Abstract
This paper examines the role of tax administration in developing countries from an economic perspective. The traditional separation of tax policy and tax administration in the literature is shown to break down in developing countries, where tax administrators decide in what manner complicated tax legislation should actually be applied. After surveying economic literature dealing with tax administration, the paper offers guidelines on how tax administrators can help implement more efficient and equitable tax systems.
1. Introduction
Unlike such disciplines as macroeconomics or tax policy, tax administration lacks a coherent body of literature or set of principles, with well defined “schools” espousing particular intellectual positions. Instead, tax administration is a loosely defined area embracing law, public administration, sociology and psychology as well as economics. Nevertheless, tax administration is closely linked to fiscal policy, since its ultimate result is to increase or lower government revenue and the overall deficit; to place higher or lower tax burdens on particular sectors of the economy; and to favor or penalize particular income classes and returns to different factors of production. In addition, tax administration may play a powerful role in influencing the efficiency of the economy by intended or unintended distortion of consumer choices and producer decisions. This paper will survey tax administration in developing countries from an economic point of view, emphasizing the above questions.
2. Role of tax administration
What do we mean by tax administration? A useful definition for the purpose of economic analysis begins with the set of statutory laws forming the basis of the tax system. This set of laws would generally include an income tax act; a customs act covering import tariffs and surcharges; an excise tax act; a general sales tax law; social security legislation; export, wealth, and property taxes (if any) and other minor taxes and fees. Such a body of legislation represents the tax system from the point of view of those who design tax policy. In contrast to the legal statutes stands the “real” or effective tax system, or the system as it is applied in practice. 1/ Tax administration can be seen as the link between the statutory laws and the tax system as actually applied. If tax administration were perfect, no difference would exist between statutory law and actual practice. In such a case, tax administrators would play a neutral role in determining the overall fiscal deficit, the relative tax burden on sectors and income classes and the efficiency of the economy. It is well known, however, that even the best tax administration collects some taxes more effectively than others. To take one example, a recent study of tax administration in the United States notes that for wages and salaries the percentage of reported income to estimated actual income is estimated at 97-98 percent, while the corresponding ratio for income from the self-employed and returns from capital (dividends and interest) is far lower. 2/
Failure to administer tax law effectively or even to administer tax law with equal ineffectiveness has economic consequences as noted above. To complicate the matter further, one should recognize that the drafting of statutory Law may take into account anticipated administrative difficulties. This kind of feedback can be seen, for example, in the use of schedular income taxes and in presumptive tax bases which are actually written into law rather than decided by administrative fiat.
Although differences between law and practice exist in industrial countries, most observers would agree that the statutory law by and large approximates the actual tax system. For many developing countries, however, the gap between statutory law and actual practice is so wide that one bears virtually no resemblance to the other. A reading of statutory laws relating to personal and company income tax, capital gains, customs duties and general sales taxes in a given developing country might convince the outside observer that its legislative tax system was close to European or North American models. In fact, however, the actual workings of the system are determined by administrators who collect a core group of easy-to-administer taxes. In this way the line of demarcation between “tax policy” and “tax administration” becomes blurred. Before examining actual tax structures and administration, however, it will be useful to look at tax policy and economic literature to see how economists have treated tax administration.
3. Tax administration and economic analysis
a. Separation of tax policy and administration
In general tax administration and tax policy have been treated as separate fields of scholarship and activity. While tax policy uses economic analysis to debate the merits and economic impact of individual taxes or tax systems, tax administration focuses on the assessment, collection and audit of a set of tax laws. Tax administration in this view “carries out the orders” of tax policy. Such a clear separation of tax administration and tax policy carries over to the literature in the fields. Although a comprehensive survey of tax policy literature is beyond the scope of this article, it would be fair to say that exploration of administrative constraints on tax policy or interconnections between policy and administration has been outside the mainstream of the literature. 3/ So far as administration is concerned theoretical economists have generally been satisfied with the admonition that taxes should not be too costly to collect. The mainstream of tax policy literature could be described as a normative approach, in which ideal objectives of tax policy are stated, and judgments about existing systems are made in light of these objectives. A recent statement of normative principles of taxation is as follows:
“There are three major principles of tax design: equity, efficiency, and administrative feasibility. The principle of equity requires that taxation conform to the community’s sense of fairness. Economic efficiency, as used here, means that taxation should not impose avoidable real costs on the community; it should not unnecessarily interfere with the attainment of the prime economic objectives of growth, stability, equitable distribution, and independence, and if feasible should promote them. Administrative feasibility implies that revenue is collected without excessive costs for the government or for taxpayers.” 4/
The reader will note that administrative feasibility refers narrowly to the fact that the cost of collection of revenue should not be overly high. The requirement that the tax system should not be excessively costly to administer has intellectual origins to Adam Smith. Apart from this dictum, however, theoretical analysis of tax policy has generally not investigated how tax administration might act as a constraint on tax policy. In retrospect, for example, one can see that theoretical objectives of equity and redistribution in the decades following World War II had practical expression in high personal income tax rates, but that little attention was given to the question of whether high tax rates might lead to avoidance and evasion, or how such problems might be dealt with in designing taxes. More recent emphasis on efficiency objectives also appears to ignore administrative concerns. As one writer has noted, “…the (optimal tax) theory is totally devoid of administrative and political content. Administrators are expected to possess costless and perfect information.…” He adds, “it might plausibly be argued that all theory must employ simplification and abstraction, and that the omission of administrative considerations can in principle be incorporated at a later stage. This argument would be more persuasive if tax administration did not itself give rise to distributional and ethical issues…” 5/
Although the normative approach of tax policy analysis has tended to ignore the practicalities of tax administration, economists have recently analyzed several closely related topics. These topics include the causes of tax evasion and a theoretical treatment of tax evasion as an economic crime committed under circumstances of risk and uncertainty. Growing interest in the underground economy has led naturally to its connection with tax evasion. In addition, a topical issue that has stimulated theoretical discussion is the supply side contention that tax evasion and avoidance will decrease if personal income tax rates at the margin are lowered.
b. Risk and uncertainty approach to tax evasion
Turning first to the theoretical literature on tax evasion, this literature treats the tax evader as a rational economic man contemplating an “economic crime,” and making decisions under uncertainty, given assumed probabilities of detection, conviction and levels of punishment. The rational economic man is expected to choose the level of compliance (evasion) that will yield the greatest “expected utility,” where expected utility is defined as the utility of the various possible outcomes (e.g., detection or non-detection of evasion) weighted by the probability that each possible outcome will occur. 6/ Although the literature is centered on the US tax system, the methods of analysis could apply to any setting, including developing countries. In this brief treatment we will set out some major questions and findings before giving any detailed criticism.
