1 Relevance of Supply-Side Tax Policy to Developing Countries A Summary
- Ved Gandhi, Liam Ebrill, Parthasarathi Shome, Luis Manas Anton, Jitendra Modi, Fernando Sanchez-Ugarte, and George Mackenzie
- Published Date:
- June 1987
Within the short span of a few years, “supply-side economics” has come to be considered in some quarters to be the “new” economics that is most relevant to policymaking for solving the economic problems of the 1980s. However, the basic propositions of supply-side economics, including the belief that taxes affect economic behavior and the substitution effects of taxes are important for the efficient allocation of resources, are as old as neoclassical economics itself. What is new is the conviction of some supply-side economists that a substantial reduction of tax burdens, in general, and the rates of income tax, in particular, will have significant effects on the level of output and growth rates. In 1984, the Fiscal Affairs Department of the International Monetary Fund undertook a research project to analyze the relevance to developing countries of the tax policy recommendations of supply-side economics made in the context of developed countries. This volume contains the studies that were prepared as part of this research project.
As explained in greater detail in Section I of this chapter, there are at least two interpretations of supply-side economics, and, consequently, of supply-side tax policy—the traditional or the “basic” view and the new or the “popular” view. Most of the studies included in this book assess the validity of the arguments of popular supply-side economics, while others deal with the validity of selected propositions of basic supply-side economics.
The volume is in three parts. Part I provides an overview and summary of findings and conclusions. Part II presents seven papers reviewing the evidence on the validity of popular supply-side tax policy. Part III contains four papers dealing with selected aspects of basic supply-side tax policy or tax policy for efficiency and growth. The book also has two appendices. Appendix I contains statistical information that is readily available on the revenue structures of developing and developed countries relevant to the various studies. Appendix II presents a selected bibliography of publications on popular supply-side economics of interest to the general reader.
The term supply-side economics originated in the United States in the mid-1970s primarily as a reaction to government economic policies based on Keynesian macroeconomic theory and represents a new way of looking at government economic policies.1 The term, however, has evolved over time and has come to mean different things to different people. It is, therefore, important at the outset to clarify in broad terms what supply-side economics stands for and then to define with greater precision those aspects of supply-side tax policy that have received the most attention in the United States and whose relevance is analyzed in the context of developing countries in the papers included in this volume.
These concepts are explained in Section I of this chapter. Section II describes the scope of the project and the broad conclusions reached under it. Sections III and IV contain the main findings and conclusions of individual papers on the validity and relevance of popular supply-side tax policy and tax policy for efficiency and growth. Finally, Section V summarizes several supply-side-oriented proposals for tax reform that have emerged from the various studies.
I. Scope of Supply-Side Economics
Supply-side writers have founded their work on the strong conviction that free markets, with few exceptions, allocate resources most efficiently.2 This belief drives both their economic tenets and the way they view politics and the social order.
On the political side, supply-side economists see governments, which are usually monopolists and not subject to the requirement of profit maximization, as inherently inefficient because of their lack of market discipline and as subject to a tendency to grow without bound. Because the agents of government have personal objectives which, by definition, differ from the goals of the society at large, neither politicians nor bureaucrats in policymaking positions can be trusted to act effectively in the social interest.3
On the economic side, the belief that any policy that distorts free-market-determined relative prices distorts resource allocation has led supply-siders to espouse at least three important propositions that have major consequences for government policy. (1) Most government regulations aimed at protecting consumers and workers are generally costly and indefensible in terms of their cost-benefit ratios; eliminating them would, therefore, improve resource allocation in the economy; (2) most welfare and entitlement programs discourage work effort (including retraining); limiting access to such programs to the really needy would, therefore, restore work incentives; and (3) personal income tax is inherently biased against work effort (on the ground that work is taxed but leisure is not), as well as against savings (since income saved is taxed twice, while income consumed is taxed only once) and investment (since productive investment is taxed but unproductive investment is not) and that high marginal income tax rates exacerbate these biases significantly; reducing marginal income tax rates would, therefore, increase labor supply, savings, and investment. As will be shown below, many of the propositions of supply-side economists are implicit in the behavioral and market structure assumptions made by most neoclassical economists.
In general, thus, supply-side economists emphasize minimizing the distortions in market-determined relative prices that result from regulations, subsidies, and high income taxes and believe that the reduction of such distortions would encourage savings and production by allowing the economic incentives of a free market to work. They also believe that the private sector is generally capable of bringing about sustained economic growth, so that there is no need to tolerate the inefficiencies of large government in the economy. At least two interpretations of supply-side economics, and, consequently, of supply-side tax policy have evolved within this general framework over time. These interpretations have been referred to in this volume as basic supply-side economics and popular supply-side economics.
Basic Supply-Side Economics: Return to Classical and Neoclassical Economics
The first interpretation, basic supply-side economics, is simply an application of classical and neoclassical economic theory to government policy-making. According to this view of supply-side economics, government economic policies should focus on aggregate supply rather than on aggregate demand. As aggregate supply is the result of the economic behavior of producers, they, rather than consumers, should be considered the driving force in the economy and their economic behavior should be considered the most important determinant of real and nominal economic activity. As government economic policies can, and frequently do, have significant negative substitution effects (drive economic agents away from rational—welfare maximizing—economic decisions), they should be structured in such a way so as to minimize the substitution effect.
If one follows this interpretation, supply-side economics is essentially no different from mainstream classical and neoclassical economics. It emphasizes the objective of efficient allocation of resources more than any other objective of economic policy and recognizes the importance of negative substitution effects of government economic policies and, particularly, of tax policies. These beliefs were also held by Smith, Say, Mill, Marshall, Pigou, and Ramsey and others who obviously were supply-siders long before the term was coined.
A basic supply-side economist believes that government tax policy can, and does, create a “wedge” between pretax and posttax producer prices as well as rates of return to factors of production and, given the negative substitution effect, is likely to distort the economic behavior of producers as well as the suppliers of factor inputs. Given the importance of efficient resource allocation to aggregate output, a basic supply-side economist seeks to reduce distortions in resource allocation that individual taxes and tax structures can cause. Distortions can arise because of a number of factors such as (1) the economic aggregate or the base on which taxes are levied; (2) tax rules and provisions that affect the taxable base for individual producers and factor suppliers; (3) the height of nominal tax rates and the degree of progression in the tax rate schedule; and (4) the interaction between inflation, the taxable base, and tax liabilities. A basic supply-side economist is one who seeks to reform all of these aspects of a tax structure.
The recommendation that tax policy be reformed along these lines is also not new; it is well known in public finance literature. Most books on traditional public finance, for example, contain detailed analyses of the effects of various forms of taxation on the efficiency of resource allocation.4 The relative merits of income and consumption as alternative tax bases and their possible effects on savings are frequently discussed at length. Similarly, the effects of alternative tax rules and provisions—relating to depreciation allowances and inventory valuation, loss-offset and carryforward privileges, debt versus equity, etc.—on capital formation, risk-taking, and financial policies are discussed in considerable detail in the literature. The argument that the “excess burden” of a tax depends on the nominal rate of the tax is also well known to students of public finance.5 The resource allocation costs of the lack of inflation-adjustment of the income tax system, which have been dealt with extensively as the rates of inflation have accelerated in the 1970s, are also well known.
Thus, basic supply-side tax policy would seem to be no different from the views of fiscal economists who, on efficiency grounds, recommend the reform of (1) the economic base on which taxes are levied; (2) various tax breaks and loopholes that signify distortionary economic signals; (3) the levels and progressivity of nominal tax rates; and (4) tax rules and provisions that raise the effective tax rates in inflationary times. If these are the aims of supply-side tax policy, then fiscal economists such as Pigou, Simon, Haig, Kaldor, Harberger, Feldstein, Boskin. and McLure obviously were supply-siders long before the term “supply-side tax policy” was conceived.6
In a sense, supply-side economics is as old as economics itself, if all that it stands for is that efficiency of resource allocation is an important objective of economic policy and that market-determined resource allocation is basically optimal. Most economists would find it hard to disagree with its contents in theory and under normal circumstances. As a clone of classical and neoclassical economics, basic supply-side economics contains policy prescriptions based on the latter’s specific assumptions relating to, first, what the proper role of the government should be and, second, how developed the commodity and factor markets are or how well they function. But one can still question whether both of these assumptions are strictly valid in the special circumstances of developing countries. To what extent, for example, should one whole-heartedly accept the “appropriate” role of the government implicit in supply-side economics (as well as in classical and neoclassical economics) which states that the main aim of the government should be ensure an efficient allocation of the economy’s resources through private initiative and enterprise and that all other roles of state, such as its role as an active agent of income redistribution or of economic stabilization or of the growth of the economy, whenever in conflict with the former, should receive lesser priority? Similarly, to what extent should one accept the fundamental faith of supply-side economists (as well as of classical and neoclassical economists) that private markets are capable of delivering “appropriate” levels of goods and services and that, in the interest of achieving maximum welfare of the society, governments should ensure a smooth working of free markets and provide few goods and services other than essential public goods, such as defense and internal security?
