Fiscal Politics
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Chapter 10. Political Institutions, State Building, and Tax Capacity: Crossing the Tipping Point

Author(s):
Vitor Gaspar, Sanjeev Gupta, and Carlos Mulas-Granados
Published Date:
April 2017
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Author(s)
Vitor Gaspar, Laura Jaramillo and Philippe Wingender 

Introduction

The building of tax capacity is closely linked to the process of economic development and growth. There is a long intellectual history behind this conception of the role of taxes and the state. Joseph Schumpeter, in his famous paper “The Crisis of the Tax State” (Schumpeter 1918), links state and tax so closely that he stresses that his qualification “tax” in “tax state” can be regarded as almost redundant. He emphasizes that taxes are not only associated with the historical origin of the state, they are also active in shaping it. In his view, the organic development of taxation was associated with the organic development of other dimensions of the state. For Schumpeter, the analysis of the consequences of taxation requires a long-term perspective that allows for structural and self-reinforcing evolutionary dynamics to play out in full. Those dynamics are not only economic but also social and political. Besley and Persson (2011, 2013, 2014a, 2014b) are interpreted as bringing a similar perspective to contemporary research.

A recent study (Gaspar, Jaramillo, and Wingender 2016) argues that there is a minimum tax-to-GDP threshold associated with higher sustained growth. The authors investigate the existence of a tipping point in tax revenue levels. Tipping points are characterized by sharp changes occurring around some threshold. The work shows that once the tax-to-GDP level reaches about 12¾ percent, real GDP per capita increases sharply and in a sustained manner over the following decade. The effect of the tax tipping point on real GDP per capita after 10 years is on the order of 7.5 percent, that is, the average country that crossed from taxes as 12.5 percent of GDP to taxes as 13 percent of GDP was likely to be 7.5 percent larger than an otherwise similar country that remained below the threshold.

Of particular note is that the tipping point occurs for both developing economies in a contemporary data set, as well as for advanced economies in a historical data set spanning a much longer period starting in the early nineteenth century. These results raise the possibility that tax thresholds and tipping points are an inherent feature of the development of modern economies and the state and institutions that facilitate their emergence.

Far from demonstrating the effect of a single variable, tax tipping points indicate the presence of much deeper and broader changes in institutions and state capacity to sustain such effects on economic growth. This raises an important question: What political conditions and institutions facilitate the shift to greater state and tax capacity?

Using case studies, this chapter attempts to illustrate the nature of political conditions and institutions that accompanied countries as they crossed the tax-to-GDP threshold. It illustrates that improvements in taxation have been a part of a deeper process of state capacity building in these countries. Countries were chosen on the basis of their levels of development at both the time of their crossing the tax-to-GDP threshold and their subsequent economic development. Care was also taken to select a group that provides different insights, both from a regional and a historical perspective. The chapter therefore focuses on the following cases: (1) Spain crossed the 12¾ percent tax-to-GDP threshold in 1983; (2) China last crossed the tax threshold in 2001; (3) Colombia saw its tax-to-GDP level exceed the threshold for the first time in 2001; and finally (4) Lagos State in Nigeria saw a substantial increase in tax capacity, although at the national level, Nigeria is still below the 12¾ percent tax-to-GDP threshold.

The case studies illustrate the enabling political conditions that supported the building of state and tax capacity. In particular, the chapter highlights three important political ingredients: constitutive institutions, inclusive politics, and credible leadership. Constitutive institutions are evident in Spain and Colombia, where an explicit political settlement between political elites and citizens embodied in the enactment of new constitutions preceded tax capacity building. Both of these countries recognized that greater levels of taxation were essential to meet the emerging spending pressures associated with the economic, social, and institutional demands prompted by their new constitutions. Inclusive politics facilitated new center-periphery agreements crucial to building new tax collection schemes, as discussed in the cases of China and Lagos State.

Credible leadership was also clearly apparent. Across the four case studies, policymakers made a deliberate decision to implement a shift in the economic model, taking advantage of opportunities offered by economic or political crises. In Spain, the transition to democracy created the opportunity to build broader coalitions around the issue of building tax capacity. In Colombia, the economic crisis of the late 1990s helped foster the political consensus needed to implement several fiscal reforms. Efforts to mobilize internal tax revenues in Lagos State can be linked to its political rivalry with the federal government following the transition from military rule. In China, the main driver for greater tax capacity was the collapse of state-owned enterprise (SOE) revenues associated with the transition out of a patrimonial state toward a market-oriented economy.

This chapter does not try to present a general theory about the institutions and politics behind state capacity. Rather, the goal is to illustrate with a few case studies the political conditions that have supported broader changes in state and tax capacity. The aim is for these cases to serve as useful input for the process of developing a more general theory that integrates politics, institutions, and tax capacity.

Political Institutions Enabling State and Tax Capacity Building

What political conditions and institutions facilitate the shift to greater state and tax capacity? This question remains unanswered and is subject to considerable debate. The literature is vast, but most scholars point to a number of institutional features that can be grouped in three sets of political conditions that underpin state and tax capacity building (Figure 10.1):

Figure 10.1.Complementarities in State Capacity

Source: Authors’ compilation.

  • Constitutive institutions: According to Fritz and Menocal (2007), at the core of constitutive institutions is the political settlement that binds together state and society, ruling elites and citizens, public service providers and taxpayers. This political settlement (typically an explicit agreement) provides the necessary legitimacy for those who govern over those who are ruled. It is a key element in creating a social pact and the sense of shared public realm that leads to an effective state capable of collecting taxes and delivering public goods. To be considered legitimate, a political settlement must be acceptable to the majority of actors who need to be brought on board a state-building process, especially in postconflict settings, democratic transitions (Haggard and Kaufman 1995), and deeply divided societies (Hesselbein, Golooba-Mutebi, and Putzel 2006). Key constitutive institutions include a written constitution, free competitive elections, security and justice mechanisms, and a functioning meritocratic civil service.