A simple example of a probability and risk aversion approach to tax evasion has been stated as follows: 7/ A US taxpayer has an income (y) of $20,000 and is planning to underpay $500 in taxes. In recent years about 2 percent of tax returns have been audited in the United States. Allowing for the fact that the Internal Revenue Service (IRS) has developed elaborate methods of detecting evaders, we can say that the probability of audit (p) for the intelligent evader does not exceed 5 percent. The maximum penalty assessed in civil fraud and negligence is 50 percent of tax owed, so the penalty rate (F) at most equals 1.5. (The probability of criminal procedure, which requires proof of intent, is almost zero, and can be eliminated by precautions available to the potential evader.) This situation can be expressed by:
| EU | = (1-p) U(y+x) + p U (y-Fx) |
| where U | = utility function |
| p | = probability of being audited |
| y | = taxpayer’s legal after-tax income |
| x | = undeclared taxes |
| F | = the penalty rate on undeclared taxes plus one. |
| EU | = (1-p) U(y+x) + p U (y-Fx) |
| where U | = utility function |
| p | = probability of being audited |
| y | = taxpayer’s legal after-tax income |
| x | = undeclared taxes |
| F | = the penalty rate on undeclared taxes plus one. |
In other words, the potential act of tax evasion is viewed as a gamble with a 95 percent chance of winning $500 (the underpayment of taxes) and a 5 percent chance of losing $750 (i.e., getting caught and paying the tax plus a penalty). On average over a period of years the bet will return $437, and it is difficult to imagine a taxpayer who would not take such a gamble.
Although this illustrative example is by no means a complete summary of the contribution of the expected utility approach, it does show fairly its fundamental weaknesses in the assumptions that (a) no allowance is made for institutional mechanisms such as withholding that would interfere with the decision of whether to evade or pay tax, and (b) given such a virtual free choice, the individual has no moral, ethical, habitual or peer group constraints on cheating. The example also points up the fact that the approach is static. In a dynamic context, the probability of detection may be changing and uncertain; the potential evader may then become more cautious. In fact, the positive contribution of the risk and uncertainty approach is that it leads us to wonder why people pay taxes at all. This “bare bones” approach in which all institutional and social constraints on tax evasion are assumed away shows that without these constraints tax administrators would face a herculean task.
Theoretical analysis has also treated seemingly obvious propositions about tax evasion, obtaining surprisingly ambiguous results. 8/ For example, the question, “Will an increase in the tax rate increase tax evasion?” would be answered in the affirmative for most situations by tax practitioners. Yet, if a high penalty rate for evasion is imposed on the evaded tax and the individual is risk-averse, then a higher tax rate would imply higher evaded tax and higher possible penalties, leading such an individual to pay tax due at the higher rate. Looking at the opposite proposition that lower tax rates would encourage compliance, a recent article examines the “popular myth” that a lowering of the tax rate (in the US context) would encourage compliance, and states… “In fact, that lowering tax rates will induce greater compliance is a claim supported by neither the theory of tax compliance nor by empirical evidence… The large share of underreporting attributable to capital gains income provides a counter-example to the notion that lower rates alone will cure noncompliance.” 9/ Thus, the seemingly obvious idea that higher rates stimulate evasion and vice versa is difficult to prove on a priori grounds.
c. Topical issues of tax evasion
In contrast to the purely theoretical risk and uncertainty approach to tax evasion, investigation of the underground economy has led to empirical efforts to measure the impact of the level of tax rates on tax evasion. While the US literature on the underground economy has focused on the personal income tax, European literature has also discussed social security and value-added taxes. In developing countries the phenomenon of the underground economy surely flourishes, and would affect foreign trade taxes as well as those mentioned above. Especially pertinent to an economic approach to tax evasion is discussion of the level of tax rates and its effect on tax evasion. In an empirical approach to this problem, Tanzi notes that one of the factors influencing tax evasion is the benefit of not paying taxes. 10/ This benefit can be measured objectively by the level of the legal tax liability. Using a regression equation in which the ratio of currency holdings to broad money (M2) is the dependent variable (and a proxy for tax evasion), Tanzi finds that variables representing the level of tax rates are highly significant in explaining changes in the currency to broad money ratio. Increases in several measures of the tax rate are associated with a greater relative use of currency, presumably because of the evasion effect.
