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Master of Public Administration & Public
ManagementSubject: M.P.A 6104 Public Sector
Economics and Finance
Lecture : 5Indirect Taxation in Developing Countries
Dr. K. Amirthalingam
Senior LecturerDepartment of Economics
University of Colombo
2013
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Indirect tax revenue (% of Total Taxes)
Country1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2011
Sri Lanka 88 86 85 84 86 85 83 85 81 79 81 81
Canada 28 29 29 27 26 24 28 26 23 .. 23 23
USA 02 02
Thailand .. .. .. .. .. .. .. 61 56 52 58 54
Malaysia 57 53 56 54 40 35 38 .. .. .. 33 30
Korea, Rep 60 60 61 63 59 62 63 59 56 .. 58 55
India 81 77 71 70 68 64 62 57 53 48 44 44
Pakistan 87 82 79 80 71 72 69 72 72 73 64 63
Uganda .. .. .. .. 85 84 79 75 73 73 69 55
Kenya .. 71 67 60 62 67 67 64 61 58 56 55
Source: World Development Indicators
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Indirect taxation is defined as taxation
imposed upon others than the person who is
intended to bear the final burden (Atkinson,1977).
The most important single fact about indirect
taxes in developing economies is thedominant role that they play in the revenue
system of almost every country.
Particularly, indirect taxes are an importantelement in stabilization tax packages that aim
at raising revenue in the short run (Bovenberg,
1986).
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Insignificant role of direct taxation in
developing countries
The role of direct taxation in developing
countries is limited.
Because narrow tax base and high
enforcement costs render direct taxation
impractical for developing countries (Yonah
and Margalioth, 2006).
As a result, developing countries depend
mainly on indirect taxes.
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Indirect taxes represent an important part of
tax revenue in developing countries but they
play only an insignificant role in developed
countries.
Tax structure and its administration are often
part of a specific cultural, social, political and
economic situation and they change with new
demands and requirements of society and
economy.
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In developing countries, the insignificant role oftaxes on individual incomes is disappointing.
because these taxes have traditionally beenconsidered the major instrument to achieve theobjective of income redistribution (Tanzi, 1987).
The requirements for an effective system of
personal income taxation are many. When the agricultural sector is large, accounting
standards are poor, the level of literacy is low andmost economic activity takes place in smallestablishments, effective taxation of personalincome is difficult in developing countries(Goode (1962) as qouted in Tanzi, 1987).
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Conditions including advice of internationalinstitutions have also prompted developingcountries to concentrate more and more onindirect taxation.
The general advice given to developingcountries over the past few decades by the
international institutions such as the IMF,World Bank and WTO has been to replace highand relatively inefficient direct taxes withmore efficient means of indirect taxes,
particularly value added tax (Yonah andMargalioth, 2006; Hatzipanayotou et al. 1994).
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In recent years, the issues relating to a shift froman income (direct) to a consumption (indirect) tax
system has been increasingly discussed amongacademics and economic policy makers (Changand Tsai, 2006).
The issues are: firstly a consumption tax isfavoured especially on the grounds of efficiencygains because it eliminates the bias againstinvestment and savings inherent in the income tax
system, thus encouraging capital accumulationand improving future living standards (Kaldor,1955; Summers, 1981);
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Secondly, consumption tax would be less
distorting than an income tax that taxes
capital income (Summers,1981);
Thirdly, annual income can be highly variable,
and people often borrow and save to reduce
the effects of that variation, so thatconsumption may be a better measure of a
household's ability to pay taxes. (Gale, 1995).
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The general problem of taxation of individuals
is complex.
There are a large number of people in anyeconomy who differ with respect to a number
of characteristics, in particular their
endowments and tastes.
On the basis of certain ethical premises, it is
decided that individuals with different
characteristics should pay varying amounts of
tax (Atkinson and Stiglitz, 1976)..
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Stern, (1987) raises the following questionsregarding taxation.
What should be the balance between thetaxation of commodities and the taxation ofincome?
What types of goods should be taxed? How progressive should the income tax be?
These questions are obviously central to
Public Finance. It is important to look at the literature on
direct and indirect taxation to answer thesequestions
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Musgrave (1969) divided the period of
economic development into two:
the early period when an economy is relativelyunderdeveloped and the later period when
the economy is developed.
During the early period, there is limited scopefor the use of direct taxes because the
majority of the populace resides in rural areas
and is engaged in subsistence agriculture andtherefore their incomes are difficult to
estimate.
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Therefore, indirect taxes play an important roleduring the early stage of economic
development. The different contributions to revenue by direct
and indirect taxes in developed and developingcountries conform to Musgraves (1969) theory.
He further notes the ratio of indirect taxes tototal taxes is related inversely to per capitaincome
because the economic structure of low incomeeconomies is not suited to the imposition ofdirect taxes, while indirect taxes can be imposedmore readily.
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Gupta (2002) emphasizes that developingcountries have a basic problem in rapidlyincreasing capital formation.
Hence, saving and investment should bepromoted.
Taxes can be used for the mobilization ofresources in the public sector to fuel public sectorinvestment.
In the mobilization of such resources, indirecttaxes can play an important role.
Given that total national income is low indeveloping countries, the scope for achievingadequate tax revenue both for administrationand for bringing about capital accumulation isvery limited (Bhatia,2006).
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Furthermore, in such economies, there is usually an
urgent need for providing basic amenities and
welfare activities such as drinking water, health
services and protection against malnutrition to a
large segment of the population.
Given this enormous need for tax revenue and given
the limited scope for direct taxation, indirect taxeshave to play a crucial role in such economies.
