IMF Policy Paper: Macroeconomic Developments and Prospects in Low-Income Developing Countries—2019
Author: International Monetary Fund
Publication Date:
11 Dec 2019
eISBN:
9781513522739
Language:
English
Keywords:
PP; commodity exporter; low-income developing country; commodity; VAT credit; VAT registration; current account; VAT refund; resolution regime; financial system; VAT return
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This paper is the fifth in a series that examines macroeconomic developments and prospects in low-income developing countries (LIDCs).

Abstract

This paper is the fifth in a series that examines macroeconomic developments and prospects in low-income developing countries (LIDCs).

Macroeconomic Developments

A. Introduction

1. Economic activity in low-income developing countries (LIDCs) has been quite robust in 2018–19, against the backdrop of significant loss of momentum in global growth.1 This apparent de-linking of growth in LIDCs from the state of the global economy is more coincidental than real: LIDCs heavily dependent on commodity exports are recovering from the large drop in commodity prices from mid-2014, while growth in other LIDCs has eased somewhat in line with the wider global trend.

2. There is a striking degree of heterogeneity across LIDCs that can undermine the value of broad-brush depictions. In interpreting developments, it has been useful to construct sub-groups of economies based on export structure (Annex I): commodity exporters, where primary products account for at least half of export earnings, and diversified exporters, where the majority of export revenues come from other sources.2 Commodity exporters can also be usefully divided into fuel and non-fuel commodity (NFC) exporters, given the markedly different evolution of fuel and NFC prices in recent years.3 Other analytical groupings that have proved to be useful include (i) frontier market economies, characterized by more developed financial systems and closer linkages to international financial markets (IMF, 2014b) and (ii) fragile states, with very weak institutional capacity or conflict situations or both (see Annex I). But there is also striking diversity of experiences within these analytical categories, with developments diverging sufficiently that movements in “averages” (of whatever type) may not be that informative. This issue reappears in several segments of the chapter.

3. The chapter discusses recent economic developments (2018–19) and the near-term outlook, focusing on the evolution of the traditional macroeconomic aggregates (growth, inflation, fiscal and external positions) and financial sector developments. One section looks at the factors that have contributed to trend growth over time in LIDCs; the level and evolution of total factor productivity (TFP) features heavily, underscoring the importance of domestic reforms that deliver efficiency gains.

B. The External Environment Facing LIDCs

4. The global economic environment facing LIDCs has weakened over the past two years, with the pace of expansion slowing sharply from a 2017 peak and projections marked down significantly relative to earlier projections. Global growth in 2019 is now projected at 3.0 percent in 2019, down from 3.8 percent in 2017 and some 0.7 points below the level forecast a year ago. Growth projections for the medium term have also been marked down, albeit by more modest margins (Figure 1), reflecting increased trade tensions, policy and geopolitical uncertainty, and weak business confidence.

Figure 1.
Figure 1.

Global Growth Projections

(Percent)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: IMF World Economic Outlook.

5. Commodity prices have recovered significantly from the lows recorded in early-2016 but remain well down on 2014 levels (Figure 2). A strong rebound in oil prices during 2018 has in good part been reversed over the past year, while non-fuel commodity prices have been broadly unchanged since 2017. Oil prices are expected to remain lower than in 2018, due to subdued global economic growth and supply developments, although geopolitical tensions are a risk factor (IMF, 2019a).4

Figure 2.
Figure 2.

Global Commodity Prices

(Index, Jan 2014 = 100)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: IMF World Economic Outlook.

6. Access to international capital markets has increased but not for all. Several LI DCs have become repeat issuers of sovereign bonds in recent years (Côte d’Ivoire, Ghana, Kenya, Nigeria, and Senegal) and some have accessed markets for the first time (Tajikistan in 2017, Papua New Guinea in 2018, and Benin in 2019) (Figure 3.A). The surge in Eurobond issuances by LIDCs broadly mirrors capital flows to emerging market economies (EMs) and reflects in good part foreign investors’ increased appetite for high yield assets during a low yield period in the debt markets of advanced economies (AEs). Notwithstanding higher portfolio flows to LIDCs as a group, more than half of LIDCs have not issued sovereign bonds in international markets over the past decade, reflecting mainly weaker economic fundamentals (particularly in lower income and fragile states). Foreign direct investment (FDI) continues to account for the bulk of private capital inflows to LIDCs, with portfolio flows fluctuating significantly from year to year (Figure 3.B), reflecting both shifts in global risk sentiment and in world commodity prices (most notable for fuel exporters).

Figure 3.
Figure 3.

Capital Inflows to LIDCs

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: Bloomberg; IMF World Economic Outlook; and IMF staff calculations. * Until May 31. Figures are based on gross inflows.

7. Remittances to LIDCs continue to grow, while aid flows remain below pre-2014 levels. Remittance flows have maintained their upward trend, driven by an increase in migrants and helped by falling transaction fees (Figure 4): the average cost of transferring money to LIDCs has fallen by 22 percent since 2011 (World Bank, 2019a) but remains high. The level of remittances dipped temporarily in 2015–16, reflecting weak economic conditions in major oil-exporting host countries. Official development assistance (ODA) to LIDCs picked up in 2017, with flows increasing by over 10 percent in nominal terms, but this rebound has merely reversed prior declines; aid as a share of LIDC GDP has steadily declined over time.

Figure 4.
Figure 4.

Remittances and Official Development Assistance Flows to LIDCs

(Billions of USD)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: OECD database; and World Bank migration and remittances database.Note: ODA = Official Development Assistance.

C. Recent Macroeconomic Developments in LIDCs

Continued Heterogeneity in Growth Paths

8. The pace of growth in LIDCs has picked up modestly during 2018–2019, averaging 5.0 percent, up from 3.6 percent in 2016 and 4.7 percent in 2017 (Figure 5). This growth pick-up runs counter to the slowing of the global economy since 2017, reflecting different dynamics at play between commodity exporters and those with more diversified export structures. Fuel exporters have been slowly recovering from the recessions that followed the large drop in oil prices in 2014; the larger NFC exporters have experienced a steady easing of growth since 2016, albeit not mirrored in many smaller countries; diversified exporters have experienced strong growth for several years, with the modest year-to-year movements broadly tracking the evolution of the global economy.

Figure 5.
Figure 5.

Real GDP Growth, 2016–19

(Percent, PPP-weighted average)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; and IMF staff calculations. * Forecast.

9. Aside from commodity price movements, factors contributing to growth at the country level vary widely. Continued strong growth in diversified exporters has been helped by large-scale investment projects (Lao P.D.R., Rwanda, Senegal), the temporary positive impact of U.S. trade and investment reallocation (Vietnam), and post-disaster reconstruction (Nepal). Adverse factors included natural disasters (Comoros, Mozambique) and security-political challenges (Afghanistan, Nicaragua, the Sahel countries, Sudan). Unsurprisingly, the pace of growth in fragile states has typically been slower than in non-fragile countries.

Aggregate Fiscal Positions Show Only Modest Changes

10. Fiscal balances improved in most commodity exporters during 2018–19, supported by a pick-up in revenues (Figure 6).5 Among fuel exporters, the median deficit fell from 5.4 percent in 2017 to a projected 2.3 percent in 2019 (below the 3.2 percent median in 2010–14), with tight financing constraints limiting expenditure growth (Table 1); Nigeria is an outlier in this context, with the fiscal position, though improving, still significantly weaker than in 2010–14 (the era of high oil prices). Deficits are also projected to decline in most NFC exporters during 2018–19:6 recovery in revenue levels (on the order of 1–1¼ percent of GDP), coupled with more modest expenditure increases, should yield a (weighted) average decline in deficit levels (by some 0.6 percent of GDP) to 2.5 percent of GDP, helping to contain debt accumulation. But movements in the aggregates can be deceptive:

  • Revenue is projected to rise in 2018–19 by at least 1 percent of GDP in 13 countries (e.g., Burkina Faso, Sierra Leone, Uzbekistan), but fall relative to GDP in 13 countries (e.g., Malawi, Lao P.D.R., Tajikistan).

