growth. Additionally, a properly designed VAT might help the states deal with their
own fiscal issues. Although the VAT is regressive relative to current income, the regressivity can
be offset in several ways, and we should care about the distributional impact of the overall tax
and transfer system, not just specific taxes. The VAT is not readily transparent in many
countries, but it would be easy to make the VAT completely transparent to businesses and
households by reporting VAT payments on receipts, just like state sales taxes are reported today.
While the VAT has led to an increase in revenues and government spending in some countries,
higher revenues are precisely why the VAT is needed in the United States, and efforts to limit
government spending should be part of an effort to enact a VAT. A new 10 percent VAT,
applied to all consumption except for spending on education, Medicaid and Medicare, charitable
organizations, and state and local government, could be paired with a cash payment of about
$900 per adult and about $400 per child to offset the cost to low-income families (the equivalent
of annually refunding each two-parent, two-child household the VAT owed on the first $26,000
of consumption).[6] In all, this VAT could raise about a net 2 percent of GDP or about $390
billion in 2017, after allowing for the offsetting effect on other taxes.
INCREASING ENVIRONMENTAL TAXES

Economists have long recommended specific taxes on fossil-fuel energy sources as a way to
address global warming. The basic rationale for a carbon tax is that it makes good economic
sense: unlike most taxes, carbon taxation can correct a market failure—namely, that people and
businesses do not pay the full cost of emitting carbon—and make the economy more efficient.
[7]
 It could also serve to raise revenue as an alternative to the taxes described above.
Although a carbon tax would be a new policy for the federal government, the tax has been
implemented in several other countries. On average, a reasonably designed U.S. carbon tax alone
could raise gross revenue by about 0.7 percent of GDP each year from 2016 to 2025 (around
$160 billion per year).[8] Carbon taxes are a good idea even if we did not need to increase
revenues, because they can contribute to a cleaner, healthier environment by providing price
signals to those who pollute. They have foreign policy benefits as well, as they plausibly reduce
U.S. demand for oil and dependence on oil-producing nations. The permanent change in price
signals from enacting a carbon tax would stimulate new private sector research and innovation to
develop new ways of harnessing renewable energy and energy-saving technologies. The
implementation of a carbon tax also offers opportunities to reform and simplify other climate-
related policies that affect the transportation sector. The regressivity of a carbon tax could be
offset in a number of ways, including refundable income or payroll tax credits.
REFORMING CORPORATE TAXATION

In the standard textbook setup, the earnings of equity holders are taxed twice: once under the
corporate tax when they are earned, and then again under the individual income tax when they
are paid to shareholders as dividends or capital gains. This summary both overstates and
misstates the real problem. First, no corporate income is fully taxed under the individual income
tax, since dividends and capital gains are taxed at preferential rates and capital gains are only
taxed when the asset is sold. Second, a significant share of dividends and capital gains accrues to
nontaxable entities—nonprofits or pensions—thus reducing the tax burden further. Third, a large
share of corporate profits is never taxed at the corporate level in the first place. Aggressive
corporate tax avoidance, including shifting funds out of the country through transfer pricing or
other mechanisms, is an important factor in corporations reducing their tax burden.

The United States has the highest top corporate rate in the world at 35 percent. For many
businesses, the tax distorts choices in favor of the noncorporate sector over the corporate sector.
For other businesses, the corporate tax burden is offset by tax preferences. In the corporate
sector, the tax favors debt over equity and retained earnings over dividends. As a result of
numerous loopholes, aggressive corporate tax avoidance, and the large share of U.S. businesses
that takes the form of non–C-corporation activity (which is in itself a form of corporate tax
avoidance), U.S. corporate tax revenues as a share of GDP are only average compared to other
countries, despite the high tax rate. In recent years, for example, corporate profits have equaled
12 percent of GDP, but corporate tax revenues have hovered around 2 percent of GDP.

Hence, the problem is not just that some forms of corporate income face two levels of tax; it is
also that some forms face no tax. As a result, the main goal of corporate tax reform should be to
tax all corporate income once and only once, at the full income tax rate. Given all of the flaws in
the corporate tax, it should not be surprising that there are several approaches to reform that
could help. None is without problems; each would address different aspects of the system.

