Introduction to Tax Policy Design and Development

Richard M. Bird and Eric M. Zolt

(Draft: April 4, 2003)

Course Objective:

• How can developing countries best design and develop their tax systems?

– Given political objectives– Given economic and political constraints– Given tax administration capabilities

Key Questions

• How do tax systems differ across countries?

• What can, or should, taxes do?

• What criteria are useful in thinking about the design and operation of tax systems?

• What constraints may limit the tax policy options available in a particular country?

Discussion in Context

• This Module serves as a general introduction to much of the material covered this week.

• No magic blueprint; no system or structure that makes sense for all countries

• Taxes just one tool available to governments. It is important to consider other government programs, especially, government expenditure programs, in designing and evaluating government activity.

Comparison of Tax Systems

• Types of taxes

• Tax levels (overall tax burden)

• Tax structure

• Developed vs. developing countries

• Recent trends

• Predictions for future

Different Types of Taxes

• Taxes on consumption– Turnover, VAT, excise, import duties and

export taxes

• Taxes on labor income– Wage taxes and social security taxes

• Taxes on business and investment income• Wealth and inheritance taxes• Property and land taxes

Aggregate level of taxes

• Differences between developed countries (38% of GDP) and developing countries (18% of GDP)

• Relationship between tax level and per capita income

• Estimates of tax capacity– Hypothetical tax to GDP ratio– VAT productivity

What explains differences?

• Different demands and tastes for government services

• Different capacities to tax– Level of economic development– Size of informal economy

• Different abilities to impose and collect taxes

Relative Use of Different Tax Instruments

• Factors influencing relative mix of different tax instruments– Revenue considerations– Administrative considerations– Fairness considerations– Transition and political considerations

Differences Between Developed and Developing Countries

• Relative use of trade taxes

• Relative use of income and consumption taxes

• Relative proportion of income taxes between individual and corporate income taxes

Trends in Tax Reform

• Increased reliance on VAT• Increased pressure to reduce trade taxes• Increased tax competition for foreign direct

and portfolio investment• Reduction in top tax rates under individual

income tax system• Reduction in top tax rates under business

profits tax

Predictions for Future

• Tax design will still be largely dictated by domestic considerations

• However, increased cross-border activity means no longer can design tax system without regard to tax systems of other countries

• Globalization will increase challenges in taxing income from capital

• Regional cooperation may lead to increased harmonization of tax systems

What Can Taxes Do?

• Raise revenue to fund government operations

• Assist in redistribution of wealth or income

• Encourage or discourage certain activities

Competing Government Objectives

• What considerations exist in choosing among the different objectives?

• The role of taxes in – Encouraging economic growth– Reducing disparity between the rich and the

poor– Reducing poverty

Criteria for Evaluating Taxes

• Efficiency

• Fairness

• Administrative feasibility

Efficiency

• Taxes influence behavior– Work vs. leisure– Save vs. spend– Choice of products– Operate in formal economy vs. operate in informal economy– Choice of location for investment

• Reduce “deadweight” or “distortion” costs– Almost all taxes distort– Costs are real costs—especially for economies where resources are

scarce– Focus on minimizing tax costs

Minimize Deadweight Costs of Taxation

• Tax bases should be as broad as possible

• Tax rates should be as low as possible

• Careful attention must be paid to taxes on production

Fairness

• Different ways to think about fairness– Horizontal and vertical equity– Focus on single tax provision, single tax, or tax

system as a whole– Focus on government activity as a whole

• Tax incidence

• Actual vs. perceived fairness

Tax Incidence

• Distinguish between who has liability to pay tax and who suffers the economic burden of taxation

• People pay taxes—in role of consumer, producer or factor supplier

• Tax incidence depends on market conditions (ability to shift taxes to others)

• Economic conditions vary among countries—hard to predict tax incidence, especially in developing countries

Administrative Feasibility

• Cost of collection

• Cost of compliance– To taxpayers– To third-parties

• Cost of enforcement

• Designing rules and regulations

• Challenges to tax administration

How Choose Among Competing Criteria?

• What factors consider in choosing among the different criteria?

• Why do countries make different choices among each other and over time?

Raise Revenue

• Match budgeted expenditures with estimates of likely revenue receipts

• Income tax elasticity– Growth of tax revenues relative to growth in the

economy

• Effect on tax revenue from economic recessions and expansions– Total tax revenues

– Revenues from specific tax instruments

Limitations of Individual Income Taxes to Redistribute Income

• Individual income taxes play a relatively small role in tax systems of developing countries

• Individual income tax is primarily a “wage withholding tax” in many countries

• No effective taxation of income from capital (including capital held outside the country)

• It may not be politically feasible to impose significant tax liability on the wealthy

Effectiveness of Different Tax Instruments in Redistribution

• Progressivity – tax as a percentage of income increases as income increases

• Income taxes and wealth taxes

• Consumption taxes are often considered to be regressive

Framework for Evaluating Benefits from Redistribution

• Social welfare function– Entitlement-based theories– Utility-based theories– Rawlesian-based theories

• Compare before and after states

Costs of Redistribution

• Trade-off of equity and efficiency

• Costs of higher tax rates depends in part of the elasticity of wage supply

• Capital flights – either into gray or black economy or out of the country

Tasks of Tax Administration

• Facilitate tax compliance

• Reduce tax evasion

• Keep tax officials well-trained and honest

Facilitating Compliance

• Process for locating and, often, registering taxpayers

• Process for determining tax liabilities

• Process for collecting taxes

• Process for providing taxpayer services

Taxation and Growth

• Does economic growth mean greater inequality?

• Is there a relationship between level of tax rates and rates of economic growth?

• Bad tax systems can stifle economic growth; however, unclear whether good tax systems can substantially increase economic growth

Pro-Growth Tax System

• Little or no tax on profits

• Tax consumption greater than income

• Encourage movement from informal to formal sector

• “Un-tax” the poor to make than more productive

Taxes and Decentralization

• Increasingly important to focus on assigning taxing and spending authority to lower levels of government

• Notion that decentralization may improve government service by increasing accountability

Tax Decentralization

• Ownership of tax revenues

• Choice of tax base

• Choice of tax rate

• Responsibility and coordination of tax administration

Taxes and Globalization

• Increased pressure to reduce trade taxes• Increased pressure on corporate tax revenue

– Tax competition– Intra-company trade increases opportunity for tax

evasion• Increased pressure on individual tax revenues

– Easier to work or invest outside of country of residence• Increased pressure on VAT revenue

– Services and intangibles larger part of value-added– Digitized products

Conclusion