What constitutes successful tax reform? A review of developing country experience
Javad Khalilzadeh-Shirazi and Anwar Shah
Tax reform has become an increasingly important element of adjustment programs in developing countries supported by the World Bank and IMF. Balance of payments disequilibria often have their origins in inappropriate fiscal policies, and there is a growing recognition that fiscal imbalances cannot be addressed simply by curtailing expenditure. Moreover, tax systems of many developing countries are often distortionary and also contribute significantly to distributional problems. Restructuring tax systems is thus perceived to be critical for the success of both macroeconomic and structural reform policies.
A World Bank research project, initiated in early 1988, examined the experience with tax reform in ten developing countries with a view toward drawing lessons for other countries contemplating similar reforms. The countries included in the study were Bolivia, Colombia, Jamaica, Indonesia, Malawi, Mexico, Morocco, the Republic of Korea, Turkey, and Zimbabwe. The results of the project, as well as of recent Bank research on a number of specific tax policy issues, were reviewed at a conference held at the Bank in March 1990. This article aims to highlight the main themes that emerged and the conclusions of the discussions.
Impetus for reform
The review of tax reform experiences indicates that tax structures in most developing countries are:
• complex—difficult to administer and comply with;
• inelastic—unresponsive to growth and the changing structure of economic activity;
• inefficient—introduce serious economic distortions while often raising relatively little revenues;
• inequitable—treat individuals and businesses in similar circumstances differently; and
• unfair—tax administration and enforcement are selective and favor those with the ability to defeat the system.
Most developing countries also face a common set of fiscal problems. There is a heavy reliance on import duties and export taxes, which undermines their long-term international competitiveness, while the potential to raise revenue through consumption taxes is not exploited. Agricultural incomes, fringe benefits, and, in some countries, public sector wages are not taxed, while taxes on unearned income, property, and wealth contribute only a small proportion of total revenues. As a consequence, personal and corporate income taxes are levied on narrow tax bases at high rates.
The existing tax systems are also widely used to advance wide ranging and often conflicting economic policy objectives, such as revenue enhancement, industrial and regional development, savings, investment, employment, and export promotion. A common practice is to levy preferential tax rates, or provide exemptions or special deductions for the preferred activity. Revenue foregone to encourage specific activities is termed a “tax expenditure” in the public finance literature. For example, to promote investment in less developed regions, many countries allow an initial tax-free period (tax holiday). However, given poor compliance and enforcement, such measures are often ill-suited to achieving individual policy objectives and simply lead to increased inefficiency as other activities have to be taxed at even higher levels.
In recognition of these factors, many countries have been reforming and many more have begun to critically evaluate their tax systems. The broad goal of tax reform is to secure an efficient tax system based on taxes that are politically feasible and administratively practicable, and produce sufficient revenue with a minimum of economic distortion. Although the scope for tax reform varies from country to country depending on the nature of the initial tax system, administrative constraints, and the government’s social and economic priorities, some general conclusions about the appropriate direction of tax reform can be drawn from the experience of the ten countries mentioned above.
Lessons from tax reform
Broadening the tax base and lowering tax rates should be the foremost goal of any tax reform initiative in developing countries. Developing countries typically levy high tax rates on narrow bases, encouraging tax evasion and compromising the fairness of the tax system. Broadening the tax base can generate higher revenues, while also providing similar tax treatment to various activities and individuals in similar economic circumstances. The distribution of tax burden among income classes is also improved by curtailing tax preferences that, for the most part, benefit the rich. Lowering tax rates mitigates the disincentive effects of taxation.
The World Bank hosted a conference in March 1990 to review tax reform experiences in developing countries and to discuss a range of issues—including taxation of foreign investment, resources and financial institutions, design of indirect taxes, tax incidence, tax policy models, and tax policy and economic growth—that are expected to dominate tax policy discussions in the 1990s. A conference volume edited by these authors will soon be published by the World Bank.
The value-added tax (VAT) should form an important element of an agenda for sales tax reform in developing countries. A broadly based sales (consumption) tax of the value-added type can raise a significant amount of public revenues in a nondistorting manner. The tax also provides an impetus for higher savings. While the overall distributional implications of such a tax are not clear, the component of VAT that falls on imports is expected to reduce rents accruing to the wealthy recipients of import and foreign exchange licenses. A VAT can further assist in improving the collection of other taxes by creating a verifiable record of transactions through production and distribution channels. This potential, though, has yet to be exploited by a developing country. The adoption of a VAT has been successful in raising additional revenues and reducing the efficiency costs of taxation in Indonesia, Turkey, Brazil, Colombia, Mexico, Korea, and Malawi. Of course, the implementation of a VAT in developing countries raises special difficulties. A VAT is unable to encompass the large number of economic activities that are carried out in the informal sector in a typical developing country. Further, to keep the poor out of the tax net, basic foods and necessities are usually exempted, creating administrative complexities. Inter-regional trade creates its own special problems for VAT administration. Simple alternative rules are adopted to provide interstate tax credits on such trade. A VAT is also not considered superior to a well-functioning retail sales tax in small island-type economies that have a narrow manufacturing base and depend heavily on cross-border trade.