  • While spending levels are projected to increase across commodity exporters as a group, the increases are concentrated in less than half of the 30 countries (e.g., Nigeria, Uzbekistan, Sudan), with spending levels falling in most of the other countries (Côte d’Ivoire, Republic of Congo, Mauritania).

Figure 6.
Figure 6.

Fiscal Trends across LIDCs

(Percent of FY GDP; PPP-Weighted Average)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; and staff calculations.Note: Data for 2019 are forecasts.
Table 1.

LIDCs: Select ed Macroeconomic Indicators

article image
Sources: IMF World Economic Outlook; and IMF staff calculations.

11. By contrast, fiscal deficits are projected to have widened marginally in diversified exporters during 2018–19 (on the order of 0.3 percent of GDP), reflecting a combination of revenue erosion and rising spending levels. There is significant variety around this aggregate picture, with the experience of larger countries driving the evolution of the (weighted) averages:

  • Revenues declined in 2018–19 by at least 0.5 percent of GDP in 12 countries (e.g., Ethiopia, Tanzania, Vietnam) while increasing by at least this margin in 10 others (e.g., Cambodia, Niger, Nepal).

  • Expenditure rose by more than 0.5 percent of GDP in 13 countries (with the increases being most marked in Cambodia, Nepal, and Togo) while falling by more than this margin in 10 countries (e.g., Bhutan, Ethiopia, Kyrgyz Republic).

12. Progress in boosting tax collection, a key component of the Addis Ababa Action Agenda, has been encouraging in several countries, but it is not a broad-based pattern across LIDCs.7 The median tax-GDP ratio across all 59 LIDCs has remained broadly unchanged at some 13 percent of GDP since 2013 (Figure 7). But there are strong and weak performers:

  • Tax revenue as a share of GDP increased by at least 2 percentage points from 2013 to 2019 in 14 LIDCs (such as Guinea-Bissau, Nepal, Uganda), helped by both tax policy reforms and improvements in revenue administration.

  • At the same time, the tax-GDP ratio declined by more than 2 percentage points in another 14 countries, influenced by domestic economic difficulties (e.g., Papua New Guinea, São Tomé and Príncipe, Zimbabwe).

  • Effective implementation of a value-added tax (VAT) is usually seen as a key contributor to boosting tax revenues—but many countries have faced challenges in the design and administration of a VAT (see Chapter 2).

Figure 7.
Figure 7.

Tax Revenues

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; and IMF staff calculations.Notes: In Panel B, selected observations have been removed to improve legibility.* Forecast.

Public Debt Vulnerabilities Remain Elevated

13. The rapid growth in public debt recorded between 2013 and 2017 slowed significantly in 2018–19, although the general trend was still an upward drift in debt burdens (Figure 8.A).

  • Debt levels in several countries (notably fuel exporters) fell sharply on fiscal tightening and recoveries of GDP and/or real exchange rates (which boosted dollar-equivalent denominators).8

  • Excluding fuel exporters, debt to GDP ratios are projected to have increased by at least 2 percentage points of GDP in 23 (of 52) countries, and by at least 5 percentage points of GDP in 11 cases (such as Liberia, Zambia). Rising primary deficits and off-budget operations have been the key drivers of debt build-ups, in part reflecting higher public investment levels.9

  • On the positive side, debt to GDP ratios are expected to decline (excluding fuel exporters) by at least 2 percentage points of GDP in 11 countries (such as The Gambia, Vietnam) and by at least 5 percentage points of GDP in three countries (including São Tomé and Príncipe).

Figure 8.
Figure 8.

LIDCs Debt Position

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

14. The number of countries facing serious debt challenges, as assessed by Bank-Fund debt sustainability assessments, has risen only marginally since 2017, after increasing sharply in the preceding four years (Figure 8B). 43 percent of countries for which DSAs are available are now assessed to be at high risk of, or in, debt distress, slightly higher than in 2017; the share of countries assessed to be at low risk of debt distress has also increased modestly10

Some Softening in External Positions

15. Current account balances weakened in many countries during 2018–19 (Figure 9), albeit with different drivers. Among fuel exporters, current account deficits narrowed over the period, helped by recovery in export revenues—except in Nigeria, where recovery in import levels dominated a transitory increase in export revenues in 2018 on the back of higher oil prices.11 Among NFC exporters, current account deficits widened markedly (exceeding 6 percent of GDP in 2018) on the basis of a surge in import levels, helped in several cases by FDI-driven imports (Lao P.D.R.) and demand for capital goods (Uzbekistan). Export growth remained strong for diversified exporters, particularly Asian LIDCs (Bangladesh, Cambodia, Vietnam) integrated into global manufacturing value chains; current account deficits widened modestly, more noticeably in smaller countries.

Figure 9.
Figure 9.

Current Account Balance

(Percent of GDP)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; IMF staff calculations.Note: Averages by LIDC subgroup are PPP-weighted.* Forecast.

16. Foreign reserve levels showed little trend movement during 2018–19 (Figure 10) but remain low in a sizable number of countries. As of end-2018, 25 LIDCs had reserves below the conventional benchmark of three months of import coverage, while the bottom quartile of countries had reserve levels of less than two months coverage. Reserves levels at such low levels leaves countries particularly vulnerable to external shocks.

Figure 10.
Figure 10.

Reserves

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; and IMF staff calculations.* Forecast.

Moderating Inflation

17. Inflation levels have eased since 2017, more noticeably in countries with flexible exchange rates (Figure 11). Among countries with pegged exchange rate regimes, the median inflation rate, already low, has fallen below 4 percent, helped by low growth in import prices. For countries with flexible exchange rates, the improvement in inflation has been more marked, as the pass-through effects from prior exchange rate depreciation faded. Outliers from these general trends include countries in conflict situations (South Sudan, Sudan, Yemen) or with shifting monetary/currency regimes (Zimbabwe).

Figure 11.
Figure 11.

Inflation by Exchange Rate Regime*

(Percent)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; IMF staff calculations.* Excluding conflict-affected cases (South Sudan, Sudan, Yemen) and a case of a currency regime shift (Zimbabwe).** Forecast.

18. Falling inflation provided space for monetary easing in countries with monetary autonomy, with real interest rates declining in most inflation-targeting countries (Figure 12A). The pace of growth of private sector credit, which declined sharply during 2014–16, began to recover somewhat in 2018—but remained negative in about 30 percent of LIDCs (Figure 12B).

Figure 12.
Figure 12.

Interest Rate and Credit Growth

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Financial Sector Developments

19. Financial sector stress remains a significant concern in many LIDCs.12 Although the number of countries recording bank failures has fallen since 2016, the assessment of IMF country teams is that an increasing number of countries are currently under financial stress— close to 40 percent in 2019, up from around 32 percent in 2017 and less than 20 percent in 2016 (Figure 13A). While regulatory capital remains stable, the share of LIDCs with elevated levels of nonperforming loans (NPLs) has trended upward, albeit with some easing in commodity exporters in 2018 (Figure 13B). With the adverse impact from past commodity price shocks on the banking sectors easing somewhat, the key drivers are now country-specific developments, including rising public arrears (Comoros, Republic of Congo, Liberia, Zambia), falling remittances (Eritrea, South Sudan, Tajikistan), and prolonged conflict (Sudan, Afghanistan). The role of financial sector safety net policies in supporting financial stability is discussed in Chapter 3.

Figure 13.
Figure 13.

LIDC Financial Sector

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: Country authorities; survey of IMF country teams; and IMF staff calculations.* The years correspond to when the surveys were conducted. The left part shows the fraction of LIDCs where bank failures were observed during the past two years of the respective survey years. The right half of the chart shows the fraction of LIDCs that are assessed that their banking sectors are “currently under stress” by the IMF country teams as of the time of the surveys (see footnote 12).** Missing values are replaced by nearest observations. Data are collected through part of the survey of IMF country teams on LIDCs, while the ultimate data sources are respective country authorities.

20. Loss of correspondent banking relationships (CBRs) remains a concern in a significant number of LIDCs. The IMF country team survey indicates that some loss of CBRs occurred in one-third of LIDCs over the past two years, with significant adverse effects on cross-border transactions in about half of these cases—typically small and/or fragile states (Djibouti, Solomon Islands, Somalia, Mauritania, Nicaragua).