  • Inclusive politics: For Acemoglu (2005, 2016) and Acemoglu and Robinson (2016), the presence of inclusive political institutions is a key determinant of state capacity building. Inclusive politics comprises two main components: pluralism and centralization. Pluralism implies broad distribution of political power and participation, constraints and checks on politicians, and the rule of law. Centralization requires the Weberian monopoly of legitimate violence over a territory and the ability of the state to regulate economic activity, impose taxes, and provide public goods. Various tensions between the center and the periphery often arise in state-building situations. According to Dobbins and others (2007), the center should be strengthened until it develops a good degree of control over general resources before engaging in horizontal redistribution among regions. At the same time, inclusive politics means that excessive centralization should be avoided by growing local capacity that works in synergy with the center (Brinkerhoff and Johnson 2008).

  • Credible leadership: The 2008 Commission on Growth and Development Report, under the chairmanship of Nobel laureate Michael Spence, attempted to draw lessons about strategies and policies that produce high levels of sustained growth in developing countries. A crucial ingredient identified by the commission was a “capable, credible, and committed government” (Commission on Growth and Development 2008, 3). By this it meant a system of governance and leadership with the flexibility to adjust policy and institutional structures to changing circumstances and opportunities, but doing so in a manner that is credible and commands broad support. Underscoring the role of leadership, Brady and Spence (2009) draw on the evidence from high-growth countries studied by the Commission on Growth and Development (2008). They identify two key stages in successful economic leadership. The first stage is the process by which the political leadership chooses an appropriate economic model and builds a political consensus to support the model. The process of choosing a new model is often associated with opportunities offered at times of economic or political crisis.1 The second stage is concerned with ensuring enough political stability for the economic plan to work. This implies that leaders have the capacity to adapt growth strategies—and to retain support for such changes—as circumstances change. Jones and Olken (2005) support this hypothesis. They study the effects of leadership on growth by looking at 57 cases in post—World War II economies in which an exogenous change in the country’s leader occurred (sudden death, resignation, and so forth). They find that the change of national leader is related to economic growth.

These political conditions are key ingredients for enabling the building of state and tax capacity. This chapter follows Besley and Persson (2011, 2013, 2014a, 2014b) and argues that state capacity is shaped by the interaction between tax capacity, legal capacity, and public administration capacity. Tax capacity not only provides a stable and elastic source of revenue for the government to finance government activities, but a government with a larger stake in the economy through a developed tax system has stronger motives to play a productive role in the economy. Public administration capacity refers to the government’s effective and efficient use of public money. This competence directly affects the ability of governments to implement policy and deliver public services, which in turn influences citizens’ trust in government. Legal capacity refers to the government’s ability to secure private property rights.

The chapter further argues that the strength of tax capacity depends crucially on social norms of compliance. Kiser and Levi (2015) emphasize that the more effective and trustworthy a government is, the more legitimacy it is likely to attain and the more it will be able to elicit compliance without excessive monitoring or punitive action. Similarly, as proposed by Levi (1988), the government can achieve a high degree of quasi-voluntary compliance with the taxation system when citizens comply with taxation out of a combination of strategic and normative considerations. Strategic considerations refer to the calculation of the probability of being caught and the punishment involved. Normative considerations refer to a sense of fairness: the citizen believes that sufficient public goods are being provided in return for tax payments, and that others are also paying their fair share. A variety of other authors have also argued that creating a culture of compliance is central to raising revenue. For example, Gordon (1989) refers to individual morality, Posner (2000) to tax-compliance norms, and Torgler (2007) to tax morale. Social norms of compliance are, in turn, closely associated with a higher demand by citizens for accountable and transparent government, as argued by Moore (2007); Bräutigam, Fjeldstad, and Moore (2008); and Ross (2004). These relationships are illustrated in Figure 10.2. In a similar vein, studies have found strong correlations between taxation and democratization (Ross 2004), public goods provision (Timmons 2005), and quality of governance (Moore 2004).

Figure 10.2.Tax Capacity, Social Norms, and Accountability

Source: Authors’ compilation.

State Capacity and Growth After Crossing the Tax Tipping Point

To provide a more granular perspective on the findings of Gaspar, Jaramillo, and Wingender (2016) described above, this section contrasts the growth and institutional performance of individual countries before and after they crossed the tax threshold.

Using the contemporary data set of the aforementioned paper, which assembles a panel for 139 countries from 1965 to 2011, 59 developing countries are found to have crossed the tax threshold of 12.88 percent of GDP without reversal (see Annex Table 10.1.1). Among these episodes, the median year for crossing the tax threshold is 2002, without clustering around any specific time periods. Figure 10.3 shows cumulative real GDP per capita growth 10 years before and 10 years after crossing the 12.88 percent of GDP tax threshold. Only 19 episodes are displayed, out of the 60 identified, based on the availability of 20 years of consecutive data around the time the tax threshold was crossed. Of these 19 cases, two-thirds saw higher ensuing cumulative real GDP per capita growth, by an average of 12 percent.

Figure 10.3.Cumulative Real GDP Per Capita Growth Before and After Countries Cross the Tax-to-GDP Threshold

(Percent)

Source: Gaspar, Jaramillo, and Wingender 2016.

Note: The graph includes only 19 episodes (out of 60) for which 20 years of consecutive data are available Cumulative growth, t–10 to t indicates countries’ cumulative GOP growth in the 10 years before crossing the tax-to-GDP threshold. cumulative growth, t to t+ 10 shows cumulative GDP growth in the 10 years after crossing the tax to-GDP threshold. The four-digit numbers after the country abbreviations indicate the calendar year in which each country crossed the tax-to-GDP threshold. ALB = Albania; ARG = Argentina; BEN = Benin; CMR = Cameroon; COL = Colombia CRI = Costa Rica; CYP = Cyprus; ESP = Spain; HND = Honduras; IND = India; KEN = Kenya; MEX = Mexico; SUR = Suriname; SWZ = Switzerland; THA = Thailand; TUR = Turkey; URY = Uruguay; VNM = Vietnam.

Using the historical data set of Gaspar, Jaramillo and Wingender (2016), consisting of a panel of 30 advanced countries between 1800 and 1980, 17 countries are found to have crossed the tax threshold of 12.65 percent of GDP without reversal (see Annex Table 10.1.1). Interestingly, several of the countries crossed the threshold around World War II. In most cases, 10-year cumulative real GDP per capita growth was considerably higher after the country crossed the tax threshold, by an average of 19 percent (Figure 10.4). Exceptions are Australia, Japan, the United Kingdom, and the United States. However, if the Great Depression is excluded for the United Kingdom and the peak of the war buildup is excluded for the United States, one would also see higher real GDP per capita growth after these two countries crossed the tax threshold.