As noted above, current attention to supply side economics has also contributed to discussion of tax evasion. A proposition advanced by supply side economists is the idea that a progressive tax rate schedule stimulates tax evasion and will yield less revenue than a proportional schedule. Using the “rational economic man” framework (divorced from institutional and social context) this proposition is true, provided that the taxpayer is risk neutral. 11/ If the taxpayer is assumed to have a decreasing absolute risk aversion, then the claim has no theoretical support, since the taxpayer would be less willing to cheat at higher tax levels. One economic insight into the question of tax evasion under a progressive rate schedule is that the substitution effect and the income effect tend to work in opposite directions. As actual income received increases under a system of progressive taxation, the relative benefit of evasion vs. payment of tax rises, so that the substitution effect leads to an increase in evasion. On the other hand, a rise in income reported that represents an increase in actual income means that the individual is richer, and with diminishing marginal utility of income has less reason to evade taxes. While theoretical analysis does not wholly confirm the widespread view that high tax rates or a progressive tax schedule cause evasion, the impact of the penalty rate on tax evasion is much clearer. According to theory, both the probability of detection and the penalty rate are clearly effective deterrents of tax evasion, and the penalty rate is relatively more effective than the probability of detection. 12/
d. Critique of theoretical approach to tax administration
This brief review of the results of theoretical models of tax evasion shows that such work is of very limited value for policy analysis or empirical study. A key assumption underlying the analysis is that taxpayers have a free choice to pay or evade taxes, or at least that all taxpayers are equally constrained in this decision. In fact, different taxpayers have different opportunities to evade, and the level of evasion can be much more easily explained by examining what these opportunities are. Clearly one important determinant of the level of evasion is whether withholding can effectively, be applied in collecting a tax. If the withholding system is virtually foolproof, any analysis of the individual’s preferences becomes academic. Even if there is collusion regarding withholding between wage-earner and employer some amount of taxes will probably have to be paid. In addition, the model of a rational man deciding whether or not to pay taxes has implicitly assumed the context of the personal income tax. In developing countries indirect taxes such as excises, import duties, and general sales taxes, form a much greater proportion of tax revenue. Administrative experience has shown that under a sales tax, the seller may collect the tax, but only turn over a portion to government by under-reporting sales. Formal analysis of this type of evasion has not been undertaken. In sum, different institutional contexts that would be highly relevant to the level and methods of evasion have generally not been taken into account. Probably the clearest conclusion of the theoretical studies is the obvious point that given a free choice, the level of evasion would be much higher than it is at present.
The lesson of the theoretical analysis, then, is that tax administrators should remove the element of free choice by such devices as withholding. An effective withholding scheme, however, requires a relatively small number of easily identifiable payers of the income. Withholding may thus be applied to wages, dividends and interest but not effectively to rental income, income of professionals and income from small businesses, where there are as many payers as receivers of such income. Withholding is most effective in taxing certain types of personal income and cannot be employed so easily in collecting taxes of greater importance in developing countries, such as excises and sales taxes.
Another conclusion of formal analysis of tax evasion is that evasion can be reduced significantly by increased penalties and a higher probability of audit. This conclusion agrees with practical observation in both developing countries and the United States. For example, the Internal Revenue Service of the United States has stated that it can raise $7 in new revenue for every dollar spent on compliance, and technical assistance missions to developing countries would agree that increased audit and greater enforcement of penalties would be cost effective. 13/ However, equity and political considerations place limits on how stiff penalties can be. The difficulty of proving intent to evade makes criminal cases scarce. Equity considerations suggest that when an individual is “caught” by random selection in an economic crime of which many others are guilty, he should not be punished too severely. In addition, the firmly held idea that “the punishment should fit the crime” sets practical limits on the penalties that can be given for tax evasion that would truly deter evaders. For example, life imprisonment for tax evasion might deter an economically rational individual, but would be inconsistent with ideas of justice. In addition, one feels that the likelihood of enforcement does indeed play a strong part in determining whether penalties work. For example, legislation exists in a number of countries whereby failure to pay property taxes results in auction of the property. If such a penalty is viewed as draconian and is unlikely to be enforced for political and social reasons, the stiff penalty loses its effect. These considerations all set a limit to penalties below what would be desirable from a tax-maximizing standard. Increasing the probability of audit by appropriating funds allowing tax administrators to audit more returns is also constrained by political considerations. Politicians may not want too efficient a tax administration.
Another way of reducing free choice to evade is through self-enforcing methods that will encourage taxpayers to report incomes and expenditures. Kaldor, in his well-known report on India, was perhaps the first economist to suggest linking taxes together to force greater compliance. 14/ Kaldor suggested that five taxes—the income tax, the capital gains tax, the wealth tax, the personal expenditure tax, and the gift tax—be filed in a single comprehensive return and assessed simultaneously. The taxes are self-checking—that is, concealment or understatement of items in order to reduce liability in a particular tax would increase liability in other taxes; and information furnished by a taxpayer in order to prevent overassessment of his own liabilities automatically reveals the receipts and gains made by other taxpayers. Higgins has carried Kaldor’s idea further by introducing a self-enforcing tax system for developing countries. Higgins’ system includes a personal income tax (including capital gains), a corporation income tax, a general sales or turnover tax, a wealth tax, a tax on excess inventory, and a personal expenditure tax. Theoretically, the Kaldor-Higgins system is self-checking because personal expenditure is defined as the excess of income over savings, and savings are equal to the increase in net wealth. Thus, taxpayers who underreport their expenditure by overstating their savings increase their wealth tax liability. A seller of a property who understates his capital gains hurts the buyer, because the buyer cannot claim the full amount of the investment, thereby forcing him to declare higher expenditures and increasing his expenditure tax liability. The excess inventory tax is designed to discourage underreporting of sales, thus helping enforce sales and income tax.