21. Access to finance has improved significantly in recent years, albeit from low levels (Figure 14). Access to financial accounts almost doubled between 2014 and 2017, largely driven by increased access to mobile accounts, but remains much lower than in EMs. IMF analysis indicates that fintech is likely to have a strong impact in increasing financial inclusion in some countries (e.g., Bangladesh, Mali), while nonbank/ microfinance institutions are likely to play a more important role in other countries (e.g., Benin, Cambodia, Tajikistan). Impediments to financial intermediation are examined further in Box 1.

Figure 14.
Figure 14.

LIDC Financial Access: Improvements from 2014 to 2017

(Percent of the population, median)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: World Bank Global Findex (Demirgüç-Kunt and others, 2018); and IMF staff calculations.

The Challenge of Low Credit and Deposits in LIDCs1

Financial intermediation in LIDCs substantially lags the levels recorded in higher-income countries. Credit to the private sector in LIDCs remained steady at about 20 percent of GDP during 2013–18, as compared with 50 percent in EMs and 90 percent in AEs. Savings held in bank deposits in LIDCs amounted to less than 20 percent of GDP, against 57 percent and 95 percent in EMs and AEs, respectively.

The 2014–2015 commodity price shock has weighed on credit growth in commodity-exporting LIDCs. Fuel exporting LIDCs saw a sharp decline in real credit by 7 percent, reflecting the scale of the price shock (Box figure). Positive credit growth continued in most diversified exporters, underpinned by sustained growth. recorded continued credit growth, facilitated by ease of inflation pressures.

uA01fig01

Real Credit and Deposit Growth

(Percent)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: IMF staff calculations.

Poor deposit mobilization is a key impediment to expanding credit, given that banks rely heavily on their own deposit bases as sources of funding. 9 percent of the adult population (15 years+) in LIDCs had a savings account at a financial institution in 2017, compared to 17 and 53 percent in EMs and AEs respectively.

Addressing impediments to deposit mobilization are key to supporting greater credit provision. The Global Findex (Demirgüç-Kunt and others, 2018) points to high banking service costs and geographical isolation as two key constraints. Greater adoption of Fintech could help address these key constraints and reduce intermediation costs (see IMF, 2017, 2019f). A well-regulated banking system, with appropriate depositor protections, is also needed to support depositor confidence (see IMF, 2016; and Chapter 3 below).

1 Prepared by Imen Benmohamed (MCD).

D. Longer-Term Growth Issues

22. Output levels increased at an annual average of 5 percent across LIDCs between 2000 and 2017, with output per worker increasing at some 2.4 percent over the same period. There are, unsurprisingly, significant differences in growth rates across country types, with growth being slower than average in fragile states, and higher in frontier markets (Figure 15). Comparisons of growth in diversified and commodity exporters point to modest differences, favoring the former. This section discusses some of the key drivers of growth, drawing on comparisons among LIDCs and between LIDCs and EMs and other analysis.

Figure 15.
Figure 15.

Growth Decomposition, 2000–17

(Percent GDP growth, average)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IM F World Economic Outlook; Penn World Tables (9.1); and IMF staff calculations.

23. A decomposition of contributions to growth in LIDCs during 2000–17 points to some troubling features, notably the role of falling productivity as a drag on growth. Aside from labor force growth, investment in productive goods (capital accumulation) was the primary contributor to growth during the period, accounting, on average, for some three-quarters of the growth achieved. (See Box 2 for analysis of the payoffs from infrastructure investment). Improvements in the knowledge, skills, education, and health of the labor force—that is, human capital—played a surprisingly modest role, most likely reflecting measurement and specification challenges.13 More striking is the negative contribution of total factor productivity (TFP: the residual unexplained by other factors) to growth among fuel exporters and fragile states, likely reflecting the severity of economic distortions in these economies, along with low levels of private sector investment (and outright destruction of productive assets) in fragile states.14

Benefits of Infrastructure Upgrades Can Be Seen from Space1

Satellite images of the earth at night, showing “night lights” (NTLs), can provide a useful indicator of economic activity in countries where output data are of poor quality. This includes measuring activity levels across regions within a country, where output data by region are often not produced.

NTL data suggest that regional convergence of activity levels in LIDCs is ongoing. Data on the evolution of NTLs per capita between 2003 and 2010 indicate that regions with less nightlight intensity are catching up with more advanced regions.

Infrastructure investments in LIDCs are associated with increased economic activity as measured by NTLs. Looking at nightlights across LIDCs in areas where infrastructure investment in three sectors— transportation, energy, and water and sanitation—took place shows increased human activity. Investments in communication infrastructure, proxied by cell phone antennas have the strongest linkages; a 50 percent increase in the number of antennas in the region is associated with a 5.6 percent increase in NTLs after two years, compared with an increase of 1–2½ percent for a 50 percent increase in investment in transportation and energy infrastructure.

uA01fig02

Changes in Nighttime Lights in LIDCs

(2003–2013)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

1 Prepared by Claudia Berg (RES), Mariya Brussevich (APD), Futoshi Narita (RES), and Jiaxiong Yao (AFR). Data sources: Bluhm and others (2018); Projects & Operations, The World Bank; Research and Evaluation Unit (2017); National Oceanic and Atmospheric Administration (NOAA)/National Geographic Data Center (NGDC); OpenCellid; World Bank Group Cartography Unit.

24. The key role of productivity for growth performance can also be illustrated by comparing the average LIDC and “fast-growing” peers—countries in the top quartile of growth performers during 2000–17. For most country groups, growth (and growth per worker) is lower than in these fast-growing peers because of a combination of less capital per worker and greater inefficiencies, as reflected in weaker (often negative) TFP growth (Figure 16). For fragile states and fuel exporters, the large growth differential (about three points per annum) is due primarily to poor productivity performance.

Figure 16.
Figure 16.

Growth Differentials vs. High-Growth LIDCs

(Percent average 2000–17)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF World Economic Outlook; Penn World Tables (9.1); and IMF staff calculations.

25. Insight can also be obtained from analyzing the factors accounting for income differentials between LIDCs and the “average” EM economy. Demographic factors, notably a higher dependency rate in LIDCs, account for only a modest component of the difference in GDP per capita (except among fuel exporters), with labor productivity differentials the dominant factor at play.15 Labor productivity differentials between LIDCs and the average EM are explained primarily by differences in levels of TFP (accounting for about one-half of the divergence), in capital per worker (about one third), and in measures of labor quality (Figure 17). Differences in labor quality play a more significant role in explaining the differentials for fuel exporters; capital per worker in oil-dominated economies is predictably high.

Figure 17.
Figure 17.

Decomposition of Labor Productivity Differential vis-à-vis the EMs

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: Human Capital Index; World Development Indicators; ILOSTAT; Penn World Tables (9.1); IMF World Economic Outlook; and IMF staff calculations.Note: Calculations based on Mourre (2009).

26. Differences in levels of human capital/labor quality between LIDCs and higher-income economies are conveniently summarized in the World Bank’s Human Capital Index (HCI).16 The scale of the differences in labor quality between AEs, EMs, and LIDCs is quite striking (Figure 18), as are the differences in labor quality among LIDCs, with fuel exporters and (less surprisingly) fragile states scoring relatively poorly to other countries and the high-growth economies scoring best17

Figure 18.
Figure 18.

Human Capital Index

(Index; 0 to 1, least to most developed)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: World Development Indicators; and IMF staff calculations.

27. The preceding discussion points to the importance of increasing investment levels to boost growth in LIDCs, but also underscores that if an economy becomes less efficient (the empirical significance of negative productivity growth) then “invest more” is, at best, a partial route to sustained growth. Clearly, where public investment is being channeled to and how projects are being executed matters greatly in determining the returns to new investment; as a corollary, tackling inefficiencies in public investment management is essential for accelerating growth. Similarly, identifying the reforms needed to unlock private sector investment—without introducing new distortions via, say, monopolies or trade protection—must be a key element of a growth promotion strategy (see Box 3 for discussion of business environment reforms). And, while the simplified methodologies used above give relatively little weight to human capital in “explaining” growth, there is a large body of compelling evidence (e.g., World Bank, 2018) that improving learning performance and the skill levels of the labor force are integral to achieving sustained and inclusive growth—as the correlations cited in the preceding paragraph support.