Figure 10.4.Cumulative Real GDP Per Capita Growth Before and After Countries Cross the Tax-to-GDP Threshold

(Percent)

Source: Gaspar, Jaramillo, and Wingender 2016.

Note: Cumulative growth, t – 10 to t indicates countries’ cumulative GDP growth in the 10 years prior to crossing the tax to GDP threshold. Cumulative growth, t to t + 10 shows cumulative GDP growth in the ten years following the crossing of the tax to GDP threshold. The four-digit numbers following the country abbreviations indicate the calendar in which each country crossed the tax to GDP threshold.

Looking beyond cumulative real GDP per capita growth, improvements are found in other indicators of state capacity after countries crossed the tax-to-GDP threshold. Using the contemporary data set, Figure 10.5 shows that countries saw lower volatility in tax revenues after crossing the threshold. This finding suggests that the increase in tax capacity was associated with greater stability of revenue, which in turn would support less volatility of government spending. Figure 10.6 shows that for many countries, the prevalence of corruption declined after crossing the tax threshold. This finding is consistent with the expectation of greater transparency and accountability demanded by citizens when tax compliance increases. Countries also saw an improvement in legal capacity indicators that are expected to be supportive of sustained economic development, in particular, protection of property rights (Figure 10.7) and regulatory quality (Figure 10.8).

Figure 10.5.Volatility of Tax Revenue

Source: Authors’ estimates.

Note: Volatility was calculated as the standard deviation of tax to GDP, taking into account the underlying

Figure 10.6.Corruption Index

Sources: Heritage Foundation Index of Economic Freedom; and authors’ estimates.

Note: The average corruption index ranges from 0 to 100, based on the Heritage Foundation Index of Economic Freedom. The index on corruption from the Heritage Foundation was transformed so that a higher index indicates higher corruption.

Figure 10.7.Protect ion of Property Rights

Sources: The Fraser Institute Economic Freedom Indicators; and authors’ estimates.

Note: Indicator is defined as “Property rights, including over financial assets, are poorly defined and not protected by law (= 1) or are clearly defined and well protected by law (= 7).”

Figure 10.8.Regulatory Quality

Sources: World Bank, World Governance Indicators; and authors’ estimates.

Note: Indicator reflects perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development.

Case Studies

This chapter attempts via case studies to illustrate the nature of political conditions that accompanied countries as they crossed the tax-to-GDP threshold. The discussion that follows illustrates that improvements in taxation have been part of a deeper process of state capacity building in these countries. Note that the aim of this chapter is not to offer a general model that would encompass these cases. Rather, the goal is to provide an overview of the political context that fostered implementation of reforms to increase tax capacity in four selected cases. For each case, the discussion covers the political conditions that have accompanied state and tax capacity building, noting the role of constitutive institutions, inclusive politics, and credible leadership. The discussion then turns to growth performance around the time the country crossed the threshold. Where available, the associated changes in the social norms of tax compliance are documented. The case studies also discuss the behavior of other indicators that suggest that tax capacity moved in conjunction with improvements in other aspects of state capacity, in particular, legal and public administration capacity.

Four cases are reviewed: Spain (crossed in 1983), China (2001), Colombia (2001), and Lagos State in Nigeria, which saw a substantial increase in tax capacity, although at the national level, Nigeria is still below the 12¾ percent tax-to-GDP threshold.2 Countries were chosen on the basis of their levels of development at the time of their crossing of the tax-to-GDP threshold and their subsequent experience in economic development to this day. Care was also taken to select a group that provides different insights from both a regional and a historical perspective. It is important to note that for each of these cases, the tax reforms discussed below do not imply that further improvements in the tax system were not needed. Indeed, most countries subsequently implemented additional tax policy and administration reforms to improve fairness, increase efficiency, and reduce administrative complexity.

Across all four case studies, constitutive institutions, inclusive politics, and credible leadership played a role in the process of state and tax capacity building. First, important constitutive institutions were in place in Spain and Colombia, where explicit political settlements between political elites and citizens preceded state and tax capacity building. In Spain, the transition to democracy and the new Constitution of 1978 paved the way to economic modernization and welfare state development. Similarly, in Colombia, the Constitution of 1991 facilitated a new distribution of power between the center and the subnational governments, increased checks and balances within the political system, and mandated more public services. In both cases, it was recognized that greater levels of taxation were essential to meeting the emerging spending pressures associated with the economic, social, and institutional demands prompted by the new constitutions. Second, inclusive politics facilitated new center-periphery agreements that were crucial to building new tax collection schemes, as discussed for China and Lagos State.

Credible leadership was also clearly present across the four case studies. In all cases, policymakers made a deliberate decision to implement a shift in the economic model, taking advantage of opportunities offered by economic or political crisis. In Spain, transition to democracy created the opportunity to build broader coalitions around the issue of building tax capacity. In Colombia, the economic crisis of the late 1990s helped foster the political consensus needed to implement several fiscal reforms. Efforts to mobilize internal tax revenues in Lagos State can be linked to its political rivalry with the federal government following the transition from military rule. In China, the main driver for greater tax capacity was the collapse in SOE revenues associated with the transition out of a patrimonial state toward a market-oriented economy. The case studies also illustrate that in all these episodes, policymakers needed to build broader coalitions to ensure enough political stability for the economic plan to work.

Spain

Political Context of Reforms to Increase Tax Capacity

The improvement in tax revenue performance observed in Spain during the early 1980s reflected the social and political consensus that emerged after the death of General Francisco Franco in 1975. A political transition to democracy was necessary in the context of intense social conflict and a deep economic crisis—including high inflation and unemployment rates and significant balance of payments and public sector deficits. In the face of these challenges, a wide public consensus emerged that the country needed to greatly improve its basic public services, welfare programs, and public infrastructure, and at the same time modernize its economic institutions, a consensus embodied in the Constitution of 1978. It was also recognized that a significant increase in public spending had to be financed through greater levels of taxation. Spain’s reform efforts during this period were further encouraged by its ambition to join the European Economic Community (EEC), the application for which was made in 1977.