Popular Supply-Side Economics: Elasticity Optimism
It is not the views of the basic supply-siders. however, that have caught the public attention since the mid-1970s. Rather, it is the views of what can be called popular supply-side economics and the extravagant claims made by its proponents for efficiency-enhancing government economic policies, in general, and income tax policies, in particular, that have become the subject of major debate in the United States and other developed countries.7 The major proponents of popular supply-side economics have written a number of articles and books during the last few years.8
Of the many policy recommendations of popular supply-side economics, the lowering of marginal income tax rates is the most important and also the best known. As one leading popular supply-side economist has stated, “The term supply-side economics has in recent years become closely associated with … a set of policy prescriptions, the most prominent of which has been a recommendation that tax rates be lowered both in the United States and in many other countries.”9
Never before have economists given so much importance to the marginal rates of income taxation, and particularly to the top marginal income tax rates, and made reduction of the progressivity of income taxation the centerpiece of reform of government economic policies. This elevation by popular supply-siders of nominal marginal income tax rates to such a height is a reaction to two major trends of recent years.
First, it is a reaction to the perceived overwhelming equity bias of traditional literature on taxation. With its preoccupation with the ability-to-pay basis of taxation and the principles of sacrifice, traditional literature generally justifies the progressivity of nominal rates of income taxation.
Second, it is a reaction to the progressive income tax systems found in all countries. The progressivity has been accentuated in recent years because of the interaction between rates of inflation and tax brackets based on nominal incomes, as a result of which taxpayers have been constantly pushed into higher income brackets during inflationary times and have been subjected to even higher tax rates under unindexed income tax systems.10 Such steep progressivity, in the opinion of popular supply-siders, intensifies the relative price effects and biases of taxation and creates “crushing” effects on all incentives to produce.11
Therefore, the first characteristic of popular supply-siders that sets them apart from basic supply-side economists is their preoccupation with tax policy and, within tax policy, a focus on the nominal progressivity of income taxation and the top marginal income tax rates rather than on the reform of the tax system in all its aspects.
Another characteristic that distinguishes the popular supply-siders from the basic supply-siders is the extravagance of their claims with regard to the effects of a reduction of marginal income tax rates on the economy. It is their conviction that because the negative substitution effects of income taxes are extremely high, reductions in marginal income tax rates will result in “rapid growth, dramatic increases in tax revenue, a sharp rise in saving, and a relatively painless reduction in inflation.”12 The popular supply-siders believe that a reduction in marginal income tax rates, especially the top rates, would increase the supply of labor significantly by inducing marked shifts from leisure to work and from nonmarket to market activity as after-tax wages increase, thereby raising marketed output and slowing down the rate of inflation. It would also increase the supply of savings and capital significantly by encouraging large shifts from consumption to savings, thereby lowering interest rates. Finally, it would redirect resources from unproductive investment and nonmarket activity to more productive uses of capital and market activity, thereby lowering unit costs, raising productivity, and removing supply bottlenecks. In short, a reduction of marginal rates of income taxes will significantly change the economic behavior of households and businesses in favor of work, savings, and productive investments and against leisure, consumption, and unproductive investments. Lower top marginal income tax rates and less progressive income taxation would also greatly discourage tax avoidance and reduce tax evasion. In a word, the popular supply-siders believe that the short-run price elasticity in the behavior of various economic agents is extremely large. Feldstein, therefore, rightly points out, “what distinguished the new [popular] supply siders from the traditional [basic] supply sider … was not the policies they advocated, but the claims that they made for those policies.”13
It is this elasticity optimism that also underlies the “Laffer curve,” supported by all popular supply-siders. According to its author, Arthur Laffer, government revenues first rise with tax rates (as long as tax rates are in the “normal range”), reaching a peak (the “Laffer hill”), and then falling (as tax rates rise to a “prohibitive range”).14 A reduction of income tax rates from the prohibitive range is believed by Laffer and all leading popular supply-siders to result in a very large expansion of economic activity and tax compliance, and hence income tax revenues.15
Thus, the popular supply-side economist aims to reduce the “exciseness” (relative price effects) of income tax rates.16 As high marginal income tax rates have large negative substitution effects, the popular supply-siders would like particularly to see the marginal rates of personal income tax reduced and expect significant increases in output and real incomes even in the short run.17 They believe that an income tax cut would actually increase tax revenue (by moving the economy back from the “prohibitive range” of the Laffer curve) rather than raise the budget deficit, because it would unleash an enormously depressed supply of labor and work effort and reduce tax evasion. And even if a tax cut did lead to an increased budget deficit, that would not “crowd out” resources available for private investment and capital formation, because a tax cut would significantly raise the private savings rate by increasing the after-tax rewards to savers. Nor would the increased budget deficit result in inflation, because increased nominal demand resulting from a budget deficit would be matched by an increased supply of goods and services, resulting from increased incentive to work and save, due to the tax cut.18
To conclude Section I, the tax systems as well as economic and other conditions of developing countries are quite different from those of developed countries. Therefore, the views of popular supply-side economists on tax policy, espoused primarily in the context of developed countries, as well as the validity of market and other assumptions made by basic supply-side economists, need to be scrutinized closely before appropriate conclusions can be drawn regarding the nature of tax reforms that would be of relevance to developing countries.
II. The Scope of the Studies and Overall Conclusions
Sections II and III highlight the findings and conclusions of individual studies included in this book. However, it is important to define the scope of the studies as well as clarify what the studies do and do not cover. Most developing countries depend on import duties and domestic commodity taxes to a significant extent (see Tables A2 and A3 in the Statistical Appendix) and some countries depend heavily on mineral taxation. These taxes have not been analyzed from a supply-side perspective in this book in view of existing research on the subject.19 The supply-side effects of excessive effective protection, implicit in the high and complicated structures of import duties prevalent in most developing countries, are well known in the literature on international trade and development economics. Also well known are their negative effects on the efficiency of resource allocation, export prospects, and growth rates, especially when they are combined with quotas and other trade restrictions, as is also usually the case in developing countries.20 Various studies carried out by the World Bank and the Fund have also convincingly alluded to the distortionary effects and anti-export biases of high import duties. Papers produced in the Fund’s Fiscal Affairs Department have reviewed natural resource taxation and excise taxation in developing countries, respectively, from the viewpoint of efficiency.21 The studies prepared under this research project, therefore, concentrated primarily on the economic effects of direct taxes, viz., income tax, corporation tax, and export duties, and attempted to review their optimality in the real (second-best) world prevalent in developing countries.22
Although the research project focused primarily on the tax policy recommendations of the popular supply-side economists and their relevance to developing countries, some comments on the objective of efficient resource allocation emphasized by all supply-side economists seem necessary. Developing countries have some very special circumstances which make the neoclassical model (achievement of efficient allocation of resources through primary reliance on private initiative and enterprise) underlying supply-side economics less than fully valid. Many of these countries, especially the low-income ones, suffer from a number of disadvantages, such as (1) highly skewed income distribution; (2) “population trap,” that is, large and rapidly growing population with high levels of absolute poverty; (3) large structural unemployment, both rural and urban, with little hope of a solution for want of appropriate labor-intensive technology; (4) dominance of agriculture, particularly less-productive peasant agriculture, sometimes resulting from existing land tenure systems; (5) unstable prices of export commodities; and (6) lack of adequate economic infrastructure, education, and human resources.23 Thus, to the extent that the governments of such countries have to concern themselves with objectives other than the efficient allocation of given resources, for example, income redistribution,24’’ economic stabilization,25 or the creation of social and economic infrastructure for economic growth,26 the supply-side approach generally has tended to be seen as being of limited relevance to these countries. Similarly, to the extent that most factor, product, and financial markets are inadequately developed in these countries, their development by the government has been considered an important objective in itself. As a result, the role of the state has been seen as far larger than that “implicit” in the supply-side approach.27 Finally, as Shome (Chapter 12) stresses, savings alone are not enough for growth, they require “complementary factors” if they are to become investment in reality, especially the removal of external constraints (such as foreign exchange availability) and domestic constraints (such as expanding the size of the market, facilitating the transfer of technology, and establishing adequate financial intermediary institutions).28 Also, growth by itself would not mean development unless it is accompanied by certain institutional reforms involving human capital formation and the creation of essential social and economic structure, agricultural reforms, population control, etc. Growth and development of developing countries are, thus, objectives that are much more complex than ensuring the efficient allocation of given resources only, and they call for a much bigger role of the state than supply-side economists are perhaps willing to concede.