Apart from these comprehensive self-checking tax schemes the value-added tax, which has been adopted by 22 developing countries, in itself constitutes a self-checking mechanism. One authority has characterized this tax as a “form of withholding” intended to implement a retail (or other) sales tax more efficiently.” 15/ Under the commonly used invoice system of administering the value-added tax, a taxpayer at any stage in the production process credits his tax paid on the prior stage against his own collections of VAT. The difference is paid to Government. In theory each taxpayer should have a strong interest in proving that VAT has been paid at the prior stage—hence the self-checking nature of the tax. Although economists have been intrigued with this self-checking mechanism, the tax in practice is far from self-enforcing; evasion occurs because taxpayers have a common interest in avoiding the tax altogether, and legal exemptions open up channels of evasion. 16/
The more grandiose self-enforcing schemes suggested by economists have generally received short shrift from tax administrators. Goode, in writing on economic aspects of tax administration, comments: “these proposals appear so unrealistic that a detailed critique is not worthwhile. In my opinion their authors exaggerated the proclivity of taxpayers to refined calculations, the capacity of tax departments for using the great mass of data that would be generated, and the receptivity of governments to fiscal innovations. I suspect that most tax administrators will regard the idea of a self-enforcing tax system as fantastical. Even if put into operation, the proposed systems would not prevent evasion in cases in which both parties to a transaction omit it from their records or understate its amount. Both parties could evade the related taxes, and as no conflict of interest would arise between them, neither would have an economic incentive to report correctly.” 17/
Despite the justified criticism of elaborate self-enforcing schemes, tax administrators may come to see a grain of truth in the logic of such schemes, and one suspects they should not be dismissed entirely. In many developing as well as industrial countries, import duties and taxes on domestic transactions are typically administered by separate departments, with little or no contact or exchange of information among them. In some countries sales and income taxes are also administered by separate departments, and outside experts usually recommend the exchange of information between these revenue departments. Such an exchange is highly advisable because gross sales are an element of income tax determination, and the exchange of information forces consistency in tax reporting. Similarly, the idea that information furnished by one taxpayer to prevent overassessment of his own liabilities automatically reveals the receipts of another taxpayer underlies the concept of the VAT. As computer systems allow great quantities of data to be stored and used, the idea of self-enforcing taxes based on matching of information from different sources becomes more possible. Computer information systems may then make more practical this “impractical” idea of economists.
As summarized above, economic analysis related to tax administration has centered on such topics as examining tax evasion under conditions of risk and uncertainty, tax evasion and the underground economy and supply side attention to tax evasion associated with high marginal tax rates. Surprisingly little attention has been given to a micro approach in which tax administration would be seen as part of a production function in producing revenue. In such an approach the production of revenue could be seen as a function of tax bases and legal rates and exemptions, but also would depend on the input of tax administration. As Shoup has stated, “To maximize tax revenue the administration must so distribute the fixed amount of resources in enforcing the several taxes and, for each tax, must so allocate resources among techniques of administration that the return on the marginal dollar of administrative expense is everywhere the same.” 18/
One difficulty with this approach is how to define “maximization” of tax revenue. A short-term cost benefit approach would lead the tax administrator to concentrate on the largest or richest taxpayers, where assessment and audit efforts would yield a high return in the short-run. Tax administrators have objected to this approach on several grounds. First of all, if substantial numbers of humbler or harder-to-catch taxpayers perceive themselves as outside the enforcement net, these taxpayers will eventually begin to evade tax, and voluntary compliance will thereby suffer. Secondly, if tax administration efforts focus too selectively on certain economic activities, the principle of horizontal equity (taxpayers of equal income are treated equally) will be violated and taxpayers may begin to perceive the entire system as unfair. Again, this perception will undermine the voluntary compliance. A longer term approach to revenue maximization would recognize these externalities. Such a long-term approach would involve audit and enforcement efforts over a broad range of the taxpaying public, with due regard paid to long-term effects on voluntary compliance as well as short-term revenue maximization goals.
Given these qualifications it would be useful to look at tax administration as an element of a revenue production function. One would try to identify and quantify the inputs of tax administration (e.g., auditors of income tax, customs collectors) and seek to measure the marginal productivity of these units. Ideally, one could then conclude what would be the best use of different tax administration inputs for a given set of taxes. Alternatively, one would devise the best set of taxes from a (longer-term) administrative revenue maximizing point of view. This set of taxes would differ from the best set of taxes from an efficiency or equity point of view, but the government authorities would then be in a position to compare explicitly the different tax sets.
Although little systematic work has been done using this approach for developing countries, technical assistance work in such countries suggests that this type of thinking would be useful. For example, in many developing countries one finds that the personal income tax is “costly” from an administrative point of view and ignores principles of marginal revenue productivity. Large numbers of tax employees check the many deductions and credits found in a typical personal income tax law, and many man-hours are spent in calculating small refunds due because the amount withheld differs slightly from the tax liability. At the same time little or no resources are used to track down self-employed taxpayers, where revenue returns would be much greater. Company tax returns are often not effectively audited, even though marginal productivity of administration could be high. Granted that staff resources may not be substitutable for different tasks, one gains the impression that better use could be made of the scarce administrative resources available.
4. Tax handles, tax administration, and tax structure
In contrast to the normative bent of tax policy literature and the game theoretic analysis of tax evasion, stands a body of tax literature based on empirical and historical thinking. This literature deals with the questions: Why does a country develop a particular tax structure (a set of taxes making up total tax revenue) and why does this tax structure differ among countries and change during the process of economic growth? 19/ (It should be noted here that “tax structure” refers to the revenue importance of different taxes, rather than the legislative content of tax laws.) This strand of tax literature not only recognizes the importance of administrative constraints on tax policy, but in contrast to the normative literature places administrative factors at the forefront. 20/ The “tax handle” theory offers a sweeping historical explanation of tax structure change. It argues first that low income economies are forced to collect revenue from easy-to-administer taxes, but that as countries develop, this administrative constraint lessens and countries become able to choose “better” taxes as defined by the normative objectives discussed above. 21/ Although economists differ on what a “better” tax structure consists of, there would be general agreement that broad based income or consumption taxes are preferable to a reliance on foreign trade taxes, and historical evidence suggests such a shift. In any case, advanced economies have a certain freedom of maneuver in choosing tax systems, while less developed countries are largely constrained by administrative considerations.
