TAX POLICY IN DEVELOPING COUNTRIES: WHAT CAN BE LEARNED FROM OECD EXPERIENCE? Christopher Heady Head, Tax Policy and Statistics Division Centre for Tax Policy and Administration OECD 2, rue André-Pascal 75775 Paris Cedex 16 France Email: christopher.heady@oecd.org Tel: +33 (0)1 45 24 93 22 Fax: +33 (0)1 44 30 6351
October 2002
This paper has been prepared for presentation at the seminar ‘Taxing Perspectives: A Democratic Approach to Public Finance in Developing Countries’, at the Institute of Development Studies, University of Sussex on 28-29 October 2002. The views expressed are those of the author and do not necessarily reflect those of the OECD or its member countries.
1
1.
Introduction
The purpose of this paper is to examine what developing countries should and should not learn about tax policy from the recent experience of OECD countries. The combined experience of these thirty countries has covered a wide range of tax policy options, and information about the advantages and disadvantages of these various options should constitute a useful resource for tax policymakers in developing countries. Of course, OECD countries differ from most developing countries in several important taxrelevant respects. These include their levels of income per capita, the relative size of the agricultural sector, the typical size of businesses, the size of the formal sector labour force and the capabilities of their tax administrations. This means that taxes that work well in OECD countries will not necessarily work well in any particular developing country. Indeed, there are considerable variations in these factors amongst OECD countries, and these variations result in significant differences in both the mix of taxes that they impose and the detailed design of individual taxes. It is therefore not sufficient to simply advise developing countries to blindly follow the lead of OECD countries. It is necessary to analyse the extent to which the situation of any particular developing country may affect whether a tax that has been successful in the OECD would also be successful there. Unfortunately, there is little publiclyavailable evidence on the success of tax policies in developing countries, and so the analysis has to be mainly theoretical. One way of identifying taxes that are successful in the OECD is to look at the current patterns of taxation and the their recent trends. After all, it is reasonable to expect that countries will expand the use of successful taxes and reduce the use of unsuccessful ones. Section 2, therefore, provides a brief description of taxes and revenues in the OECD and contrasts them with data from a selection of low-income countries. This naturally leads to the question of whether developing countries would benefit from moving nearer to the OECD tax patterns, which is the subject of section 3. Although revenue patterns provide considerable information about countries’ tax systems, there is a considerable amount of detail that they do not reveal. In addition, there may be tax changes that would be desirable on economic and/or social grounds that are not implemented for political reasons. It is therefore worthwhile examining some of the tax policy issues that have been the subject of discussion and debate in OECD countries. These include the desirability of environmentally related taxes, the scope for increasing property taxes, the effect of the tax system on international trade and investment and the desirability of establishing special tax incentives for particular economic and social purposes. These are important issues for developing countries, and section 4 considers what they should learn from these debates. The paper concludes, in section 5, with a brief summary of what developing countries can usefully learn from this experience.
2
2.
Tax and revenue patterns
The main tax policy trends in recent years in OECD countries can be summarised as: • a reduction of personal and corporate income tax rates, accompanied by substantial base-broadening • simplification of tax rate structures • an increase in social security contributions, partly reversed recently in Europe • a switch away from traditional sales and excise taxes towards VAT, followed by increases in VAT rates These have contributed to the following recent general revenue patterns, shown in table 1, although other economic forces have also had a role to play: • Personal income tax share has fallen slightly • Corporate income tax share has risen slightly • Share of social security contributions has risen • VAT revenues have risen • Excise duty revenues have fallen Table 2 shows the resulting distribution of tax revenue among major taxes for OECD countries in 2000.1 The OECD average shows that the vast bulk of tax revenue, i.e. over 80 per cent, comes from three main sources: income taxes, taxes on goods and services, and social security contributions (other payroll taxes are zero or very small in most countries). However, countries vary considerably in the relative importance of these three main revenue sources. Notably, Australia and New Zealand do not collect social security contributions (although they do collect payroll taxes). There are also substantial differences across countries in the share of taxes on property, which are generally lower in continental Europe than elsewhere. Overall, the European Union relies more on consumption taxes and social security contributions and less on personal income tax than the OECD average. In contrast, the United States collects more in personal income tax and property tax but less in consumption taxes and social security. Japan is similar to the United States in its low share of consumption taxes but collects much less in personal income tax, offsetting this with higher levels of corporate tax and social security contributions. In order to compare the OECD tax mix with that of developing countries, table 3 reports the share of main taxes in total current (tax and non-tax) revenues in 1999 for a selection of lowincome countries (as defined by the World Bank), three World Bank defined groups of countries and the OECD for 1999.2 Unfortunately the detail in the tax categories available for developing 1. A cautious interpretation of the numbers in this table is called for. The split between personal and corporate income tax can be seriously misleading for two reasons. First, many OECD countries have some form of integration between corporate and personal income taxes, so that a portion of corporate taxes are refunded to the shareholders as a reduction in personal income tax. This is reflected in the statistics as a reduction in the revenue from personal income taxes, but it could be just as well regarded as a reduction in corporate tax revenue. Second, OECD countries vary in the extent to which businesses are incorporated. For example, German firms are much less likely to be incorporated than firms in the United States. This means that Germany reports a much lower share of tax revenue coming from corporate income tax, even though the taxes on business are higher. 2 Note that the difference in OECD figures between tables 1 and 2 is only partially due to the difference in the reporting year (required because of the longer lag in the collection and publication of developing country tax
