Abstract
The paper deals with the activities of Fund staff with taxation. It is made up of four parts. Part I outlines the connection between Fund major activities and taxation. Part II surveys general influences on Fund staff with implications for tax work. Part III outlines the relationship between Fund-supported programs and changes in tax systems. Part IV focuses on the structure, rather than the level, of taxation. It outlines in broad terms the prevalent thinking of Fund staff on the structure of taxation.
I. Fund Activities and Tax Reform
The question addressed in this paper is whether the International Monetary Fund follows a specific approach to tax reform. In other words, is there a given level and structure of taxation that the Fund recommends to countries? 1/
The above question could be answered in the affirmative or in the negative, but in both cases the answer would be only partly correct. The reason is that the Fund follows what is essentially a case-by-case approach that is responsive to the conditions that exist in each country. The macroeconomic conditions of each country, its social structure and priorities, its external debt situation, its administrative capabilities, and other relevant considerations are taken into account in developing tax recommendations best suited to that particular country. In this sense there are no guidelines given to Fund missions to deal with tax policy, and there is no specific Fund approach to tax reform. However, it would be a little misleading to say that there is no typical Fund way of addressing the question of tax reform. Over the years, some traditions have developed within the institution. These inevitably influence the way Fund missions approach the question of tax reform, and thus to some extent influence the recommendations made.
Fund involvement with tax reform may come in at least three different contexts: (a) through its “surveillance” activity; (b) through its lending operations; and (c) through requests by member countries for technical assistance. The involvement and influence that the Fund has on the tax system in each of these situations differ somewhat. It is mainly in technical assistance work that the Fund’s involvement is a close one and extends to issues of tax structure and administration. Of course, technical assistance may be, and in fact it has become, closely tied to lending operations in several countries.
1. Surveillance
Surveillance is the general term used to describe the Fund’s responsibility to watch over macroeconomic developments that have international or systemic implications in member countries. For example, fiscal imbalances in one country will often bring about problems with its balance of payments, which in turn may affect other countries. If the country is a large one, these effects on other countries can be substantial. The Fund is required by its articles of agreement to monitor these developments and to attempt to address them through the collective impact of its various activities. In the fiscal area, surveillance focuses, inter alia, on the size of the fiscal imbalance and on its relationship to other macroeconomic variables, such as the inflation rate, the exchange rate, the rate of growth, the current account of the balance of payments, the growth of external debt, and so forth.
When the size of the fiscal imbalance is seen to be creating difficulties with respect to some of the country’s macroeconomic objectives, the country is advised to reduce it. This has been a fairly regular recommendation over the years. It is conveyed through so-called Article IV consultations, through “summing ups” of the discussion by the Board of Executive Directors, through pronouncements of the Fund’s Managing Director, or through other channels. However, it is only rarely that this recommendation to a country specifies whether the fiscal imbalance should be reduced by raising taxes or by reducing public spending. The Fund has traditionally been neutral about the size of the public sector, as long as that size is not seen as having adverse implications for fiscal imbalances and for the balance of payments. However, because of the growth of fiscal disequilibria in many countries, often caused by large increases in public spending, in recent years the Fund has often advised countries to reduce their level of public spending.
2. Fund lending operations
Over the years, the Fund has stood ready to extend financial assistance for a limited period of time to countries that were facing financial difficulties and agreed to make needed changes in their economic policies. Although all countries can take advantage of this Fund service, and several large industrial countries did so in the past, during the 1980s Fund lending operations have involved mainly developing countries. This lending is done through several “facilities” in support of adjustment programs and is conditioned by the commitment of the borrowing country to follow policies mutually agreed by the Fund and the country’s authorities. Fund supported programs may be fairly specific about the needed reduction in the size of the fiscal imbalance over a specified period of time.
This reduction is derived from what is generally referred to as a “financial programming exercise,” which is essentially an empirical exercise that, through the use of various economic identities and assumptions, establishes links between the fiscal imbalance and the current account of the balance of payments. 1/ Financial programming has evolved over the years to accommodate new objectives and new economic assumptions. In its current use it is a far more flexible tool than some critics seem to believe. It is essentially a useful framework within which to address a problem.
Although Fund-supported programs generally limit their fiscal prescriptions to variables such as credit expansion to the government and the size of the fiscal deficit, they may at times make pointed reference to the level and the structure of taxation. Furthermore, they may encourage the program country to approach the Fund for technical assistance specifically aimed at raising the level of taxation, or even at changing its tax structure. This is done when the level of public spending is seen as being rigid downward, or as being inefficiently low, or when the level of taxation has recently declined or is considered low, given the country’s level of development. In these cases technical assistance may become closely linked with a program. Only in rare cases has a Fund-supported program specified a desirable level of taxation. The choice of how to reduce a fiscal gap is generally left to the country. However, the Fund does play a role in assisting the country in developing a specific fiscal policy package, if so required.
3. Technical assistance
Much of the involvement by Fund staff with specific aspects of tax reform comes from technical assistance missions. The tax systems of a large number of countries have been influenced by this Fund activity.
Technical assistance is provided at the specific request of a country, and advice is given confidentially to the country’s authorities. That advice is largely shaped by the objectives of the country’s authorities, either as expressed by the Minister of Finance or as outlined in budget speeches, development plans, and other official documents. The Fund is free to decline a request for assistance, and often it tries to obtain a reformulation of the terms of reference, if it feels that the country’s expectations are not realistic, or if the request does not reflect what the Fund thinks should be the country’s major concerns. Of course, at times the authorities are not too explicit about the ranking of (or the trade-offs among) the objectives that they wish to achieve through a tax reform, Given the widespread need for additional revenue in recent years, technical assistance advice is often influenced by the often unstated objective of revenue generation. Even when the immediate impact on tax revenue may be minor, administrative improvements aimed at raising the elasticity of the tax system will eventually result in a higher tax to GDP ratio than would result without those improvements.
Fund staff advice can be very specific when it relates to technical aspects of the existing tax system, or to making administrative improvements in that system (for example, computerizing the operations of the value-added tax, improving customs administration, developing audit procedures, introducing taxpayer identification numbers, etc.).