The broad conclusion of the research project is that the supply-side tax policy which focuses on marginal income tax rates alone (the popular version) is too narrow and is of limited relevance to many developing countries, especially the low-income countries. The view of supply-side tax policy which stresses broadening the tax base and rationalizing the rates of not only income tax but also of other taxes so as to remove all tax-related distortions (the basic version) is of greater relevance to such countries.29 In addition, the research project has established that the impact of the tax system of a developing country on the potential for its development depends on a variety of factors such as (1) the reliance of the tax system on income-related taxes; (2) the interaction between tax rates, the tax base, specific tax incentives for savings and capital formation, and the tax administrative capacity, as they each affect savers and income earners; (3) the rate of inflation and the degree of inflation-indexation of depreciation and other provisions of the tax system, which determine the effective tax burdens of producers and income earners and their after-tax rewards; (4) the interaction between tax policy and other macroeconomic policies of the government, which affects the prices of foreign exchange, capital, and labor; and (5) the degree of imperfection in or the level of development of the labor market, the capital market, the foreign exchange market, financial institutions, credit markets, etc. As is shown by the papers that follow, these factors are of fundamental importance and developing countries have some very special circumstances with respect to all of these, so that the advice of lowering the marginal income tax rates must be examined in this wider context. Once this approach is taken, the high degree of elasticity and growth optimism, which the popular supply-siders frequently take for granted subsequent to a reduction of high marginal income tax rates, must be moderated in the special circumstances of the developing countries.
More specifically, the research project has established that while the popular view of supply-side tax policy (that the height of nominal tax rates matters for incentives) has to be valid for developing countries, other tax and nontax factors are equally important, if not more important for growth and development. While tax policy undeniably affects the behavior of taxpayers, factors such as inflation and rigid nontax policies of developing countries are frequently more severe disincentives to economic agents. Similarly, though labor supply, financial savings, and investment in developing countries do respond to economic incentives and tax policy, they are frequently affected by market imperfections and institutional factors as well and their price elasticities tend to be low in the short run. In relation to income taxation in particular, the finding is that the overall reliance of developing countries, particularly the low-income ones, on this tax is extremely low. Hence, any policy reform in the area of income taxation can, at best, be expected to have a limited impact on the growth of the economy. Furthermore, while the present nominal levels of personal income taxation are high in many developing countries, their negative economic effects on capital incomes are frequently neutralized, partially if not fully, by the very generous tax incentives granted to savers and investors. Indeed, lowering marginal personal income tax rates, while at the same time broadening the tax base and removing the liberal tax incentives in order to contain the short-run revenue loss, in the context of many developing countries could well lead to an increase in the tax burden on savings and investments. There is also some evidence that in developing countries, given their inflationary situations, the disincentive effects of high rates of taxes other than individual income tax, such as of export duties, and certain provisions of corporation tax, such as historic cost depreciation, first-in-first-out basis of inventory valuation, and other provisions, are far greater than those of high marginal income tax rates on individuals. In light of all this, several efficiency and growth-oriented tax reform ideas have emerged from the research project, which are consistent with the views of basic supply-side tax policy. These are highlighted in Section V, below.
III. Validity and Relevance of Popular Supply-Side Tax Policy
This section summarizes the findings and conclusions of the papers contained in Part II of the book which assess the validity and relevance of the policy prescriptions of popular supply-side economics in the context of the special circumstances of developing countries.
Validity of Popular Supply-Side Tax Policy
The validity of the popular supply-side tax policy prescription for developing countries requires positive answers to the following five questions.
Are labor supply, savings, and investment highly price-sensitive?
Do income tax policies (tax rates combined with liberal tax incentives for savings) significantly reduce savings, especially the availability of financial savings?
Do income tax policies (tax rates combined with generous tax incentives and other tax provisions affecting investors) significantly reduce investment?
Do high and progressive income tax rates significantly increase income tax evasion?
Have government revenues increased significantly in the short run, in line with the Laffer curve, when top marginal income tax rates have been reduced?
A positive answer to all these questions in the institutional and economic circumstances of the developing world would imply that the tax policy prescriptions of the popular supply-side school are valid and require careful consideration by the policymakers of developing countries. Six papers included in Part II of this book attempt to answer the above-mentioned five questions, while the seventh paper reviews some econometric evidence on the interrelationship between reliance of developing countries on income taxes and their growth rates.
Price Responsiveness of Labor Supply, Savings, and Investment
Using some simple macroeconomic models, Mackenzie (Chapter 2) establishes that, theoretically, a reduction of income tax rates can have aggregate supply effects as well as effects on aggregate demand and liquidity. However, he also shows that the supply effects are far less significant than the demand and liquidity effects unless the income tax reductions are drastic and the price elasticities of labor supply and savings are very high. To illustrate his point, he takes the readily available empirical estimates of elasticities for a well-integrated and well-functioning competitive market economy as that of the United States. (Economies of some middle-income developing countries may well have similar features.) Even for such an economy, he establishes that for the income tax cut to be self-financing, labor supply elasticity will have to be 15, when savings elasticity is assumed to be within the limits of reported empirical research. He shows that if the labor supply and savings elasticities are low (as they, in fact, are for the United States where savings elasticity has been estimated by some studies to be between 0.2 and 0.4 and labor supply elasticity has been estimated to be around 0.2), the increases in the rate of growth of real output would not be particularly great in the first ten years following a significant reduction of income tax rates. He estimates that a 20 percent across-the-board reduction of income tax rates for both capital and labor, given a savings elasticity of 0.4 and a labor supply elasticity of 0.2, and other economic parameters similar to those of the U.S. economy, will raise the average annual growth rate of 3 percent over a ten-year period to at most 3.14 percent. In the extreme case, when both elasticities equal 1.0 and the tax rate on labor incomes is reduced by 20 percent and that on capital incomes by 50 percent, the average annual growth rate of 3 percent over a ten-year period increases to 3.77 percent. Mackenzie, thus, concludes from his theoretical analysis that some positive supply-side effects are certain from an across-the-board reduction of income tax rates but how large the effect will be will depend upon the price elasticities of labor supply, savings, and investment. The size of these elasticities is an empirical question and must depend on the structural features of the economy or economies in question. However, on balance, the potential impact of sweeping income tax rate cuts on the growth rates of a representative economy of the type some middle-income developing countries may have does not seem to be very high.
Ebrill (Chapter 3) surveys the empirical evidence on the price responsiveness of labor supply, savings, and investment in developing countries. He finds a dearth of solid empirical work and the direct evidence on price responsiveness to be rather limited. He, therefore, looks for indirect evidence.
On labor supply, he reviews studies on subjects such as rural-urban migration, the effects of minimum wage laws, and the determinants of earning functions and concludes that “some indirect support” does exist for the proposition “that supply-side considerations have a role in the determination of the equilibrium wage” (p. 67). He also concludes that “although the empirical work supports the existence of a well-defined aggregate labor supply function, it appears not to be very elastic” (p. 67). In rural areas, in particular, the evidence is that labor supply decisions are determined by a variety of factors other than the wage rate (labor markets are frequently interlocked with other factor markets and widespread land-lease contracts and sharecropping arrangements make for imperfect labor markets). As a result, the labor supply function is price inelastic.
On savings, he finds that savings data in developing countries are very inadequate and that the development economics literature has dealt little with the question of interest elasticity of savings. Ebrill, therefore, seeks out indirect evidence again. Most available estimates of consumption functions in developing countries, for example, reveal that aggregate savings are affected more by income as well as by noneconomic factors, such as demographic factors, income distribution, life span, occupational patterns, and urban-rural distinction, than by interest rates. However, the empirical literature evaluating the effects of financial repression (artificially low interest rate ceilings) widely prevalent in developing countries demonstrates that financial savings may be sensitive to changes in interest rates. He, therefore, concludes that “even though aggregate savings may not be very interest-sensitive, the allocation of that aggregate between conventional financial assets and alternatives such as curb market funds and works of art is indeed responsive to economic incentives” (p. 74). Of course, changes in income tax rates may be powerless in influencing even the allocation of aggregate savings if financial policy is “wrong.”
On investment, Ebrill finds much of the empirical evidence from developing countries to be against the neoclassical framework which explains investment simply in terms of the cost of capital. Foreign investment is said to be influenced by factors such as the presence of natural resources, proven record of economic performance of a country, threat of expropriation, degree of urbanization, and the availability of advanced infrastructure rather than by the availability of fiscal incentives. Domestic investment, on the other hand, is shown to be influenced by factors such as the availability of domestic savings, retained earnings of businesses, public investment outlays in support of private productive activity, trade policy, and the degree of protection, and, in the specific case of agricultural investment, by distortions associated with price support systems and marketing boards. Ebrill, therefore, concludes that while investors do react to economic incentives, “investment [in developing countries] is influenced by a number of factors” (p. 81).
Ebrill sums up his findings on the subject of price responsiveness in developing countries as follows: “Although the empirical literature examining the impact of tax policy on labor supply, savings, and investment leaves much to be desired, it nonetheless appears that changes in tax policy will have some effects. The behavior of these aggregates appears, however, to be determined as much by other elements… . Given the existence of widespread market failure in many developing countries, the impact of changes in tax policies may be quite difficult to predict… [and] it may be the case that a more promising supply-side approach might be one that also aims at alleviating the most obvious sources of market failure” (p. 82).
