Unlike such disciplines as macroeconomics or tax policy, tax administration lacks a coherent body of literature or set of principles within which well-defined “schools” espouse particular intellectual positions. Instead, tax administration is a loosely defined area that embraces law, public administration, sociology, and psychology as well as economics. Nevertheless, tax administration is closely linked to fiscal policy because its ultimate result is to increase or lower government revenue and the overall fiscal deficit; to place higher or lower tax burdens on particular sectors of the economy; and to favor or penalize particular income classes and different factors of production. In addition, tax administration may play a powerful role in influencing the efficiency of the economy by making intended or unintended distortions of consumer choices and producer decisions.
I. Role of Tax Administration
A useful definition of tax administration for the purpose of economic analysis begins with the set of statutes forming the basis of the tax system. In general, this set of laws would include an income tax act; a customs act covering import tariffs and surcharges; an excise tax act; a general sales tax law; social security legislation; export, wealth, and property taxes (if any); and other minor taxes and fees. Such a body of legislation represents the tax system from the point of view of those who design tax policy. In contrast to the legal statutes stands the “real” or effective tax system, or the system as it is applied in practice (Tanzi (1987b)). Tax administration can be seen as the link between the statutory foundation and the operative tax system. If tax administration were perfect, tax administrators would play a neutral role in determining the overall fiscal deficit, the relative tax burden on sectors and income classes, and the efficiency of the economy. It is well known, however, that even the best tax administration collects some taxes more effectively than others. A recent study of tax administration in the United States, for example, estimates that for wages and salaries the ratio of reported income to estimated actual income is 97-98 percent, whereas the corresponding ratio for income from the self-employed and for returns from capital (dividends and interest) is far lower (Skinner and Slemrod (1985)). Failure to administer tax law effectively or even to administer tax law with equal ineffectiveness, then, has economic consequences as noted above.
Although differences between law and practice exist in industrial countries, the set of tax statutes by and large approximates the actual tax system. For many developing countries, however, the gap between tax law and actual taxation is so wide that one bears virtually no resemblance to the other. A reading of statutes relating to personal and company income tax, capital gains, customs duties, and general sales taxes in a given developing country might lead the observer to believe that the country’s legislative tax system was close to European or North American models. The actual workings of the system, however, are determined by administrators who collect a core group of easy-to-administer taxes. In this way the line of demarcation between “tax policy” and “tax administration” becomes blurred. Before examining actual tax structures and administration, however, it will be useful to consider tax policy and the economic literature to see how economists have treated tax administration.
II. Tax Administration and Economic Analysis
In general, tax administration and tax policy have been treated as separate fields of scholarship and activity. Whereas tax policy uses economic analysis to debate the merits and economic impact of individual taxes or tax systems, tax administration focuses on the assessment, collection, and audit of a set of tax laws. Tax administration in this view “carries out the orders” of tax policy. Such a clear separation of tax administration and tax policy carries over to the literature in the two fields. Although a comprehensive survey of tax policy literature is beyond the scope of this paper, it would be fair to say that exploration of administrative constraints on tax policy, or of interconnections between policy and administration, has been outside the mainstream of the literature.1 As far as administration is concerned, theoretical economists have in general been satisfied with the admonition that taxes should not be too costly to collect. The mainstream of the tax policy literature could be described as a normative approach, in which the ideal objectives of tax policy are equity, efficiency, and administrative feasibility (Goode (1984, p. 76)).
“Administrative feasibility” refers narrowly to the fact that the collection cost of revenue should not be overly high. The requirement that the tax system should not be excessively costly to administer has intellectual origins to Adam Smith. Apart from this dictum, however, theoretical analysis of tax policy has in general not investigated how tax administration might act as a constraint on tax policy. In retrospect, for example, one can see that theoretical objectives of equity and redistribution in the decades following World War II had practical expression in high personal income tax rates, but little attention was given to whether high tax rates might lead to avoidance and evasion, or to how such problems might be dealt with in designing taxes. More recent emphasis on efficiency objectives also appears to ignore administrative concerns. As one writer has noted, optimal tax theory “is totally devoid of administrative and political content. Administrators are expected to possess costless and perfect information...” (Ricketts (1981, p. 42)). He adds that “it might plausibly be argued that all theory must employ simplification and abstraction, and that the omission of administrative considerations can in principle be incorporated at a later stage. This argument would be more persuasive if tax administration did not itself give rise to distributional and ethical issues...” (p. 43).2
Although the normative approach of tax policy analysis has tended to ignore the practicalities of tax administration, economists have recently analyzed several closely related topics. These topics include the causes of tax evasion and a theoretical treatment of tax evasion as an “economic crime” committed under circumstances of risk and uncertainty. Growing interest in the underground economy has led naturally to its connection with tax evasion. In addition, a topical issue that has stimulated theoretical discussion is the supply-side contention that tax evasion and avoidance will decrease if personal income tax rates at the margin are lowered.