II. The Fund and Tax Reform; General Aspects
Although there is no specific Fund approach to tax reform, a certain modus operandi has developed within the institutions, and particularly within the Fiscal Affairs Department, which influences the advice provided in this area. Before dealing with this modus operandi, it should be stressed that Fund staff members are keenly aware of, and thus respond to, outside influences, just as one would expect any alert group of professionals to do. These influences make themselves felt in many ways.
First of all, the hiring policy of the institution is heavily biased toward younger economists with recent advanced economic training in major universities. Thus, “fresh blood” is continuously being injected in the institution, bringing new academic thinking and new technical advances. This is one way of introducing technical innovation into the institution.
Secondly, because of its cosmopolitan background, the Fund staff is inevitably influenced by the prevailing political and social winds. In the 1960s, high tax levels, highly progressive income taxes, and extensive government intervention in the economy were fashionable, both politically and academically. In the 1980s, supply-side and public choice thinking, and the prevailing view that large public sectors and extensive governmental intervention may have negative effects on economic performance, could not fail to influence Fund staff and, thus, its approach to tax reform. Fund thinking and research have reflected these influences and have affected the work of tax missions. Fund missions are much more concerned now about possible disincentive effects of high tax rates and high tax levels and they are less likely to recommend them to a country. Comparing the research papers and the technical assistance reports written in the 1960s with those written in the 1980s, one cannot fail to be impressed by the difference in attitudes and assumptions. The point is that, if there is a Fund view, it is not rigid and cast in stone, but one that is continuously being shaped by new events and thinking.
Thirdly is the attitude of the countries’ policymakers to tax advice. One aspect that may surprise economists involved for the first time in tax reform missions is the extent to which countries are influenced by what happens in other countries. To me, it was a great surprise to discover, in my earliest experiences with tax missions, that policymakers were far less interested in the latest academic thinking than in what other (and especially more successful) countries were doing, or had done. Almost without exception, they requested information about the level, structure, and administration of taxes in other countries. Very rarely, if ever, were they interested in the latest academic thinking. This may explain in part why new and academically fashionable thinking in taxation, such as optimal taxation or expenditure-based taxation, has still not had much influence in tax policy. 1/
In part as a consequence of this attitude, over the years Fund staff has assembled information that could satisfy the authorities’ requests. These cross-country comparisons have become fairly standard features o! technical assistance reports. They have also influenced some of the published or unpublished research. In other words, they have become a regular feature of the Fund approach to tax reform. An important point to understand, however, is that, while these crosscountry comparisons have certainly played a role in shaping the thinking of Fund staff and the advice that it gives, they may have never been, and certainly they are not now, the rigid reference point that some critics have at times assumed them to be.
Take, for example, the cross-country information on tax levels. Over the years, several Fund studies have estimated statistical relationships between the level of taxation, as a share of gross domestic product, and various, and presumably exogenous variables, such as per capita income, the openess of the economy, mineral exports, and so forth. 2/ These studies have been useful, not because they provide an objective way to determine the tax level that a country should have (a normative use of the information), but to support a case for a tax increase when the country’s macroeconomic situation strongly suggested a need for a cut in the level of the fiscal deficit and expenditure reduction was considered difficult or undesirable. Through the use of these studies, an argument would be made that if other equally situated countries had been able to collect a significantly higher tax ratio, then this country should be able to do likewise. 1/ Occasionally, this information has been used to support an argument for a cut in public spending, if the country’s tax level was higher than in similar countries, and if there was reason to believe that the high level of taxation was having damaging effects on the economy. Similar information, related to tax structure or tax administration, has been used for similar purposes in those areas. 2/
In conclusion, an important feature of the Fund approach has been its use of the rich and varied experience provided by other similarly situated countries. This experience has much to offer and advice based on it is often likely to be better received and, perhaps, more useful than advice based on purely theoretical and untested considerations.
III. Fund-Supported Programs and the Level of Taxation
When the Fund enters into a financial arrangement, the balance of payments position of the country is generally considered unsustainable. The country is often running a large current account deficit and its foreign exchange reserves are very low. Furthermore, it may be in arrears to its foreign creditors. In this situation, the country would face increasing resistance to obtaining the external financial resources necessary to finance its balance of payments gap. It would thus be forced into larger arrears or to intensifying import and other restrictions. The main objective of a Fund-supported financial program is to help reduce an otherwise unfinanceable disequilibrium in the balance of payments without resorting to such actions.
Difficulties in the balance of payments of a country are often a symptom of inadequate domestic policies. Such policies may have excessively restricted the country’s supply as, for example, when the prices paid to producers of export commodities are kept artificially low, or may have generated excess demand. 3/ Fund-supported financial programs are aimed at inducing countries to replace these policies by more viable ones. Experience, as well as theoretical considerations, indicate that often, though not always, a major cause for the external imbalance of a country is excessive monetary expansion. By increasing nominal incomes, this expansion leads to increases in domestic prices and, especially when exchange rates are pegged, encourages imports, discourages exports, and induces capital flight and the “dol1arization” of the economy.
Monetary expansion does not occur in a vacuum. Especially in developing countries, it often finds its origin in actions of the public sector. In the absence of sizable capital markets, developing countries can often finance large fiscal deficits mainly by foreign borrowing and by domestic monetary expansion. 1/ When foreign borrowing is constrained, or becomes unavailable, and when borrowing from the private sector is limited or not possible, monetary expansion is the only alternative, but it soon becomes incompatible with fixed or pegged exchange rates. 2/ In any case, there is a clear limit to how much fiscal deficit (in real terms) can be financed by monetary expansion. 3/ This limit is further reduced by the fact that high inflation lowers real tax revenue because of collection lags and other factors. The longer the collection lag, the higher the initial tax to GDP ratio, the Lower the monetization of the economy, and the higher the sensitivity of the demand for money with respect to the rate of inflation, the more Limited will be the net revenue from monetary expansion. 4/
When a financial program is being negotiated, the Fund mission will often recommend either revenue increases or expenditure cuts, depending on which of these alternatives appears to be preferable from an economic and social point of view. If the fiscal deficit has been caused mainly by substantial recent expansion in expenditure, and if this expansion cannot be justified on the basis of equity and efficiency considerations, Fund missions are more likely to recommend expenditure cuts. If, on the other hand, the reason for the fiscal deterioration has been a fall in revenue, or if, on the basis of inter-country comparisons, tax revenues are unusually low in that particular country, then the Fund is likely to recommend revenue increases. But again there is no a priori level of taxation that is considered desirable. In many cases, both sides of the budget require adjustment.