The Unión de Centro Democrático (UCD) government, elected in 1977 with 34.4 percent of the vote, managed to build a national political consensus in 1977–79, during which all political parties signed the Moncloa Pacts. Early in its time in office, the UCD government presented an economic program that included economic adjustment measures together with fiscal structural and financial system reforms. However, when negotiations with social organizations stalled, the government decided to seek an agreement across all political parties in Parliament. Enrique Fuentes Quintana, Vice President for Economic Affairs, convinced political parties to negotiate and to use his Economic Reparation and Reform Program as a basis. These agreements were called the Moncloa Pacts. Success of the Moncloa Pacts was based on the subordination of collective negotiations to price stability and the use of progressive taxation and public expenditure policies as instruments of income distribution (Comin 2007).

The Moncloa Pacts provided the blueprint for fundamental tax system reform. The tax system under the Franco regime exercised a low and regressive tax burden, with widespread tax evasion. The Moncloa Pacts addressed both tax policy and tax administration. On tax policy, they included four main elements: (1) a personal income tax, with a comprehensive tax base and progressive tax schedule, to replace the existing income tax; (2) a permanent personal net wealth tax, properly harmonized with the personal income tax, applicable on real wealth bases and with a progressive tax schedule; (3) a corporate income tax, without the exemptions that had been frequent in the previous corporate income tax; and (4) the introduction of a value-added tax (VAT) to align indirect taxation with the EEC’s system.

The UCD government took the first steps toward strengthening tax compliance, but did not fully advance the reforms outlined in the Moncloa Pacts. Early on, the government managed to pass Law 50/1977 of Urgent Tax Reform Measures. A personal net wealth tax was introduced in 1978. The main objective of the new wealth tax was not to increase revenues but rather to obtain information on all sources of income to adequately apply the new personal income tax to be introduced in 1979. Conscious of pervasive tax evasion, the government coupled the introduction of the net wealth tax with a tax amnesty provision to motivate taxpayers to reveal hidden sources of income. Other measures implemented during this period included the abolition of bank secrecy and the introduction of criminal sanctions for fiscal offences (Sánchez Maldonado and Gómez Sala 2007). However, little progress was made in modernizing the tax administration.

Reforms stalled following the approval of the Constitution of 1978. Party differences became significant in the context of the 1979 elections. Disagreements among social and business groups with regard to details of fiscal reform eroded the previous consensus. The various UCD governments that followed did not reach the majority in Parliament needed for passage of reform, which prevented implementation of the tax reforms set out in the Pacts. Moreover, fragmentation within the UCD itself further weakened the government.

Sufficient political clout to implement the tax reforms outlined in the Moncloa Pacts was not achieved until the early 1980s. The momentum for tax reform gained support with the Socialist Party’s ample win in the 1982 elections (with 48.1 percent of the vote), as well as Spain’s preparations for joining the EEC in 1986. The VAT was introduced through Law 30/1985, a condition for entering the EEC. The government took decisive steps to reorganize the tax administration. It substantially increased human resources and invested in information systems. Measures were put in place to fight tax fraud. It introduced the New Tax Management Procedure, which increased the use of self-assessment for collecting the main taxes, and established a unique taxpayer’s personal identification code. Territorial deconcentration was a further important change in the organizational reform of the tax administration (see Onrubia 2007).3

Performance of Growth and State-Capacity Indicators

Beginning in 1983, cumulative growth of real GDP per capita was greater than that observed in earlier years and remained relatively higher until the global financial crisis (Figure 10.9).4

Figure 10.9.Spain: Taxation and Cumulative Growth of Real GDP per Capita over Ensuing 10 Years

(Percent)

Sources: IMF, World Economic Outlook database; Organisation for Economic Co-operation and Development Tax Statistics; and authors’ estimates.

Note: Tax-to-GDP figures do not include social security contributions. The red dashed line indicates the tax threshold of 12 3/4 percent of GDP.

During this period, the increase in tax revenues can be attributed both to changes in the tax system and to greater compliance rates. The change in the overall social norms of tax compliance can be illustrated using the response to the question “Is it justifiable to cheat on taxes if you have a chance?” from the World Values Survey (Martinez-Vazquez 2007). The social norm of compliance is measured by those that answer “it is never justifiable to cheat on taxes.” The sharp increase in this measure for Spain from 1981 to 1994, shown in Figure 10.10, suggests that there was a significant improvement in citizens’ willingness to voluntarily comply with taxation. Furthermore, available government data confirm the improvement in tax compliance over the period. In 1990, the Commission for the Study and Prevention of Tax Evasion quantified personal income tax compliance during the period 1979–87 to illustrate the extent of tax evasion and avoidance. Table 10.1 shows notable improvement in tax filing as well as income reporting in the early 1980s.

Figure 10.10.Spain: Social Norms of Tax Compliance

Source: World Values Survey. 1981–2014 Longitudinal Aggregate v.20150418. World Values Survey Association (www.worldvaluessurvey.org).

Note: The red dashed line indicates the time period in which Spain crossed the tax threshold of 12 3/4 percent of GDP.

Table 10.1.Spain: Personal Income Tax Compliance, 1979–86
19791980198119821983198419851986
Filing (percent of potential tax returns)52.256.956.256.159.458.761.064.1
Tax Base Reporting
Share of True Taxable Income42.947.848.949.650.850.552.055.1
Share of True Labor Taxable Income54.062.163.464.866.666.768.971.3
Share of True Nonlabor Taxable Income22.323.324.625.223.424.626.230.4
Source: Onrubio 2007.
Source: Onrubio 2007.

China

Tax is the foundation of state governance. It plays an important role in social and economic life.