Given all of the flaws in the corporate tax, it should not be surprising there are several
approaches to reform that could help.
One option would be to replace some or all of the corporate income tax with a tax on shareholder
wealth accumulation, as proposed by Eric Toder and Alan Viard. Under this approach, there
would be no corporate tax. Instead, “American shareholders of publically-traded companies
would be taxed on both dividends and capital gains at ordinary income tax rates, and capital
gains would be taxed upon accrual,” rather than realization.[9]
Alternatively, the U.S. corporate income tax could be converted into a corporate cash-flow tax.
This idea, proposed by both the House Republicans[10] and Alan Auerbach,[11] would essentially
be a VAT with a wage deduction. It would encourage new investment by replacing deductions
with immediate expensing for physical investment. The tax would be applied on a destination
basis, which essentially limits the focus of the tax to transactions occurring exclusively on
domestic soil and thus avoids all international transfer pricing issues.
A major change in the treatment of foreign source income should also be considered. In a pure
worldwide system, all income from around the world is taxable, and all costs are deductible. In a
pure territorial system, income earned outside the country is not taxable, and costs incurred
outside the country are not deductible. A key issue, of course, is how income and expenses are
allocated to each country because firms go to great lengths to move income to low-tax countries
and deductions to high-tax countries. Most advanced countries lean toward a territorial system.
The United States, by contrast, leans toward a worldwide system, but there is an important
exception—taxes on actively earned foreign income are deferred until the income is repatriated
to the United States. Currently, U.S. firms have more than $2 trillion in actively earned funds
overseas that have not been repatriated and therefore go untaxed. This income is often described
as being “trapped” outside the United States.[12] This characterization is only partially correct,
though. The money may actually be in a bank in the United States and funding investment in the
United States. However, the funds cannot be used to pay dividends to shareholders or to buy
back firm shares until the funds are “repatriated” to the corporation, a legal procedure that
generates a tax liability.

There are two general proposals to deal with the issue of funds sitting “abroad.” One is to move
to a worldwide system without deferral.[13] The other is to move toward a territorial system.[14] As
noted, a big issue with territorial systems is that they increase the incentives that already exist to
shift income into low-tax countries and deductions/costs into high-tax countries. The
implementation of a territorial system would need to be accompanied by very stringent rules
about income and cost-shifting. There has been a desire on the part of some lawmakers to have a
one-time repatriation tax holiday, perhaps to finance infrastructure.[15] This would be a mistake,
and would simply encourage firms to shift more funds overseas in an effort to gain a future tax
advantage.[16]
REVISING TREATMENT OF LOW- AND MIDDLE-INCOME EARNERS

Under a progressive income tax, the highest statutory marginal tax rates are placed on the
highest-income households. Under our current system, however, low- and middle-income
earners often face very high effective marginal tax rates. These earners are in income ranges
where increased earnings cause phaseouts of tax subsidies and benefit programs. The net effect
of earning more—including higher wages, higher income tax payments, and lower program
benefits—can impose quite significant effective tax rates on such households. This situation is
unfair to those families, is inefficient, and discourages actions that would enhance social and
economic mobility.

For example, Melissa Kearney and Lesley Turner note that a secondary earner in a married
household typically pays a higher effective tax rate on the margin than the primary earner. This
issue arises because the two incomes are combined to form one tax unit, even though the
secondary earner often has a lower individual income than the primary earner (and would have a
lower marginal tax rate if filing as a single person). This is particularly problematic for low- and
middle-income households because it discourages additional work to support their family, which
could result in extra income that may reduce their benefits or even render the family ineligible
for programs such as food assistance or the Earned Income Tax Credit (EITC). On both fairness
and economic grounds, Kearney and Turner propose a 20 percent secondary-earner tax deduction
until a cap is reached. This deduction would improve the incentive to work, provide more
economic security to working low- and middle-income families, and mitigate the secondary-
earner penalty. On net, the authors estimate that their proposal would cost the federal
government $8.2 billion per year.[17]
Of course, another option to mitigate the tax burden faced by low- and middle-income earners is
to expand eligibility for the EITC or transform the Child and Dependent Care Credit (CDCC) to
a refundable benefit.[18] Both of these programs are already executed through the tax code in an
effort to aid low- and middle-income families, and changes to the programs could expand
economic opportunity or increase the degree of fairness in the system. Specifically, EITC
benefits could be raised for families with fewer than two children, especially for childless
workers. This improves the incentives for work in these households, and it can lead to better
economic outcomes for the associated families. By converting the CDCC to a refundable credit,
low-income families would be able to reap greater benefits from the program and retain more
disposable income. Additionally, it would incentivize the use of higher-quality child care. To
make these options revenue neutral and prevent them from exacerbating the long-term revenue
issues described above, the income eligibility caps for these programs could be lowered or other
provisions could be removed.
TAXING THE RICH