Fund missions have become increasingly sensitive to possible disincentive effects of tax increases as well as to the distributional and efficiency aspects of cuts in public expenditure. 1/ These aspects are now receiving closer attention. However, it must be emphasized that the final word as to how fiscal imbalances are to be reduced lies with the authorities of the member country.
When a country agrees to a Fund program, it commits itself to the observance of certain “performance criteria.” These are specific agreements about policy actions to be undertaken by the country for the program to remain in force. The majority of Fund-supported programs include, inter alia, performance criteria related to total domestic bank credit expansion, and to the use of domestic bank credit by the government. The first is aimed at restricting total monetary expansion while the second ensures that the private sector is not crowded out by government borrowing. 2/ The nonobservance of performance criteria interrupts a country’s right to Fund financial resources until new understandings are reached with the Fund. Some programs also include understandings about other fiscal actions to be pursued during the period of the program. Such understandings may include, for example, the removal of subsidies or changes in particular taxes. However, in general the country will not have any binding commitments related to the level of the tax revenue or the level of government expenditure.
Since monetary data are usually more reliable and more timely than fiscal data, and excessive monetary expansion is often considered to be the basic problem, the behavior of the fiscal deficit is, in many cases, monitored through the amount of credit expansion absorbed by the government. That is, it is monitored from “below the line.” 1/ This credit expansion is largely an indication of the monetary expansion for which the fiscal deficit is directly responsible. In some cases, a Fund financial program stipulates (not as a performance criterion but as a desirable objective) the reduction in the fiscal deficit, expressed as a proportion of the gross domestic product, that is considered desirable to obtain. This ratio cannot be used for monitoring the performance of a program since the basic information is not available until well after the period for which it would be required.
Recently the Fund has been paying much more attention than in earlier years to structural changes in the economy, recognizing that over the longer run it is these structural changes which will bring about durable improvements in the balance of payments and promote growth. These changes require a close scrutiny of the tax system, of subsidies, and of other aspects to assess how they may affect the longer-run growth prospects of the economy. 2/ Unfortunately, it is very difficult to quantify these effects although there is often no question about their direction.
The ultimate objective of a Fund program is not just the improvement in the balance of payments in the short run but a durable improvement, hopefully accompanied by a higher rate of growth. The achievement of this objective often requires, in addition to demand management, major structural changes in the economy. For this reason, the distinction between fiscal policy for stabilization and fiscal policy for growth cannot be sharp. Whenever stabilization policies are pursued, their effects on growth must be kept in mind. By the same token, whenever a country attempts to accelerate its rate of growth, it must pay close attention to the effects of this policy on the balance of payments and on the rate of inflation. Tax reform should not be pursued in isolation of stabilization policy but this does not mean that the major goal of tax reform must necessarily be stabilization. However, at times it may be necessary to rely on inefficient taxes in the short run if there are no better available alternatives and if an increase in the tax level is essential to macroeconomic stability.
It is difficult to ascertain the relationship between Fund-supported programs and economic growth in general and the role of taxation in those programs in particular since countries often come to the Fund when they are in serious economic difficulties, they may not fully observe all the negotiated agreements, and, furthermore, programs involve a large number of instruments. As a Fund study has put it:
“Aside from monetary and exchange rate policies, a typical Fund program calls for fiscal measures, such as reductions in government expenditures and increases in taxation, increases in domestic interest rates and producer prices to realistic levels, policies to raise investment and improve its efficiency, trade liberalization, and wage restraint.” 1/
That study separates the various policies into three groups: demand-side, supply-side, and policies to improve international competitiveness. Tax policy can of course play a role in each of these groups of policies.
Tax policy can be important because of its structural elements and because of the role that it plays in financing public expenditures. The allocation of investment, the channeling of savings to domestic borrowers, whether private savings stay in the country or become flight capital, whether individuals contribute their maximum effort to work, whether they produce the most efficient combination of goods and services, whether they prefer to sell what they produce domestically or abroad, are all aspects affected to some extent by both the level and the structure of the tax system.
The level of taxation will be a major determinant of whether (a) the government has the financial resources to maintain a high level of public investment, (b) it maintains an adequate level of spending for operations and maintenance related to the existing infrastructure, (c) it maintains adequate expenditure for the creation and maintenance of human capital, and, finally, (d) whether the country is able to service its debt. A low level of taxation will reduce the ability of the government to do all of these things. However, a high level of taxation is no guarantee that the above will be done since, as it unfortunately happens in too many cases, the additional resources may be channeled toward military expenditure, 2/ bloated public sector payrolls, subsidies to urban middle classes and to inefficient public enterprises, and so forth. Furthermore, there may be a tendency to Spend too much on (unprofitable) capital projects and too little on operations and maintenance operations. 3/ And, of course, a higher level of taxation is likely to require higher tax rates which may be associated with higher tax-induced inefficiencies.
Empirical evidence indicates that the connection between capital spending, and especially between public sector investment, and economic growth is tenuous and uncertain. 1/ For example, for a sample of 23 developing countries for which the information was available, the growth of gross domestic product over a ten-year period (GDP) was correlated with the average ratio of total investment over GDP (i/GDP) and with the average ratio of public sector investment in total investment (PI/I) over the same period. The period was broadly 1975 to 1985. The statistical results are shown by the following equations: 2/
These results, admittedly, based on a very simple specification of the possible relationship, hardly provide a strong endorsement for the role of investment in general and for that of public investment in particular. Other groupings of countries give at times better statistical results but the results seem to be highly sensitive to the inclusion of particular countries. For example, simply adding Botswana to the above sample changes the equation as follows: 3/
Two conclusions generally follow from this kind of analysis. First, the same share of investment in GDP can be associated with highly different rates of growth depending on how carefully investment projects are selected and depending on other factors such as the international environment, social and macroeconomic stability, the general quality of economic policy, and so forth. Therefore, simply increasing the level of investment without insuring higher productivity is likely to generate disappointing results. Second, while it is true that in countries where the growth rate has been very high (say, Botswana, Korea, Malaysia, Singapore), the share of investment in GDP has also generally been very high, the relationship between the rate of growth and the level of (especially public) investment, may go both ways. It is possible that a high rate of growth may itself generate resources that induce the upgrading of capital infrastructure. For example, in the countries of the Middle East the high growth rate that accompanied the rise in the price of oil after 1974 brought about large capital spending. It is especially for these countries that one finds a high correlation between the rate of growth and the level of investment over the 1975-85 period.