Other writers have emphasized the administrative constraints on tax policy at early stages of economic development. Mutén points out that developing countries face a scarcity of resources (personnel) and thus attach high priority to taxes that are easy to collect. Such taxes include taxes with few taxpayers, such as excises and sales taxes at the manufacturing level, together with foreign trade taxes, such as import and export duties. More complicated taxes, such as the net wealth tax, death and gift duties are then imposed only on a few large taxpayers. The tax strategy followed by most developing countries thus consists of “catching the big fish in the modern sector and largely abstaining from taxes aimed at the traditional and subsistence sectors.” 22/
The insight that administrative constraints in part determine the tax structure of developing countries appears accurate if we examine the actual tax structure of developing countries among themselves and in contrast to industrial countries. For developing countries a detailed examination of tax structure has been undertaken by Tanzi, using a pool of 82 countries divided by strata of per capita income. The group of countries with the lowest per capita income represents the countries in which the tax structure is most determined by administrative considerations—i.e., the availability of accessible tax handles. For these countries import duties—based on a very convenient tax handle—account for 32 percent of total tax revenue. The personal income tax—a much more difficult tax to collect—accounts for only 9 percent of tax revenue. In contrast, for the most wealthy developing countries (those above US$1,550 per capita income), the share of import duties drops to only 18 percent of tax revenue, even though the share of imports in GDP has not changed. For the same group of higher income countries the share of the personal income tax rises to 13 percent, indicating a greater use of this difficult-to-collect tax. (Table 1).
When developing countries as a whole are compared with industrial countries, the importance of administrative constraints in determining the tax structure is again demonstrated. The tax structure of an “average” developing country is shown at the bottom of Table 1. Foreign trade is the leading tax source, representing at least one-third of total tax revenue, with import duties much more important than export duties. Excises (mainly on beverages, tobacco and fuel) account for 11–12 percent of the total; some type of sales tax represents about 10 percent. Direct taxes include a personal income tax representing 11 percent. Social security taxes vary widely with the level of development and amount to 9 percent on average; wealth and property taxes about 2 percent; and miscellaneous other taxes 3 percent.
In an important sense the categories of taxes in the developing world are misleading, because the actual tax bases are much narrower than the names imply. Although precise data to prove the point are not available, one could say with a high degree of certainty that most of the revenue from import duties stems from a small group of highly taxed consumer goods, perhaps amounting to no more than 25 percent of total imports. (For a sample of 14 countries, exempted imports amounted to 43 percent of total imports.) The personal income tax is mainly collected from withholding taxes on wages of civil servants and employees of large firms, and so is often more accurately characterized as a payroll tax on wages than a general income tax. Most of the yield of the corporate income tax stems from a handful of modern (often foreign) enterprises, and most excise revenue from duties on beer, liquor, tobacco and fuel. The bulk of the yield from the “general” sales tax again stems from a selected group of consumer imports in low-income developing countries, although in higher income countries the domestic base becomes more significant. As Tanzi notes of the “general” sales tax, …“In most countries the value added at the retail and often even at the wholesale level is exempt, services are exempt and so are many categories of goods… these legal exemptions must be augmented by the illegal ones owing to tax evasion… It is unlikely that in many countries more than 20 percent of domestic value added is subject to this form of taxation.” 23/
Tax Revenue by Type of Tax and by Group of Countries 1/
(In percent of total taxes)
Average of sample of 82 countries. Refers to three-year period generally centered around 1979.
Tax Revenue by Type of Tax and by Group of Countries 1/
(In percent of total taxes)
| Per Capita Income | Total Taxes (3) | Income Taxes | Domestic Taxes on Goods and Services | Foreign Trade | Social Security (16) | Wealth and Property (17) | Other (18) | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total (8) | General sales, turnover, VAT (9) | Excises (10) | Other (11) | ||||||||||||||
| Total (12) | Import duties (13) | Export duties (14) | Other (15) | ||||||||||||||
| Total (4) | Individual (5) | Corporate (6) | Other (7) | ||||||||||||||
| Range (1) | Average (2) | ||||||||||||||||
| < 300 | 206 | 100.00 | 20.83 | 9.09 | 11.03 | 1.71 | 29.45 | 13.38 | 12.64 | 3.43 | 42.55 | 32.01 | 11.01 | 0.14 | 3.53 | 2.33 | 2.39 |
| 300 < γ < 650 | 510 | 100.00 | 25.95 | 10.20 | 15.03 | 1.58 | 26.18 | 8.60 | 12.61 | 4.97 | 39.05 | 30.62 | 7.25 | 0.17 | 8.58 | 2.24 | 2.81 |
| 650 < γ < 1550 | 1,086 | 100.00 | 33.06 | 11.85 | 20.78 | 7.03 | 24.09 | 8.89 | 10.43 | 4.77 | 30.07 | 24.07 | 8.40 | 0.07 | 9.15 | 2.94 | 3.72 |
| 1550 < | 2,554 | 100.00 | 39.19 | 12.97 | 24.79 | 2.25 | 24.13 | 7.65 | 11.38 | 5.09 | 20.39 | 18.24 | 2.57 | 0.06 | 14.48 | 2.75 | 2.62 |
| All countries | 1,043.9 | 100.00 | 29.75 | 10.90 | 17.54 | 3.28 | 26.09 | 9.67 | 11.86 | 4.56 | 33.37 | 26.51 | 7.06 | 0.12 | 9.29 | 2.55 | 2.90 |
Average of sample of 82 countries. Refers to three-year period generally centered around 1979.