The Risk and Uncertainty Approach to Tax Evasion
The theoretical literature on tax evasion treats the tax evader as a rational economic agent contemplating an economic crime and making decisions under uncertainty, given assumed probabilities of detection, conviction, and levels of punishment. The rational economic agent is expected to choose the level of compliance (evasion) that will yield the greatest “expected utility,” with expected utility defined as the utility of the various possible outcomes (for example, detection or nondetection of evasion) weighted by the probability that each possible outcome will occur.3 Although the literature is centered on the U.S. tax system, the methods of analysis could apply to any setting, including developing countries.
A simple example of a probability and risk aversion approach to tax evasion has been stated as follows: A U.S. taxpayer has an income (y) of US$20,000 and is planning to underpay $500 in taxes (see Skinner and Slemrod (1985)). In recent years about 2 percent of tax returns have been audited in the United States. Allowing for the fact that the Internal Revenue Service (IRS) has developed elaborate methods of detecting evaders, one can say that the probability of audit (p) for the intelligent evader does not exceed 5 percent. The maximum penalty assessed for civil fraud and negligence is 50 percent of tax owed,4 so the penalty rate (F) at most equals 1.5. (The probability of criminal procedure, which requires proof of intent, is almost zero and can be eliminated by precautions available to the potential evader.) This situation can be expressed by
EU = (1-p)U(y +x) + pU(y-Fx),
EU = expected utility of tax evasion
U = utility function
p = probability of being audited
y = taxpayer’s legal after-tax income
x = undeclared taxes
F = the penalty rate on undeclared taxes plus 1.
In other words, the potential act of tax evasion is viewed as a gamble with a 95 percent chance of winning $500 (the underpayment of taxes) and a 5 percent chance of losing $750 (that is, getting caught and paying the tax owed plus a penalty). On average, over a period of years the bet will return $437, and it is difficult to imagine a taxpayer who would not take such a gamble.
Although this illustrative example is by no means a complete summary of the contribution of the expected utility approach, it does show its fundamental weaknesses in the assumptions that no allowance is made for institutional mechanisms, such as withholding, that would interfere with the decision of whether to evade or pay tax; and that, given such a virtually free choice, the individual has no moral, ethical, habitual, or peer constraints on cheating. The example also points out that the approach is static. In a dynamic context, the probability of detection may be changing and uncertain; the potential tax evader may then become more cautious. Indeed, the positive contribution of the risk and uncertainty approach is that it leads one to wonder why people pay taxes at all. This bare-bones approach, in which all institutional and social constraints on tax evasion are assumed away, shows that without these constraints tax administrators would face a herculean task.
Theoretical analysis has also treated seemingly obvious propositions about tax evasion, obtaining surprisingly ambiguous results (see Richupan (1987)). For example, the question of whether an increase in the tax rate would increase tax evasion would be answered in the affirmative by tax practitioners for most situations. Yet, if a high penalty rate for evasion is imposed on the evaded tax and the individual is risk averse, then a higher tax rate would imply higher evaded tax and higher possible penalties, leading such an individual to pay tax due at the higher rate. With respect to the opposite proposition—that lower tax rates would encourage compliance—a recent article examines the popular myth that a lowering of the tax rate (in the U.S. context) would encourage compliance, and states that “... lowering tax rates will induce greater compliance is a claim supported neither by the theory of tax compliance nor by the empirical evidence” (Graetz and Wilde (1985, p. 359)). Moreover, “the large share of underreporting attributable to capital gain income [(before 1986] provides a counterexample to the notion that lower rates alone will cure noncompliance” (Graetz and Wilde (1985, p. 360)). Thus, the seemingly obvious idea that higher tax rates stimulate evasion, and vice versa, is difficult to prove on a priori grounds.