Coordinated tax reform offers significant advantages over isolated piecemeal tinkering with the tax system. A coordinated reform ensures consistency of individual tax changes with the overall objectives. For example, a reduction in tariffs without a corresponding increase in other taxes can increase the fiscal deficit and exacerbate macroeconomic difficulties. A coordinated reform of these taxes would combine reductions in tariffs with an offsetting increase in consumption taxes that would apply equally to both domestic production and imports. Further, to enhance overall economic performance, tax reform should be integrated closely with overall structural adjustment measures.
Improved tax administration is a prerequisite for the success of tax reform. In developing countries, the success in broadening the bases of existing taxes and having lower tax rates continues to be compromised by tax administration difficulties. The apparent lack of success in this area is attributable to several factors: selective and lax enforcement practices; ineffective tax administration, in part, due to political inertia; institutional and political difficulties associated with bringing agricultural income into the tax net; and a disenchantment with income taxes as revenue instruments in an environment where tax evasive behavior is the rule rather than the exception. Thus, it is important to concurrently reform tax administration while attempting to restructure the tax system.
The use of the tax system for nonrevenue objectives (e.g., tax preferences for specific investments) should be curtailed. While the tax system can legitimately be used to further social and economic goals, such a use often leads to a major drain on the national treasury by conferring windfall gains on existing activities or through a shift of resources to tax preferred activities, thus ultimately reducing the tax base. Thus, in devising tax policies to meet economic and social objectives, potential gains must be weighed against the potential losses in efficiency and revenues that might be associated with these measures. Recently, Colombia, Mexico, Indonesia, and Jamaica have introduced reforms to curtail the use of the tax system for nonrevenue goals.
Tax reform must take into account initial conditions at home and abroad. In reforming their tax systems, developing countries are severely constrained not only by their own institutional settings but also by the tax structure in capital-exporting countries. For example, the US foreign tax credit regime impedes the adoption of a cash-flow system of taxation (a system where all expenditures are deducted from the income base in the same year they are incurred) in developing countries. This is because, under such a system, taxes paid to developing nations by US investors cannot be credited against their home tax liabilities. Notwithstanding this, domestic circumstances may be such that a complete redesign of tax systems could lead to serious transition difficulties. Developing countries must, therefore, take initial conditions at home and abroad into account to ensure that the reform effort will succeed.
Indonesia’s tax reform experience
Prior to 1983, Indonesia derived less than one third of its revenues from non-oil sources. Over the years, the tax system was unsuccessfully used to accomplish nonrevenue objectives, such as regional and industrial development and developing an egalitarian society. In the process, most revenue sources, especially income and sales taxes, were subject to multiple rates on narrow bases. A lax tax administration compounded these problems further. While the inadequacies of the tax system were recognized, growing oil revenues served to detract attention from the urgent need for reform. The oil crisis of the early 1980s, however, provided an impetus for diversifying revenue sources. Against this backdrop, the tax reform measures introduced in 1983 emphasized raising revenues through broad-based consumption taxes and improvements in tax administration. This was to be achieved, however, by minimizing tax induced distortions in resource allocation and protecting the poorest of the poor from the tax net
A value-added tax was introduced along with a luxury sales tax. Personal and corporate tax bases were broadened and subjected to lower nominal tax rates. A three-rate structure (15 percent, 25 percent, and 35 percent) applicable to income from all sources replaced 17 personal income tax rates and 3 business income tax rates. Most special tax preferences were eliminated, but the basic exemption level for personal income taxes was increased to remove nearly 90 percent of the population from the reach of the income tax.
Indonesia’s tax reform strategy had a measurable degree of success in meeting its stated objectives. In just three years, non-oil revenues as a share of GDP rose nearly 50 percent. This success is largely attributable to the introduction of a VAT. The VAT also eliminated the cascading effects of earlier sales taxes and preferential tax treatment of imports over domestically manufactured goods. Further, business inputs and exports were spared from taxation.
Indonesia carried out major changes in its tax system over a three-year period. Its experience demonstrates that a developing country with the political will to undertake a major overhaul of its tax system can succeed in reaping significant economic benefits from such an initiative.