3
countries is not as fine as that in table 2. The listing of a selection of low-income countries rather than a group average is required because no group average was provided. The selection of these countries is based on the availability of 1999 data in the World Bank database, which originally came from the IMF’s Government Finance Statistics Yearbook. Table 3 shows substantial differences between the OECD and developing countries in the mix of their tax revenues. OECD countries collect a higher share of revenue from income taxes than any other country or group, with the sole exception of Indonesia. More striking differences from the OECD average are the generally low usage of social security taxes (except for previously centrally planned economies and upper-middle income countries) and the high revenue from trade taxes (which are so small in OECD countries that the Revenue Statistics does not compute an average). There is also a generally lower share of income tax in total revenue. Finally, most developing countries place a higher reliance on sales taxes than does the OECD average. These general differences in revenue shares in comparison with industrialised countries should not mask the substantial differences between low-income countries (or, indeed, between OECD countries). The differences in revenue patterns between most developing countries and the industrialised world are easy to explain in terms of administrative convenience. The high proportion of the workforce employed by well-established companies facilitates the heavy reliance placed on social security taxes and income taxes in industrialised countries. In contrast, the low-income countries' reliance on international trade taxes reflects the relative ease of observing and valuing goods as they cross international frontiers. However, there are other, non-administrative forces at work. Trade taxes on imports were often introduced as part of a strategy of import substitution, while those on exports reflect in part the export of primary products over which the countries have some monopoly power. Although these differences are easy to explain, this does not mean that they are desirable. It may be the case that developing countries should change their revenue structures nearer to those of the OECD countries. Such changes would involve: • Reducing the role of taxes on international trade • Increasing the use of social security contributions • Greater use of income taxes. In addition, following recent tax policy trends in OECD countries would involve: • simplification of personal and corporate income taxes • greater use of VAT to collect sales tax revenue. • greater use of environmentally related taxes. The advantages of these changes are discussed in the next section. The concentration will be on the structure of taxes, rather than the tax-to-GDP ratios that countries should aim for. As with OECD countries, this is very much an individual matter for each developing country, reflecting the desired balance between private and state provision of goods and services. However, it is data). It is mainly due to the need to express them as a percentage of total current revenue (not just tax revenue), in order to be consistent with the World Bank database.
4
likely that a number of developing countries would wish to increase their tax-to-GDP ratios, both to reduce any budget deficit and to improve the services they provide. Clearly, a more efficient tax structure would make that goal easier to achieve.
3.
The desirability of changing tax patterns
The purpose of this section is to analyse whether developing countries would benefit from adopting the changes outlined in the previous section. The changes are discussed one at a time, but the order in which they are discussed is designed to bring out the links between them.
3.1 Reducing taxes on international trade Standard economic theory suggests that taxes on international trade have a major distortionary effect, and this is backed up by the positive growth experience of most countries that have become more open to international trade. In addition, the imposition of taxes on such a narrow base can cause problems of revenue shortfalls if the base does not grow as fast as the economy as a whole. Of course, it can be argued that export taxes are beneficial because they exploit monopoly power in primary export markets, but this should be viewed with some suspicion because of the threat of new entrants into the market if world prices rise too high. Also, the reduction of import duties often runs into serious political opposition, with the domestic producers of protected goods using the threat of large-scale unemployment as a consequence of trade liberalisation. However, trade liberalisation normally increases export potential and opens up new job opportunities, so a wellphased reduction in protection can improve social welfare considerably. Many low-income countries have, indeed, succeeded in reducing their dependence on trade taxes. Given the budgetary situation in most developing countries, any lost revenue from reducing trade taxes must be balanced by increases in tax revenue elsewhere. In principle, this is not a problem: the replacement of an import duty on a consumer good by a domestic sales tax at the same rate will yield at least as much revenue as before without raising prices. This is because the base of the tax is broadened to include domestic production as well as imports without increasing marginal cost. This leads us on to considering the use of VAT, as this is now the sales tax of choice in OECD countries.
3.2 Greater use of VAT In addition to replacing the revenue lost from removing taxes on international trade, VAT is often recommended as a replacement for existing commodity taxes. There are three main reasons for this: • It broadens the tax base by including services, which have usually not been taxed before. This reduces distortions in relative prices and allows revenue to grow in line with GDP as the structure of the economy changes.
5
•
•
It eliminates the cascading involved in turnover taxes and some manufacturers’ sales tax systems. This also reduces distortions in relative prices, as well as in incentives for industries to vertically integrate. It can also be completely removed from exports, and so enhances international competitiveness. Its self-enforcing mechanism means that compliance is higher.