Topical Issues of Tax Evasion
In contrast to the purely theoretical risk and uncertainty approach to tax evasion, investigation of the underground economy has led to empirical efforts to measure the effect of the level of taxation on tax evasion. Whereas the U.S. literature on the underground economy has focused on the personal income tax, the European literature has also discussed social security and forms of the value-added tax (VAT). In developing countries, the underground economy surely flourishes and would affect foreign trade taxes as well as those mentioned above. In an empirical approach to this problem, Tanzi (1982, pp. 78-80) notes that one of the factors influencing tax evasion is the benefit of not paying taxes. This benefit can be measured objectively by the level of legal tax liability. Using a regression equation in which the ratio of currency holdings to broad money (M2) is the dependent variable (and a proxy for tax evasion), Tanzi found that variables representing the level of tax rates are highly significant in explaining changes in the ratio of currency to broad money. Increases in several measures of the tax rate are associated with a greater relative use of currency, presumably because of the evasion effect.
As noted above, supply-side economics has also contributed to discussion of tax evasion. A proposition advanced by supply-side economists is that a progressive tax rate schedule stimulates tax evasion and will yield less revenue than a proportional schedule. Using the framework of the rational economic agent (divorced from institutional and social context), this proposition is true provided that the taxpayer is risk neutral.5 If the taxpayer is assumed to have a decreasing absolute risk aversion, then the claim has no theoretical support, since the taxpayer would be less willing to cheat at higher tax levels. One economic insight into the question of tax evasion under a progressive rate schedule is that the substitution effect and the income effect tend to work in opposite directions. As actual income received increases under a system of progressive taxation, the relative benefit of evasion versus tax payment rises, so that the substitution effect leads to an increase in evasion. In contrast, a rise in reported income that represents an increase in actual income means that the individual is richer, and with diminishing marginal utility of income has less reason to evade taxes. Whereas theoretical analysis does not wholly confirm the widespread view that high tax rates or a progressive tax schedule cause evasion, the effect of the penalty rate on tax evasion is much clearer. According to theory, both the probability of detection and the penalty rate are clearly effective deterrents to tax evasion, and the penalty rate is relatively more effective than the probability of detection.6
Critique of the Theoretical Approach to Tax Administration
This brief review of the results of theoretical models of tax evasion shows that such work does not yet capture enough real-world conditions to be of great use to policymakers. A key assumption underlying the analysis is that taxpayers have a free choice to pay or to evade taxes, or at least that all taxpayers are equally constrained in this decision. Different taxpayers actually have different opportunities to evade, and the level of evasion can be much more easily explained by examining what these practical opportunities are. Clearly one important determinant of the level of evasion is whether withholding can effectively be applied in collecting a tax. If the withholding system is virtually foolproof, any analysis of the individual’s preferences becomes academic. Even if there is collusion between wage earner and employer in withholding, some amount of taxes will probably have to be paid. In addition, the model of a rational agent deciding whether or not to pay taxes has implicitly assumed the context of the personal income tax. In developing countries, indirect taxes such as excises, import duties, and general sales taxes form a much greater proportion of tax revenue. Administrative experience has shown that under a sales tax the seller may collect the tax but only turn over a portion to the government by underreporting sales. Formal analysis of evasion under different types of taxes in different countries has not been undertaken, although further work in this direction is certainly possible. Probably the clearest conclusion of the theoretical studies is the obvious point that, given a free choice, the level of evasion would be much higher than it is at present.
The lesson of the theoretical analysis, then, is that tax administrators should remove the element of free choice by such devices as tax with-holding. An effective withholding scheme, however, requires a relatively small number of easily identifiable payers of the income. Withholding may thus be applied to wages, dividends, and interest, but it cannot be applied effectively to rental income, income of professionals, and income from small businesses, of which there are as many payers as receivers. Another conclusion from formal analysis of tax evasion is that evasion can be reduced significantly by increased penalties and a higher probability of audit. This conclusion agrees with practical observation in both developing countries and the United States. For example, the IRS has stated that it can raise $7 in new revenue for every dollar spent on enforcing compliance, and technical assistance missions to developing countries would agree that increasing the likelihood of audit and enforcing penalties more stringently would be cost effective (see Wall Street Journal, May 8, 1986).