At times policymakers tend to favor politically popular over more efficient, but less popular, projects. To the extent that politically attractive but relatively unproductive public investment diverts resources away from private sector investment, its contribution to growth may even be negative, especially if the resources are partly obtained through costly foreign credit. 1/ In part because of these reasons Fund-supported financial programs have for the most part not aimed at achieving a level of taxation that would make possible a high level of public sector investment. Generally, it has been assumed that the improvement in the economic environment associated with a low fiscal deficit and a low rate of inflation, as well as the better allocation of resources that would accompany the structural changes recommended by a Fund-supported program, would promote a higher rate of growth. The improved environment would stimulate private sector investment.
In addition to the growth objective, the servicing of the external debt has also implications for the level of taxation recommended in a Fund-supported financial program. The orderly servicing of the external debt requires two types of transfers: (a) the releasing of foreign exchange to the public sector by the private sector when, as is often the case, exporters are private individuals; and (b) the transfer of this foreign exchange by the public sector to the foreign creditors. In other words, if the servicing of the external debt is to occur without inflation, a net positive change in the fiscal balance must accompany the net positive change in the trade account. 2/ Or, putting it differently, the government must be able to buy the foreign exchange from the private sector without generating inflation. If government bonds cannot be sold to the private sector, and if noninterest public expenditure cannot be reduced, only a higher level of taxation can make this possible. Given the circumstances of a particular country, a precise level of taxation can be calculated. Ceteris paribus the needed level of taxation will fall if a debt package reduces the service charge on the foreign debt.
IV. The Fund and the Structure of Taxation
Much of the Fund technical work in taxation deals with tax structures rather than with tax levels. For example, many of the requests for technical assistance received by the Fund concern the modification of specific elements of the tax system. However, the distinction between level and structure is somewhat artificial since the tax structure is almost always affected by changes in the tax level; by the same token the tax level is almost always affected by changes in the structure. Truly revenue-neutral tax reforms exist only in theory and not in practice. Even when a tax reform does not affect revenue in the short run, it will do so over the longer run since tax reforms almost always change the elasticity of the tax system.
It is perhaps worthwhile to mention also the relationship that exists between macroeconomic policies and the structure (and the level) of taxation. A high rate of inflation, for example, will often reduce the importance of income taxes and ad rem excise taxes. A highly overvalued exchange rate will often reduce the importance of import duties and, to some extent, of sales taxes,, and so forth. This implies that Fund-supported programs that help to bring about macroeconomic adjustment will indirectly affect both the level and the structure of taxation.
Fund staff has not developed a structure of taxation that it clearly prefers over all other structures. Fund tax missions are not given guidelines which tell them how a given tax system should be reformed. They are free to analyze each situation on its own merit and to propose measures deemed appropriate for that situation. Since the situation changes dramatically from country to country, no standard recipe would fit all of them.
In arriving at the desirable tax structure that they will recommend, Fund missions take into account: (a) the government’s priorities; (b) the country macroeconomic situation (rate of inflation, balance of payment situation, etc.); (c) the strength and honesty of the country’s tax administration; (d) the existing statutory tax structure; (e) the structure of the economy; and (f) a variety of other factors such as constitutional or legal limitations, prevailing customs and attitudes, the incidence of the existing tax system, and so forth. The objective is to propose modifications to the existing system which will move it in the desirable direction without creating so much turmoil as to make the new system unmanageable.
The factors mentioned above constrain the number of feasible options and, to some extent, influence the final tax structure. For example, government priorities may rule out some alternatives. A high rate of inflation may rule out heavy reliance on income or land taxes. The weakness of the tax administration may rule out all but the simplest options. Legal considerations, as for example, arrangements on revenue sharing between the central and the local government, earmarking, or tax treaties may rule out other options. The structure of the economy may still rule out some other options (as, for example, retail sales taxes). And, of course, the maxim that “old taxes are good taxes” would argue against a major overhaul of the tax system. There is only so much change that a tax administration can absorb at any one time. The weaker is the administration, the more limited are the feasible options. This discussion should make it clear why textbook solutions are rarely right for specific countries. Those solutions generally ignore the various constraints that exist in the real world. Fund tax missions have learned through considerable experience to pay adequate attention to these constraints.
The work of a tax mission will begin with the assembly of relevant statistics and basic laws. In many cases, these are not easily available and much time and effort may have to be allocated to this task. This task is followed by detailed discussions with those charged with the administration of those laws to assess whether questions of interpretation, or administrative regulations, are not introducing significant wedges between the effective and the statutory tax system. In this process major administrative shortcomings will be identified. The mission will then attempt to estimate differences between the actual tax bases and the theoretical ones. In most cases, major differences are discovered. The degree of tax erosion may be very large—up to 90 percent for some taxes. Estimates of realistic potential bases are made, major distortions in the present system are identified, and some idea of tax incidence is formed. Econometric models have rarely been used in these exercises; however less formal empirical approaches have often been followed. 1/ Eclecticism has guided much of this work. The last stage of the work is to make some estimates of the revenue impact of the proposed changes. In some cases, these estimates may not be much more than educated guesses.
In recent years Fund missions have been much more concerned with issues of horizontal equity than with those of vertical equity. Highly progressive statutory tax systems have rarely resulted in highly progressive effective tax systems. However, the high statutory progressivity has often resulted in substantial horizontal inequity because of differential evasion possibilities among groups of taxpayers. Therefore, proportional general sales taxes have gained in popularity as compared with highly progressive income taxes. Furthermore, there has been less effort than in the past aimed at globalizing income taxes. With the fall in statutory progressivity, the implementation of a global income tax has been a less important goal than it was when the statutory rate structure was much more progressive.