However, VAT does have problems if introduced into some low-income countries. It is a difficult tax to administer, for both the taxpayer and the tax authorities. This has ruled it out as a possibility in some countries, and a wish to reduce its administrative complexity has usually led to advice that only a single rate of VAT should be used, the only exception being zero-rating for exports. Such a single rate VAT does not distort consumer choice between alternative goods, and so is consistent with the idea of tax neutrality. The only non-uniformity in domestic commodity taxes would then be the excises on alcohol, tobacco and petrol and the exemptions from VAT that are granted to some traders mainly for reasons of administrative convenience. Another important argument against VAT is its alleged regressivity, especially if it is applied at a single rate. In some OECD countries, such as Mexico and the U.K., applying a lower rate or even a zero rate to a wide range of ‘sensitive’ goods offsets this. However, this conflicts with the argument for a single rate of VAT in developing countries because of administrative problems, especially if VAT refunds have to be made to a large number of traders. Instead, an exemption of small-scale agriculture can be used to give favourable treatment to the food consumed mainly by the poor, as has been done in Uganda and Zambia (Gray and Chapman, 2001). This has the added benefit of eliminating the administrative costs of assessing large numbers of small farmers for VAT, but may not be sufficient to meet the distributional concerns. For OECD countries, this conflict between the simplicity (and economic efficiency) of a single rate and its regressivity is not so strong for two reasons. One is simply that OECD tax administrations and taxpayers are more able to deal with the complexity, although it should be noted that some of the more recent OECD countries to adopt VAT (Australia and Korea) have done so with a single rate. The second reason is based on the observation that direct payments to households are usually superior on distributional grounds to consumer price subsidies or lower rates of tax. The intuition behind this result is that richer people will consume more of the lightly taxed goods (as they consume more of all goods) and therefore benefit more from the policy than poorer people. The direct payment is better because it will at least give everybody the same benefit, and can sometimes be tailored to target particularly vulnerable demographic groups. This argument is analysed in the practical context of tax reform in the Czech Republic by Heady and Smith (1995). They show that the distributional benefits of applying a lower rate of VAT (5% instead of the standard 23%) could have been achieved by imposing the standard rate on all goods and services, and using the resulting extra revenue to increase personal income tax allowances and three state benefits: pensions, child benefit and unemployment benefit. However, this alternative approach did result in an increase in the overall marginal tax rate (income tax, social security contributions, sales taxes and benefit withdrawals) of between 1 and 3 percentage points, depending on household income. Such an increase could discourage labour supply. This contrasts with the theoretical result of Deaton and Stern (1986), who show that direct payments can be designed to achieve the distributional goals without increasing the distortion of labour
6
supply. The difference between theory and practice probably arises because of the limited range of direct subsidies in use in the Czech Republic. The applicability of this theoretical superiority clearly of cash transfers depends on the government's ability to administer direct payments, and it can be argued that many countries lack the administrative capacity to identify the recipients and prevent fraud. However, this does not mean that the theoretical result has no significance for developing countries. Some countries may be able to administer direct payments or operate anti-poverty programmes such as food-forwork. For those that cannot, the result points to the need to target consumer subsidies (or low rates) as well as possible. Subsidies should be applied to specific goods with a low, or even negative, income elasticity of demand. More general subsidies or low VAT rates, such as those applied to food, may fail to achieve much redistribution because of limited differences in consumption patterns between the rich and the poor across broad categories of goods.3 The importance of direct payments is illustrated by Siqueira’s (1995) results from calculating optimal sales tax rates for Brazil. She contrasts the case where there is a uniform direct payment to all households with the case where such a payment is not possible. Even the uniform payment to all households does not produce uniform optimal sales taxes, because the rural population has different consumption patterns from urban inhabitants. As the rural population is poorer, and the direct payment is not differentiated between sectors, differential sales taxation still has redistributive power.4 However, without the direct payment, sales tax rates become much more differentiated, and the optimal tax on food is negative, and very large if there is any serious aversion income inequality. If it had been possible to disaggregate the food category within the model, it is certain that this subsidy would be focussed on a small number of food items of particular importance to the poor. Thus an inability to implement direct payments to households means that it may be more difficult for developing countries to design a VAT system that is neither too difficult to administer nor too politically unpopular because of its regressivity. This may be part of the reason why VAT revenues have not grown as fast in some developing countries as they have in the OECD. Certainly, Gray and Chapman (2001) identify VAT exemptions on major household consumer items as a principal factor limiting tax yields in the countries they consider.
3.3 Greater use of income taxes The problems that some developing countries have with the distributional effects of VAT might also be partly due to the heavy reliance that many of them place on sales taxes. OECD countries typically have a tax mix with less sales tax and more income tax. This has the dual benefit that
3
This importance of narrow targeting is confirmed for South Africa by Alderman and Ninno (1999). They show that a VAT exemption for maize can be justified but that other tax exemptions have less to recommend them. In particular, an exemption for meat is not justified. 4 This does not contradict the Deaton-Stern result, as the optimal direct payments in this case would have different for rural and urban households. Instead, it illustrates the consequences of an inability to set the direct payments at their optimal levels.