Mr. Jun Wang, Commissioner, State Administration of Taxation of the People’s Republic of China, March 2016

Political Context of Reforms to Increase Tax Capacity

In the late 1970s, China embarked on a path toward a market-oriented economy. While maintaining the overall framework of predominant public ownership, China adopted a policy of opening up trade and investment with the rest of the world and restructured its domestic economy. The government gradually relaxed mandatory planning, decentralized economic decision making, and allowed market forces to influence an increasing number of prices. For example, more investment was channeled from capital goods to consumer goods production. The government raised the prices for agricultural products by more than 20 percent in 1979 and significantly increased grain imports. Steps were taken to decentralize foreign trade and give more fiscal autonomy to provincial governments. Preferential policies were conferred on special economic zones to attract foreign investment. Importantly, reforms were launched to provide incentives to state-owned enterprises (SOEs) to increase production (see Bell and others 1993; Coase and Wang 2013).

China initiated its reform process in the wake of a major political transition. Following the death of Mao Zedong in 1976, the ultra-left faction (referred to as the “Gang of Four”) was ousted from power by a coalition of moderate forces consisting of senior veterans of the Communist Party and younger cadres that had emerged during the period of the Cultural Revolution (Bell and others 1993). The party was initially led by Mao’s designated successor, Hua Guofeng. During this time, the economy was partially recentralized and the planning apparatus strengthened. An ambitious 10-year development plan was launched, focused on investment in heavy industry and strong reliance on imports of capital equipment. However, the plan was soon abandoned because the surge in capital imports resulted in serious balance of payments problems.

By late 1978, reformist views gained dominance within the party, spearheaded by Deng Xiaoping. At the Third Plenum of the Central Committee of the Communist Party in December 1978, the leadership resolved to focus the party’s work on reforming those aspects of the economic system that had impeded economic development. There was, however, no unanimity in views on the pace and nature of reform, particularly the role of the market versus planning. Conservatives favored retaining a central role for planning in a reformed economic system, whereas the more radical elements envisaged a greatly diminished and reformed role for planning (Bell and others 1993). Despite periodic shifts in policy emphasis, the more radical views prevailed. In 1992, a decisive ideological change occurred when the party called for the establishment of a socialist market economy.

As part of its reform efforts, the Chinese authorities sought to increase their tax capacity rather than rely solely on the profits from SOEs. Before 1978, state enterprises were required to turn all of their profits over to the state, which was the main source of government revenue (Lin 2009). Tax reform efforts began in 1979. State enterprises were allowed to keep part of their profits to expand production and to issue bonuses and awards to workers. In 1983, SOEs became subject to income taxes instead of contributing their profits. However, widespread evasion prompted the government to shift to a “contract responsibility system.” Rather than trying to monitor each company’s sales and profits, the government instead signed a contract with each SOE specifying its tax liability for the next several years. In some of these contracts, tax payments were set ex ante, usually based on the previous year’s profits plus an increment. Other contracts consisted of a base payment with a supplementary tax imposed on profits earned above a set level. In 1989, the government launched a new tax reform under which SOEs were required to submit a portion of their profits to the government after paying corporate income taxes.

The sharp decline in the tax-to-GDP ratio during the early 1990s exposed the weaknesses in China’s tax administration. Some studies estimated that up to 30 percent of SOEs, 60 percent of joint ventures, 80 percent of private enterprises, and 100 percent of individual street vendors failed to comply with their tax obligations in the mid-1990s (Brondolo and Zhang 2016). China’s impending accession to the World Trade Organization—application for which took place in December 1995—increased the urgency for tax reform.

The sharp drop in revenues limited the ability of the central government to conduct macroeconomic or redistributive policies (Ahmad 2011), which prompted the Chinese government to undertake comprehensive reform of the tax system. The 1994 tax reform included four main elements:

  • Simplification and standardization of the tax structure. The government lowered the income tax rate from 55 percent to a universal rate of 33 percent. A new VAT was enacted at 17 percent on most goods and services, and a reduced rate of 13 percent on agricultural products and inputs, energy, and minerals.

  • Change in revenue sharing between the central and local governments. In the previous system, local governments collected taxes and then remitted a negotiated amount to the central government. The reform divided taxes into three distinct categories: central, local, and shared. The central government was assigned all revenue from consumption (excise) taxes, customs duties, and import-related VAT and consumption taxes. Shared taxes included domestic VAT, enterprise income tax, and personal income tax. All remaining taxes, including the business turnover tax on services, social security contributions, and stamp duties on real estate transactions, were allocated to local governments. In general, harder-to-collect taxes were assigned to local governments, which presumably had an information advantage over the national government (Wang 1997).

  • Centralization of the tax administration. The central government established its own revenue collection agency, the State Administration of Taxation (SAT). The SAT was charged with collecting central and shared taxes, while the local tax system was to collect local taxes. This reform was crucial for enforcement. Local governments could no longer game the tax-sharing mechanism by strategically lowering their tax effort or reclassifying revenues to reduce remittances to the center (Wang 1997).

  • Curbing the ability of local governments to grant tax breaks. In the previous system, local governments had discretion to grant reduced tax rates and tax exemptions. They had often used this discretion to channel budgetary funds into extrabudgetary funds, thereby reducing the revenues shared with the center. The reform required local governments to obtain approval by the State Council for any tax exemption.

To strengthen tax administration, the Tax Collection Law was enacted in 1992. The law set out the procedures for each tax administration function, vested the tax authorities with powers to enforce the tax laws, and defined the rights and obligations of taxpayers. In 1994, the government launched the Golden Tax Project to establish a computerized database of the records of both taxpayers and tax collectors (central and local).

To garner political support for the reform and persuade provinces to relinquish tax space to the SAT, the center agreed to three main concessions. The first concession by the center was to agree to a lump-sum transfer to each province to ensure that revenue after 1993 would not be lower than that in 1993. Of course, local governments also wanted a share in the revenues from the new taxes, especially the VAT. Therefore, the second concession by the center was to increase the central compensation to provinces by 30 percent of the average growth rate of VAT and consumption tax collections. A third concession was to allow a two-year “transitional period” in which tax breaks authorized by local governments in years before the reform would continue to be effective, and lower corporate income tax rates would be applicable to some enterprises with low profitability (Wang 1997). The first concession was geared toward obtaining political support from the richer provinces. The second concession was a lure for all the provinces. The last concession was geared toward obtaining political support from the poorer provinces, which collectively were large in number.