Tax missions have been much more concerned than in the past with efficiency aspects of taxation. This concern has often resulted in recommendations to broaden bases while lowering rates. Because of administrative considerations and lack of reliable statistical information, Fund missions have refrained from recommending differential tax rates based on elasticities. Along the same line there has been a diminishing enthusiasm for tax incentives. Finally, given the prevalence and intractability of inflation, tax missions have aimed at making the tax system more neutral with respect to inflation.
Let me now turn more specifically to the general pattern of tax structure that seems to have received more support by Fund staff in recent missions. 1/ Table 1 will serve as a reference table in the following discussion.
Tax Revenue by Type of Tax and by Country Group
(In percent of GDP)
Tax Revenue by Type of Tax and by Country Group
(In percent of GDP)
| Per Capita Income (US$) | No. of Countries | Total Taxes | Income Taxes | Domestic Taxes on Goods and Services | Foreign Trade | Social Security | Wealth and Property | Other | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | General sales, turnover, VAT | Excises | Other | |||||||||||||||
| Total | Individual | Corporate | Other | |||||||||||||||
| Range | Average | Total | Import duties | Export duties | Other | |||||||||||||
| 0 - 339 | 223 | 15 | 13.96 | 3.36 | 1.47 | 2.09 | 0.22 | 4.75 | 3.03 | 1.39 | 0.28 | 5.51 | 4.12 | 1.07 | 0.32 | 0.35 | 0.13 | 0.27 |
| 340 - 729 | 489 | 15 | 17.97 | 5.83 | 2.50 | 3.32 | 0.21 | 5.53 | 2.90 | 2.07 | 0.58 | 5.64 | 4.76 | 0.66 | 0.21 | 0.91 | 0.32 | 0.36 |
| 730 - 1,309 | 929 | 15 | 16.65 | 5.81 | 2.13 | 3.51 | 0.26 | 5.76 | 2.13 | 2.44 | 1.08 | 4.56 | 3.93 | 0.42 | 0.20 | 0.89 | 0.50 | 0.36 |
| 1,310 - 2,749 | 1,889 | 16 | 17.99 | 4.69 | 1.97 | 2.11 | 0.72 | 6.96 | 2.70 | 2.60 | 1.68 | 3.88 | 3.20 | 0.61 | 0.07 | 2.27 | 0.55 | 0.56 |
| 2,750 or more | 6,332 | 15 | 18.20 | 7.10 | 2.39 | 4.10 | 0.54 | 4.48 | 1.99 | 1.48 | 1.00 | 3.65 | 3.22 | 0.05 | 0.37 | 1.54 | 0.61 | 0.67 |
| All countries | 1,963 | 76 | 16.98 | 5.36 | 2.10 | 3.04 | 0.40 | 5.49 | 2.55 | 2.01 | 0.93 | 4.66 | 3.86 | 0.56 | 0.24 | 1.59 | 0.42 | 0.44 |
Tax Revenue by Type of Tax and by Country Group
(In percent of GDP)
| Per Capita Income (US$) | No. of Countries | Total Taxes | Income Taxes | Domestic Taxes on Goods and Services | Foreign Trade | Social Security | Wealth and Property | Other | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | General sales, turnover, VAT | Excises | Other | |||||||||||||||
| Total | Individual | Corporate | Other | |||||||||||||||
| Range | Average | Total | Import duties | Export duties | Other | |||||||||||||
| 0 - 339 | 223 | 15 | 13.96 | 3.36 | 1.47 | 2.09 | 0.22 | 4.75 | 3.03 | 1.39 | 0.28 | 5.51 | 4.12 | 1.07 | 0.32 | 0.35 | 0.13 | 0.27 |
| 340 - 729 | 489 | 15 | 17.97 | 5.83 | 2.50 | 3.32 | 0.21 | 5.53 | 2.90 | 2.07 | 0.58 | 5.64 | 4.76 | 0.66 | 0.21 | 0.91 | 0.32 | 0.36 |
| 730 - 1,309 | 929 | 15 | 16.65 | 5.81 | 2.13 | 3.51 | 0.26 | 5.76 | 2.13 | 2.44 | 1.08 | 4.56 | 3.93 | 0.42 | 0.20 | 0.89 | 0.50 | 0.36 |
| 1,310 - 2,749 | 1,889 | 16 | 17.99 | 4.69 | 1.97 | 2.11 | 0.72 | 6.96 | 2.70 | 2.60 | 1.68 | 3.88 | 3.20 | 0.61 | 0.07 | 2.27 | 0.55 | 0.56 |
| 2,750 or more | 6,332 | 15 | 18.20 | 7.10 | 2.39 | 4.10 | 0.54 | 4.48 | 1.99 | 1.48 | 1.00 | 3.65 | 3.22 | 0.05 | 0.37 | 1.54 | 0.61 | 0.67 |
| All countries | 1,963 | 76 | 16.98 | 5.36 | 2.10 | 3.04 | 0.40 | 5.49 | 2.55 | 2.01 | 0.93 | 4.66 | 3.86 | 0.56 | 0.24 | 1.59 | 0.42 | 0.44 |
Foreign trade taxes account for about one third of total tax revenue collected by developing countries and for much larger percentages in many of the poorer developing countries. Foreign trade has provided an important tax handle to governments when revenue from other sources was not available. The use of these taxes represents a second best alternative. If the alternative of domestic taxes were available, it would always be preferred. Much of the work in taxation by Fund staff has in fact been directed at bringing about a substitution of foreign trade taxes by domestic taxes.
Export taxes have especially been singled out for elimination or, at least, for sharp reduction because of their negative impact on foreign currency earnings. Perhaps, in part because of the advice by Fund staff, the use of these taxes has been sharply reduced in recent years. In some cases, however, these taxes continue to be tolerated either because of the absolute need for revenue or because they have been imposed at times of major devaluations or when the prices of export commodities was unusually high.