7
the adverse distributional impact of the sales taxes is not so great and that the redistributive nature of personal income taxes can partly offset it.5 The difficulty in many developing countries is that income taxes are comparatively difficult to administer, especially for people who are not formal sector employees, while most of the people are too poor to pay significant amounts of income tax. It therefore makes sense for developing countries to only gradually increase their reliance on income taxes. Nonetheless, it should be noted that the best time to reform an income tax system is when there are relatively few people paying it, as there are fewer vested interests in the current system. Thus, as discussed below, simplification of income taxes is worth addressing in all countries.
3.4 Simplification of income taxes In those countries at a sufficiently high level of development to operate a significant personal income tax system there is often scope for reducing exemptions (broadening the base and promoting neutrality again) and simplifying the rate structure in much the same way as has been happening in OECD countries. This can often improve equality as the exemptions usually relate to items that are not relevant to the poor. Similar modifications, together with improvements in accounting practices, can also benefit company taxation. There has been a general tendency to encourage lowering the rates of both personal and corporate income taxes, because of concerns over tax evasion and disincentives. However, there is little evidence on the effects of rate reductions on both of these concerns, and it is important to remember that personal income taxes are usually the only part of the tax system that is significantly redistributive. Thus the choice of income tax rates is difficult with the current lack of information. There is no research that suggests the lowering of rates and the broadening of bases is not suitable for developing countries, provided the changes are designed in such a way as to avoid revenue loss. If anything, the large opportunities for tax evasion in developing countries suggests that income tax rates should be lower than in the developed world.6 Also, many developing countries have very narrow tax bases, with large numbers of exemptions, many of which have been designed to protect the interests of powerful groups.7 In these circumstances, base broadening can have the triple advantages of raising revenue, improving economic efficiency and achieving greater redistribution. As with OECD countries, administrative ease and theory point in the same direction as far as the rate structure of personal income tax is concerned: a single rate of income tax with a high exemption level will be administratively feasible (by reducing the number of tax payers and allowing withholding at source) and achieve even more redistribution than an income tax system with sharply increasing marginal rates.
5
Shome (1999) argues that Latin American countries would benefit from a shift from sales taxes to income taxes. 6 This does not imply that the governments should not take other actions to improve tax compliance, such as the strengthening of tax administrations and improvements in government performance that increase its legitimacy and convince the taxpayer that they will receive something in return. 7 Gautier and Reinikka (2001) show that tax exemptions mainly benefit large firms in Uganda.
8
Many developing countries have different rates of corporate income tax for different sectors.8 These are typically a legacy from a period when the government’s role in the allocation of resources was more significant. They distort the market mechanism and increase administrative and compliance costs without producing any improvement in revenue collection or income distribution. Their removal is a prime example of a situation where tax simplification can do nothing but good. Many countries also apply different rates of corporate income tax to companies of different size. These have more justification than sectoral differences as they are often designed to compensate for disadvantages that small businesses suffer, in terms of tax compliance costs and poorer access to capital markets. However, OECD experience suggests that they can distort competition between large and small firms and provide incentives for firms to split into smaller units in order to benefit from the lower taxes. It would therefore be better if simplified tax procedures and moves to improve capital markets tackled these disadvantages more directly.
3.5
Greater use of social security contributions
One of the interesting patterns revealed by table 3 is that low-income countries, with few exceptions, either have no social security contributions or have them at a similar level to those in the OECD countries. This reflects the fact that, to a considerable extent, the choice here is whether or not to have a social security system. This, in turn, is related to views about whether or not the state should, or is able to, provide social security or whether it should be left to families and the private sector. However, there are countries that have chosen to provide at least some social security without levying substantial levels of social security contributions. In developing countries, this could be because of a limited coverage of the population, perhaps those in formal sector employment. In some OECD countries, like Australia, Denmark and New Zealand, it is because they would rather fund their social security system from general taxation. What then are the advantages of social security contributions over general taxation as a method of funding social provisions? First, there is the political advantage of earmarking a tax for something that the population will generally approve of. Second, social security contributions are usually easier to administer than personal income taxes, because they are usually levied only on employment income and do not have deductions for the personal circumstances of the employee. However, OECD countries have also discovered two disadvantages. One is that their simplicity usually means that the tax has little, if any, redistributive effect. The other is that it can raise labour costs, particularly for the low paid, and thus cause unemployment. Indeed, a number of OECD countries have recently introduced policies of reducing employers’ social security contributions for low paid workers, in an attempt to reduce unemployment. This suggests that developing countries should be cautious in considering the introduction of social security contributions.
8
Tanzi and Zee (2000) report such differential rates in Egypt, Paraguay, Vietnam and Zambia.
9
4.