Tax Policies and Financial Savings
What is the optimal tax policy toward financial savings in developing countries and is the sharp reduction of marginal income tax rates its most important element? In Chapter 4, Ebrill reviews the existing literature in search of a theoretical answer to these questions and finds that the literature is inconclusive; in addition, the literature does not adequately accommodate the special circumstances of developing countries. He identifies at least four characteristics of developing country situations (they exist in all developing countries although their magnitudes may vary): (1) artificially low interest rate ceilings which, given the rates of inflation, frequently result in financial repression; (2) relatively underdeveloped financial institutions and capital markets; (3) the existence of unorganized capital markets; and (4) the use of compulsory savings schemes by the governments.
Ebrill then develops a modified illustrative optimal tax framework to take into account some of the characteristics of the financial structures of developing countries, in particular the existence of financial repression and curb markets. To start with, his model shows that, under normal circumstances, the optimal tax on financial savings depends on its own-price elasticity. While the evidence indicates that financial savings are interestelastic to some degree, he admits that no useful point estimates can be made of the relevant price elasticity and, therefore, of the optimal tax rates. Once, however, the special circumstances of developing countries are taken into account, the model suggests that the optimal taxation of financial savings changes. If the degree of financial repression in a developing country is large, and if for some reason this distortion cannot be removed, his modified optimal tax framework indicates that “a subsidy rather than a tax is appropriate” (p. 106). In turn, if the use of subsidies is precluded for fiscal or other reasons, then “consumption … is more appropriate than income as a tax base” (p. 106).
Ebrill argues that the optimal tax treatment of financial savings depends critically on the degree of financial repression, which varies widely both across countries and over time. “Accordingly, there is no single recommended policy such as reducing marginal tax rates. Each country has to be considered individually” (p. 108). Depending on the particular country that is under consideration, “the optimal tax treatment of financial savings runs the gamut from subsidies to substantial taxation” (p. 92).
Tax Policies and Investment
The rate of tax affects the cost of capital and, therefore, affects the level of investment—this much is built into the neoclassical framework of investment behavior. In many developing countries, the nominal rate of corporation income tax is high but, as Table A15 in the Statistical Appendix shows, tax incentives and deductions for investment are relatively liberal and it is the combination of both of these, along with the rate of inflation as it interacts with capital allowances, capital gains, and interest deductibility provisions, that determines the cost of capital. In Chapter 5 Ebrill reviews the income and corporate tax structures of 31 developing countries and makes cost-of-capital estimates. His results show that “Indeed … the tax system in many countries subsidizes the cost of investment at low inflation rates.”At high rates of inflation, on the other hand, their tax systems (especially those featuring depreciation allowances and inventory valuations based on historic costs) are such as to be a “source of investment disincentives.” For several countries with very high inflation rates, he finds the disincentive effects to be pronounced (p. 126).
Relating the share of gross domestic investment in gross domestic product (GDP) to his cost-of-capital estimates for 31 developing countries, Ebrill shows that while after-tax cost of capital has a significant impact on investment levels, other variables, especially the rate of inflation and the growth of exports, are equally important which, at least, “raises the question of which is the most promising path for policy to take” (p. 132).
He concludes, therefore, that strong policy recommendations concerning the effectiveness of income and corporate tax rate reductions alone for encouraging investment in developing countries should be resisted and attention should be paid to controlling inflation and alleviating distortions to exports. All this suggests “that supply-side based tax reform proposals [advocated by popular supply-siders] are only of limited use” (pp. 133-34) and additional tax reforms, such as indexation of depreciation allowances or taxing corporations on a cash flow basis (i.e., full expensing of all investment and disallowing the deductibility of interest payments on debt), are equally important.
Progressivity and Income Tax Evasion
The effect of high and progressive taxation on income tax evasion is commonly taken for granted and with ample justification. Richupan (Chapter 6) surveys the theoretical and empirical literature on income tax evasion to locate the basis of this perceived relationship. He concludes that “the theoretical literature does not support the claim that an increase in the tax rate will lead to an increase in tax evasion” (p. 148) or “that a progressive tax rate schedule stimulates tax evasion” (p. 151). The empirical studies on the subject are, however, sketchy and indirect and do not yield a definitive conclusion on the subject.
Richupan, however, finds that the theoretical literature contains stronger conclusions regarding the role of other tax and nontax factors in encouraging income tax evasion. In particular, high penalty rates and high probability of detection are shown to have a negative effect on tax evasion. Income tax evasion is also shown to be strongly influenced by nontax factors such as the type of income and perception of fiscal equity. In the special circumstances of developing countries, nontax factors such as price controls, government regulations, and civil service salaries, are all shown to contribute positively to income tax evasion.
Thus, Richupan ends up doubting the effect that a reduction of income tax rates alone or even income tax reforms generally will have on the degree of income tax evasion which is far higher in developing countries than in developed countries.
Evidence on the Laffer Curve
One important assumption of popular supply-side economics is that if tax rates are sufficiently high (the “prohibitive range”) then a reduction in tax rates would lead to an increase in tax revenues. The implicit assumption in this relationship is that the substitution effect of a tax cut is positive and the factor elasticities are very large.
Ebrill (Chapter 7) tests the validity of this assumption and the Laffer curve with data from Jamaica and India, two developing countries that had very high marginal income tax rates and where in the 1970s the top marginal income tax rates were significantly reduced. He points out that an ideal test of the Laffer curve would involve relating income tax yield among the highest income groups with proxies for tax rate reductions and other explanatory variables. Using the data for PAYE taxpayers in Jamaica between 1979 and 1981 only, and adjusting it for changes in income distribution, real growth rates, and inflation over time, Ebrill concludes that “data are consistent with the existence of a Laffer curve in Jamaica” (p. 188); however, he mentions many reservations about this conclusion. Data availability is better for India and Ebrill’s analysis of the effects of a marginal income tax reduction introduced in that country in 1975 leads him to conclude that “the data on India, at least for the years selected … do not support the Laffer curve hypothesis” (p. 192).
Ebrill recognizes the limitations of his methodology, which had to be tailored to use the available (rather poor quality and inadequate) data, and admits that existence of market imperfections, improvements in income tax administration, and other variables may account for his results. Nevertheless, he concludes that “assertions to the effect that developing countries are operating in regions of the Laffer curve, where tax rate reductions would lead to revenue increases, should be treated with caution” (p. 175) and that “the results [obtained for Jamaica and India] could easily be rationalized using non-Laffer curve explanations” (p. 193). He, therefore, cautions that none of his results can be seen as a complete endorsement of the narrow (popular) supply-side approach (marginal income tax rate reductions) and that the broader (basic) supply-side approach (removal of tax distortions irrespective of the source) may still induce significant supply-side response.
The answers to the five questions set out at the beginning of this subsection can be summed up as follows. Although there is some indirect evidence that the assumptions underlying the popular supply-side tax policy may be valid for developing countries, the research has highlighted many other factors, special to the circumstances of developing countries, which may be of equal or greater importance to the expansion of labor supply, savings, and investment as well as the reduction of income tax evasion, considered desirable by supply-side economists. In particular, the research shows that developing countries need to pay attention to the development of labor and capital markets and to removing other economic policy distortions such as high minimum wages, overvalued exchange rates, interest rate ceilings, and inflationary financing of the budget. Even in the area of income tax policy, the alternatives of inflation-adjustment of depreciation allowances and inventory valuations, conversion of income tax to some form of consumption tax (i.e., the exemption of savings or, at least, a moderation of the tax burden on capital incomes), and the replacement of a corporation tax based on profits by a tax based on cash flow may affect savings and investment more significantly than a simple reduction of marginal income tax rates. Similarly, raising income tax penalties and increasing the probability of detection of income tax evaders, through legislative and administrative improvements, may also be more effective in reducing income tax evasion in developing countries than just lowering marginal tax rates and reducing the progressivity of income taxation.
Thus, the conclusion of the research is that it is not that the popular supply-side tax policy prescription of reducing the excessively high marginal income tax rates, in the interest of improving growth prospects, is invalid but that there are other important tax and nontax determinants of the behavior of economic agents and economic growth in developing countries. The fact that developing countries are quite heterogeneous and that their governments must, at this stage of development, pursue a variety of objectives (including redistribution, economic stabilization, and mobilizing revenue for providing essential social and economic infrastructure and its maintenance) further complicates the task of arriving at a unique conclusion about the levels and structure of taxation that will be valid for all developing countries. Advice on tax policies must, therefore, struggle with this multiplicity of objectives; in doing so it must also take into account the uses to which government revenues are put and assess their economic and social necessity.30
Relevance of Popular Supply-Side Tax Policy
In assessing the relevance to developing countries of the popular view of supply-side tax policy, one needs to assess the reliance of developing countries on income taxes, in particular (1) the relative importance of income tax revenues in such countries; (2) the height of their income tax rates; and (3) the scope and generosity of various tax reliefs to savings and investments and the impact of these on the effective tax rates on capital incomes. These topics are treated below. Furthermore, one also needs to consider the empirical evidence on the growth rates of the developing countries that rely heavily on income taxes, which is explored by Mañas-Antón in Chapter 8.