Import duties have been more tolerated than export taxes although, as indicated above, Fund missions would have a strong preference for replacing them by domestic indirect taxes. However, often this substitution is not feasible on administrative grounds or it would require rates for domestic indirect taxes that would be considered undesirable. Furthermore, many developing countries favor the use of import duties and quantitative import restrictions on grounds that have to do with import substitution, protection of domestic industry, and so forth. Because of these reasons. Fund missions have often proposed the elimination of import restrictions and the decrease of high import duties to more reasonable levels. Occasionally, they have also recommended the imposition of a minimum ad valorem import duty on the totality of imports. Such a tax is recommended (a) to raise revenue; (b) to provide a minimum degree of protection if the government wishes to protect local industry; and (c) to improve the structure of effective protection. A minimum tax on all imports levied with a relatively low rate (say, 5 percent to a maximum of 20 percent) can provide the government with a powerful tax instrument and with significant revenue. These minimum taxes have been introduced by several countries. However, at times, the governments have been unwilling or unable to apply them to all imports as recommended. In some cases, these taxes have been used as presumptive or advanced minimum payments on corporate income taxes. As such, they could be credited against the income taxes paid by the enterprises.
Domestic taxes on goods and services provide another third of total tax revenue for the developing countries taken as a group (see Table 1). These are made up of general sales taxes, excises, and other miscellaneous indirect taxes.
In recent years Fund missions have favored the introduction of value-added taxes (VAT). In fact Fund staff has assisted many countries with the various steps required to introduce a VAT. The preferred option has been that of a single-rate VAT applied on as large a base as feasible, including services and imports but excluding exports. Such a tax can generate large revenue with relatively short lags and low rates. Furthermore, the revenue effect of a rate change is immediate and easily measurable. The insistence on a single rate on a broad base is based mostly on practical considerations. First, increasing the number of rates would significantly increase administrative difficulties. This increase in difficulties is not compensated by a significant improvement in equity since it is very difficult to discriminate among products in such a way as to significantly increase the progressivity of the tax through rate discrimination. 1/ Generally, the Fund has favored the exemption of small producers mainly for administrative reasons. Various reports have indicated that much of the value added is generated by a small proportion of the enterprises. In any case, the exempted small producers would still pay taxes on their purchases from larger enterprises or from importers so that the revenue loss connected with their exemption is less than one would assume.
In addition to the general sales taxes, Fund missions have often recommended the use of excises (a) to discourage the consumption of particular products; (b) to provide some equity to the tax system if a specific product is clearly associated with the consumption of those with high incomes; (c) to make the consumers of some products pay for costs associated with their provisions or their use but not normally incorporated in the price of the product; or, (d) simply to generate additional revenue. Excises have been recommended over import duties to discriminate against the importation and the consumption of luxury products. Revenue considerations have often prevailed over theoretical considerations in recommending these taxes. Fund missions have recommended that the use of excises be limited to few products or services. They have, thus, often recommended the elimination of many low-yielding excises.
Table 1 indicates that income taxes taken together are about as important as domestic taxes on goods and services. However, their relative contribution to total revenue is influenced by the level of economic development. Income taxes are far more important among the 15 countries in Table 1 with per capita incomes over US$2,749 than among those with per capita incomes of less than US$340. Table 1 indicates also that in developing countries corporate income taxes are more important than personal income taxes. 1/
As far as the personal income taxes are concerned, Fund missions have in recent years recommended that they should be applied with lower rates than they used to be applied in the past. It would be rare for a Fund mission now to recommend a top marginal rate that exceeded 40 percent. Fund missions have paid a lot of attention to the relationship that must exist between the country’s per capita income, the country’s income distribution and the level of the basic exemption, and the levels at which various rates will apply. It is often found that in many developing countries the exemption level is too high if measured against the country’s per capita income and that the highest marginal tax rate begins to apply at levels where only few taxpayers are Likely to be found. A broad “guideline” has been that personal exemptions should normally not exceed the per capita income of the country and top rates should begin to apply at, say, about ten times the per capita income.
Fund missions have typically proposed very few rates--almost never more than five and often less than that; they have recommended that withholding at the source be applied as far as possible; they have recommended the elimination of most deductions; and, for activities in which it is difficult to measure income, they have supported the use of presumptive bases for taxation. However, the agricultural sector, the growth of the informal economy in many countries, and the distortions of tax bases created by inflation continue to create problems which are difficult to solve and which have been variously addressed by staff missions.
The one area in which there has been, perhaps, less convergence of views is in the taxation of enterprises. Apart from the broad view that the tax rate on corporations should be Lowered from the 45 to 55 percent range to, say, the 30 to 40 percent range, and that the tax base should be expanded by abolishing tax incentives and other deductions, advice by fund staff has remained very eclectic. There has been skepticism about proposals to replace corporate income taxes by cash-flow taxes. There has been some predisposition toward the integration of personal with corporate income taxes when administrative considerations made this integration possible. However, in other cases, Fund missions have been satisfied to continue recommending the so-called classical system that taxes corporations once on their profits and then, again, it taxes the individual shareholders on the dividends that they receive.
One area in which Fund missions have shown a lot of imagination has been in their recommendations related to the use of minimum taxes. These recommendations have been made when widespread tax evasion or a major erosion of the tax base greatly reduced the yield from the taxation of enterprises. Minimum taxes have been related (a) to the economic income of corporations, that is to the income before tax holidays and other incentives sharply reduced the taxable base. In one case a minimum tax of 5 percent on the pre-deductions income of the corporations was recommended. Minimum taxes have been related (b) to the turnover of the enterprises. A common recommendation has been to impose a 1 percent (or a slightly different percentage) minimum tax on the turnover of the enterprise. This recommendation has been made especially when enterprises were declaring losses over a string of many years, thus raising questions about the veracity of their accounts. The assumption has been that turnover can be estimated more easily than profits. In particular cases, the minimum tax has been related to the value of the enterprise’s imports rather than turnover. A more recent approach has been to impose a minimum tax (c) calculated as a percentage of the gross assets of the enterprises. The minimum tax on the gross assets of enterprises has been recommended in situations of high inflation when the determination of profits becomes very difficult. Generally, the minimum tax is a fixed percentage--say, 1 percent--of gross assets. This tax has been proposed either as a final tax, in place of a tax on enterprises, or as a tax rebatable against the corporate income tax.