Tax Revenue by Type of Tax and by Group of Countries 1/
(In percent of total taxes)
| Per Capita Income | Total Taxes (3) | Income Taxes | Domestic Taxes on Goods and Services | Foreign Trade | Social Security (16) | Wealth and Property (17) | Other (18) | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total (8) | General sales, turnover, VAT (9) | Excises (10) | Other (11) | ||||||||||||||
| Total (12) | Import duties (13) | Export duties (14) | Other (15) | ||||||||||||||
| Total (4) | Individual (5) | Corporate (6) | Other (7) | ||||||||||||||
| Range (1) | Average (2) | ||||||||||||||||
| < 300 | 206 | 100.00 | 20.83 | 9.09 | 11.03 | 1.71 | 29.45 | 13.38 | 12.64 | 3.43 | 42.55 | 32.01 | 11.01 | 0.14 | 3.53 | 2.33 | 2.39 |
| 300 < γ < 650 | 510 | 100.00 | 25.95 | 10.20 | 15.03 | 1.58 | 26.18 | 8.60 | 12.61 | 4.97 | 39.05 | 30.62 | 7.25 | 0.17 | 8.58 | 2.24 | 2.81 |
| 650 < γ < 1550 | 1,086 | 100.00 | 33.06 | 11.85 | 20.78 | 7.03 | 24.09 | 8.89 | 10.43 | 4.77 | 30.07 | 24.07 | 8.40 | 0.07 | 9.15 | 2.94 | 3.72 |
| 1550 < | 2,554 | 100.00 | 39.19 | 12.97 | 24.79 | 2.25 | 24.13 | 7.65 | 11.38 | 5.09 | 20.39 | 18.24 | 2.57 | 0.06 | 14.48 | 2.75 | 2.62 |
| All countries | 1,043.9 | 100.00 | 29.75 | 10.90 | 17.54 | 3.28 | 26.09 | 9.67 | 11.86 | 4.56 | 33.37 | 26.51 | 7.06 | 0.12 | 9.29 | 2.55 | 2.90 |
Average of sample of 82 countries. Refers to three-year period generally centered around 1979.
In accordance with the “tax handle” theory, then, the effective tax structure of developing countries (as opposed to the legislative tax system) is characterized by reliance on a half dozen narrow tax bases, reflecting administrative convenience. “Administrative convenience” takes on a number of meanings in this context. For import duties the centralization of taxable goods in a port leads to ease of administration. Export duties also apply to goods concentrated in a port and may be applied to a central marketing board or a few large exporters in lieu of collecting personal income tax from a multitude of small farmers. For excises production of goods is concentrated in a few factories. The problem of valuation is simplified by this concentration, or can be circumvented entirely by using specific duties or administered reference prices. For the personal income tax withholding of taxes on wages paid by large enterprises and government is the meaning of “administrative convenience.” Other taxes such as the corporate income tax may be inherently more difficult to administer, because the base of net profits requires more sophisticated accounting measures such as depreciation. In such cases administrative convenience may take the form of simply accepting, with only perfunctory audit that presents no serious challenge, a reasonable amount of taxation as defined by the firm. If firms are unwilling to contribute a “reasonable” sum, governments may then adopt simple rules of thumb, such as using a percentage of gross sales to replace the concept of net profit.
Table 2 shows a comparison of tax structure in the average developing country (as defined by the sample) with tax structures in such industrial countries as the United States, United Kingdom, France, Germany, and Japan. In this table, tax revenues are shown as a percentage of GDP. We previously noted in Table 1 that foreign trade taxes are the most important source of revenue in low-income developing countries and remain important for middle and upper income developing countries. In contrast, such taxes are scarcely used for revenue purposes in the industrial countries shown in Table 2. Another important difference in tax structure between developing and industrial countries is that the latter rely to a much greater extent on a single broad-based income or consumption tax. Revenue from taxes on general consumption such as VAT amounted in 1984 to 9 percent of GDP in France, 5.6 percent in the U.K., and 6.3 percent in Germany, while VAT or other general sales taxes averaged only 1.6 percent of GDP in developing countries. For the same year personal income tax amounted to over 10 percent of GDP in the United States, the United Kingdom, and Germany compared with 1.9 percent of GDP in the average developing country. 24/
Tax Structure in Developing and Selected Industrial Countries
(Each tax category as percent of GDP)
Average of sample of 82 countries. Refers to three-year period generally centered around 1979.
1984 data.
Tax Structure in Developing and Selected Industrial Countries
(Each tax category as percent of GDP)
| Income Taxes | Foreign Trade Taxes | Domestic Taxes on Goods and Services | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | Personal income | Corporate profits | Other | Total | Exports | Imports | Total | VAT, sales | Excises | Other | |
| Developing countries 1/ | 5.5 | 1.9 | 3.1 | 0.6 | 5.6 | 1.1 | 4.5 | 4.4 | 1.6 | 2.0 | 0.8 |
| United States 2/ | 12.3 | 10.2 | 2.1 | — | 0.3 | — | 0.3 | 4.6 | 2.1 | 2.5 | — |
| United Kingdom 2/ | 14.7 | 10.3 | 4.4 | — | 0.4 | — | 0.4 | 11.1 | 5.6 | 5.4 | — |
| France 2/ | 7.9 | 6.0 | 1.9 | — | 0.2 | — | 0.2 | 12.7 | 9.0 | 3.7 | — |
| Germany 2/ | 12.6 | 10.5 | 2.0 | — | 0.4 | — | 0.4 | 9.8 | 6.3 | 3.5 | — |
| Japan 2/ | 12.5 | 6.7 | 5.8 | — | 0.3 | — | 0.3 | 3.6 | — | 3.6 | — |
Average of sample of 82 countries. Refers to three-year period generally centered around 1979.
1984 data.
Tax Structure in Developing and Selected Industrial Countries
(Each tax category as percent of GDP)
| Income Taxes | Foreign Trade Taxes | Domestic Taxes on Goods and Services | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | Personal income | Corporate profits | Other | Total | Exports | Imports | Total | VAT, sales | Excises | Other | |
| Developing countries 1/ | 5.5 | 1.9 | 3.1 | 0.6 | 5.6 | 1.1 | 4.5 | 4.4 | 1.6 | 2.0 | 0.8 |
| United States 2/ | 12.3 | 10.2 | 2.1 | — | 0.3 | — | 0.3 | 4.6 | 2.1 | 2.5 | — |
| United Kingdom 2/ | 14.7 | 10.3 | 4.4 | — | 0.4 | — | 0.4 | 11.1 | 5.6 | 5.4 | — |
| France 2/ | 7.9 | 6.0 | 1.9 | — | 0.2 | — | 0.2 | 12.7 | 9.0 | 3.7 | — |
| Germany 2/ | 12.6 | 10.5 | 2.0 | — | 0.4 | — | 0.4 | 9.8 | 6.3 | 3.5 | — |
| Japan 2/ | 12.5 | 6.7 | 5.8 | — | 0.3 | — | 0.3 | 3.6 | — | 3.6 | — |
Average of sample of 82 countries. Refers to three-year period generally centered around 1979.