Performance of Growth and State-Capacity Indicators

China last crossed the 12¾ percent of GDP tax threshold in 2001. Tax to GDP had risen above the threshold in the 1980s, but as the result of great reliance on revenues from large, capital-intensive SOEs. By the early 1990s, tax to GDP had dropped below the threshold. Brondolo and Zhang (2016) attribute the decline in the tax-to-GDP ratio to a number of structural factors, including (1) less reliance on revenues from SOEs, not fully compensated for by taxation of non-SOEs; (2) a relative shift in value added from goods to services, with the former having higher effective tax rates than the latter; and (3) an increase in the trade surplus, which reduced the tax base because exports are excluded from the VAT base. It is important to stress that the drop in the contribution from SOEs has a deep structural interpretation. State dependence on revenues from state property or entrepreneurial activities is, from the viewpoint of the development of the tax state, a characteristic of an earlier stage of development. From this viewpoint, it is only after shifting away from overreliance on SOE taxation that China built tax capacity on a sustained basis.

As illustrated in Figure 10.11, cumulative growth of real GDP per capita over the 10 years since 2001 was considerably higher than that observed in earlier years. Furthermore, several indicators related to legal capacity and accountability improved noticeably after crossing the threshold, including protection of property rights, regulatory quality, and corruption (Figure 10.12). However, the World Values Survey does not show improvements in the social norms of compliance—the willingness to pay taxes remained basically unchanged.

Figure 10.11.China: Taxation and (Cumulative Growth of Real GDP per Capita over Ensuing 10 Years

(Percent)

Sources: IMF, World Economic Outlook database; National Bureau of Statistics of China, China Statistical Yearbook 2014; and authors’ estimates.

Note: The red dashed line indicates the tax threshold of 12 3/4 percent of GDP.

Figure 10.12.China: Social Norms of Compliance and Other Institutional Indicators

Sources: The Fraser Institute Economic Freedom Indicators; Heritage Foundation Index of Economic Freedom; World Bank, World Governance Indicators; World Values Survey 1981–2014 Longitudinal Aggregate v.20150418 World Values Survey Association (www.worldvaluessurvey.org); and authors’ estimates.

Note: All indicators were rescaled to range between 0 and 1. Social norm of compliance corresponds to the share of survey respondents who answer that “it is never justifiable to cheat on taxes”; a high value of the protection of property rights indicates that they are clearly defined and well protected by law; a high value of the perception of corruption index indicates a low perception of corruption; and a high value of the regulatory quality index indicates that the government is perceived to have strong ability to formulate and implement sound policies and regulations.

Colombia

Strengthening our tax, budget, and planning institutions is an essential part of progress towards development. Achieving this requires substantial improvements in all our institutions and in politics.

Mr. Guillermo Perry Rubio, Minister of Finance and Public Credit 1994–96, February 2014

Political Context of Reforms to Increase Tax Capacity

The increase in tax capacity in Colombia can be seen as a response to the new political, economic, and social demands that emerged from the 1991 Constitution. The 1991 Constitution sought to increase state presence by devolving fiscal and political power to subnational governments. This entailed giving subnational governments an increasing proportion of central government revenues. The constitution extended the coverage of basic social services and strengthened the judiciary. The new constitution also increased checks and balances within the political system. The president lost some capacity as an agenda-setter relative to the previous period, while Congress and the Constitutional Court gained relative power (Cárdenas, Junguito, and Pachón 2006).

These reforms gave rise to significant spending pressures. Furthermore, independence of the central bank, approved as part of the constitution, restricted its capacity to finance the government. The country was simultaneously embarking on a series of economic liberalization policies. Increased spending linked to the new constitution was coupled with other expenditure pressures, particularly those related to the financial imbalance in the pension system and increased resource demands from the defense sector. Higher tax revenue was therefore crucial to finance the sharp increase in spending and offset the decline in revenue from the reduction in trade tariffs.

Several structural economic and fiscal reforms were implemented in the early 1990s. Cesar Gaviria, a candidate of the Liberal Party, was elected president with 48.2 percent of the vote. The government had a majority coalition in Congress, thus facilitating the enactment of difficult reforms. Structural reforms to liberalize the economy included the reduction of trade barriers, privatization, labor market reform, and opening of the capital account. In 1990, tax changes were introduced mainly with the aim of encouraging savings and deepening capital markets through the repatriation of capital, among other measures. The authorities reduced the corporate tax rate, introduced a much lower tax rate on income from repatriated capital, and exempted stock market income from taxation. As spending pressures continued to mount, tax reform was introduced in 1992–93 with the objective of lowering the fiscal deficit. The VAT rate was increased to 14 percent and the base broadened. An income tax surcharge was introduced to fund national security expenditure. Public enterprises, public funds, and financial cooperatives became subject to taxation. Tax administration reforms included implementation of audit plans, introduction of computerized audit management, improvement of the monitoring and recovery of tax arrears, and introduction of stiffer sanctions for tax evasion and contraband (IMF 2001).

The ensuing administration of Ernesto Samper intended to advance structural tax reform but lacked political backing. Samper, from the Liberal Party, began his presidency with a majority coalition in Congress but suffered a deep political crisis following allegations of illicit campaign contributions. The Administration proposed a tax reform in 1995 to eliminate VAT and income tax exemptions and strengthen tax administration. However, the government was unable to garner support, even from its own party members in Congress. Weak party discipline was further fueled by the willingness of individual members of Congress to protect the narrow tax interests of their campaign finance contributors (Salazar 2013). To increase revenues, the government ended up relying mostly on the increase in the general VAT rate to 16 percent.

Further reform was achieved in the late 1990s, with political support facilitated by the need to respond quickly to the economic and financial crisis. Andres Pastrana took office as president in 1998, but without a congressional majority. He won 51.9 percent of the vote in the run-off election as the candidate for the Great Alliance for Change party, a multiparty coalition made up of heterogeneous political groups. However, soon after elections, Colombia faced a deep crisis. Following the Asian and Russian financial crises, Colombia’s exchange rate came under pressure, the economy entered recession, Colombia lost its investment-grade rating, there was a mortgage crisis, and several banks had to be intervened. The magnitude of the economic and financial crisis, however, helped foster the political consensus needed to implement several fiscal reforms (Olivera, Pachón, and Perry 2006). A temporary financial transactions tax was created to finance financial sector rescue operations. The 1998 tax reform increased the VAT tax base, eliminated some exemptions, and mandated the subscription of public bonds in proportion to net wealth. The 2000 tax reform made permanent the financial transactions tax and increased some VAT bases. The reform also contributed to a reduction in tax evasion and strengthening of tax administration by introducing heavier penalties and supporting improvements in collections through electronic filing (see González and Calderón 2002).