28. Against this background, it is encouraging that most LIDCs have been making strides in improving public infrastructure and access to education over time, often from a low base.

  • Most LIDCs have made significant progress in improving access to electricity, although the largest gains are observed for countries that already have relatively high access (Lao P.D.R., Bhutan, Nepal), with countries with low initial access levels achieving more modest gains (Burundi, Chad, Malawi, Niger).

  • Progress in improving the quality of infrastructure since 2007 has been significant (Niger, Rwanda), with several countries now at or close to the average score for EMs; that said, quality has been eroded in several fragile or conflict-affected states (Burundi, The Gambia).

  • Primary school enrollment levels have increased in most LIDCs that were not already approaching full enrollment in 2007 (Côte d’Ivoire, Burkina Faso, Niger)—but the quality of education provided remains a serious impediment to growth, with only 44 (29) percent of pupils in early primary education grades (2 or 3) achieving at least a minimum proficiency level in mathematics (reading), as compared with an average of 58 (61) percent in EMs.18

Key Structural Reforms to Improve Productivity

Weak productivity performance points to the importance of tackling the most salient constraints on the business environment, which has been shown to have an important influence on productivity growth.1 There is striking variation in the quality of the business climate across LIDCs, with large differences between the average LIDC and the top performers (a benchmark group comprising Kenya, Kyrgyz Republic, Moldova, Rwanda, and Vietnam): for example, it takes about 80 days to register property in the average LIDC, compared to an average of 24 days in the benchmark group.

uA01fig03

Potential Impact of Reforms

(Score to be gained if gap is closed with LIDC top performers)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: World Bank Group, “Doing Business;” and IMF staff calculations.

Sizable improvements in the business climate could be achieved if the average LIDC were to introduce reforms sufficient to bring key elements of the business environment to the “frontier,” defined here as the average level for each indicator in the benchmark group. The implications for the Doing Business (DB) indicator of falling short of the frontier on various indicators are illustrated in the above chart.2

Areas with potentially high returns in terms of boosting the DB indicator include access to credit, access to reliable electricity, facilitating property registration, making it easier to pay taxes, and protecting minority investors. Strategically targeted actions can produce quick payoffs: for example, Rwanda’s DB score increased from 69.8 in 2017 to 78.9 in 2019 on the basis of enactment of an insolvency law and simplifying the regulatory environment for businesses.

1 See October 2019 WEO (IMF, 2019a, Chapter 3) for analysis of the impact of structural reforms in EMs and LIDCs; and World Bank (2019b, “Doing Business: Training for Reform”) on returns to improving the environment for doing business.2 To assess the impact of individual reforms, the score of each LIDC is replaced with the average of the top five LIDCs in the Doing Business Indicators (DBI) ranking.

E. Outlook and Risks

29. The outlook remains broadly favorable over the medium term (Table 1). Growth is forecast at some 5.1 percent in 2020, from 5 percent in 2019, and increasing marginally in the ensuing years (Figure 19). This is lower than the 6 percent average growth recorded in the decade prior to the 2014 commodity price shock, reflecting a less benign external environment19 Fiscal and external balances are projected to slightly weaken in the near term before strengthening along with favorable baseline growth prospects over the medium term.

Figure 19.
Figure 19.

LIDC Projected Real GDP Growth, 2013–22

(Percent)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: WEO databases, and IMF staff calculations.

30. Downside risks are significant. External risks include geopolitical and trade tensions, volatility in commodity prices, a sharp rise in risk premia, and a faster-than-anticipated slowdown in China or the euro area. Newly-developed measures indicate that trade uncertainty is increasingly becoming a source of concern for LIDCs (Figure 20). Trade exposure to China—measured as the share of exports to China—is high at more than 20 percent for several LIDCs integrated into global value chains (Myanmar, Vietnam), while demand from China plays a key role in supporting metals and other commodity prices.20 Domestic risks include threats to fiscal management during the election cycle, intensifying security issues in some regions, climatic events, and sluggish implementation of key reforms.

Figure 20.
Figure 20.

World Trade Uncertainty Index

(Percent; share of countries with a spike in the index)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: World Trade Uncertainty Index (Ahir, Bloom, and Furceri, 2018).Note: The World Trade Uncertainty Index is based on text mining of the quarterly country reports by the Economic Intelligence Unit, counting the number of mentions of the word “uncertainty” and its variants within a proximity to keywords related to trade.

31. The majority of LIDCs are vulnerable to large-scale natural disasters and likely to suffer significantly as climate change proceeds (Figures 21A and 21B). Disaster events and climatic development can have large and long-lasting economic costs, particularly for those with weak economic buffers and less developed disaster response frameworks. There is substantial room for improvement for low-income countries due to inadequate investment in required infrastructure as well as limited use of ex-ante financing instruments such as insurance (IMF, 2019c).

Figure 21.
Figure 21.

Effects of Natural Disasters

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: EM-DAT Database 2019; and IMF staff calculations.Note: LIDCs include the 59 countries in this report and non-LIDCs cover 134 countries.

32. Upside risks may support growth and income convergence. As described in Box 2, new technologies—such as mobile devices—have provided significant gains for LIDCs and could support further economic growth and economic inclusion, if accompanied by a commensurate accumulation of human capital. Regional economic integration has supported strong growth in several Asian LICs, underscoring the potential gains from a closely integrated African Continental Free Trade Area.

F. Conclusions and Policy Issues

33. Economic growth in LIDCs, at 5 percent per annum, has been reasonably robust in 2018–19, despite a significant loss of momentum in the global economy. Commodity-dependent economies continue to fare less well than countries reliant on other export sectors, with the latter group continuing to achieve trend growth rates on the order of 6 percent per annum. Looking ahead, the outlook for commodity exporters is expected to improve as countries exit the post-2014 export price-driven slowdowns, but global downside risks threaten this outlook.

34. Fiscal positions have changed only modestly at the aggregate level since 2017, but with country-specific factors delivering a diverse array of outcomes at the country level. Growth of public debt levels has slowed significantly from previous years, but more than two-fifths of LIDCs remain at high risk of (or already in) debt distress. In the crucial area of boosting tax collections, one-quarter of LIDCs have increased tax revenue/GDP ratios by at least two percentage points since 2013 (showing what can be done)—but as many experienced a decline of similar magnitude over the same period (showing what can go wrong).

35. There has been a marked increase in current account deficits in NFC exporters since 2017, financed by a mix of FDI and access to external capital markets. Foreign reserve positions show little trend movement: in the bottom quartile of countries, reserves cover less than two months of prospective imports—a continuing cause for concern.

36. On the monetary/financial side, inflation levels have been easing, helped by limited increases in import prices and the fading of pass-through effects of earlier exchange rate depreciations. Interest rates have been declining in countries with monetary autonomy, with the multi-year decline in the growth of credit to the private sector beginning to turn around. IMF staff assessments point to current financial stress in close to 40 percent of LIDCs (on an upward trend), highlighting the need for proactive regulatory actions (and clearance of government payment arrears, where relevant) in these countries.

37. Analysis of growth patterns in LIDCs highlights the drag of low and falling TFP levels on productivity. Higher levels of public investment are warranted, but only if directed to the right projects and executed efficiently. Creating a business environment conducive to boosting private investment is essential: a handful of countries have made impressive strides in improving the business climate, showing the way forward for the many that have achieved much less. There is abundant evidence on the importance of improving human capital for growth prospects. In this context, it is encouraging to note that most LIDCs have been making progress in tackling infrastructure gaps and improving school enrollments, although strengthening the quality of education is an immediate and pressing concern.