Relative Insignificance of Individual income Taxation
The data given in Tables A2-Table A4 in the Statistical Appendix confirm that the individual income tax is a relatively unimportant source of revenue in many developing countries, particularly in those that do not have large and significant mining sectors. While there are important differences among countries of the developing world, on average, the individual income tax accounts for only 2 percent of GDP and 11 percent of all tax revenue, compared with 8 percent and 29 percent, respectively, in developed countries. From a limited number of developing countries for which it has been possible to collect information (see Table A5 and A6 in the Statistical Appendix), it is clear that individual income tax, on average, is paid by less than 5 percent of the population (mostly wage and salary earners) and the income assessed to tax is less than 14 percent of GDP (mostly through withholding taxes). Richupan (1985) has listed a variety of factors that may be responsible for the relative insignificance of personal income taxation in developing countries.31
Even though income tax is an unimportant source of tax revenue and affects a relatively small proportion of high income earners, the progressivity of its nominal rate structure may still be such as to have serious disincentive effects on income earners who matter. Data given in Table A9 of the Statistical Appendix throw light on the rate structures of personal income taxation in selected developing countries.
Levels of Individual Income Taxation
The income tax rate schedules of 32 developing countries, summarized in Table A9 of the Statistical Appendix, show that the top marginal income tax rate exceeds 55 percent in nearly one half of the 32 selected countries. In 4 developing countries, the top marginal rates exceed 65 percent (Table 1). The threshold levels of income at which income tax starts applying in most developing countries are the equivalent of about one time the per capita GDP before personal allowances are taken into account and less than twice the per capita GDP after personal allowances are taken into account (see Table A12 in the Statistical Appendix). The availability of personal allowances, deductions, and preferences (see Statistical Appendix Table A10) does neutralize some of the burden of high marginal tax rates, and in most developing countries the top marginal income tax rates apply only to very high income levels, as high as 50 times the per capita income. However, in 3 developing countries, top marginal tax rates are payable by income earners earning less than 10 times the per capita GDP (Table 2), which is relatively low.
|Maximum or Top Marginal Tax Rates||Number of Countries||Applies to Income Less Than 25 Times PCGDP1||Applies to Income over 25 Times PCGDP1|
|Up to 35||0||3||0||1||0||2|
PCGDP = per capita gross domestic product at current market prices.
The shift in the distribution of countries is due to the major revisions in the tax rate schedules implemented by some countries.
Frequency distribution of income levels (in terms of PCGDP) for 1985 does not add to total number of countries in the sample because the relevant information is not available for two countries.
PCGDP = per capita gross domestic product at current market prices.
The shift in the distribution of countries is due to the major revisions in the tax rate schedules implemented by some countries.
Frequency distribution of income levels (in terms of PCGDP) for 1985 does not add to total number of countries in the sample because the relevant information is not available for two countries.
Marginal Tax Rate
Income (As multiple of
|Papua New Guinea||50||56.9|
|Trinidad and Tobago||70||7.9|
Estimated total incomes take into account the personal exemptions, the personal allowances, and an estimate of the various deductions and tax preferences available to the taxpayer at that income level in each country. PCGDP = per capita gross domestic product at market prices.
Estimated total incomes take into account the personal exemptions, the personal allowances, and an estimate of the various deductions and tax preferences available to the taxpayer at that income level in each country. PCGDP = per capita gross domestic product at market prices.
Tax Reliefs for Personal Savings and Investments
Individual income taxpayers in many developing countries enjoy a number of incentives for personal savings and investments which reduce the effective tax rates on capital incomes, and these have important supply-side implications. The former include deductions for life insurance premiums and pension contributions and exemptions from income taxation of interest and dividend incomes (see Table A10 in the Statistical Appendix), while the latter include, among other things, the levy of a final withholding tax on selected investment incomes at rates substantially lower than the top marginal income tax rates (Statistical Appendix Table All). Furthermore, income tax holidays for periods between five to ten years are widespread in developing countries for those taxpayers whose incomes are derived from the establishment of new businesses or the expansion of existing businesses (see Statistical Appendix Table A15).
All these features of the income tax systems take away much of the “bite” of high nominal income tax rates, especially with respect to savings and investment incomes, and selected forms of capital incomes enjoy substantial “subsidies” under the income tax systems of developing countries. As Ebrill (Chapter 5) shows, under zero rates of inflation, the cost of capital in most developing countries is extremely small (some countries even “subsidize” capital) and it is only the lack of indexation or inadequate indexation of the income tax systems that raises the cost of capital in high-inflation developing countries. However, as only “selected” forms of capital incomes are preferentially treated, tax-caused distortions in the use of savings continue to prevail in many developing countries, and investments not enjoying preferential tax treatment (usually speculative and unproductive investments) obviously are the ones that are taxed at the high marginal income tax rates noted earlier. In addition, as various studies included in this book show, savings and investment decisions in developing countries are also distorted by other governmental policies such as administered interest rates (Chapter 4) and overvalued exchange rates, quantitative trade restrictions, and producer price ceilings (Chapter 11)
Relationship Between Income Tax Ratios and Growth Rates
If the levels of income taxation have the significantly detrimental effects on growth rates that popular supply-siders claim, countries whose governments rely less heavily on income taxation should enjoy relatively higher growth rates than those whose governments rely more heavily on such taxation. Taking this as his starting point, Mañas-Antón (Chapter 8) presents some empirical evidence on the interrelationship in selected developing countries between output growth and the reliance on income taxes. He uses readily available cross-country and pooled cross-country time-series data and estimates of multiple regression equations with a variety of specifications, all containing important determinants of growth derived from the Dennison growth accounting tradition.
His regressions show that the ratio of income taxes to total tax revenue (as well as to GDP) and the growth rate of output are negatively related and that the regression coefficients are significant, but this result does not hold in all specifications. When the ratios of individual and corporate income taxes to total tax revenue are related to growth rates, the regression coefficients are still negative but statistically insignificant in both cases.
Mañas-Antón, therefore, concludes that “while there is some evidence supporting a negative relationship between output growth rates and the reliance of a country on income taxes, this relationship cannot be asserted with much confidence” (p. 218). He calls this conclusion “tentative” and recognizes the many limitations of his analysis: cross-section regression analysis, for example, can be easily criticized as an improper test of a time-series proposition; the model specification itself was limited by the available data and, therefore, may be inadequate.
Evidence thus far suggests that, given the limited scope of income taxation in most low-income developing countries, and the very few taxpayers who are subject to top marginal income tax rates in many developing countries, lowering the top marginal income tax rates alone (the popular supply-side tax policy) may well be of lesser consequence from an efficiency point of view than reforming the scope of the tax base, various tax rules and provisions, and other aspects of the income tax structure. For supply-side tax policy to be relevant to developing countries, it must also encompass reforms in the rates and bases of taxes other than income tax, which are more important in developing countries and which may have more significant supply-side effects than the level and structure of income tax rates. A review of the other characteristics of the tax systems of developing countries is, therefore, essential and a supply-side look at other aspects of their tax policies is called for. The papers included in Part III of the book review selected aspects of the tax systems of developing countries that are significant from the point of view of efficiency and growth.
IV. Tax Policy for Efficiency and Growth
The overall level of taxation is claimed by all supply-side economists to have significant effects on the growth rates in developing countries, and the structure of taxation is believed to have significant effects on the incentives of economic agents and the efficiency of resource allocation in the economy. One must, therefore, ask the following questions.
What will the tax systems of developing countries look like in theory if incentives and the efficient allocation of resources were the major concern of the policymakers?
How efficient are the very generous tax incentives that are frequently given to agricultural, manufacturing, and other enterprises by the policymakers of developing countries in order to induce economic growth?
When are export duties, which are so dominant in the revenue structures of many low-income developing countries, justified on grounds of efficiency and growth?
What is the precise role of tax policy in removing the various structural bottlenecks to economic development and helping the growth of developing countries?
The answers to these questions are explored in the four papers included in Part III.
Tax Structure for Incentives and Efficient Resource Allocation
Gandhi (Chapter 9) points out that taxation has always been an instrument with multiple objectives. It is not that the traditional literature on taxation has ignored the efficiency objective of taxation, or the distortionary economic effects of various taxes, but that a tax system based solely on efficiency criteria would not be viable on political and other grounds. It would ignore entirely the equity objective and is unlikely to generate adequate revenue to run a modern government or to allow for the provision and maintenance of basic social and economic infrastructure that is necessary for economic development. Furthermore, it would contain certain taxes that would not be easy to administer.