There are three reasons to increase the tax burden on high-income households. First, their income
has increased dramatically over the past several decades, yet their tax payments have not kept
pace. Second, if the fiscal reforms described above are implemented, the main benefit will be
economic growth, but such growth in the past several decades has accrued largely to high-
income households, who should thus be expected to pay for it. Third, despite much rhetoric to
the contrary, reasonable variations in taxes on high-income households do not appear to have any
negative discernible impact on growth.[19]
There are many ways to boost revenue collected from high-income households. The most
prominent examples would include higher taxes on capital gains and dividends, restrictions on
tax expenditures, higher income tax rates, or a tighter estate tax. Taxing carried interest as
ordinary income also makes sense in principle, but is difficult to implement without creating new
forms of avoidance and, as a result, would raise very little revenue.

CONCLUSION

The U.S. tax system is far from ideal, and there are several areas for improvement. Reforming
the system so that it pays for government spending, treats taxpayers fairly, and improves
incentives for productive activity can alleviate many issues and only be a plus from an economic
standpoint.
Critical Issues in Taxation and Development
Edited by Clemens Fuest and George R. Zodrow

Experts analyze the policy challenges of taxation in developing countries, including corruption,
tax evasion, and ineffective political structures.

Overview
Author(s)

Summary
Experts analyze the policy challenges of taxation in developing countries, including
corruption, tax evasion, and ineffective political structures.

Many developing countries find it difficult to raise the revenue required to provide such basic
public services as education, health care, and infrastructure. Complicating the policy challenges
of taxation in developing countries are issues that most developed countries do not face,
including widespread corruption, tax evasion and tax avoidance, and ineffective political
structures. In this volume, experts investigate crucial challenges confronted by developing
countries in raising revenue.

After a comprehensive and insightful overview, each chapter uses modern empirical methods to
study a single critical issue essential to understanding the effects of taxes on development.
Topics addressed include the effect of taxation on foreign direct investment; forms of corruption,
tax evasion, and tax avoidance that are specific to developing countries; and issues related to
political structure, including the negative effects of fiscal decentralization on the effectiveness of
developmental aid and the relationship between democracy and taxation in Asian, Latin
American, and European Union countries that have recently experienced both political and
economic transitions.

ContributorsClemens Fuest, Timothy Goodspeed, Shafik Hebous, Michael Keen, Christian

Lessmann, Boryana Madzharova, Giorgia Maffini, Gunther Markwardt, Jorge Martinez-
Vazquez, Paola Profeta, Riccardo Puglisi, Nadine Riedel, Simona Scabrosetti, Johannes Stroebel,
Mirco Tonin, Arthur van Benthem, Li Zhang, George Zodrow
IRS statistics are pretty reliable. So when it comes to tax problems, it is easy to identify the most
common IRS problems taxpayers face.
Each year, the IRS publishes its Data Book which gives insight into taxpayer issues. You can
read other IRS reports from various sources like the General Accountability Office, the Treasury
Inspector General for Tax Administration (TIGTA), and the IRS advisory committees to glean
more data into tax problems. Here are the six most common problems faced by taxpayers:

Tax Problem # of taxpayers annually Comments

 Over  150 different types  of

IRS penalties
 Only  11% of all penalties are
abated

Penalties  80% are related  to individual

“The IRS penalized me for late taxpayers
29.5 million  taxpayers annually
payment, late filing, or an  Most common  penalty is
inaccurate tax return” “failure to pay”
 Failure to pay, estimated tax,
and failure to file
penalties  make up 96%  of all
penalties for individuals

 Over $539 billion is currently

owed to the US Treasury
 84% are individual taxpayers
(16.8 million owe the IRS)
Unpaid taxes As of 2019,  20.1 million  owe
“I owe but I cannot pay” and cannot pay  Over 90% obtain a streamlined
installment agreement
 IRS is  actively chasing  11.2
million delinquent accounts

Non-filers 10.6 million (individual only)  Identified non-filers through

“I have not filed my required 50.5 million business non-filers W-2s/1099s
tax return”
 Likely several million more if
you include small businesses
 Tax Problem # of taxpayers annually Comments

 IRS can file a return for

taxpayer called a “substitute for
return” using information in its
possession (W-2s/1099s)

 Known as the IRS Automated

Underreporter Program
(CP2000 notice)
Underreport income
“I did not report all of my W- 2.0 million  (2019)  Out of 150 million individual
2s/1099s” filers,  27 million taxpayers  do
not report all W-2s/1099s
 Average amount owed :  $3,336

 Individuals only
Math error notices  Most common error is incorrect
“I made an error and the IRS tax calculation
1.9 million  (2019)
adjusted my refund/balance
owed”  IRS adjusts return
automatically by notice

 74% are  done by mail

 89% of returns  audited are
changed by the IRS
Audits
1.1 million   (2019)  Mail audit-  average amount
“I am being audited by the IRS”
owed : $6,164
 Field audit:   average amount
owed :  $68,122

Tax problem categories can overlap as Many taxpayers have multiple issues. For example, if a
taxpayer has an audit, a late filing, or the inability to pay, they can also have penalties. The
reality is that the most common issue facing taxpayers is trying to understand their IRS
notices. About 10% of all taxpayers get an IRS notice. Those taxpayers have to navigate and
figure out if they have one or more of the issues listed above, or a different issue not listed here
like identity theft.

How do taxes affect the economy in the long run?

 TAXES AND THE ECONOMY
FEDERAL BUDGET AND ECONOMY
Q.
How do taxes affect the economy in the long run?

A.
Primarily through the supply side. High marginal tax rates can discourage work, saving,
investment, and innovation, while specific tax preferences can affect the allocation of
economic resources. But tax cuts can also slow long-run economic growth by increasing
deficits. The long-run effects of tax policies thus depend not only on their incentive effects
but also their deficit effects.

Economic activity reflects a balance between what people, businesses, and governments want to
buy and what they want to sell. In the short run, demand factors loom large. In the long run,
though, supply plays the primary role in determining economic potential. Our productive
capacity depends on the size and skills of the workforce; the amount and quality of machines,
buildings, vehicles, computers, and other physical capital that workers use; and the stock of
knowledge and ideas.

TAX INCENTIVES

By influencing incentives, taxes can affect both supply and demand factors. Reducing marginal
tax rates on wages and salaries, for example, can induce people to work more. Expanding the
earned income tax credit can bring more low-skilled workers into the labor force. Lower
marginal tax rates on the returns to assets (such as interest, dividends, and capital gains) can
encourage saving. Reducing marginal tax rates on business income can cause some companies to
invest domestically rather than abroad. Tax breaks for research can encourage the creation of
new ideas that spill over to help the broader economy. And so on.

Note, however, that tax reductions can also have negative supply effects. If a cut increases
workers’ after-tax income, some may choose to work less and take more leisure. This “income
effect” pushes against the “substitution effect,” in which lower tax rates at the margin increase
the financial reward of working.

Tax provisions can also distort how investment capital is deployed. Our current tax system, for
example, favors housing over other types of investment. That differential likely induces
overinvestment in housing and reduces economic output and social welfare.