1984 data.
5. A critical view of tax structure in developing countries
We have argued above that tax administration constraints have largely determined the actual (as opposed to statutory) structure of taxation in developing countries. Although statutory laws resemble those of industrial countries, a handful of easy-to-administer taxes account for virtually all revenue. If one compares this actual tax structure of developing countries with ideal norms of a desirable tax structure, it would be difficult to find a greater contrast. The prototype tax structure of developing countries can be criticized on stabilization, efficiency, and equity grounds.
From a stabilization point of view a tax system should be composed of one or at most several predominant taxes with a rate schedule that can be adjusted quickly and with a high degree of certainty to alter the amount of purchasing power available to the private sector. These predominant taxes can then be used to increase or cut back private spending in order to achieve stabilization goals related to growth, prices, or the balance of payments. Because the tax systems of developing countries are cluttered and tax bases are narrow, adjustment of revenue for stabilization purposes must come about by piecemeal measures, generally raising rates on indirect taxes such as import surcharges, excises or sales tax, since these taxes are considered to increase revenue with greater certainty and speed. From a dynamic point of view the continued reliance on these tax bases for revenue needs tends to be self-defeating, as higher rates on the narrow bases further distort the allocation of resources and lead to evasion or consumer resistance. In sum, the lack of a predominant broad based tax and the clutter of rates and exemptions on existing taxes make it difficult to use the system for stabilization purposes.
From an efficiency point of view a good tax system is considered to be one that leads to the least amount of distortion of relative prices, both the prices facing the consumer and those facing the producer. Although only a lump sum poll tax would satisfy the criterion of noninterference in all relative prices, broad based income or sales taxes with one or a few rates are considered desirable in that they lead to less distortion in consumer and producer prices. Against this view some theorists would argue that taxation of products with low elasticity of demand would bring about less interference with consumer choices. In any case, in developing countries many different import and excise tax rates on narrow bases are combined with a variety of exemptions to produce almost random effects on consumer choice and producer incentives. Efficiency goals are also compromised by selective administration of the personal and corporate income tax. Because the personal income tax is in practice mainly a tax on wages, companies using more labor intensive productive methods are at a disadvantage. Large companies are forced to pay tax while small companies and retailers can avoid taxes.
The heavy reliance on foreign trade taxes can be singled out as the most undesirable aspect of developing country tax systems from the point of view of both stabilization and resource allocation. From a stabilization point of view foreign trade taxes tend to tie government revenue to unpredictable fluctuations of export commodity prices and so aggravate fiscal stabilization problems. A vicious circle can also begin if a reduction in imports imposed for demand management purposes leads to a fall in import duties, thereby enlarging the fiscal deficit. From a resource allocation (efficiency) point of view trade taxes have no place in a “first-best” tax structure. The discriminatory nature of trade taxes ensures that their use imposes both a production distortion cost and a consumption distortion cost. Import duties, often relied upon for revenue, may lead to excessive effective protection and encourage inefficient domestic industry. However, some general level of protection may be desired for domestic production. In sorting out the place of excise duties, sales tax and import duties it has been suggested that a sales tax be used for revenue and stabilization purposes, selective or even a single ad valorem duty on imports for protective purposes, and excise taxes to influence the pattern of consumption. 25/
Equity goals are also heavily compromised by the tax structure of developing countries. To an outsider this tax structure may appear to be highly progressive because the rate structure of the personal income tax is often highly progressive. On closer examination, however, the vertical equity of the system is compromised by the fact that the personal income tax collects a relatively small share of total revenue and applies mainly to wage earners, whose incomes may be lower than the self-employed. High nominal rates on luxury consumer imports such as motor vehicles may equally be offset by exemptions and evasion. Excises on such staples as cigarettes and beer are clearly regressive when taken in the context of the monetized sector. Thus an apparent vertical equity in rate structure of personal income tax and import duties is negated by a combination of selective administration and legal exemptions. With regard to horizontal equity—the principle that those with equal incomes pay equal taxes—the tax structure of the typical developing country is perhaps more clearly inequitable. For the income tax, selective administration on wages favors the self-employed, partnerships, and income from capital. Taxes on consumption also violate horizontal equity because of their uneven and almost random application.
On a broader basis one can say that selective administration of the statutory tax system systematically discriminates against the modern sector of the economy. The modern sector tends to fall into the income tax net because it keeps better accounts, is more centralized, and thus more revenue productive from the point of view of the tax collector. Although a heavier burden of taxation on the modern sector may be appealing on equity grounds, one should bear in mind that the present tax system tends to impede the growth of the dynamic sector that may be the key to more rapid long-term growth.
6. Strategies for tax administration
Economic advice to tax administrators in developing countries would seem to point to several alternative paths. We have seen earlier that strict application of the time-honored marginal cost equals marginal revenue principle would lead administrators to apply their efforts toward short-run revenue maximizing activities that would eventually undermine voluntary compliance. This strategy would also tend to reinforce the existing selective administration pattern, by which tax handles are chosen on the basis of administrative ease in producing revenue. Such a strategy is aimed directly at increasing short-term tax levels; administrators facing large budget deficits and consequent demands for revenue may feel they have no choice but to follow such a strategy in the short run. However, we have emphasized the cost of simply choosing easy to administer tax handles in terms of the impact on tax structure, and objectives of efficiency, equity, and stabilization.