Equity and political considerations, however, place limits on how stiff penalties can be. The difficulty of proving the intent to evade makes criminal cases scarce. Equity considerations suggest that when an individual is “caught” by random selection in an economic crime of which many others are guilty, he should not be punished too severely. In addition, the firmly held belief that “the punishment should fit the crime” sets practical limits on the penalties that would truly deter tax evaders. For example, life imprisonment for tax evasion might deter an economically rational individual but would be inconsistent with commonly held ideas of justice. In addition, one feels that the likelihood of enforcement does indeed play a strong part in determining whether penalties work. For example, legislation exists in some countries whereby failure to pay property taxes results in auction of the property. If such a penalty is viewed as draconian and is unlikely to be enforced for political and social reasons, the stiff penalty loses its effect. These considerations all limit penalties to a level below what would be desirable from a tax-maximizing standard. Increasing the probability of audit by appropriating funds to allow tax administrators to audit more returns is also constrained by political considerations. Politicians may not want too efficient a tax administration.
Another way of reducing free choice to evade is through self-enforcing methods that will encourage taxpayers to report incomes and expenditures. Kaldor (1956), in his well-known report on India, was perhaps the first economist to suggest linking taxes to force greater compliance.7 Kaldor suggested that five taxes—the income tax, the capital gains tax, the wealth tax, the personal expenditure tax, and the gift tax—be filed in a single comprehensive return and assessed simultaneously. The taxes are self-checking—that is, concealment or understatement of items to reduce liability for a particular tax would increase liability for other taxes—and information furnished by a taxpayer to prevent over-assessment of his own liabilities automatically reveals the receipts and gains made by other taxpayers. Higgins (1959, pp. 524-44) carried Kaldor’s idea further by introducing a self-enforcing tax system for developing countries. Higgins’ system included a personal income tax (including capital gains), a corporation income tax, a general sales or turnover tax, a wealth tax, a tax on excess inventory, and a personal expenditure tax. Theoretically, the Kaldor-Higgins system is self-checking because personal expenditure is defined as the excess of income over savings, and savings are equal to the increase in net wealth. Thus, taxpayers who underreport their expenditure by overstating their savings increase their wealth tax liability. A seller of a property who understates his capital gains hurts the buyer, because the buyer cannot claim the full amount of the investment, thereby forcing him to declare higher expenditures and increasing his liability under the expenditure tax. The tax on excess inventory is designed to discourage underreporting of sales, thus helping to enforce the sales tax and income tax.
The more grandiose self-enforcing schemes suggested by economists have in general received short shrift from tax administrators. “Most tax administrators,” Goode (1981, p. 266) writes, “regard the idea of a self-enforcing tax system as fantastical.” Despite the justified criticism of elaborate self-enforcing schemes, tax administrators may come to see a grain of truth in their logic, and one suspects these schemes should not be dismissed entirely. In many developing as well as industrial countries, import duties and taxes on domestic transactions are typically administered by separate departments, with little or no contact or exchange of information among them. In some countries sales and income taxes are also administered by separate departments, and outside experts usually recommend the exchange of information between these revenue departments. Such an exchange is highly advisable because gross sales are an element of income tax determination, and the exchange of information forces consistency in tax reporting. Similarly, the idea that information furnished by one taxpayer to prevent overassessment of his or her own liabilities will automatically reveal the receipts of another taxpayer underlies the concept of the VAT. As computer systems allow increasingly great quantities of data to be stored and used, the idea of self-enforcing taxes based on matching information from different sources becomes more possible. Computer information systems may then make more practical this “fantastical” idea of the economists.