BUDGET EFFECTS

Tax cuts can also slow long-run economic growth by increasing budget deficits. When the
economy is operating near potential, government borrowing is financed by diverting some
capital that would have gone into private investment or by borrowing from foreign investors.
Government borrowing thus either crowds out private investment, reducing future productive
capacity relative to what it could have been, or reduces how much of the future income from that
investment goes to US residents. Either way, deficits can reduce future well-being.

The long-run effects of tax policies thus depend not only on their incentive effects but also on
their budgetary effects. If Congress reduces marginal tax rates on individual incomes, for
example, the long-run effects could be either positive or negative depending on whether the
resulting impacts on saving and investment outweigh the potential drag from increased deficits.

PUTTING IT TOGETHER

That leaves open questions on how large incentive and deficit effects are, and how to model
them for policy analysis. The Congressional Budget Office and the Joint Committee on Taxation
each use multiple models that differ in assumptions about how forward-looking people are, how
the United States connects to the global economy, how government borrowing affects private
investment, and how businesses and individuals respond to tax changes. Models used in other
government agencies, in think tanks, and in academia vary even more. The one area of consensus
is that the most pro-growth policies are those that improve incentives to work, save, invest, and
innovate without driving up long-run deficits.

The Urban-Brookings Tax Policy Center (TPC) has developed its own economic model to
analyze the long-run economic effects of tax proposals. In TPC’s model, simple reduced-form
equations based on empirical analysis determine the impact of tax policy on labor supply, saving,
and investment. TPC used this model to estimate the long-run economic and revenue effects of
the Tax Cuts and Jobs Act.

Updated May 2020

PHL needs to move tax collection processes online, says ADB report

January 4, 2022 | 12:31 am

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By Jenina P. Ibañez, Senior Reporter

THE PHILIPPINE government must move its tax collection processes online to cut costs and
improve compliance among individuals and businesses, the Asian Development Bank (ADB)
said.

ADB Southeast Asia economist Aekapol Chongvilaivan said such reforms will help improve tax
revenue collections.

“Our recent report on tax reforms in Southeast Asia emphasizes the need to shift from manual
paper-based systems to digital systems to reduce the costs of tax administration and compliance
for individuals and corporates,” he said in an e-mail.

In a report A Comprehensive Assessment of Tax Capacity in Southeast Asia, the ADB said a
narrow tax base in the region is attributed to its large informal sector.

In the Philippines, economic activities outside the tax systems make up 28% of the gross
domestic product.

“There are various reasons for a large informal economy — such as weak tax enforcement,
inefficiencies of tax administration, and tax avoidance behaviors among others,” the report said.

The high costs of tax compliance, ADB added, discourages small- and medium-sized businesses
from complying with the rules.

“In the context of the Southeast Asian countries, there is a huge opportunity for tax authorities to
leverage on tax administration measures that aim to reduce costs of compliance and promote
voluntary compliance by simplifying tax registration.”

The report suggested that digital taxation can help governments quickly improve revenues
without changing existing rules.

Mr. Chongvilaivan, the co-author of the report, said the Bureau of Internal Revenue’s (BIR)
digital initiatives have helped address issues in tax administration and payments.

The ADB is helping the BIR to develop taxpayer online registration and data management, he
said.
“(The system) would help enrich taxpayers’ services, thereby reducing their compliance costs
and bringing them into tax systems.”

Finance Secretary Carlos G. Dominguez III has said that local government units should digitalize
their tax processes after a Supreme Court ruling expanded their share of National Government
revenues starting this year.

Mr. Dominguez said local governments will have to develop electronic business registration and
renewal as well as local tax and fee assessment and collection.

Both national and local governments should improve revenue generation to make the country’s
fiscal resources last during the coronavirus disease 2019 (COVID-19) pandemic, he said.

In December, the Finance chief said that nearly 100% of annual income tax returns were filed
online last year, higher than the 90% in 2020 as more Filipinos use digital tools for transactions.

Only 10% of taxpayers filed taxes digitally in 2015, he said.

Co-authored by ADB Taxation Administration Expert Annette Chooi, the report released in
December said digital technology will cut transaction costs and improve tax transparency.

“Following the use and adoption of electronic services or e-services, such as e-filing and e-
payment, many Southeast Asian countries see an increase in tax collection.”