A more desirable strategy for tax administrators is to support changes in the effective tax structure that would enhance the above objectives. Although tax administrators cannot change legislation they can help implement and/or make possible changes in legislation that would improve the effective tax structure. These efforts would be aimed at implementing more broadly based income and consumption taxes in order to reduce dependence on foreign trade taxes. For the personal income tax this strategy would mean directing administrative efforts toward income other than wages and salaries, and especially earnings of the self-employed. For the company tax, efforts should be made to reach smaller firms so that such firms are not subsidized relative to larger, more modern establishments. With regard to consumption taxes, administrative efforts should support legislative changes to broaden the scope of sales taxes, making possible their appliciation to services and to retail establishments. This type of administration effort would help create a broad-based consumption tax that would not discriminate between domestic and foreign goods and that would be useful for stabilization purposes.
In following a policy of using administrative measures to promote a better tax structure consideration should be given to using less sophisticated taxes that would still broaden the tax base. At present, the combination of sophisticated tax laws and inadequate administration produces an all or nothing situation in which potential tax bases are not exploited because application of the existing law is not possible. One approach to solving this dilemma has been to tax income through presumptive methods—that is, to decide on the basis of various objective indices that the taxpayer has a given (presumed) income. For example, Francophone African countries have been among the leaders in adopting minimum corporate income taxes based on the idea that a corporation’s income tax payments should at least be equal to a certain percentage of gross receipts. Personal income tax in several developing countries is based on visible signs of wealth, such as the taxpayer’s residence, servants or automobiles. In practice, this method has been difficult to apply, and standard assessments have been used to estimate the income of “hard-to-tax” groups. For farmers such assessments may be related to the potential output of their land, while professionals may be assessed a minimum income tax based on an estimate of average potential earnings. Although presumptive taxes involve administrative problems of their own and have not yet provided a completely successful answer to the problem of taxing “hard-to-tax” groups, this approach may be preferable to random or selective administration of theoretically superior tax legislation. 26/
7. Summary and conclusions
This paper has examined tax administration from an economic perspective, observing first of all that the normative bent of tax policy analysis has tended to separate the fields of tax policy and tax administration. The idea that the two fields should be separated, however, breaks down in the context of developing countries, where administrators in effect make tax policy by deciding how sophisticated laws should be applied in practice.
The application of formal economic models to tax evasion is assessed. In general it may be concluded that such models have contributed little in the form of policy analysis because they abstract from institutional restraints on the taxpayers’ decision to pay or evade taxes. The models do not take into account different opportunities to evade among different types of taxes and taxpayers. These models have been useful in reinforcing the conclusion that devices such as withholding should be applied whenever possible to restrict the taxpayer’s freedom of choice. The models also indicate that increased probability of audit and higher penalties would be desirable.
Although normative and theoretical treatment of taxation has generally ignored the issue of administrative constraints on tax policy, a strand of literature based on historical and empirical analysis of tax structure has placed administrative considerations at the forefront.
This “tax handle” literature broadly argues that administrative constraints determine the tax bases and forms of taxation that can be employed at early stages of economic development. Empirical observation of the tax structure of developing countries indeed shows that tax revenues are collected from a handful of easy-to-administer taxes. The resulting tax structure, with its heavy emphasis on foreign trade taxes, narrow tax bases and high nominal tax rates is costly in terms of the economic objectives of efficiency, stabilization, and equity. Tax administrators are often asked to place sole emphasis on increased revenue collection by governments that need to reduce large fiscal deficits. However, a single-minded pursuit of revenue goals can aggravate the problems of tax structure mentioned above. Tax administrators would be better advised to direct their efforts toward assisting tax policy-makers in implementing broad-based income and consumption taxes and reducing reliance on foreign trade taxes. This effort may well involve the use of simplified forms of taxation applied over a broader base as opposed to overly sophisticated taxes that are rarely or only selectively applied.
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The author is grateful for comments from Vito Tanzi, M. Casanegra de Jantscher, Peter S. Griffith, Carlos A. Silvani, and David C. Nellor. Any remaining errors or omissions are my own.
This point is made in Tanzi (1987).
Several economists have written on aspects of tax administration without integrating these writings with theories of tax policy (see References). In addition, in the context of advice on practical situations, a number of perceptive economists have given attention to administrative constraints on tax policy.
See Ricketts (1981), in the book of readings by Peacock and Forte (1981). For a statement of optimal tax theory, see Atkinson and Stiglitz (1980).
This literature begins with Becker (1968). For a recent critical summary see Conference on Tax Administration Research, vol. 1 (IRS), 1985.
See Skinner and Slemrod, 1985. The reader should note that after 1986 the civil fraud penalty was raised from 50 to 75 percent and modified. The change does nto affect the substance of the argument.
For a summary of this literature see Richupan (1985).
See Tanzi (1982), chapter 4, “Underground Economy and Tax Evasion in the United States: Estimates and Implications,” pp. 78-80.
An additional assumption is that the elasticities of the supply of labor are such that the actions of higher income taxpayers gaining from the change more than offset those of lower income taxpayers losing from the change.
See Richupan (1985). For a full exposition of the application of supply side taxation ideas to developing countries see Gandhi (1985).
See Wall Street Journal, May 8, 1986.
See Kaldor (1956) and Hart (1967).
See Bird (1983).
See Casanegra de Jantscher (1986).
See Goode (1981).
See Shoup (1974).
This literature includes Hinrichs (1966), Lotz and Morss (1967), Chelliah (1970), Bahl (1971), Chelliah, Baas, and Kelly (1975), Tait, Graetz, and Eichengreen (1979), and Tanzi (1981).
A complete explanation of differences in effective tax structures would certainly acknowledge that differences in the structure of production and income distribution play a role in determining tax structure. For example, the fact that large numbers of the population in many developing couantries live at poverty levels explains why a mass income tax would not be feasible.
The tax handle theory has also been used to explain different tax levels as well as tax structure among different countries. See the references above.
See Mutén (1981).
See Tanzi (1987).
Data for developing countries refer to a three-year period generally centered around 1979 (see Table 2).
See Tanzi (1987).
For a more complete discussion of the use of presumptive income assessments, see Tanzi and Casanegra de Jantscher (1986).