Performance of Growth and State-Capacity Indicators

After crossing the tax threshold in 2001, Colombia saw cumulative real GDP per capita growth over the ensuing 10 years that was higher than observed in earlier years (Figure 10.13). The increase in tax revenues was accompanied by an improvement in several indicators associated with willingness to pay taxes, legal capacity, and accountability (Figure 10.14). The social norm of compliance, as measured by the World Values Survey, increased noticeably after Colombia crossed the threshold, suggesting that the increase in collections was linked in part to greater voluntary tax compliance. Corruption was perceived to be less prevalent, which suggests that higher taxation prompted greater demand for government transparency and accountability. Measures of protection of property rights and regulatory quality also improved, suggesting that the increase in taxation was accompanied by strengthening of the country’s legal capacity.

Figure 10.13.Colombia: Taxation and Cumulative Growth of Real GDP per Capita over Ensuing 10 Years

(Percent)

Sources: IMF, World Economic Outlook database; Organisation for Economic Co-operation and Development Tax Statistics; and authors’ estimates.

Note: Tax-to-GDP figures do not include social security contributions. The red dashed line indicates the tax threshold of 12 3/4 percent of GDP.

Figure 10.14.Colombia: Social Norms of Compliance and Other Institutional Indicators

Sources: The Fraser Institute Economic Freedom Indicators; Heritage Foundation Index of Economic Freedom; World Bank, World Governance Indicators; World Values Survey 1981–2014 Longitudinal Aggregate v.20150418. World Values Survey Association (www.worldvaluessurvey.org); and authors’ estimates.

Note: All indicators were rescaled to range between 0 and 1. Social norm of compliance corresponds to the share of survey respondents who answer that “it is never justifiable to cheat on taxes”; a high value of the protection of property rights indicates that they are clearly defined and well protected by law; a high value of the perception of corruption index indicates a low perception of corruption; and a high value of the regulatory quality index indicates that the government is perceived to have strong ability to formulate and implement sound policies and regulations.

Lagos State, Nigeria

As we improved tax administration and revenues grew, the citizenry became more interested in government’s developmental programs, literally insisting on seeing the benefits of their contribution.

Mr. Ade Ipaye, Special Adviser for Taxation and Revenue in Lagos State 2007–11, May 2016.

Political Context of Reforms to Increase Tax Capacity

Despite strong growth since the 1990s, Nigeria faces large weaknesses in its economic and human development. Nigeria’s real GDP per capita has doubled since 1995. However, when compared with countries with similar income levels, Nigeria lags behind across many human development indicators, such as life expectancy, infant mortality, and educational attainment. A central driver of Nigeria’s growth has been the oil sector (Akinlo 2012), which makes the country vulnerable to oil price volatility and calls into question whether growth rates can be sustained. Indeed, after the sharp decline in oil prices since 2014, the Nigerian economy fell into recession in 2016. This situation is not uncommon for resource-rich countries. On average, countries that have an abundance of natural resources often show a record of relatively poor economic performance compared with non-resource-rich countries, as shown by Torvik (2009); Arezki, Gylfason, and Sy (2011); and IMF (2015). Furthermore, Collier and Goderis (2007) find that although in the short term an increase in commodity export prices raises growth, in the long term, growth is substantially reduced.

Heavy reliance by the government on oil revenue has prevented Nigeria from building its own tax capacity. Non-oil tax revenues averaged about 4 percent of GDP between 2005 and 2015, which puts it among the countries with the lowest tax collections in the world. This rate is also well below the levels of taxation in countries with similar income levels. Unsurprisingly, the weak tax capacity is associated with weak indicators of legal and public administration capacity.

Despite very weak tax capacity at the national level, the experience of Lagos State illustrates that it is possible to improve tax capacity and voluntary tax compliance, which in turn can foster greater legal and public administration capacity. Since the early 2000s, the Lagos State government has succeeded in boosting tax revenues to develop basic infrastructure, expand public services, and improve law enforcement.

Efforts to improve tax capacity in Lagos State can be traced back to the early 2000s. Nigeria began a transition away from military rule following the death of General Sani Abacha in 1998. National and state elections were held in 1999. Bola Tinubu was elected governor of Lagos State as the candidate of the Alliance for Democracy, the opposition party to the Nigerian President’s People’s Democratic Party (PDP). Governor Tinubu was reelected in 2003, again as a candidate from the opposition party to the president. His successor, Babatunde Fashola, elected in 2007 and reelected in 2011, was also from the opposition party to the PDP-controlled national government. As prominent opposition leaders, Lagos State politicians were eager to demonstrate that they could deliver more benefits to their constituents than the PDP. Building tax capacity was crucial for their objectives, given that resource allocations (including revenue sharing of oil receipts) received by Lagos State were insufficient to meet their spending needs. For example, according to De Gramont (2015), in 2002, the state government’s personnel costs alone exceeded its statutory allocation from the federal government.

Governor Tinubu made taxation an early priority. In the late 1990s, the Lagos State government lacked basic tax capacity. Taxes were paid in cash to revenue officials who gave out handwritten receipts. The state finance ministry was not able to clearly track payments made into state bank accounts. State revenue staff were ill-equipped to effectively audit businesses. Tax evasion was pervasive. During Tinubu’s first term, tax collection was shifted from cash transactions toward electronic payments through banks. Taxes could now be paid directly into government coffers at a number of bank branches. Greater attention was also placed on enforcement.

Tax administration in Lagos State reached a turning point in 2005. Political rivalry added further impetus to the ongoing reform process aimed at increasing internal revenues when, in 2004, President Obasanjo cut off federal funding for local governments in Lagos State because of a dispute over the creation of new local governments. As a first step, management of the existing internal revenue board was replaced by a new team and it was given greater autonomy. The revenue board was then transformed into a new agency, the Lagos State Internal Revenue Service (LIRS). LIRS came into full force in 2007. It was able to pay higher salaries and use greater flexibility in hiring and internal management than the ordinary civil service. As a result, it was able to attract better-qualified staff and offer better training (Asaolu, Dopemu, and Monday 2015).