Annex I. Country Group of Low-Income Developing Countries

The country grouping “low-income developing countries (LIDCs)” was introduced for analytical purposes in 2014 (IMF, 2014a) and updated in late 2017 (IMF, 2018a, Annex I). The group is defined by having per capita income levels below a set threshold and the economic structures that are insufficiently close to be widely seen as emerging market economies (EMs). The country group was updated in 2017 (effective as of October 2017 WEO), resulting in the current 59 countries. The LIDC group serves as a standardized definition of the “low-income country” universe in IMF’s analytical work. There is no operational implication of being categorized in the LIDC group nor any connection to access to specific types of IMF financing. Growth experiences within the LIDC group has been very diverse (Annex Figure 2).

The subgroups of the LIDC group are defined in two dimensions: export types and financial development levels (Annex Figure 1; Annex Table 1). Export types are based on the WEO’s analytical groups by source of export earnings. “Fuel exporters” are those that fuel consists of more than half of their export earnings. “Non-fuel commodity (NFC) exporters” are those that primary products consist of more than half of their export earnings. The rest of LIDCs are named “diversified” exporters. “Frontier markets” are defined as those with financial depth and institution settings comparable to EM (IMF, 2014b, Appendix II). “Fragile states” are those with less than 3.20 of the CPIA rating or where there is a peacekeeping operation in the preceding three years.

Annex Figure 1
Annex Figure 1

Low-Income Developing Countries and Subgroups

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Annex Table 1.

Low-Income Developing Countries and Subgroups

article image
Note: see IMF (2014a, 2018a) for the details of the classification. The number of countries is shown in the parentheses.

Côte d’Ivoire and Papua New Guinea are included in both the “frontier market” and “fragile state” groups.

References

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The Vat Experience in Lidcs

38. The Value-Added Tax (VAT)21 is at the heart of efforts to strengthen revenue mobilization in developing countries, including LIDCs, but remains in some respects contentious. There is scope and need to raise more from other taxes too, including the personal income tax and property tax; but progress on the former is difficult, and the revenue potential of the latter is limited. Moreover, in the areas of trade taxation and corporate income taxation the pressures, including from international tax competition and multinational avoidance, are likely to be on preserving rather than increasing revenue. This makes it hard to see how LIDCs can reach the Sustainable Development Goals (SDGs)—with median additional spending needs for them of around 17 percent of GDP22—without strengthening the VAT, both as a source of revenue and in catalyzing wider administration reform. In many countries, however, the VAT remains a source of controversy related to difficulties in properly managing VAT refunds, capacity constraints in administering large numbers of tax payers, and distributional concerns. While the last few years have seen much attention devoted to the problems of international taxation faced by developing and other countries, the less striking but potentially more important challenges of strengthening the VAT have received relatively little attention.

39. This chapter reviews core aspects of VAT policy and administration in LIDCs.23 While it is important to consider all elements of tax (and spending) systems as a package, this chapter focuses on selected aspects of the VAT. It looks first at the performance of the VAT in LIDCs and then, in turn, at core challenges of implementation and lingering concerns about distributional effects. In all this, it is important to bear in mind that the ‘VAT’ label conceals quite wide variation in terms, for instance, of scope and nature of exemptions, degree of rate differentiation, level of registration threshold, and restriction on crediting and refunds.24 In some cases, these features—of practice as well as design—can be such that there is room to question whether the tax is truly a VAT or not.

G. The Performance of the VAT

40. The VAT is a central element of the tax systems of most LIDCs, and its introduction is planned in more. Around three-quarters of LIDCs have adopted a VAT (Figure 22), which on average raises around 30 percent of their total tax revenue. Several more plan adoption (Bhutan, Bangladesh, and Liberia) while others are small islands or have particularly low administrative capacities, for example fragile states, for which a VAT may not be suitable. Countries have had a variety of objectives in introducing the VAT; some to replace earlier sales taxes or trade taxes in a revenue-neutral way, so reducing distortions and fostering growth;25 some to mobilize additional revenues and strengthen their fiscal balance; some to promote growth through higher spending financed by the VAT.

A Primer on the VAT1

The key features of the Value-Added Tax are that it is a broad-based tax levied at multiple stages of production, with taxes on inputs credited against taxes on output (and refunded or carried forward—ideally with interest—if this leads to excess credit). That is, while sellers are required to charge the tax on all their sales, they can also claim a credit for taxes that they have been charged on their inputs. Such a system thus secures revenue by collecting it throughout the process of production—unlike a retail sales tax—but without distorting production decisions, as, in particular, a turnover tax does.

Suppose, for example, that firm A sells its output (assumed, for simplicity, to be produced using no material inputs) for a price of $100 (excluding tax) to firm B, which in turn sells its output for $400 (again excluding tax) to final consumers. Assume now that there is a VAT at 10 percent. Firm A will then charge firm B $110, remitting tax of $10 to the government. Firm B will charge final consumers $440, remitting tax of $30: output tax of $40 less a credit for the $10 of tax charged on its inputs. The government thus collects a total of $40 in revenue. In its economic effects, the tax is thus equivalent to a 10 percent tax on final sales (there is no tax incentive, in particular, for B to change its production methods or for the two firms to merge), but the method of its collection secures the revenue more effectively.

“Zero-rating” refers to a situation in which the rate of tax applied to sales is zero, though credit is still given for taxes paid on inputs. In this case, the firm will be due a full refund of taxes paid on inputs. In a VAT designed to tax domestic consumption only, exports are zero-rated, so that exports leave the country free of any VAT. This is consistent with the “destination principle,” which is the international norm: it requires that the total tax paid on a good be determined by the rate levied in the jurisdiction of its final sale with revenue accruing to that jurisdiction.

“Exemption” is quite different to zero-rating in that, while tax is again not charged on outputs, tax paid on inputs cannot be reclaimed. Thus, no refunds are payable. In this case, because tax on intermediate transactions remains unrecovered, production decisions may be affected by the VAT.

1 Source: Adapted from Ebrill, Keen, and Perry, 2001, The Modern VAT.
Figure 22.
Figure 22.

Number of Countries with a VAT Rate

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: IBFD

41. LIDCs with a VAT raise significantly more total revenue than those without do (Figure 23), though that may also reflect differences in other characteristics that affect potential tax yield.26

Figure 23.
Figure 23.

LIDCs with Vs. LIDCs without a VAT: Mean Total Tax Revenue, 2000–2017

(In percent of GDP)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: World Revenue Longitudinal Database (WoRLD).

42. An increased average ratio of total revenue to GDP in LIDCs since 2000 (2.1 percent of GDP) largely reflects increased VAT revenue (1.5 percent) (Figures 24 and 25). There were also modest gains in personal income tax and corporate income tax, all serving to more than offset declining trade tax revenue.

Figure 24.
Figure 24.

WEO Income Groups: Mean Total Revenue, 2000–2017

(In percent of GDP)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: WoRLD.
Figure 25.
Figure 25.

WEO Income Groups: Mean VAT Revenue, 2000–2017

(In percent of GDP)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: WoRLD.

43. The increased revenue from the VAT in LIDCs mainly reflects improvements in C-efficiency27 rather than changes in the standard tax rate or levels of consumption. Decomposing the average 4 percent annual increase in the ratio of VAT revenue to GDP suggests that this has been driven mainly by increases in C-efficiency, while the average standard rate has remained broadly constant (Figure 26).28 What has driven this marked increase in C-efficiency, however, is unclear. One possibility, clearly welcome, is an improvement in compliance. Another is an increase in reduced rates of tax or the elimination of exemptions on final consumption goods, which many advising on VAT policy would welcome (for reasons discussed in section I below).29 Another, unwelcome, is that this may reflect an increasing denial of VAT credits and refunds (an issue taken up below). More work is needed to understand the precise drivers of the underlying forces at work.30

Figure 26.
Figure 26.

Composition of Changes in VAT-to-GDP Ratio by WEO Income Group, 2012–2017

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Sources: IMF staff estimates using WoRLD Revenue Longitudinal Database and WEO data.