He establishes what the tax systems of developing countries would look like if efficient allocation of resources were the sole concern of the policymakers. They would consist of a poll tax, a tax on land area, a tax on windfall profits, a tax on potential income, taxes on items with inelastic demand or supply, and taxes for internalizing the negative production and consumption externalities; they would not consist of any other taxes such as income tax, corporation tax, capital gains tax, payroll tax, wealth tax, gift tax, and inheritance tax. Export duties and import duties would also not be included in such tax systems except under very exceptional circumstances. The rates of taxation under an “efficient” tax system would be strictly dictated by optimizing formulas based on price elasticities and would contain little or no progression—in any case, they could not be raised simply for revenue reasons. Also, there would be no place for special tax incentives and preferences in such a tax system. The efficiencyoriented tax structure is, thus, shown by Gandhi to be no more than a theoretical ideal which could not be realistically adopted by any developing country.
Role of Tax Incentives
Tables A13 to A15 in the Statistical Appendix examine the structure of corporation tax and corporate tax incentives in 32 developing countries.32 They show that only a few developing countries have high corporate tax rates (55 percent or over) but most do have very liberal tax deductions and incentives. Most developing countries offer tax depreciation allowances on a replacement basis or accelerated basis and investment tax credits or investment allowances ranging between 5 percent and 30 percent of the cost of capital assets. Many developing countries give special deductions for intangible expenditures, such as manpower training and research and development expenditures, as well as for expenditure related to export production. Carry forward of unutilized holiday period depreciation and losses for almost indefinite periods is also permitted in most developing countries. Many developing countries also offer favorable tax treatment of capital gains and partial indexation provisions, and almost one third of the selected developing countries permit liberal inventory valuations for tax purposes. Shareholders frequently enjoy relief from double taxation of dividends through partial imputation of the corporation tax. However, the most significant of all tax incentives to corporate investment is the complete income tax holidays, for varying durations (often extendable) and for a variety of purposes, which are offered in most developing countries; dividends and capital gains earned by individual and corporate stockholders during the tax holiday period are also frequently tax exempt.
Thus, in developing countries investment incentives are generous enough to reduce the cost of capital considerably and to lower the average tax burden on capital incomes as compared to what is incorporated in the nominal tax rate schedules. In fact, as Ebrill (Chapter 7) shows, the governments of many developing countries “subsidize” productive investments in priority sectors of their economies.
Given the widespread use of liberal tax incentives in developing countries to achieve a variety of developmental goals, Sanchez-Ugarte (Chapter 10) looks at tax incentives from the supply-side point of view and concludes that “even though the granting of tax incentives under certain circumstances might be economically rational, this policy presents severe limitations and drawbacks…. The attempt by some developing countries to use a vast array of liberal tax incentives to counteract the negative economic effects of high marginal tax rates of narrowly based taxes and/or wrong economic policies with regard to wage rates, interest rates, exchange rates, and so on is likely to be ineffective and even counterproductive” (p. 273). Sanchez-Ugarte divides the efficiency case for tax incentives into a “pure” case and an “impure” case. A pure case for tax incentives exists whenever externalities exist and tax incentives for regional development, encouragement of risk-taking and savings, dampening the shortrun output disturbances, and promoting research and development are all justified on this basis. The impure case for tax incentives exists only as an offset to distortions created by other economic policies whose reform is considered infeasible by policymakers for one reason or another. Sanchez- Ugarte then describes the distortions created by inappropriate trade, tax, and wage policies and shows how tax incentives can be designed to counteract their distortionary effects. He concludes that tax incentives “are never the most appropriate policy to follow” (p. 258) because they are prone to induce diverse and often unpredictable distortions in the economy and illustrates this by examining specific tax incentives in terms of the criterion of efficiency.
As stated earlier, Sanchez-Ugarte points out that tax incentives as applied in most developing countries are often ineffective. For tax incentives to be effective, he lists five conditions: (1) they should be directed to limited objectives which should be economic and not political; (2) there should be little red tape and discretion in granting them; (3) they should be predictable, though not necessarily permanent; (4) the specific tax incentive should closely match the objective which is being pursued; and (5) the design of the tax incentive should attempt to take into account its general equilibrium effects on the economy. It is, thus, no simple task to design effective tax incentives and Sanchez-Ugarte concludes that “tax incentives are no substitute for an efficient tax system” (p. 274).
Optimality of Export Duties
Many low-income developing countries rely as much on export duties as on income tax. Sanchez-Ugarte and Modi (Chapter 11) examine a sample of 71 developing countries that levy export duties and find that 29 countries derive more than 10 percent of their tax revenue and more than 1 percent of GDP from such duties. Almost all of the 71 developing countries rely heavily on one or more export items, generally coffee, cocoa, tea, bananas, rubber, groundnuts, tin, bauxite, and phosphates, and the average rates of these duties are frequently high, thus affecting incentives for production and exports.
Sanchez-Ugarte and Modi review the levels and structures of existing imposts, both explicit and implicit, on exports in selected developing countries and reach three important conclusions. First, they find the actual level of export taxation in the majority of developing countries to be higher than the level that can be considered even country optimal, let alone world optimal. This result arises primarily due to the high implicit export taxes, in the form of overvalued or multiple exchange rates, producer price ceilings, or quantitative restrictions on exports, prevalent in many developing countries. Given the small but significant values of the supply elasticities of agricultural products estimated in the literature, they show that the detrimental effects of the high export taxation existing in many developing countries on the level of their exports are significant. Second, they find that the taxation of “windfall” profits through export taxes will be nondistortionary only when the tax is unexpected and temporary—which is difficult to attain in practice. Finally, they show that the operation of producer income stabilization schemes reduces significantly the present value of revenue to producers, without significantly reducing riskiness. Hence, such schemes are distortionary and discourage production and exports.
Thus, Sanchez-Ugarte and Modi show that in the majority of developing countries analyzed in the chapter, the reduction of export taxes can be expected not only to increase exports but also to enhance the economic well-being of the specific country and the world as a whole. However, the authors conclude that over the short and medium runs the existence of market imperfections in commodity markets could well preclude many developing countries from benefiting from the supply-side effects of lowering export taxes, while the government revenues would be lowered. With respect to revenues, they argue, however, that many developing countries can reduce effective levels of export taxation without losing revenue (in a few cases even gaining revenue) if the nonrevenue-yielding implicit export taxes (exchange rate overvaluation, quantitative restrictions on exports, etc.) are removed, so that the base of explicit export taxes expands.
Limits of Tax Policy for Economic Development
Shome (Chapter 12) forcefully argues that in a developing country, “tax policy can theoretically be a powerful instrument in targeting all … factors of development” (p. 327) but only under appropriate conditions. He shows how tax policies can and have in practice operated in certain developing countries to influence the conditions of development such as raising the investment rate, closing the foreign exchange gap, encouraging financial intermediation, assisting in human resource development, and controlling population, where necessary. But, then, taxation has its limitations and difficulties: it simply cannot be effective in the attainment of too many objectives; frequently, not all individuals in a developing country are covered by the tax regime; the capacity to administer even moderately sophisticated taxes is limited in many of these countries; and the taxpayer’s economic behavior is not always affected solely by prices. In addition, tax policy must be supported by complementary changes in other policies of developing countries, especially those relating to the monetary and financial sector, as well as the removal of structural bottlenecks to development. Shome, therefore, rightly states, “Thus, while economists have to, and indeed, do assign a major role to tax policy in tackling development and growth, and sometimes successfully, it must be done with perspicacity” (p. 330). Similar sentiment is expressed in other chapters, viz., in Ebrill (Chapter 4), where a strong case is made from the supply-side point of view for removing financial repression and other distortions to the development of the capital markets; in Ebrill (Chapter 5), where a strong case is made for the control of inflation; and in Sanchez-Ugarte and Modi (Chapter 11), where a strong case is made for the removal of distortions to exports, including overvalued exchange rates.
To sum up Section IV, the research has established that tax structures of most developing countries depend a lot more on commodity taxes, such as import and export duties, sales taxes, and excise duties, than on income taxes. Even income taxes in these countries take on the characteristics of consumption taxes because of the very generous tax incentives and tax reliefs granted to savings and investments. In addition, many facets of a given tax, other than tax rate, such as the tax base, exemptions, and allowances, can significantly distort taxpayer behavior. If developing countries are to reach their full growth potential, they may need efficiency-oriented reforms of the entire tax systems, corporate tax incentives, export duties, and other important elements of their tax structures, and not only of the marginal rates of income tax, considered sufficient by popular supplysiders.
V. Supply-Side Tax Reforms for Developing Countries
Various supply-side tax proposals relevant to developing countries, as well as the limitations of tax policy in developing country circumstances, emerge from the papers included in the book. This section summarizes what should or should not be expected from strictly supply-side tax reforms.