As summarized above, economic analysis related to tax administration has centered on such topics as examining tax evasion under conditions of risk and uncertainty, tax evasion and the underground economy, and supply-side attention to tax evasion associated with high marginal tax rates. Surprisingly little attention has been given to a microeconomic approach in which tax administration would be seen as part of a production function in producing revenue. That is, the production of revenue could be seen as a function of tax bases and legal rates and exemptions but also would depend on the input of tax administration. As Shoup (1975, p. 505) has stated, “to maximize tax revenue the administration must so distribute the fixed amount of resources in enforcing the several taxes and, for each tax, must so allocate resources among techniques of administration that the return on the marginal dollar of administrative expense is everywhere the same.”
One difficulty with this approach is how to define maximization of tax revenue. A short-term, cost-benefit approach would lead the tax administrator to concentrate on the largest or richest taxpayers, from whom assessment and audit efforts would yield a high return in the short run. Tax administrators have objected to this approach on several grounds. First, if substantial numbers of humbler or harder-to-catch taxpayers perceive themselves as outside the enforcement net, these taxpayers will eventually begin to evade tax, and voluntary compliance will thereby suffer. Second, if tax administration efforts focus too selectively on certain economic activities, the principle of horizontal equity (that is, equal treatment of taxpayers of equal income) will be violated, and taxpayers may begin to perceive the entire system as unfair. Again, this perception will undermine voluntary compliance. A longer-term approach to revenue maximization would recognize these externalities. Such a long-term approach would involve audit and enforcement efforts directed toward a broad range of the tax-paying public, with due regard paid to long-term effects on voluntary compliance as well as to short-term goals of revenue maximization.
III. Tax Handles, Tax Administration, and Tax Structure
In contrast to the normative bent of the literature on tax policy and the game-theoretic analysis of tax evasion stands a body of tax literature that is based on empirical and historical thinking. This literature deals with the questions of why a country develops a particular tax structure (a set of taxes responsible for total tax revenue) and why this tax structure differs among countries and changes during the process of economic growth.8 (Note that “tax structure” refers here to the revenue importance of different taxes, rather than to the legislative content of tax laws.) This strand of tax literature not only recognizes the importance of administrative constraints on tax policy, but in contrast to the normative literature places administrative factors at the forefront.9 The “tax handle” theory offers a sweeping historical explanation of tax structure change. It argues that low-income economies are forced to collect revenue from easy-to-administer taxes (or tax handles), but that this administrative constraint lessens as countries develop and become able to choose “better” taxes as defined by the normative objectives discussed above.10 Although economists differ on the recipe for a “better” tax structure, there would be general agreement that broadly based income or consumption taxes are preferable to a reliance on foreign trade taxes, and historical evidence suggests such a shift. In any case, high-income economies have a certain freedom to maneuver in choosing tax systems, whereas low-income economies are in large part constrained by administrative considerations.
The insight that administrative constraints in part determine the tax structure of developing countries appears accurate if one examines the actual tax structure of developing countries among themselves and in contrast to industrial countries. For developing countries, a detailed examination of tax structure has been undertaken by Tanzi (1987a, 1987b), who used a pool of 82 countries divided by strata of per capita income. The group of countries with the lowest per capita income represents countries in which the tax structure is most determined by administrative considerations—that is, the availability of accessible tax handles. For these countries, import duties—based on a very convenient tax handle—account for 32 percent of total tax revenue. The personal income tax—a much more difficult tax to collect—accounts for only 9 percent of tax revenue. In contrast, for the most wealthy developing countries (those with per capita income above US$1,550) the share of import duties drops to only 18 percent of tax revenue, even though the share of imports in gross domestic product (GDP) has not changed. For the same group of higher-income countries the share of the personal income tax rises to 13 percent, indicating a greater use of this difficult-to-collect tax.
When Tanzi compared developing countries as a whole with selected industrial countries, the importance of administrative constraints in determining the tax structure was again demonstrated. Foreign trade taxes are the most important source of revenue in low-income developing countries and remain important for middle- and upper-income developing countries. In contrast, such taxes are scarcely used for revenue purposes in the major industrial countries. Another important difference in tax structure between developing and industrial countries is that the latter rely to a much greater extent on a single, broadly based income or consumption tax. Revenue from taxes on general consumption, such as the VAT, amounted in 1984 to 9 percent of GDP in France. 5.6 percent in the United Kingdom, and 6.3 percent in the Federal Republic of Germany, compared with an average of 1.6 percent in developing countries. For the same year, personal income tax amounted to over 10 percent of GDP in the United States, the United Kingdom, and Germany—compared with 1.9 percent of GDP in the average developing country.