44. There remain, nonetheless, large shortfalls in many LIDCs between actual VAT revenue and the revenue that would be expected with full compliance and the application of a single rate to all final consumption—closing which offers the prospect of significant additional revenue.31 These gaps—which (confidential) IMF country work suggests, reflect in roughly equal parts noncompliance and deviations from uniform treatment of all consumption items—commonly amount to around 9 percent of GDP. Raising C-efficiency to 100 percent is not feasible (and perhaps not desirable) but illustrating the scale of the potential, if LIDCs in the lower quartile by C-efficiency were to raise it to the LIDC median, would raise additional revenue of around 3.5 percent of GDP.

45. In spite of the growing number of countries with a VAT, two countries have recently eliminated the VAT or seriously considered doing so—for different reasons. Zambia contemplated repealing the VAT because of the difficulty in managing VAT refunds, but the recently approved budget has explicitly retained it, and the authorities plan to address issues related to administrative challenges. Malaysia32 eliminated VAT amidst with its impact on prices and thus the poor. Such discontent with the VAT is troubling. It is also not wholly new, and it is notable that all countries that have previously removed a VAT, however, subsequently reintroduced it (for example Belize, Grenada, Malta, and Vietnam); for them, the wisest response to perceived difficulties with the VAT ultimately proved to be not its removal but its improvement. The next two sections take up two core elements for such improvement.

H. Implementation Challenges

46. Improving the implementation of the VAT—challenging in many LIDCs, as elsewhere— is a centerpiece of wider tax administration reform. More effective VAT management can help realize more fully the potential of the VAT as a productive and efficient revenue source in LIDCs. Moreover, the VAT—as a broad-based tax resting on self-assessment—has wider significance as a catalyst of wider administrative reform. Spillover effects on other taxes—not least those on small businesses and the self-employed—can be considerable.33 Rios and Seetharam (2017), for instance, find that VAT stimulated the registration of small enterprises in India.34 Building institutional capacity to properly manage VAT helps the tax administration upgrade its level of expertise and professionalism. Effective VAT management does, however, require the fundamentals to be in place.35 The challenges that many LIDCs face in implementing the VAT are symptomatic of weak tax administration—not of inherent flaws in the VAT itself.36

47. Improving VAT implementation thus requires attention to the core competencies of tax administration—gathering and using information; identifying, measuring, and treating compliance risks; and managing core processes (IMF, 2015). While these broader and overarching aspects of administrative reform are critical, the rest of this section focuses on core VAT-specific issues—of managing VAT credits and taxpayer registration—that are particularly important for LIDCs.

Dealing with VAT Credits

48. The management of credits is one of the most challenging aspects of the VAT for all countries—including LIDCs. As Bird (1993) notes, a VAT invoice is comparable to a check written on the government. The challenges of dealing with this are most evident when excess credits arise— that is, when credit for taxes on inputs exceed tax due on sales—and the government really does pay money to taxpayers. But it also arises when credits simply reduce a positive liability.

49. The management of excess credits, notably for exporters—which can be substantial— is a particular focus of attention in LIDCs as elsewhere. Excess credits arise most pervasively for exporters (since exports are zero rated)37 but can also arise for startups and others with heavy investment in excess of output, and in the presence of multiple VAT rates (with inputs potentially taxed more heavily than outputs). The amounts can be substantial, including in LIDCs: anywhere from 0.3 percent of GDP38 to perhaps as high as 0.7 percent of GDP.39 There is also evidence that in some countries the stock of excess credits continues to grow, which suggests VAT regimes severely limit refunds or other avenues of access to those credits (Figure 27). Managing refunds has been a persistent and widespread challenge for VAT administration and has created tensions between the business community and the government. Failure to pay proper refunds to exporters can have an especially pernicious effect on the economics of the VAT, turning it in part into a tax on exports—with some evidence that this has indeed caused real damage in lower-income countries.40

Figure 27.
Figure 27.

Stock of VAT Credits in an Asian LIDC

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: IMF staff calculation using country data provided in the context of a RA-GAP Study.

50. Concerns with fraud are a key reason why many LIDCs (and others) limit VAT refunds. The risk is real. A credit fraud using missing electronic cash registers to issue false invoices and claim refunds is estimated to have cost one LIDC two percent of GDP.41 In an attempt to guard against such frauds, while most LIDCs allow taxpayers who predominantly make zero-rated supplies to apply for refunds they require others to carry forward their VAT credit to the next tax period or beyond. Many countries subject all refund claims to audit, even for taxpayers who regularly apply for refunds (such as exporters), and without applying any risk profiling. As a result, the processing time for refunds can be months or even years. The result can be a tax that is a VAT in name only.

51. Some LIDCs have responded to the challenge of dealing with refunds by establishing special tax treatments for particular taxpayer segments—further complicating administration. Some have introduced mechanisms based on withholding by the buyer of part of the VAT that is payable by a supplier, or imposing a “reverse charge,” in order to ensure that VAT due is paid to the government.42 If broadly adopted (such as in Kenya, Zambia, and Zimbabwe), these mechanisms tend to make administration more complex, affect taxpayer cashflow and often result in more taxpayers being in a net credit position,43 so amplifying the problem it was intended to address. Such special mechanisms, and others—such as the exemption of mining companies (primarily exporters) in the Democratic Republic of Congo from VAT on their imports—increase the complexity of administering the VAT and the likelihood of errors, risk further distortions (between imports and domestic suppliers, for example) and require innovative control mechanisms.

52. The failure to manage refunds adequately not only undermines the economic merits of the VAT but can result in a large and often unmonitored buildup of government liabilities. It is commonly assumed that since businesses cannot operate for very long if spending more on inputs than they receive from their sales, any excess credit accumulated should be quickly used up, but in many of the countries for which they have been assessed, stocks of excess VAT credits are large and may still be growing (Figure 27). They represent a large, unfunded, and unaccounted government liability.

53. The attention paid to the management of VAT refunds can detract from wider VAT compliance issues—which call for a comprehensive risk-based strategy. A false input VAT credit reduces revenue by the same amount whether it leads to a refund claim or a reduction in net VAT payable, and it is not helpful to separate out the refund risks from those in other stages of the VAT cycle. Experience shows that attempts to ease the tensions around VAT refunds in isolation (rather than as part of a comprehensive and targeted program to build compliance) have mixed results, and jeopardize the tax administration’s understanding of taxpayer behavior, which increases revenue risks. Key elements of a strategy to address VAT compliance issues more widely are outlined in Box 5.

54. Ensuring that the Treasury has enough funding for the timely payment of refunds is one of the most challenging aspects of VAT administration in LIDCs.44 Few LIDCs have ensured that the Treasury allocates enough funding to meet approved, risk-assessed VAT refund claims. As long as governments view VAT refund payments as a government expenditure, instead of a regular budget line item associated with VAT management,45 LIDC tax administrations will lack an incentive to manage VAT refunds properly. There are ways to address this issue, for example by setting aside part of VAT revenue to cover expected refunds. One Southern African country, for example, used tax returns to estimate the amount needed for refunds, which was segregated from the collection account at the central bank and allocated to the payment of refunds. Unfortunately, this mechanism was dismantled in 2013/14: subsequently, less funding was allocated for VAT refunds and claims accumulated.

Elements of a Comprehensive VAT Compliance Strategy

These include:

  • Controlled and monitored registration: See main text below on eligible taxpayers.

  • On time-and full filing: In addition to supporting the tax assessment, a VAT return should provide needed information to control the VAT value chain. Non-filing compromises the verification of compliance not only for the non-filer, but also for its clients and suppliers.

  • Prompt and full payment: Non-payment risks creating credit claims not matched by government receipts.

  • Verification using third party information, such as: customs data, government acquisitions and large taxpayers’ (especially manufacturers and distributors) transactions.

  • Controlled issuance of invoices: Many countries have developed mechanisms to do this: Paraguay implemented risk-based criteria to establish the number of VAT-invoices that would be authorized to be printed, while in Cabo Verde, printing companies are required to report (electronically) the sequencing of the invoices printed to each taxpayer, and taxpayers are required to report the invoices issued and received.

  • Facilitation of compliance with reporting requirements. Several Francophone African countries (including Benin, Cameroon, and Chad) started in 2016–18 to publicize a list of active taxpayers authorized to issue VAT-credit-generating invoices, leading to improved compliance and making it easier for tax auditors to verify the legitimacy of VAT credits claimed. As a result, VAT collection in these countries improved by 5–15 percent in real terms.