Other tax policy issues
This section looks at a number of tax issues under discussion in OECD countries that are not directly related to the tax mix issues discussed in section 3. It looks at four topics: the use of environmentally related taxes, property taxes, the effect of the tax system on international trade and investment, and the use of special tax incentives (especially those related to foreign direct investment).
4.1 Environmentally related taxes Under the heading of environmentally related taxes, OECD governments continue to derive their largest revenues from excise taxes on transport fuels. Excluding fuel taxes, environmentally related taxes make only a very minor contribution to government revenues. Nonetheless, the data show that they can have important environmental benefits. For example, Denmark reports a reduction in the revenue from the tax on nickel-cadmium rechargeable batteries, demonstrating that an environmentally successful tax can erode its own base. The tax has raised the price of these batteries, which are very toxic if disposed of without proper precautions, to such an extent that consumers have switched to other less environmentally damaging alternatives. Despite pressures from the environmental lobby for higher environmentally related taxes and the introduction of new taxes in several countries, the importance of these revenues has stayed fairly constant in industrialised countries over the past few years. The OECD average ratio of environmentally related taxes to GDP has stayed approximately constant from 1994 to 2000 at about 2 percent, with just under half of the countries showing an increase. However, as the Danish example shows, the revenue they raise cannot measure the effectiveness of environmentally related taxes. This suggests that developing countries would be well advised to impose taxes on motor fuels, as they are easy to administer, raise a substantial amount of revenue and improve environmental quality. However, other environmentally related taxes are much harder to administer and raise relatively small amounts of revenue. They should, therefore, be seen simply as a method of improving the environment rather than raising revenue.
4.2
Taxation of Land
In OECD countries, table 1 shows that property taxes (including taxes on land) have declined in relative importance. This might seem rather surprising as land taxation has traditionally been seen as non-distortionary, and its immovability makes land an attractive tax base in the face of growing international tax competition for mobile capital. The explanation is that it is very politically unpopular, partly because it is much more visible than most other taxes and partly because it is seen as unfair. There are always examples of people on small incomes, such as
10
widows, who have to pay heavy taxes on their family homes. This apparent unfairness has often been exacerbated by delays in property re-valuations. In contrast, land taxation may be particularly attractive in many developing countries because ownership is often strongly concentrated amongst the rich, especially in ‘settler economies’ such as Zimbabwe, and it is one of the few ways of taxing agriculture.9 In addition, it is a tax that is difficult to avoid, and so should be attractive to countries with limited administrative capabilities. Against this, there is the argument that land taxes increase the risk of landowners, as the tax is certain while the revenue is not. Despite these advantages, there are technical difficulties in taxing land. The technical difficulties arise from variations in land quality and from making sure that the right person pays the tax. For a land tax to be horizontally equitable, the tax should be paid by the landowner and depend not only on the land area but also on its value. The first issue can arise when land is rented on long leases. In such cases, the levying of tax on the occupier of land (which is usually administratively easiest) will result in the tax being borne by a (possibly poor) tenant rather than the landowner until the lease can be renegotiated. The second issue can cause serious measurement problems, especially when there is not a well-developed land market. However, some countries do have yield data for agricultural land that is used in tax assessments. Nonetheless, problems can arise even in these countries. For example, the agricultural tax in China makes use of the records of grain yields from each plot of land. The difficulty arises because some land near cities has been switched from grain production to market gardening. This has increased the profitability of the land, arising from a natural locational advantage (transport problems prevent farmers further from the cities from taking up the cultivation of these more perishable crops). In theory, this should lead to an increase in the tax on the land used for market gardening, but the use of grain yields as a measure of quality prevents this from happening and generates considerable horizontal inequality. Another technical difficulty arises from the possibility of land improvement, resulting from investment by the landowner. As such improvements are not inelastically supplied, it can be argued that they should be excluded from the land tax in order to avoid discouraging an activity that contributes towards economic growth. If it were excluded, the base of the land tax would be “unimproved land”. This, however, leads to three other problems. First, it is hard to be absolutely clear about the point at which land changes from being “unimproved” to being “improved”. Second, the time at which some pieces of land became improved will be many years ago, and it can be difficult to obtain records on what its productivity then was. Third, rich people could invest in land that has been greatly improved, thus minimising their tax burden and creating apparent horizontal inequity.10
9
Gray and Chapman (2001) identify the effective failure to tax the agricultural sector as one of the three principal factors limiting tax yield in the countries their study covers. Khan (2001), in his survey agricultural tax policy in a range of developing countries, argues that a tax on agricultural land should be a focus for raising government revenue. 10 However, this could encourage rich landowners to sell land they do not value so highly, thus increasing the amount of land available for the rest of society.
11
Political opposition that uses the technical problems, and the apparent inequities that they produce, to discredit the tax, compound these difficulties. However, table 2 shows that some OECD countries (e.g. Korea and the UK) raise considerable revenues from property taxes. This shows that land tax can raise substantial revenues if it is well designed and if political opposition is well handled. Low-income countries, therefore, should give serious thought to raising more revenue in this way, especially in view of the difficulties of raising other tax revenues.