In accordance with the tax handle theory, then, the effective tax structure of developing countries (as opposed to the legislative tax system) is characterized by reliance on a half dozen narrow tax bases, reflecting administrative convenience. “Administrative convenience” takes on a number of meanings in this context. For import duties, the centralization of taxable goods in a port leads to ease of administration. Export duties also apply to goods concentrated in a port and may be applied to a central marketing board or to a few large exporters in lieu of collecting personal income tax from a multitude of small farmers. For excises, production of goods is concentrated in a few factories. The problem of valuation is simplified by this concentration or can be circumvented entirely by using specific duties or administered reference prices. For the personal income tax, withholding of taxes on wages paid by large enterprises and government is the meaning of administrative convenience. Other taxes, such as the corporate income tax, may be inherently more difficult to administer because the base of net profits requires more sophisticated accounting measures such as depreciation. In these cases administrative convenience may take the form of simply accepting, with only perfunctory audit that presents no serious challenge, a “reasonable” amount of taxation as defined by the firm. If firms are unwilling to contribute a reasonable sum, governments may then adopt simple rules of thumb, such as using a percentage of gross sales to replace the concept of net profit.
IV. A Critical View of Tax Structure in Developing Countries
Although the tax statutes in developing countries resemble those of industrial countries, a handful of easy-to-administer taxes account for virtually all revenue. If one compares the actual tax structure of developing countries with ideal norms of a desirable tax structure, it would be difficult to find greater contrast. The prototypical tax structure of developing countries can be criticized on stabilization, efficiency, and equity grounds.
For stabilization, a tax system should comprise one or at most several predominant taxes with a rate schedule that can be adjusted quickly and with a high degree of certainty to alter the purchasing power available to the private sector. These predominant taxes can then be used to increase or cut back private spending to achieve stabilization goals related to growth, prices, or the balance of payments. Because the tax systems of developing countries are cluttered and tax bases are narrow, adjustment of revenue for stabilization purposes must come about by piecemeal measures—in general the raising of rates on indirect taxes such as import surcharges, excises, or sales tax because these taxes are considered to increase revenue with greater certainty and speed. From a dynamic point of view, the continued reliance on these tax bases for revenue needs tends to be self-defeating: higher rates on the narrow bases further distort the allocation of resources and lead to evasion or to consumer resistance. In sum, the lack of a predominant, broadly based tax and the clutter of rates and exemptions on existing taxes make it difficult to use the tax system for stabilization purposes.
For efficiency, a good tax system is considered to be one that leads to the least amount of distortion of relative prices, both in the prices facing the consumer and in those facing the producer. Although only a lump-sum poll tax would satisfy the criterion of noninterference in all relative prices, broadly based income or sales taxes with one or a few rates are considered desirable in that they lead to less distortion in consumer and producer prices. Against this view some theorists would argue that tax-ation of products with low elasticity of demand would bring about less interference with consumer choices. In any case, in developing countries many different import and excise tax rates on narrow bases are combined with a variety of exemptions to produce almost random effects on consumer choice and producer incentives. Efficiency goals are also compromised by selective administration of the personal and corporate income taxes. Because the personal income tax is in practice mainly a tax on wages, companies using more labor-intensive productive methods are at a disadvantage. Large companies are forced to pay tax, whereas small companies and retailers can avoid taxes.
The heavy reliance on foreign trade taxes can be singled out as the most undesirable aspect of tax systems in developing countries from the point of view of both stabilization and resource allocation (Green a way (1981)). From the standpoint of stabilization, foreign trade taxes tend to tie government revenue to unpredictable fluctuations of export commodity prices, and so to aggravate fiscal stabilization problems. A vicious circle can also begin if a reduction in imports imposed for demand management purposes leads to a fall in import duties, thereby enlarging the fiscal deficit. From the standpoint of resource allocation (efficiency), trade taxes have no place in a “first-best” tax structure. The discriminatory nature of trade taxes ensures that their use imposes both a production distortion cost and a consumption distortion cost. Import duties, often relied upon for revenue, may lead to excessive effective protection and may encourage inefficient domestic industry.