V. Concluding Comments
For a reader who had expected to find a well-defined approach to tax reforms by Fund staff, this may have been a somewhat disappointing paper. There is simply no clearcut approach by Fund staff that answers the question of what the level and structure of taxation of a country should be.
Over the years, the Fund staff has shown some preference to bring about the required fiscal adjustment on the expenditure side, but it has been aware of the social and economic costs that this may involve. Thus, its focus has been on expenditures that could be regarded as unproductive or socially less important. The fact that in countries undertaking Fund-supported adjustment programs public investment has often fallen, and that the servicing of the debt requires an improvement in the fiscal accounts, and the need to maintain the level of some social or pro-poor expenditures have in recent years highlighted the necessity of raising the tax level in some countries. With higher taxes, both public investment and interest on the debt could be financed without excessive inflationary consequences. However, supply-side considerations have made Fund missions highly sensitive to the disincentive effects of tax increases. For example, Fund missions have been critical of export taxes and of high marginal tax rates in general. Single-rate and broad-based general sales taxes have often been recommended because they can raise the level of taxation with presumably low efficiency costs, and especially because of administrative considerations.
Perhaps it is also fair to mention that, so far, optimal tax theory has not had much influence on the advice given by Fund missions because of the feeling that that theory has not paid sufficient attention to administrative and other constraints. If optimal tax literature came to take full account of administrative difficulties, it would probably turn out that the practical rules followed by Fund missions are broadly consistent with its main message. Also, so far, expenditure-based taxation (as distinguished from consumption-based taxation) has not been recommended by any tax mission. The view has been that administrative difficulties would prevent the use of comprehensive expenditure taxes in developing countries. The experiences of India and Sri Lanka in the 1960s with that form of taxation continue to provide a strong incentive against recommending this form of taxation. 1/
References
Atkinson, A. B. and J. E. Stiglitz, Lectures on Public Economics (New York: McCraw Hill, 1980).
Blejer, Mario I., and Mohsin S. Khan, “Government Policy and Private Investment in Developing Countries,” IMF Staff Papers, Vol. 31 (June 1984).
Gandhi, Ved P., editor, Supply-Side Tax Policy: Its Relevance to Developing Countries (Washington, D.C.: International Monetary Fund, 1987).
Gandhi, Ved P., “Vertical Equity of General Sales Taxation in Developing Countries” (mimeo, 1979).
Goode, Richard, Government Finance in Developing Countries (Washington, D.C.: The Brookings Institution, 1984).
International Monetary Fund, Fund-Supported Programs, Fiscal Policy, and Income Distribution, A Study by the Fiscal Affairs Department of the IMF, Occasional Paper No. 46 (Washington, D.C., September 1986).
International Monetary Fund, The Monetary Approach to the Balance of Payments, (Washington, D.C., 1981).
International Monetary Fund, Theoretical Aspects of the Design of Fund-Supported Adjustment Programs, a Study by the Research Department of the IMF, Occasional Paper No. 55 (Washington, D.C., September 1987).
Khan, Mohsin S. and Malcolm D. Knight, “Fund-Supported Adjustment Programs and Economic Growth,” Occasional Paper No. 41 (IMF: Washington, D.C, November 1985).
Newbery, David and Nicholas Stern, editors, The Theory of Taxation for Developing Countries (New York: Oxford University Press, 1987).
Polak, Jacques, Financial Policies and Development (Paris: OECD, 1989).
Porter, Richard C., “Recent Trends in LDC Military Expenditures,” World Development, Vol. 17, No. 10 (1989).
Reisen, Helmut and Axel van Trotsenburg, Developing Country Debt: The Budgetary and Transfer Problem (Paris: OECD, 1988).
Tait, Alan A., Value-Added Tax (Washington, D.C: International Monetary Fund, 1988).
Tanzi, Vito, “The Public Sector in the Market Economies of Developing Asia,” Asian Development Review, Vol. 5, No. 2.
Tanzi, Vito, “Inflation, Real Tax Revenue and the Case for Inflationary Finance: Theory with an Application to Argentina,” International Monetary Fund Staff Papers, No. 25, September 1978. Republished, in revised form, in Mario I. Blejer and Ke-young Chu, editors, Fiscal Policy, Stabilization, and Growth in Developing Countries (Washington, D.C.: International Monetary Fund, 1989).
Tanzi, Vito, “Is There a Limit to the Size of Fiscal Deficits in Developing Countries?” in Public Finance and Public Debt, edited by Bernard Herber (Detroit: Wayne State Press, 1986).
Tanzi, Vito, “Quantitative Characteristics of the Tax Systems of Developing Countries,” in The Theory of Taxation for Developing Countries, edited by David Newbery and Nicholas Stern (New York: Oxford University Press, 1987).
Tanzi, Vito, “Tax System and Policy Objectives in Developing Countries: General Principles and Diagnostic Tests,” in Tax Administration Review, January 1987.
Tanzi, Vito, “Fiscal Policy, Growth, and the Design of Stabilization Programs” in Mario I. Blejer and Ke-young Chu, editors, Fiscal Policy, Stabilization and Growth in Developing Countries (Washington, D.C.: International Monetary Fund, 1989).
Revised version of 3 paper presented at the International Seminar in Public Economics and National Institute of Public Finance and Policy Conference, Delhi, India, January 11-13, 1990. It will be included in the Conference volume.
The views expressed are strictly personal. They do not necessarily reflect official Fund positions. The author is grateful to Liem Ebrill, Ved Gandhi, Richard Hemming, C. A. Mackenzie, A. F. Mohammed, P. Shome, and, especially, Richard M. Bird, Montek Ahluwalia, and Nicholas Stern for comments son an earlier draft.
Since the Board of Executive Directors of the IMF does not have an official view of tax reform, references to the Fund must be interpreted as references to Fund staff rather than to the Board which, in a legal sense, represents the IMF.
A good reference is Theoretical Aspects of the Design of Fund-Supported Adjustment Programs, A Study by the Research Department of the International Monetary Fund. Occasional Paper No. 55 (IMF: Washington, D.C., September 1987). A collection of earlier Fund contributions to the theoretical underpinnings of the financial programming exercise is contained in International Monetary Fund, The Monetary Approach to the Balance of Payments, (Washington: IMF, 1981).