4.3
The effects of the tax system on international trade and investment
One aspect of the OECD tax treatment of international trade has already been mentioned: its negligible revenue from taxes on international trade. However, as exports often involve the establishment of overseas branches or subsidiary companies and a growing share of international trade takes place within multi-national corporate groups, the taxation of cross-border businesses is as important as the import and export duties themselves. As each country has the power to design its own tax system, businesses that operate in two or more countries may find that the different tax systems interact in a way that increases the taxes that they pay, thus providing a disincentive to international trade and investment. In an attempt to overcome such disincentives, OECD countries have developed networks of tax treaties with other countries, designed to prevent ‘double taxation’ of the same tax base by more than one country. To some extent, these treaties have also addressed the less common issue of ‘double non-taxation’, where it is possible for income to not be taxed in any jurisdiction. These tax treaties are generally based on the ‘OECD Model Tax Convention’, and enshrine the principle of residence-based taxation. That is, they are based on the idea that income taxes on world-wide income should be paid in the country of residence, as this is the country that typically provides public services to the taxpayer. Nonetheless, these treaties do generally allow for significant taxation by the ‘source country’, the country in which the income was earned. Thus an overseas subsidiary will pay corporate tax and withholding taxes in the country where it operates, while its parent company will be able to claim a credit for this tax when it pays tax in its country of residence on its world-wide income.11 These tax treaties are regarded as a major method of reducing the tax impediments to both international trade and investment. An important feature of both the OECD model treaty and the, very similar, UN model is an article that protects the tax base of each country from manipulation of declared profits by multinational enterprises. The two main forms of manipulation are the use of manipulated ‘transfer prices’ (where non-market prices are used for transactions between different parts of a multinational group) and ‘thin capitalisation’ (where a subsidiary is financed disproportionately by debt, the interest on which is deductible from taxable profits). The article allows countries to base their taxes on the profits that would have accrued if these manipulations had not been carried out. This can be a complicated process, but is found to be increasingly necessary in OECD countries.
11
Some countries, instead, do not tax the parent company on its world-wide income if that income was already taxed in the source country.
12
OECD countries have found that their treaties have encouraged large-scale international trade and investment. Developing countries may well find that they will be able to attract more foreign investment if they enter into tax treaties with the countries from which such investment might come. As explained above, such treaties may well protect a country’s tax base as well as reassuring potential investors that they will not be subject to double taxation. It has been argued that the OECD model places too much emphasis on residence taxation, especially by the limits that are typically placed on withholding taxes and the widespread denial of tax sparing.12 This could hurt developing countries because they are much more likely to be the source country than the residence country of a multi-national group. The significance of this criticism is hard to judge, but it is worth pointing out that the rates of withholding taxes are negotiable between treaty partners. In addition, a large number of developing countries offer significant tax concessions to foreign investors, suggesting that they are willing to sacrifice potential tax revenues in order to attract foreign investment. The question of whether such concessions are worthwhile is addressed below.
4.4
Special tax incentives
All OECD countries, and probably most countries in the world, have special provisions in their personal and corporate income tax systems to favour particular groups of the population or provide an incentive for particular types of behaviour. These can be motivated by a combination of political, economic and social considerations. Once established, such tax concessions are hard to remove even though their original justifications no longer apply, and so there is typically a growing number of such concessions, and their costs, in terms of foregone revenue, continue to grow. It was partly a recognition of the costs of these concessions that led to their partial removal in the trend towards lower tax rates and broader tax bases. However, not all tax concessions have been removed. For example, most OECD countries provide tax relief for people with children, for people who own their own homes and for people who save for their retirement. At the corporate level, many OECD countries provide tax relief to small firms and to firms that invest in research and development. An exhaustive list of all the tax reliefs in OECD countries would require a small book. The desirability of many of these reliefs are the subject of debate, between those who either benefit from them or who value the activity that is encouraged and those who think that the foregone revenue would be better spent by a further lowering of the statutory tax rates. It is hard to provide general lessons to developing countries in this area, except to recommend caution: reliefs are much harder to remove than to introduce. Nonetheless, there is an area of tax incentives that has caused controversy and is particularly relevant to developing countries: the most idea that company taxation should be designed to provide incentives for inward foreign direct investment (FDI). Such FDI, it is argued, could 12
Tax sparing occurs when the source country provides a tax relief and the residence country allows a foreign tax credit for the tax that would have been payable if the tax relief had not been applied. The denial of tax sparing effectively removes a large part of the incentive value of tax reliefs offered to attract foreign direct investment.