Equity goals are also heavily compromised by the tax structure of developing countries. To an outsider this tax structure may appear to be highly progressive because the rate structure of the personal income tax is often highly progressive. On closer examination, however, the vertical equity of the system is compromised by the fact that the personal income tax collects a relatively small share of total revenue and applies mainly to wage earners, whose incomes may be lower than those of the self-employed. High nominal rates on luxury consumer imports such as motor vehicles may equally be offset by exemptions and evasion. Excises on such staples as cigarettes and beer are clearly regressive when taken in the context of the monetized sector. Thus an apparent vertical equity in rate structure of personal income tax and import duties is negated by a combination of selective administration and legal exemptions. With regard to horizontal equity—the principle that those with equal incomes pay equal taxes—the tax structure of the typical developing country is perhaps more clearly inequitable. For the income tax, selective administration on wages favors the self-employed, partnerships, and income from capital. Taxes on consumption also violate horizontal equity because of their uneven and almost random application.
On a broader basis, one can say that selective administration of the statutory tax system in developing countries systematically discriminates against the modern sector of the economy. The modern sector tends to fall into the income tax net because it keeps better accounts, is more centralized, and thus is more revenue-productive in the eyes of the tax collector. Although a heavier burden of taxation on the modern sector may be appealing on equity grounds, one should bear in mind that the present tax system tends to impede the growth of the dynamic sector that may be the key to more rapid long-term growth in developing economies.
In view of the above criticisms, the tax administrator is left with a dilemma. Strict adherence to a cost-benefit, revenue-maximizing strategy would worsen efficiency distortions in the present tax structure and would eventually undermine voluntary compliance. But political pressure for immediate revenue to reduce large fiscal deficits may be strong. In such circumstances, the tax administrator should strive to balance immediate revenue objectives with the need to support changes designed to produce a “better” tax structure in terms of the efficiency, equity, and stabilization goals mentioned above. These latter efforts would seek to reduce dependence on convenient tax handles and to tackle the more difficult problem of implementing more broadly based income and consumption taxes.
AtkinsonA.B. and JosephE. StiglitzLectures on Public Economics (New York: McGraw-Hill1980) Lectures 12 and 14.
BahlRoy W.“A Regression Approach to Tax Effort and Tax Ratio Analysis,”Staff PapersInternational Monetary Fund (Washington) Vol. 18 (November1971) pp. 570–608.
BirdRichard M.“Income Tax Reform in Developing Countries: The Administrative Dimension,”Bulletin for International Fiscal Documentation (Amsterdam) Vol. 37 (January1983) pp. 3–14.
ChelliahRaja J.“Trends in Taxation in Developing Countries,”Staff PapersInternational Monetary Fund (Washington) Vol. 18 (July1971) pp. 254–327.
ChelliahRaja J.Hessel J.Baas and Margaret R.Kelly“Tax Ratios and Tax Effort in Developing Countries, 1969-71,”Staff PapersInternational Monetary Fund (Washington) Vol. 22 (March1975) pp. 187–205.
GhandiVed P.“Tax Structure for Efficiency and Supply-Side Economics in Developing Countries,”in Supply-Side Tax Policy: Its Relevance to DevelopingCountries (Washington: International Monetary Fund1987) pp. 225–49.
GoodeRichard“Some Economic Aspects of Tax Administration,”Staff PapersInternational Monetary Fund (Washington) Vol. 28 (June1981) pp. 249–74.
GoodeRichardGovernment Finance in Developing Countries (Washington: The Brookings Institution1984).
GraetzMichael J. and Louis L.Wilde“The Economics of Tax Compliance: Fact and Fantasy,”National Tax Journal (Columbus, Ohio) Vol. 38 (September1985) pp. 355–63.
GreenawayDavid“Taxes on International Transactions and Economic Development” in The Political Economy of Taxationed. byAlan T.Peacock and FrancescoForte (Oxford, England: Blackwell1981).