For the basic reference on this thinking, see Atkinson, A.B. and J.E. Stiglitz, Lectures on Public Economics (New York: McCraw Hill, 1980). For applications of these theories to developing countries, see The Theory of Taxation for Developing Countries, edited by David Newbery and Nicholas Stern (New York: Oxford University Press, 1987).
See the discussion on taxable capacity and tax effort studies in Richard Goode, Government Finance in Developing Countries (Washington, D.C.: The Brookings Institution, 1984), pp. 84-88.
For example, the fact that Chile could collect one of the highest ratios in the world from its value-added tax has been a strong argument in advising other Latin American countries to enhance their lax collection from the VAT. For estimations of the contribution of the VAT to total tax revenue, see Alan A. Tait, Value-Added Tax (IMF: 1988).
For a recent example of a cross-country comparative Lax study, see Vito Tanzi, “Quantitative Characteristics of the Tax Systems of Developing Countries,” in The Theory of Taxation for Developing Countries, edited by David Newbery and Nicholas Stern (Oxford University Press, 1987), pp. 205-41.
At times the initial shock may be foreign induced. However, domestic policies may be inadequate to cope with such a shock.
Borrowing from the domestic private sector can finance fiscal deficits without monetary expansion. There is, however, often a low limit to this source. Furthermore, a growing domestic debt to GDP ratio is likely to lead in time to serious difficulties. For an analysis of the sources of financing fiscal deficits and their limits in developing countries, see Vito Tanzi, “is There a Limit to the Size of Fiscal Deficits in Developing Countries?” in Public Finance and Public Debt, edited by Bernard Herber (Detroit: Wayne State Press, 1986), pp. 139-52.
Actually, arrears provide an alternative and costly way of financing deficits. The accumulation of arrears (both domestic and foreign) has been a frequent way to finance fiscal deficits in many developing countries.
That limit is reached at a rate of inflation where the elasticity of the demand for real balances is unity. A higher rate of monetary expansion would increase inflation and reduce the demand for real balances enough to reduce government revenue from inflationary finance.
For the technical details and for some realistic simulations, see Vito Tanzi, “Inflation, Real Tax Revenue and the Case for Inflationary Finance: Theory with an Application to Argentina,” International Monetary Fund Staff Papers, No. 25, September 1978, pp. 417-51. Republished, in revised form, in Mario I. Blejer and Ke-young Chu, editors, Fiscal Policy, Stabilization, and Growth in Developing Countries (IMF: 1989).
See Ved Gandhi, editor, Supply-Side Tax Policy: Its Relevance to Developing Countries (Washington, D.C.: International Monetary Fund, 1987); and Fund-Supported Programs, Fiscal Policy, and Income Distribution, A Study by the Fiscal Affairs Department of the IMF (Occasional Paper No. 46, September 1986).
It should be appreciated that the use of domestic bank credit by the government is not the same thing as the fiscal deficit. It is monetary expansion associated with the deficit that is often seen as the major problem at least in the short run. In the past, when foreign borrowing was widely available, many programs would also limit government foreign borrowing to prevent the growth of foreign debt.
The basic accounting identity in a financial programming exercise is ΔM = ΔR + ΔD). That is the change in the money stock (ΔM) is the sum of the change in the domestic currency value of international reserves (ΔR) and the change in domestic credit (ΔD). The change in domestic credit can in turn be decomposed in credit to the government and credit to the private sector.
See Vito Tanzi. “Fiscal Policy, Growth, and the Design of Stabilization Programs” in Mario J. Blejer and Ke-young Chu, editors, Fiscal Policy, Stabilization and Growth in Developing Countries (IMF, 1989).
Mohsin S. Khan and Malcolm D. Knight, “Fund-Supported Adjustment Programs and Economic Growth,” Occasional Paper 41 (Washington: IMF, November 1985), p. 2.
See Richard C. Porter, “Recent Trends in LDC Military Expenditures,” World Development, Vol. 17, No. 10 (1989) pp. 1573-1584.
See Vito Tanzi, The Public Sector in the Market Economies of Developing Asia,” Asian Development Review, Vol. 5, No. 2, pp. 31-57.
Public investment may “crowd in” or “crowd out” private investment, depending on circumstances. The crowding out may occur if too much credit is diverted toward public spending or if high public spending leads to a deterioration in the macroeconomic environment, and thus to an increase in economic uncertainty. It may also occur if public investment produces an output that directly competes with the output of the private sector. For the effect of public investment on private investment, see Mario I. Blejer and Mohsin S. Khan, “Government Policy and Private Investment in Developing Countries,” IMF Staff Papers, Vol. 31 (June 1984), pp. 379-403.
The numbers in parenthesis are t values.
Two stars indicate significance at the 1 percent level.
Of course, private investment can also be distorted by factors such as subsidized credit, overvalued exchange rates, and excessive investment incentives.
See, on this issue, Helmut Reisen and Axel van Trotsenburg, Developing Country Debt: The Budgetary and Transfer Problem (Paris: OECD, 1988), and Jacques Polak, Financial Policies and Development (Paris: OECD, 1989).
Computational general equilibrium models have been used in research papers but not in technical assistance missions.
For an elaboration of some of these points, see Vito Tanzi, “Tax System and Policy Objectives in Developing Countries: General Principles and Diagnostic Tests,” in Tax Administration Review, January 1987, No. 3, pp. 23-34. I should emphasize that this represents a very personal interpretation of a large body of information. It is unlikely that everyone in the Fiscal Affairs Department of the IMF would fully share these views.
See Ved P. Gandhi, “Vertical Equity of General Sales Taxation in Developing Countries” (mimeo, 1979). The alternative of determining rates on the basis of demand elasticities for various products has not been followed, first, because of lack of information about these elasticities and second, and most importantly, because of the administrtive difficulties mentioned.
See also Vito Tanzi, “Quantitative Characteristics of the Tax Systems of Developing Countries,” in David Newbery and Nicholas Stern, editors, op. cit.
See Richard Goode, op. cit., p. 143-146.