Acknowledging the limited influence of tax policy in the current developing country environment, as stressed by Shome (Chapter 12), is the first step toward adopting feasible supply-side tax reforms. Then there are other limitations that have to be acknowledged. For tax policy to have a strict efficiency orientation, it should not be used as an instrument of major redistribution. However, income and wealth distribution is highly skewed in developing countries, and few policy instruments, other than land reforms and social welfare expenditures, are readily available to governments to affect major redistribution. Consequently, the policymakers of developing countries will have to take bold political decisions on this issue viz., the extent to which they want the tax system to be the main instrument of redistribution and are willing to control tax avoidance and evasion and make the nominal tax structure truly effective. Finally, as Gandhi (Chapter 9) argues, a tax system dictated by efficiency considerations would certainly be desirable except that the benefits of such a tax structure would be large only when many assumptions, which may not be readily descriptive of the special circumstances of developing countries, are satisfied. As a result, he shows that such a tax system is not going to be easily accepted by policymakers. Indeed, very radical reforms in tax bases as well as tax rates will be needed strictly in the interest of efficiency objectives and may involve the substitution of existing taxes with entirely new and even administratively difficult taxes, such as replacing the income tax by the levy of a tax on ability and potential income.
In practice, tax systems in most countries attempt to fulfill multiple objectives, including many politically motivated ones, and end up having distortionary economic effects, and the tax systems of developing countries are no exception. From a supply-side perspective, it would be desirable if taxation were used only for the attainment of as few objectives as possible, for example, correcting “market failures” and providing adequate government revenues with minimal distortions to resource allocation and disincentives to factor supplies. Achieving a limited degree of redistribution can easily be accommodated in the framework of supply-side tax policy, if that were to be politically acceptable. The papers presented in this book contain a number of proposals for reform relevant to the longer-term tax sys tems of developing countries that are, at once, practical and in the supplyside spirit. 33
First, the tax systems should over time attempt to reduce their reliance on narrowly based taxes unless such taxes fall on real windfall profits and scarcity rents or correct some negative externality. The views of Gandhi (Chapter 9) on the efficient tax system and Sanchez-Ugarte and Modi (Chapter 11) on export duties more than amply bear this out.
Second, on income taxation, there is a case for lowering the excessively high marginal tax rates presently existing in many developing countries while (1) expanding the tax base through the removal of most allowances, deductions, exclusions, and tax credits; (2) indexing the tax base for inflation; and (3) improving income tax laws and administration, particularly raising the penalty rates and probability of detection. There is no case for a separate capital gains tax; real capital gains can be treated as ordinary incomes and taxed under income tax without any preferential tax treatment. Similarly there is no case for a separate payroll tax or social security taxes on labor incomes. The arguments in support of these positions are amplified in Ebrill (Chapter 5), Richupan (Chapter 6), and Gandhi (Chapter 9).
Third, in relation to income taxation again, a strong case is made by Ebrill (Chapter 4) for the removal of savings from the base of income taxation (i.e., for increased reliance on broad-based consumption taxation), especially in circumstances where, for a variety of noneconomic reasons, interest rates must remain at artificially low levels and adequate pretax rates of return to savings are precluded.
Fourth, on corporate taxation, the case is made on efficiency grounds to (1) reduce the scope of tailor-made tax incentives and (2) index depreciation allowances and inventory valuation for inflation. Sanchez-Ugarte (Chapter 10) suggests that tax incentives be restricted only to the efficiency-oriented ones, such as those that encourage risk-taking and savings, research and development, and, under certain circumstances, regional distribution of economic activity. Ebrill (Chapter 5) proposes indexation of the corporate tax base and even taxation of corporations, on a cash-flow basis, which will allow all capital outlays to be immediately expensed and disallow the deductibility of interest payments, thereby eliminating many of the distortions of existing corporation taxes. Gandhi (Chapter 9) restates various arguments made in the literature against the levy of any separate corporation tax and for the removal of double taxation of dividends.
Fifth, on export taxation, the recommendation is made by Sanchez-Ugarte and Modi (Chapter 11), on efficiency grounds, that tax levels be reduced in most of the developing countries in the medium term; it is only under circumstances of temporary high world prices that temporarily the levy of high export duties to mop up excess demand generated by “windfall profits” is justified. However, given the developing countries’ present reliance on export tax revenue and the limitations of tax handles and tax administration capacity in these countries, the reforms in this area may have to be gradual. Furthermore, the effectiveness of such a course of action will depend on the removal of many obstacles to free world trade that still exist. Nevertheless, the unwanted supply-side effects of export duties can be reduced by avoiding export duties on agricultural products with relatively high supply elasticity and imposing them on others on a sliding scale of tax rates to approximate them as much as possible to a tax on “windfall” incomes. In the long run, the rates of export duties should be such as to allow the exporters to earn an “adequate” after-tax rate of return on labor and capital; under no circumstance should this be less than what is achievable in other sectors of the economy. In relation to commodity stabilization schemes, the suggestion is made in Sanchez-Ugarte and Modi (Chapter 11) to streamline the administration of marketing boards in order to reduce the costs of their operations and to return to producers, over time, all profits generated in the process of commodity price stabilization.
Sixth, on wealth taxes, Gandhi (Chapter 9) shows that, in the interest of neutrality and removing distortions in the use of savings, the tax systems of developing countries should not rely on the highly differentiated and narrowly based wealth taxes (such as taxes on income-generating agricultural land). Nor should they rely on taxes that are levied on productive wealth (financial assets, capital equipment, and the like) if the wealth creation process is not to be damaged. Wealth taxes should primarily be directed toward those elements of wealth that have inelastic supply, such as land, or are for personal use, such as homes, automobiles, and yachts. Taxation of transfers of wealth, through gifts and bequests, is also justified, on grounds of intergenerational equity, as are taxes on unproductive wealth, especially holdings of jewelry, precious metals, and land and real estate for speculative purposes, on grounds of controlling negative externalities.34
Finally, on commodity taxes, though these have not been explicitly analyzed in the papers contained in this volume, a few reform proposals suggest themselves in the interest of promoting efficiency and positive supplyside effects and growth.35 Among others, the following need to be particularly mentioned: (1) Only final consumption goods, and not raw materials, intermediate goods, or capital goods, should be taxed to avoid cascading.36 (2) Commodity taxes should not discriminate between alternative sources of supply for consumption, viz., domestic output and imports, through the levy of differential rates of taxation. (Separate taxes can be imposed on imports if protection for “infant industry” is desired; however, the policymakers must ensure that import taxes are not too high or too diverse to begin with and that a timetable has been set for their gradual removal.) (3) Both consumer goods and consumer services should be taxed to avoid distortions in consumption patterns.37 (4) Commodity taxes should be levied as close as possible to the retail stage of the production/ distribution process to avoid pyramiding. All these can be achieved through the adoption of a broad-based retail sales tax or, better still, a value-added tax of the consumption type preferably at rates which are not unreasonably high or excessively differentiated. (5) Excise duties can justifiably be levied on items that have relatively inelastic demand (such as selected necessities), or have negative externalities (such as alcohol, tobacco, and gasoline), or are complementary to leisure (such as recreational vehicles, ski equipment, and other “luxury” goods).38 Levy of excise duties as substitutes for “user fees,” whenever the latter are administratively difficult, is also justified.39 (6) Exports, which are subject to domestic commodity taxes, deserve to receive complete drawback of such taxes. The arguments in support of some, though not all, of these reform proposals are discussed in Gandhi (Chapter 9).
All the above-mentioned tax reform proposals are consistent with the efficiency objective, if not the equity objective; they are also consistent with the view of basic supply-side tax policy as described at the beginning of this chapter. Quite a few of them could well imply a significant revenue loss in the short run.40 Gandhi (Chapter 9), therefore, stresses that in the short run, supply-side and efficiency-oriented tax reforms must go hand-inhand with expenditure reforms and reforms of public enterprise pricing if high and unsustainable fiscal deficits and their inflationary consequences are to be avoided by developing countries. He also points out that the positive results of supply-side tax reforms on growth rates should more realistically be expected in the longer run and then only if such tax reforms are (1) significant and permanent and (2) coupled with very substantial reforms in other macroeconomic policies (such as exchange rates, interest rates, wage rates, and agricultural and other prices). Mackenzie (Chapter 2) establishes the importance of the former, while Ebrill (Chapters 3, 4, and 5), Sanchez-Ugarte (Chapter 10), and Sanchez-Ugarte and Modi (Chapter 11) stress the importance of the latter. Finally, given the heterogeneity of individual country situations with respect to market conditions and existing tax systems, it is clear from the research that supply-side and efficiency- oriented tax reform packages would need to be tailored to the specific needs and circumstances of individual developing countries, including the distributional and stabilization objectives of their governments, if any.
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Bartlctt (1985, p. 18) points out that the term was coined by Professor Herbert Stein of the University of Virginia in April 197b, as described in Stein (1984. p. 241).