HartAlbert G.“An Integrated System of Tax Information: A Model and a Sketch of Possibilities of Practical Application Under Latin American Conditions” Occasional Paper (New York: School of International Affairs, Columbia University1967).
HigginsBenjamin H.Economic Development: Principles Problems and Policies (New York:Norton1959).
HinrichsHarley H.A General Theory of Tax Structure Change During EconomicDevelopment (Cambridge, Massachusetts: Law School of Harvard University1966).
KaldorNicholasIndian Tax Reform: Report of a Survey (New Delhi: Government of India, Ministry of Finance, Department of Economic Affairs1956).
LotzJørgen R. and Elliott R.Morss“Measuring Tax Effort’ in Developing Countries,”Staff PapersInternational Monetary Fund (Washington) Vol. 14 (November1967) pp. 478–97.
MusgraveR.A. and M.GillisFiscal Reform for Colombia (Cambridge, Massachusetts: Law School of Harvard University1971).
RichupanSomchai“Income Tax Evasion: A Review of the Measurement Techniques and Some Estimates for the Developing Countries” (unpublished; Washington: International Monetary Fund1984).
RichupanSomchai“Determinants of Income Tax Evasion: Role of Tax Rates Shape of Tax Schedules and Other Factors” in Supply-Side Tax Policy: Its Relevance toDeveloping Countries (Washington: International Monetary Fund1987) pp. 140–74.
RickettsMartin“Tax Theory and Tax Policy” in The Political Economy ofTaxationed. byAlan T.Peacock and FrancescoForte (Oxford, England: Blackwell1981).
ShoupCarl S.“Economic Aspects of Tax Administration” in Readings onTaxation in Developing Countriesed. byRichard M.Bird and Oliver S.Oldman (Baltimore, Maryland: Johns Hopkins University Press1975).
SkinnerJonathan and JoelSlemrod“An Economic Perspective on Tax Evasion,”National Tax Journal (Washington) Vol. 38 (September1985) pp. 345–53.
TaitAlan A.Wilfred L.M.Gratz and Barry J.Eichengreen“International Comparisons of Taxation for Selected Developing Countries” Staff PapersInternational Monetary Fund (Washington) Vol. 26 (March1979) pp. 123–56.
TanziVito“Tax Policy in Middle-Income Countries: Some Lessons of Experience” (unpublished; Washington: International Monetary Fund1981).
TanziVitoed.The Underground Economy in the United States and Abroad (Lexington, Massachusetts: Lexington Books1982).
TanziVito (1987a) “Tax Systems and Policy Objectives in Developing Countries: General Principles and Diagnostic Tests” Tax Administration Review (Panama) No. 3 (January3) pp. 23–34.
TanziVito (1987b) “Quantitative Characteristics of the Tax Systems of Developing Countries” in The Theory of Taxation for Developing Countriesed. byDavid M.G.Newbery and Nicholas H.Stern (New York: Oxford University Press for the World Bank1987) pp. 205–41.
* Mr. Mansfield, Senior Economist in the Fiscal Affairs Department, holds degrees from Oberlin College and Princeton University.
Economists have, however, incorporated tax-administrative constraints in the context of advice on practical situations; see, for example, Musgrave and Gillis (1971). A recent treatment of administrative problems is contained in Bird (1983).
For a statement of optimal tax theory, see Atkinson and Stiglitz (1980).
For a recent critical summary of this literature, see United States (1985).
Note, in what follows, that after 1986 the civil fraud penalty was raised from 50 percent to 75 percent of taxes owed and modified. The change does not affect the substance of the argument.
An additional assumption is that the elasticities of the supply of labor are such that the actions of higher-income taxpayers who will gain from the change more than offset those of lower-income taxpayers who will lose from the change
See Richupan (1987). For a full exposition of the application of supply-side taxation ideas to developing countries, see Gandhi (1987).
See also Hart’s (1967) analysis of the Latin American context.
A complete explanation of differences in effective tax structures would certainly acknowledge that differences in the structure of production and income distribution play a role in determining tax structure. For example, that large numbers of the population in many developing countries live in poverty explains why a mass income tax would not be feasible.
The tax handle theory has also been used to explain different tax levels as well as tax structures among different countries (see the references cited in footnote 8).