  • Effective use of technology: IT is an essential feature of effective tax administration, not least the data-intensive VAT, but is not a solution itself. Examples include the implementation of electronic invoicing and electronic fiscal devices, which can provide the tax administration with useful information. Only a few tax administrations actually use the data so obtained to cross-check tax return information, which in the long run may limit the benefits on compliance of the new technologies. Casey and Castro (2015) analyze the use of electronic fiscal devices (electronic cash registers and fiscal printers) by developing countries and argue they can only be effective if they are part of a comprehensive compliance strategy. Dabla-Norris and others (2019) find that in Peru, VAT e-invoicing increased firm sales, purchases and value-added by almost 10 percent, mostly among relatively smaller firms and in sectors with higher non-compliance. However, the aggregate effects on actual VAT collections are small.

  • Treating taxpayers according to their risk-profile: Establishing a set of treatments according to the taxpayer risk-profile: for taxpayers that pose only a low risk, this may mean facilitating compliance (such as pre-filled returns, providing guidance, supporting compliance with their tax obligations);46 for high risk-taxpayers, closely monitoring their activities (for example frequent verification programs; in-depth review/analysis of their claims and returns, repeated visits to their premises, closely monitoring the issuance of invoices, performing comprehensive audits, requiring guarantees under some circumstances); for compliant taxpayers, prioritizing their queries47 and offering cooperative arrangements to reduce compliance costs.

55. Accumulated refund claims can jeopardize sound macro fiscal policies. The amounts at stake are so large that their macroeconomic impact can be significant, with risk of an inflated impression of the government’s receipts, understatement of the fiscal deficit and the creation of a significant contingent liability. 48

Managing Registration

56. The threshold level of sales at which registration to charge the VAT becomes compulsory is a critical anchor for any VAT. Practice in LIDCs (and elsewhere) varies widely (Figure 28), which may reflect insufficient attention to the key tradeoffs that the decision involves.49

Figure 28.
Figure 28.

LIDCs: VAT Thresholds, 2019

(In thousands of PPP dollars)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: IBFD

57. Common IMF advice is that a high registration threshold be set as a transitory measure until the tax administration strengthens its capacity to administer a larger number of taxpayers.50 Ebrill and others (2001) highlight, for instance, that the concentration of potential VAT revenue in the largest taxpayers justifies the establishment of a high threshold, since it favors the deployment of scarce administrative resources towards activities that are expected to produce more revenue. VAT gap studies that have been conducted with IMF assistance corroborate the striking importance of large taxpayers for VAT collection: data for five countries show that, on average, the 20 percent of taxpayers who declared the largest volume of sales (including exempted, zero-rated or taxed transactions) account for 87 percent of total VAT collection. On one East African LIDC, the top 10 ten percent of taxpayers with the highest turnover account for 90 percent of total VAT revenues. Experience in LIDCs has shown that increasing the threshold can help improve VAT management. 51

58. This strategy requires, however, close attention to voluntary registration—which in many LIDCs is very high. Allowing those below the threshold to register voluntarily eases the potential distortion that otherwise arises from unrecovered VAT on their purchases. But these taxpayers impose a burden on the tax administration’s capacity: they require more attention—in services and education, and in verification and enforcement actions—which diverts the tax administration’s resources away from the larger taxpayers that are responsible for the bulk of tax collection. Voluntary registration also provides opportunities for “bogus traders,” whose sole purpose is producing invoices for themselves or for others and creates opportunities for fraudulent VAT recovery. More extensive voluntary registration faces the tax administration with diversified compliance risks.52 For instance, it increases non-filing risks, which weakens VAT administration along the whole value-chain. Figure 29 illustrates the potential scale of the problem: in this LIDC in Francophone Africa only 916 of 3,685 registered taxpayers are considered by the administration as potential VAT taxpayers, and of those only 199 are net payers.

Figure 29.
Figure 29.

An African Francophone Country Example—VAT Taxpayer Population

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: Country data.

59. A robust program to ensure integrity in registration reduces the space for fraud and tax evasion. Properly checking and identifying the bona fides of new registrants prevents fraudsters from accessing the VAT value-chain and reduces opportunities for tax evasion and fraud. Paraguay improved the registration process by incorporating biometric data and linking the taxpayer address to Global Positioning System coordinates. Deregistering taxpayers who are defunct helps address fraud through the issuance of false invoices in their name. While de-registering taxpayers has a critical role to play in VAT management, LIDCs often pay limited attention to maintaining a robust tax register.53

60. Registration issues are closely related to wider questions concerning the ‘self-enforcing’ nature of the VAT. To the extent that buyers are registered for the VAT, there is an incentive for their suppliers to register too, in order to ensure that no unrecovered input VAT passes to the final stage. On the other hand, if, for instance, buyers are not registered then their suppliers have an incentive not to register either. There is evidence that both ‘good’ and ‘bad’ chains of VAT compliance can emerge,54 with implications for production efficiency. But results are mixed on whether compliance is best promoted—and ‘informality’, in that sense, reduced—by strengthening enforcement downstream (at or close to retail stage) or upstream.55 The latter is more in line with the traditional appeal for tax administration of withholding mechanisms (though not necessarily of the add-on type mentioned above).

I. Distributional Aspects

61. Concerns have often been expressed regarding the regressivity of the VAT. This was one argument invoked for its removal in Malaysia, for example, while Bhutan faced some early challenges to VAT adoption as concerns arose around its impact on vulnerable groups. Some civil society organizations see a tension between heavy reliance on the VAT and efforts to reduce inequality, on occasion asserting that IMF’s advice focuses on increasing tax collection and efficiency rather than progressivity (Oxfam, 2017).

62. In practice,56 the VAT may not be as regressive as often supposed. Reduced rates and exemptions often reduce regressivity, but, as seen below, are a very poorly targeted way of helping vulnerable groups. Reflecting this, some studies find the VAT to be distributionally neutral (for example in Namibia, Ethiopia, Togo: see World Bank (2017), Hill and others (2017) and IMF (2017b), respectively). And there are further effects at work that are not always captured in analyses of VAT incidence:

  • The VAT registration threshold implies, for instance, that sales by small retailers—where the poorest often buy—are VAT exempt. Where data enabling the identification of such purchases are available, the moderating impact of this has been found to be substantial.57 To the extent that the benefits of non-registration are not passed on the consumer, they likely remain with the seller, who in turn is also likely to be of relatively low income.

  • Food production for home consumption is also de facto exempt, with similar effect. More generally, studies which assume58 the incidence of noncompliance to be equal across all consumption/income deciles overstate the regressivity of the VAT: for a sample of 15 countries Bachas (2019) finds that top decile has 27 percent less untaxed consumption than the bottom one.

  • The effect is further amplified if regressivity is assessed not in terms of payments relative to income but relative to aggregate consumption—which is many would argue is likely a better indicator of economic wellbeing.59 The VAT then becomes a close to neutral or—due to untaxed consumption—even a slightly progressive tax. Alavoutunki, Haapanen, and Pirttila (2019), for instance, find that the adoption of VAT has not led to increased inequality when measured based on consumption, whereas measuring based on disposable income suggests that VAT introduction raises inequality.