Supply-sidcrs accept that (he existence of pure public goods, such as defense and internal security, and some merit goods, such as protecting the welfare of the extremely needy, provides a rationale for social action. However, they believe that policymakers would not necessarily provide even these goods in the optimum quantity or at the lowest possible cost
Recent literature on “optimal taxation” also deals extensively with this subject. The optimal taxation literature lakes this objective and the neoclassical framework as starting points hut reaches very different conclusions on tax reform. For a discussion of the difference between a supply-side tax economist and an optimal tax economist, sec Gandhi (Chapter 9).
The argument that “excess burden” rises monotonieally with the nominal tax rate belongs to the partial equilibrium tax theory. According to this argument, an income tax by its very nature causes an excess burden vis-à-vis a lump sum tax (i.e., it causes a reduction of utility in excess of that which would have occurred had the tax been collected as a lump sum) and that partial equilibrium analysis suggests that, in an economy completely free of distortions, including distortions caused by other taxes, the higher the rate of tax, the higher the excess burden. In fact, under highly simplified assumptions regarding the shapes of demand and supply curves, the excess burden of a tax (which is not lump sum) is given by the square of the rate of the tax. Theoretically, thus, the rate of the tax docs have a very significant effect on the economic behavior of the taxpayers. Sec Rosen (1985. Chapter 12)
Ture(1982b). Hall and Rabushka (1983), and the authors of the report by the U.S. Treasury Department (1984) also belong to the basic supply-side school since they seek tax reform in a wider sense, as described above.
Cf., Feldstein (1986).
For the views of popular supply-siders, sec Lafferand Seymour (1979); Meyer(1981); U.S. Congress (1981); Bartlett (1982); Fink (1982). Raboy (1982); Hailstones (1982a. 1982b); Ro-berts(1982, 1984); Gilder (1981); and Canto. Joines, and Latter (1983). Also see Appendix 11 for additional references.
Canto, Joines, and Laffer (1983, p. ix).
Under current law, everyone will face the top rate sooner or later,” Kemp (1981, p. 94).
Wanniski (1981, p. 38).
This is how Fcldstein (1986. p. 27) has summed up the position of popular supply-siders; he, however, does not believe in it.
Feldstein (1986, p. 27).
For an elaboration of the Laffer Curve, see Canto, Joines. and Laffer (1983, pp. 2-24) and Wanniski (1983, pp. 97-115). The Laffer curve is not essential to the basic premise of supply-side economies that leaner governments are better.
Commentson the Laffer curve can be found in Hemming and Kay (1980), Blinder (1981), Moszer (1982). Henderson (1982), Buchanan and Lee (1982), Fullerton (1982), Mirowski (1982), and Malcolmson (1986). For a test of the validity of the Laffer curve in one developed country and two developing countries, see Feige and McGee (1983) and Ebrill (Chapter 7), respectively. Also see Wanniski (1983, Chapter 11).
Wanniski (1981, p. 43) and Ture (1982a. p. 26). The nominal marginal tax rates are important for incentives, while the average effective tax rates are important for their implications about the size of government and income distribution. Both Wanniski and Kemp would like to see the marginal income tax rates ultimately range between 5 percent and 35 percent. See Wanniski (1981, pp. 45-46 and p. 49) and Kemp (1981, p. 52). Both of them favor the top rale of 35 percent, which is merely expression of an opinion and is not derived from any theoretical or economic arguments. The popular supply-siders do not want, as one might think, to do away with progressivity in the marginal rates of income taxation in the short run. although they would probably prefer a flat but low rate income tax in the long run. In their opinion, excessive progressivity of tax rates is often evaded and avoided, and never achieves the intended reduction in income inequalities.
Keynes also believed in tax cuts, but only if they were not accompanied by expenditure cuts, so as to make fiscal deficits stimulative during recessions. Popular supply-siders, on the other hand, do not consider the size of the budget deficit to be of any macrocconomic relevance. See also Bechtcr (1982).
Nontax revenue policies of the government, including prices charged for various government services as well as outputs of autonomous public enterprises, can also have taxes or subsidies implicit in them. The supply-side effects of such implicit taxes, if any. were not analyzed under the research project either.
For a theoretical exposition of and empirical evidence on this sec Corden (1974, 1975). Empirical work on the effect of foreign trade regimes on the economic development of ten developing countries has been carried out under the auspices of the National Bureau of Economic Research. The results of this work are summarized in Bhagwati (1978) and Krueger(1978). See also Balassa (1971).
Given the importance of foreign investment to the growth of most developing countries, the effects of tax policies on foreign investment should have been covered. However, this w-as omitted because experience shows that foreign investment decisions are usually affected by a number of economic (e.g., market size, availability of raw materials and skilled manpower), financial (e.g., development of capital market, registration and financial disclosure requirements for mobilizing domestic equity), institutional (e.g., entry and ownership regulations), and political factors, and tax policy is frequently of lesser importance in these decisions. To the extent tax policy is importaot, however, it seems from the survey of the literature that each developing country’s tax policy will have to be tailor-made to suit its special circumstances. In this process, all tax rules and tax incentives (not tax rates alone) affecting the net return on retentions in, and remittances from, the “host” developing country will have to be reformed. The tax policies of neighboring countries and of countries in similar situations will have to be taken into account. Full account will also have to be taken of the tax systems of the “home” country of potential investors, including the availability of tax deferral, tax sparing, and foreign tax credit provisions. The scope of the double taxation treaty agreements between the“host” country and the “home” country will also need to be considered. Finally, the nature of foreign investment (whether it is “footloose” or “country-specific”) and its volatility as well as the existence of tax havens will also be relevant. For the importance of some of these factors see International Monetary Fund (1985b). Also see Ebrill (Chapter 3).
Todaro (1985, especially Part II).
There is ample evidence that the distribution of income is far more skewed in developing countries than in developed countries. See Lccaillon and others (1984, especially Table 9 and p. 41).
See Killick and others (1984, especially Part I).
As Todaro (1985) has pointed out, “whether one likes it or not, Third World governments must inevitably assume a more active responsibility for the future well-being of their countries than the governments of the more developed nations… . Central to this new role will be institutional and structural reform in the fields of land tenure, taxation (to mobilize resources for investment, lacking private financial markets], asset ownership and distribution, educational and health delivery systems, credit rationing, labor market relations, pricing policies, the organization and orientation of technological research and experimentation … and the very machinery of government and planning itself” (pp. 52b-27).
Cf., Streeten (1979, pp. 21-52).
Recent income tax reform efforts in Indonesia, India, the Philippines, and Jamaica and a few other developing countries reflect this strategy. See Gillis (1985). India. Ministry of Finance (1985), Yoingco (1986). and Bahl and others (1987) for descriptions of these efforts.
ds Rosen (1985) points out, “The fact that a tax generates an excess burden is not necessarily ‘bad.’ One hopes, after all, that the tax will be used to obtain something beneficial for society either in terms of purchase of public goods or income redistribution” (p. 296). The uses to which government revenues are put are, therefore, not entirely irrelevant. Available data suggest that central governments of developing countries devote an average of over 40 percent of their total expenditure (including net lending) to the provision of economic services (viz., agriculture, electricity, roads, and transport and communications) and for capital formation as against an average of about 15 percent by those of developed countries. See International Monetary Fund (1985a. pp. 46-63). Unfortunately, expenditure data are not readily available to make a similar comparison for all levels of government.
In addition to fundamental factors such as the underdeveloped structure of the economy (e.g., the prevalence of subsistence agriculture and small and poorly equipped production and business units in the manufacturing and service sectors) and the consequent lack of adequate tax handles, Richupan stresses the roles of government economic policies and the low efficiency of tax administration.
For a fuller description of the features of corporate tax structures in developing countries, see Modi (1987).
In the short run, the needs of economic stabilization and demand management could well preclude the immediate adoption of some of the reform proposals dictated by supply-side objectives. Under such circumstances, government revenue, needed to manage fiscal deficits in the short run, should preferably be raised through consumption taxes and not through an increase in the rates of income taxes if the negative supply-side effects are to be minimized.
Taxation of unproductive wealth can present certain administrative and compliance problems.
Theoretically, from an efficiency point of view, there should be no commodity taxation if the income tax rate schedule has been chosen optimally. This is so because, under fairly reasonable assumptions, the levy of differential commodity taxes is not likely to improve social welfare. However, if for some reason, income tax is not optimal, differential commodity taxes can be designed to improve welfare.
Consumption of leisure being nontaxable, allocative efficiency requires that consumption of goods and services should not be taxed too highly.
The basic argument underlying the latter is the nontaxability of leisure itself. An efficient tax system here is an equity-oriented tax system as well.
For example, if the use of roads by motorists causes wear and tear and road fees cannot be easily collected, taxation of gasoline can be a good substitute for appropriate road user charges.
This is likely to be so as existing tax systems of developing countries frequently have (1) double or multiple taxation of the same base; (2) nonindexation of tax bases with respect to inflation; and (3) inefficient taxes such as export duties.