The impact of tax policy on international competitiveness has not received much attention in tax reform analysis. It appears that developing countries are often engaged in wasteful tax competition by offering an increasing array of incentives to foreign investors, while not paying adequate attention to the tax regime that a potential investor faces in his home country. An investor from a country with a worldwide system of taxation can be taxed by the host country at the home country tax rate, for instance, the US tax rate, without adverse incentive effects. Further, the host country must ensure that income is not shifted to low-tax countries or to tax havens through transfer pricing (i.e., pricing intracorporate transactions in such a way so as to attribute most of the profit to a low-tax location).
The credibility of the tax regime is the key to the success of any tax reform. A stable tax policy environment encourages businesses to take a longer-term perspective in their finance and investment decisions. Making tax changes without giving adequate consideration to transitional arrangements can undermine the credibility of a tax regime. Therefore, transitional arrangements require much more careful analysis than they have hitherto been given in developing countries. Greater attention to preparation, analysis of reforms, advance consultation, as well as providing a reasonable period of adjustment prior to implementation, grandfathering provisions, and historical consistency of tax reform would establish business confidence in the credibility of the tax regime. In general, a stable tax regime should be the goal, and frequent tax changes should be avoided.
Political economy of tax reform
Tax reform is often a sensitive and difficult process. Since the gains from comprehensive reform often become visible only in the medium to long term, it is a major challenge to form a political coalition to carry through a wholesale reform. The pragmatic course is often to strive for incremental reforms in a consistent manner over time. Historical consistency of tax reform, while desirable, is difficult to attain in practice. In Colombia, for instance, a net wealth tax was considered an important progressive element of taxation in the 1974,1986, and 1988 reform episodes, but it was repealed in 1989. Similarly, broadening the income tax base, when accompanied by the lowering of tax rates, does not invite significant opposition to forestall reform. If, however, after introducing these changes, tax preferences are later restored to appease special interests, the initial tax reform effort would have contributed to a deterioration in the budget as, in the final analysis, lower rates would be applicable to a still narrower base.
Tax changes also create winners and losers. Each tax change introduces some efficiency and vertical equity (i.e., a relatively higher tax burden on higher income classes) tradeoffs that must be recognized and appropriately addressed. In developing countries, this situation is dealt with by using exemptions. It is important to identify gains and losses by income class, by geographic region, and by political affiliation so that the long-run viability and sustainability of reform measures can be objectively evaluated. Short-term tax measures to meet nonrevenue objectives should be avoided, as they create strong political constituencies wedded to these measures. A comprehensive reform offers some possibility of balancing the gains and losses of various groups, an opportunity that does not usually arise in piecemeal reform.
Country experiences suggest that tax reform proposals must be viewed in the context of the economic and institutional setting of the country in question. For example, in low-to middle-income countries, such as Colombia, Indonesia, and Malawi, revenue gains from the broadening of income taxes are expected to be modest, and VAT is therefore expected to be the mainstay of the revenue raising effort. On the other hand, in newly industrialized countries such as Korea, there is considerable potential for revenue enhancement from the broadening of bases. In a federal country, the way powers of taxation are assigned among levels of government typically constrains tax reform choices. For example, in India, the introduction of a federal VAT is being constrained by state level opposition. States are worried that a federal VAT would leave them less discretion to set state and local sales taxes. In Pakistan, the octroi tax, which is a tax on inter-regional trade, could not be repealed as it is a significant source of local revenues. Land taxation is no longer an important source of revenue for developing countries. This need not be the case if local governments are given access to this revenue source. A local land tax would be seen as a user charge for local public services and, therefore, offers potential for raising substantial amounts of revenue in a nondistorting manner.
Tax administration plays a key role and, therefore, tax policy advice must consider current administrative practices and what potential there may be for improvement. Experience suggests that compartmentalizing public policy in various departments (or even various branches of the same departments) limits tax reform options. For example, in none of the countries studied were tax and transfer options considered simultaneously. The range of choices was restricted to alternative tax instruments, and direct expenditure options were excluded.
The local political and civil service elite in the country must assume the “ownership” of the proposals if the reforms are to succeed. Further, participation by local experts in the design of the reform enhances chances for its success as they are a better judge of the political pulse of the country. The success of tax reform in Colombia and Malawi can partly be attributed to the trained core of local experts that worked closely with foreign advisors.
The way to increase compliance is to make sure not only that the people are consulted on the reform proposals but also that they are given a clear idea about how—and on what—the money will be spent. In Malawi, there was a wide consultation process on income tax changes to gauge taxpayer reaction before the proposals were finalized. This helped to ensure that the final reforms were acceptable to a majority of the affected population.
Finally, whatever choices may be made on the path to reform, it helps to have a coherent overall plan in place before implementation begins. Further tax reforms must be responsive to changing economic and social conditions.