13
contribute to the increase in productivity by introducing modern machinery and providing skills to a currently poorly trained workforce. The issues here are complex and cannot be discussed in full in the confines of this paper, but an outline of the relevant considerations can be sketched. A more detailed analysis of the case for granting tax incentives to FDI, and the advantages and disadvantages of alternative incentive mechanisms, is provided in OECD (2001). The first point to bear in mind is that tax is only one of a large number of factors that multinational firms take into account in deciding where to invest. What is more, as many of the tax incentives relate to company income tax, tax only becomes an issue if the other factors are sufficiently positive for the firm to expect the project to be profitable. As a result of this complex of considerations, it has often been argued that tax incentives for FDI are relatively ineffective. However, recent evidence suggests that tax incentives can have a noticeable effect on the location of investment, especially between locations that are similar in other respects. There is, therefore, growing support for the idea that tax incentives can be effective in attracting FDI. However, there is also recognition of the fact that neighbouring countries, which may often offer similar non-tax attractions, could compete against each other in offering tax incentives in a way which provided a benefit to the investor without increasing the total amount of FDI allocated to the region. This risk has been taken so seriously in the European Union (EU), that it has developed a ‘code of conduct’, which inter alia forbids EU countries offering tax concessions to foreign-owned firms that are not available to domestic firms.13 Despite the risks of losing substantial revenues and of provoking a competitive response from neighbours, many countries do offer tax incentives to FDI in such forms as tax holidays, accelerated depreciation or investment tax credits. The question that countries have to answer is whether the additional investment created by such incentives is really worth the revenue forgone14 from investments that would have been made without the incentives. This is often very difficult to judge, and the answers are likely to vary from country to country.
5.
Conclusions
This paper has considered what lessons developing countries can learn from OECD tax policy experience. Of course, the circumstances of developing countries are very diverse, and so it is not possible to come to general conclusions. Nonetheless, some reasonable generalisations do emerge.
13
This competition for real investment should be distinguished from competition for mobile services, which typically require little investment apart from a ‘brass plate’ and provide very limited benefits to the local economy. The issues involved in the latter case are discussed in OECD (1998) and form the basis of the OECD’s work on ‘harmful tax practices’. 14 An additional problem that can arise, if the FDI incentives are subject to administrative discretion, is the increased opportunities for the corruption of public officials.
14
First, there are some trends in recent OECD countries that many developing countries could well benefit from following: •
Simplification of personal and corporate tax systems by reducing the number of tax rates and tax reliefs, thus producing a system with low rates and a broad base.
•
Reduction in the use of taxes on international trade.
•
Increased use of taxes on land.
•
The encouragement of international trade and investment, while defending the domestic tax base, by entering into tax treaties and applying rules to prevent manipulation of reported profits.
Second, there are some trends in OECD countries that could be useful in some developing countries if they have sufficient administrative capacity: •
Greater use of VAT.
•
Greater use of personal income tax.
• Greater use of environmental taxes. Finally, there are two directions in which developing countries should be very cautious in following, although they may be appropriate in some circumstances: •
The use of social security contributions.
•
The use of tax incentives for special purposes, particularly for the encouragement of foreign direct investment.
15
References Alderman, H. and Ninno, C. (1999) “Poverty Issues for Zero Rating Value-Added Tax (VAT) in South Africa” South Africa: Poverty and Inequality Informal Discussion Paper Series 19936 (Washington, DC: World Bank). Deaton, A. and Stern, N. (1986) “Optimally uniform commodity taxes, taste differences and lump-sum grants” Economic Letters, vol. 20, pp. 263-6. Gauthier, B. and Reinikka, R. (2001) “Shifting Tax Burdens through Exemptions and Evasion” Policy Research Working Paper 2735 (Washington, DC: World Bank). Gray, J. and Chapman, E (2001) Evaluation of Revenue Projects Synthesis Report Volume 1, Evaluation Report EV636 (London: Department for International Development). Heady, C. and Smith, S. (1995) “Tax and benefit reform in the Czech and Slovak Republics” in Newbery, D. (ed) Tax and Benefit Reform in Central and Eastern Europe (London: Centre for Economic Policy Research). Khan, M. (2001) “Agricultural taxation in developing countries: a survey of issues and policy” Agricultural Economics, vol. 24, pp. 315-328. OECD (1998), Harmful Tax Competition: An Emerging Global Issue (Paris: OECD). OECD (2001), Corporate Tax Incentives for Foreign Direct Investment: A guide for Economies in Transition, OECD Tax Policy Studies, No. 4. (Paris, OECD). Shome, P. (1999) “Taxation in Latin America: Structural Trends and Impact of Administration” IMF Working Paper WP/99/19. Siqueira, R. (1995) “Optimal taxes for Brazil: combining equity and efficiency” Annals of the XVII Meeting of the Brazilian Econometric Society (SBE), vol. 2 (Salvador). Tanzi, V. and Zee, H. (2000) “Tax policy for emerging markets: developing countries” IMF Working Paper WP/00/35.