Governor Fashola continued to make taxation a central focus of his administration. LIRS increased its monitoring capacity. In-house audit capacity was increased. A self-assessment filing system for individuals was introduced. Efforts were made to bring informal-sector workers into the tax net through payment of a flat tax. Meanwhile, infrastructure construction and public service reforms accelerated to clearly display to citizens the benefits of their tax contributions.

As part of the reform process, significant efforts were made to increase voluntary tax compliance. Since 2007, regular tax stakeholder conferences have been convened with representatives from the private sector, labor unions, civil society groups, and informal-sector associations to discuss tax payment and their expectations from the government. Public works projects in Lagos display large signs urging people to pay their taxes. LIRS has enlisted public figures to record messages about the importance of tax payment and runs a tax essay competition for youth.

Figure 10.15.Lagos State: Tax Revenue, by Source, 1998–2011

Source: De Gramont 2015.

Public perceptions that the state government has been doing its job well appear to have influenced individuals’ readiness to pay taxes. De Gramont (2015) reports a 2010 survey in which 74 percent of respondents said they were some-what or very satisfied with the state government’s use of tax revenues. Bodea and Lebas (2014) report that residents of Lagos expressed the highest support among all residents of urban centers in Nigeria for the statement that “citizens should always pay their taxes.”

The impact of these tax system reforms has been remarkable. Between 1999 and 2010, internal tax revenues increased almost eightfold, as shown in Figure 10.15. Both revenues and tax audit penalties increased markedly after the 2005 tax administration overhaul. As a result of these efforts, in 2014, about 70 percent of Lagos State government revenue was derived from internally generated tax revenue.

Conclusions

This chapter complements a recent study (Gaspar, Jaramillo, and Wingender 2016) on the determinants of economic growth and development of state capacity. While the previous study uncovered a robust and significant statistical threshold effect of the level of taxes on subsequent growth, the current chapter attempts to document the political environment that supported broader changes in state capacity that accompanied the crossing of the tax threshold in the four cases analyzed.

This chapter’s goal is not to present general theory about the institutions and politics behind state capacity. Rather, the aim is to illustrate with a few case studies the political conditions that have supported broader changes in state and tax capacity. We hope that the insights into these cases can serve as useful input for the development of a more general theory that integrates politics, institutions, and tax capacity.

Across all four case studies, constitutive institutions, inclusive politics, and credible leadership played a role in the process of state and tax capacity building. Constitutive institutions were in place in Spain and Colombia, where explicit political settlements between political elites and citizens preceded state and tax capacity building. Inclusive politics facilitated new center-periphery agreements that became central elements of the building of tax capacity, as discussed for China and Lagos State. Credible leadership was also clearly apparent across the four case studies. In all cases, policymakers made a deliberate decision to implement a shift in the economic model, taking advantage of opportunities offered by economic or political crisis.

This chapter also makes the case that improvements in tax-to-GDP levels can only be sustained when accompanied by changes in social norms of tax compliance. Greater tax compliance then entails greater demand by citizens for an effective, trustworthy, and equitable government. Spain and Colombia saw sustained increases in taxpayers’ compliance norms after crossing the 12¾ percent tax-to-GDP threshold. This finding suggests that the improvement in tax collections was not only due to stricter tax enforcement but was also the result of greater voluntary compliance. The case studies also show lower perceptions of corruption, suggesting that higher taxation generated greater demand for government transparency and accountability. In China and Colombia, stronger tax capacity was also accompanied by improved legal capacity, such as the protection of property rights and regulatory quality. The Nigeria case study illustrates that sustained economic and human development does not follow if growth is not accompanied by the building of state and tax capacity.

As in the quote that serves as the epigraph to the section on Nigeria, the evidence collected here is suggestive of the importance of a double-sided accountability social contract. As tax administration and tax capacity improve, social norms of behavior change, leading to quasi-voluntary compliance on the part of taxpayers. Tax revenues become more important and elastic, allowing government revenues to become more stable. Public governance improves as citizens demand (and the administration delivers) accountability. As the process deepens, public administration increasingly focuses on the public good and acquires the capacity to deliver. It is from such deep social, institutional, and political dynamics that we find the explanation for a tipping point in tax-to-GDP levels that significantly accelerates the growth and development process.

Annex 10.1.1 Year in Which Countries Crossed the Tax-To-GDP Threshold Without Reversal
Annex Table 10.1.1.Year in Which Countries Crossed the Tax-to-GDP Threshold without Reversal
Contemporary Data Set (12.88 percent of GDP threshold)Historical Data Set (12.65 percent of GDP threshold)
Albania1998Liberia2006Australia1940
Argentina1993Malawi2004Canada1940
Armenia1997Maldives2011Chile1959
Bahamas, The2006Mexico2000Czechoslovakia1921
Benin1999Mali2002Denmark1955
Bolivia2004Mozambique2009Finland1941
Burkina Faso2011Nepal2010France1920
Cabo Verde1992Nicaragua2010Germany1934
Cameroon2000Papua New Guinea1978Italy1949
Chad2010Peru2003Japan1895
China2001Philippines2005Korea1965
Colombia2001Portugal1976Netherlands1940
Costa Rica1998Solomon Islands2003Norway1946
Cyprus1979Spain1982Portugal1953
Dominica1977Sri Lanka2010Sweden1943
Dominican Republic2004South Africa1973United Kingdom1916
El Salvador2010Suriname1995United States1943
Ethiopia2010Swaziland1988
Gambia, The2006São Tomé and Príncipe2004
Georgia2004Tajikistan2002
Ghana2010Thailand1979
Greece1966Togo2003
Guinea2005Tonga1993
Honduras1990Turkey1992
India1976Uruguay1985
Kenya1994Vanuatu1984
Kiribati1987Vietnam1992
Kyrgyz Republic2002Zambia2010
Lao P.D.R.2009Zimbabwe2010
Lebanon2002
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