  • While empirical work generally assume that the VAT is fully passed on to consumers, this may not be the case. For advanced economies at least—as in other areas, there is little if any evidence for LIDCs—there are signs that the benefits of reduced rates of VAT, often intended to help the poor, are less than fully passed on.60

63. But the more fundamental point is that the contributions of the VAT to poverty and inequality reduction need to be seen in the context of the overall tax and spending system. The VAT is well suited to raising revenue in a relatively efficient way, but—being based on anonymous transactions rather than finer indicators of ability to pay—is hard to tailor to serve equity concerns. Even in advanced economies, where the personal income tax and other instruments can be more effectively structured to ensure a degree of progressivity on the tax side, equity objectives are mainly served through a range of spending instruments. So too in LIDCs, equity aims are primarily pursued by public spending, both in-kind—health and education services—and, to a lesser but perhaps growing extent, cash transfers. Indeed, recent studies by Commitment to Equity (CEQ) Institute, IMF and World Bank on fiscal incidence and income distribution (Table 2) stress that the VAT is an important tool to finance the desired social spending programs geared toward poor households and the provision of other, broad-based, critical public goods. (IMF, 2017b).61 Fabrizio and others (2017) present a model-based analysis on fiscal reforms and inequality for several LIDCs to comprehensively capture the economic impact of fiscal reform packages in a general equilibrium setup. In particular, they analyze the impact of reform package including VAT increase in Honduras and Uganda. The model has also been applied in other IMF studies, for example for Benin (IMF, 2018), Senegal (IMF, 2019), and Cambodia (Hansen and Gjonbalaj, 2019). These applications broadly indicate that VAT is a preferred reform option regarding the economic and distributional impact, if complemented by mitigating spending measures.

Table 2.

Findings from Recent Fiscal Incidence Studies

article image
Note: CEQ’s microsimulation methodology adopted in most of the studies, with certain modifications to account for data availability. Consumption-based deciles (derived from household budget surveys) and Gini calculations used in most cases; informality is usually assumed to be homogeneous across households’ distribution; embedded VAT calculated using input-output tables where available.

Focus on the analysis of the incidence of VAT reduced rates and exemptions, rather than the existing VAT.

64. No other more progressive and practicable instrument capable of raising comparable amounts of revenue has been identified as an alternative to the VAT. The most obvious instrument is the personal income tax (PIT), but its revenue performance remains weak in many developing countries—and as discussed in the previous section, the development of the VAT is intended to catalyze a further strengthening of the PIT. Some have argued for heavier reliance on tariffs, including as a more effective way to tax noncompliant businesses, but the underlying formal argument neglects the key point that the VAT is also levied on imports.62 Moreover, while tariffs are often excluded from incidence analyses such as those of CEQ, the limited available evidence suggests that these may well be more regressive than the VAT (Bird and Zolt, 2005; Gemmell and Morrissey, 2005). Looking towards the top of the distribution, while there is no doubt that worthwhile additional revenue could be obtained by addressing evasion by the wealthy and avoidance by multinationals, and developing property taxation, the prospects for revenues from these sources to substantially replace VAT in the near future are remote.

65. Reduced rates and exemptions are widely used in LIDCs to mitigate the regressivity of the VAT but are poorly targeted as distributional devices. 63 Examples among LIDCs include Ethiopia, Malawi, and Mozambique, that have continued introducing VAT exemptions or reduced rates. The point is simply that the poor may spend a larger proportion of their budgets on basic items such as food for example, but the better off spend absolutely more, and so receive a larger share of the total benefits. A study by Warwick and others (forthcoming) for Ethiopia, Ghana, Senegal, Sri Lanka, Vietnam, and Zambia confirms that while preferential rates reduce poverty, they are expensive and much of their benefit accrues to better off individuals (see Figure 30). IMF analysis suggests much the same to be true of the prospective VAT, and reliefs, now under discussion in Bhutan (Box 6): with a uniform VAT, the poorest three deciles pay only 9 percent of the overall VAT, while 60 percent of all VAT would be collected from the three top deciles (the richest households)—enough to compensate the poor through targeted transfers. It may nonetheless be the case that if the weight attached to the well-being of the poorest is great enough, and instruments for compensating them weak enough, rate reliefs and exemptions are warranted on equity grounds. But a premium is clearly placed on finding more effective ways of supporting the poorest.

Figure 30.
Figure 30.

Incidence and Cost of VAT Exemptions and Reduced Rates

(In 2011 PPP USD and percent of consumption)

Citation: Policy Papers 2019, 039; 10.5089/9781513522739.007.A001

Source: Warwick and others (forthcoming).

66. Advances in digitalization may come to provide better targeted ways to temper the regressivity of the VAT, while retaining the policy and administrative advantages of a broad-based VAT levied at a single rate—achieving something akin to the possibility in more advanced economies of reshaping income tax and income-related transfers. Ainsworth (2006), for instance, proposed a scheme of individualized VAT (’digital VAT’ or ‘D-VAT’) where those eligible to purchase goods and service free of VAT would do so using a biometric ID card (a solution similar to a point of sale exemption sometimes available to diplomats). Barreix, Bes, and Roca (2012) proposed a similar version of a personalized VAT where the benefits are delivered through crediting an e-card in the amount equivalent to the monthly VAT liability calculated on a presumptive basis (consumption basket of the cut-off decile a person is in). These personalized VATs in LIDCs however, can amplify VAT refunds. A more direct approach is to use biometric identification to target cash compensation, a possibility that countries are beginning to experiment with. Possibilities (Box 7) range from targeted transfers to bank accounts (e.g., India) to VAT rebates using digital wallets (e.g., Thailand).64 Simply using part of the VAT receipts to finance an equal poll subsidy to all adults could more than compensate the poorest while leaving significant additional revenue.

J. Conclusion

67. The VAT is a central element of the tax system in many LIDCs raising a large share of their overall revenues—and its performance there has been improving. Nevertheless, the VAT remains contentious in some respects. Implementation is challenging for many LIDCs and concerns also arise around the regressivity of the VAT and its impact on vulnerable households.

68. Two key areas for improving implementation are the treatment of VAT credits and management of the VAT threshold. Instead of focusing the attention of the tax administration excessively on VAT refunds, a comprehensive risk-based strategy is needed to address VAT compliance issues more widely. Furthermore, sufficient funding should be ensured for the timely payment of refunds. The registration threshold should be set in line with the capacities of the administration and increasing the threshold until the tax administration capacities have strengthened can help improve VAT management. Voluntary registration below the threshold also imposes a burden on tax administration and can divert resources from large taxpayers. Overall, VAT management requires the same core competencies as administering other taxes, so building institutional capacity to properly manage VAT helps the tax administration to upgrade its wider capacities.

Innovative Mechanisms for Mitigating the Impact of VAT Regressivity: Lessons from Emerging Market Economies

India established the Direct Benefit Transfer (DBT) system in 2013 as a way of paying subsidies to citizens living below poverty line directly through their bank accounts. The processing of payments is based on the Aadhaar (unique identity number), which covers 93 percent of the adult population. In the run up to the introduction of Goods and Services Tax (GST) in India, there was public discussion of mitigating its distributional impact by—instead of exempting necessities—using the DBT system (through Aadhaar-linked bank accounts) to supplement the incomes of the poorest. It was estimated that a DBT of Rs 2,000 per annum to every individual below the poverty line (BPL) would more than offset any incremental impact of GST, at a cost less than 20 percent of the exemptions. In the event, however, with the DBT at a preliminary stage, India opted for exemptions and reduced rates.

Thailand introduced in late 2018 a system to pay back consumption tax to the recipients of the government’s welfare scheme. State Welfare Smartcard (SWS) holders—unemployed, and/or with low income—swipe their cards at shops with electronic data capture terminals, with 5 percentage points of the 7 percent VAT returned to their e-wallet, 1 percentage point going towards contribution to the National Savings Fund or the holder’s savings account and the rest to the Revenue Department; the rebate is capped at around US$16 equivalent per month. Five months after its launch there were 14.5 million smartcard holders and the Government had transferred around US$650 thousand to the e-wallets and an additional amount of around US$120 thousand to the holder’s savings account.

69. Concerns with the regressivity of the VAT are sometimes over-stated, and risk leading to even less pro-poor policies. Reduced rates and exemptions can somewhat mitigate the adverse distributional impact, but they do so at a high cost and in a poorly targeted way. Equity concerns need to be assessed and addressed in the context of the overall tax and benefit system, integrating the effect of the VAT with the contribution of other taxes and the social safety net. Targeted benefit programs can be efficient tools to mitigate the distributional effects. Advances in digitalization may also provide innovative ways to offset some of the distributional impact. The VAT can be highly effective in raising revenues, and no alternative less regressive and practicable revenue sources for LIDCs have been identified that are capable of raising as much (much-needed) revenue.

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