16
TABLE 1
Tax structures in the OECD countriesa
Personal income tax Corporate income tax Social security contributionsb (employee) (employer) Payroll taxes Property taxes General consumption taxes Specific consumption taxes Other taxesc Total
1965 26 9 18 (6) (10) 1 8 12 24 2 100
1975 30 8 22 (7) (14) 1 6 13 18 2 100
1985 30 8 22 (7) (13) 1 5 16 16 2 100
1995 27 8 25 (8) (14) 1 5 18 13 3 100
2000 26 10 25 (8) (15) 1 5 18 12 3 100
a) Percentage share of major tax categories in total tax revenue. b) Including social security contributions paid by the self-employed and benefit recipients (heading 2300) that are not shown in breakdown over employees and employers. c) Including certain taxes on goods and services (heading 5200) and stamp taxes. Source: Revenue Statistics
17
TABLE 2
Tax revenue of major taxes as a percentage of total tax revenue, 2000 (1) Type of Tax AUSTRALIA AUSTRIA BELGIUM CANADA CZECH REPUBLIC DENMARK FINLAND FRANCE GERMANY GREECE HUNGARY ICELAND IRELAND ITALY JAPAN KOREA LUXEMBOURG MEXICO (3) NETHERLANDS NEW ZEALAND NORWAY POLAND PORTUGAL SLOVAK REPUBLIC SPAIN SWEDEN SWITZERLAND TURKEY UNITED KINGDOM UNITED STATES OECD TOTAL Unweigthed average EUROPEAN UNION Unweigthed average
Personal
Corporate
Social security
income (2)
income (2)
and other payroll
Property
Goods and
of which:
services
General consumption
36.7 22.1 31.0 36.8 12.7 52.6 30.8 18.0 25.3 13.5 18.6 34.4 30.8 25.7 20.6 14.6 18.3 27.3 14.9 42.8 25.6 23.2 17.5 10.0 18.7 35.6 30.6 21.5 29.2 42.4
20.6 4.7 8.1 11.1 9.8 4.9 11.8 7.0 4.8 11.6 5.7 3.3 12.1 7.5 13.5 14.1 17.7 .. 10.1 11.7 15.2 6.9 12.2 8.3 8.6 7.5 7.9 7.0 9.8 8.5
6.2 40.4 30.9 16.4 43.8 5.0 25.6 38.4 39.0 30.6 32.9 7.8 13.7 28.5 36.5 16.9 25.6 17.5 38.9 0.9 22.5 30.0 25.7 41.2 35.1 32.4 33.6 16.9 16.4 23.3
8.9 1.4 3.3 9.7 1.4 3.3 2.5 6.8 2.3 5.1 1.7 7.1 5.7 4.3 10.3 12.4 10.6 1.4 5.4 5.4 2.4 3.3 3.2 1.7 6.4 3.4 8.1 3.1 11.9 10.1
27.5 28.4 25.4 24.4 32.0 32.5 29.1 25.8 28.1 36.1 40.5 45.0 37.2 28.4 18.9 38.3 27.3 53.1 29.0 34.5 34.4 36.6 39.9 35.9 29.8 20.7 19.7 40.7 32.3 15.7
12.3 19.0 16.3 14.5 18.9 19.6 18.0 16.9 18.4 22.7 26.1 29.4 21.5 15.8 8.9 17.0 14.3 18.7 17.3 24.7 19.7 22.2 24.2 22.3 17.6 13.4 11.5 23.3 18.4 7.5
26.0
9.7
25.8
5.4
31.6
18.3
25.6
9.2
28.4
5.0
30.0
18.2
(1) Rows do not add to 100 because some minor taxes are omitted and general consumption taxes (mainly VAT) are a sub-category of taxes on goods and services. (2) The breakdown of income tax into personal and corporate tax is not comparable across countries. (3) The figure for personal income tax in Mexico combines personal and corporate income tax. Source: Revenue Statistics 1965-2001.
18
TABLE 3 Tax Mix for Selected Low-income Countries and Groups of Countries (1999)
Selected low-income countries Azerbaijan Bangladesh Bhutan Burundi Cameroon Congo, Republic Côte d’Ivoire Georgia Guinea India Indonesia Kyrgyz Republic Madagascar Moldova Mongolia Myanmar Nepal Nicaragua Pakistan Sierra Leone Sudan Tajikistan Uganda Ukraine Vietnam Yemen, Republic Group averages Lower-middle income Upper-middle income Non-OECD high income OECD
Sales Taxes as % of revenue
Trade Taxes as % of revenue
Income Taxes as % of revenue
Social Security Taxes as % of revenue
22 11 20 21 21 8 22 10 10 25 59 15 15 5 7 17 17 12 23 26 15 7 16 11 22 16
22 0 0 7 0 0 6 17 1 0 2 0 0 26 20 0 0 13 0 0 0 17 0 39 0 0
40 40 13 44 26 15 18 55 5 28 28 58 25 50 41 28 35 58 29 22 35 59 64 37 35 9
9 23 2 20 28 6 47 4 77 21 3 4 56 8 5 4 27 7 14 49 29 13 10 4 20 10
18 19 13 32
4 21 6 22
36 38 31 28
10 4 1 0
Source: World Bank, World Development Indicators, OECD Revenue Statistics, and author’s calculations. Note: Rows do not add to 100 because of other taxes and non-tax revenues.