Linked to this same argument, that developing
countries need greater capital accumulation, is theargument that direct taxation, particularly at high
progressive rates of taxation, is detrimental to
increasing private savings and entrepreneurship15
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Merits of Indirect Taxation
There are merits and demerits
However, the success of a good indirect tax systemmainly depends on how far a tax authority minimizesthe demerits while maximizing the merits of indirecttaxation.
Indirect taxation is an effective method of raisingrevenue with less adverse economic effects (Atkinson,1977).
Supply-side economists believe that indirect taxes are
preferable to direct taxes because they create less of adisincentive to work since employees retain more ofwhat they earn, resulting in greater long run outputand a lower general price level.
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Indirect taxes are a powerful tool in enhancing
the production and investment activities of the
economy through guiding resource allocation.
For example, the imposition of a high sales tax
on a particular good would raise the price of
that good and discourage its demand.
Reduced profitability of this item will then lead
to less investment in this product and divert
resources to more profitable ventures.
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Indirect taxes can also be oriented towardsincreasing employment or encouraging theadoption of a particular technology.
For example, if the intention is to encouragecapital-intensive techniques, labour intensiveoutput can be taxed more heavily and vice a
versa. Similarly certain types of indirect taxes are
sometimes referred to as sin taxes, for exampletaxes on alcohol and cigarettes.
These types of taxes are levied by governments todiscourage individuals from partaking in suchactivities.
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Governments favour such taxes as they are
easily accepted by the general public andgenerate high revenues.
Indirect taxes can be made progressive ifnecessities are exempted from taxation and
luxuries are subjected to heavy rates oftaxation so that the tax rates would be higherfor the high priced goods or for goods of
superior quality. Such taxation would be progressive in nature
as these goods are purchased mainly by richpeople.
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Another merit of indirect taxes is that they can
be used as Pigovian taxes.
A Pigovian tax is a tax levied to correct the
negative externalities of a market activity.
For instance, a Pigovian tax may be levied on
producers who pollute the environment to
encourage them to reduce pollution.
In a true market economy, a Pigovian tax is the
most efficient and effective way to correct
negative externalities.
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From an administrative perspective indirect
taxes are generally easier to implement than
direct taxes.
Indirect taxes are included in the price of a
commodity so that they cannot be easily
evaded.
A major argument in favour of indirect taxes
has been that they are relatively easy and
inexpensive to administer (Khan, 2001) and soare appropriate particularly in developing
countries.
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Demerits of Indirect Taxation
Indirect taxes are heavily criticized for unnecessarily
imposing heavy burdens on the lower income classes(Pechman, 1990).
The burden of an indirect tax is more difficult to
assess than a direct tax and in general such taxesconsidered to make a tax structure less progressive
(Henderson, 1948).
Gupta (2002) notes that if a given amount is to be
collected through taxes, the burden of the tax or thesacrifice involved would be greater in the case of
indirect taxes than direct taxes.
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This is because indirect taxes impose an excess
burden through affecting the price and
demand for a commodity. excess burden depending on the change in
price that in turndepends on the demand and
supply elasticity of the product Elasticity determines the feasibility of shifting
the burden from producer to retailer to
consumers. Thus, an indirect tax has a greater adverse
effect on the allocation of resources than a
direct tax.23
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Many people are unaware of how much they arepaying as indirect taxes this goes against one ofthe basic principles of a good tax systemnamely that taxes should be transparent.
If indirect taxes are too high this creates anincentive to avoid taxes through boot-legging
a good example of this would be attempts toevade the high levels of duty on cigarettes bysmuggling them.
At a macro level indirect taxes can cause cost-
push inflation, which in turn can fuel a rise ininflation expectations.
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An important demerit of indirect taxes is that they tend
to be regressive.
Since each individual pays the same rate on their
purchases, the poor pay a larger proportion of their
incomes as indirect taxes.
As a result, indirect taxes can adversely affect efficiency
and inter-sectoral (and inter-personal) distribution ofincome (Khan, 2001).
On distributional grounds, indirect taxes are regarded
as inferior to direct taxes.
Therefore, indirect taxes are generally not suitable from
the point of view of removing inequalities of income
and wealth (Gupta, 2002).
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Minimizing Welfare loss Imposed by Indirect Taxation
Belan and Gauthier (2006) emphasize that the tax
system should meet two fundamental propertiesfor the collection of a given amount of fiscalliabilities to induce the least welfare loss.
First, in accordance with Lipsey and Lancasters
(1956) second best principle, every consumptiongood should be taxed, since a larger fiscal baseallows for reducing tax rates, which alleviates thedistortions caused by state intervention on the
economy.
Second, tax rates should generally not beuniform, and inelastic goods should be taxedmore heavily (Ramsey, 1927).
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This is called the Ramsey taxation principle or
the inverse elasticity rule.
The basic idea behind Ramseys taxationprinciple is to minimize the deadweight loss
which accompanies the use of commodity
taxation. The applicability of the Ramsey rule of taxation
is hampered by the fact that little is known
about the magnitudes of the relevant elasticitiesof goods (Kleven, 2004).
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Ramsey considered the case of one consumer (orequivalently identical consumers who are treatedidentically), and so we have a simple efficiency
problem where distributional considerations areignored.
Notice that the one consumer (identical consumers)
case is somewhat artificial: if so we could and should raise all the required
revenue by a poll tax and have zero commoditytaxes (Stern, 1987).
Furthermore, as quoted in Atkinson and Stiglitz(1972), Prest (1967) and Musgrave (1959) arguethat Ramseys result has been ignored or dismissedas being of little practical significance.
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However, the inverse elasticity rule normally
applies only to a constant cost case in which
average cost (and hence marginal cost) ishorizontal (ibid).
In a competitive market, while the constant cost
case is plausible, it assumes away the producerssurplus.
Though, the constant cost case is plausible in a
competitive market situation, the relevance ofthe constant cost case to an imperfect market
situation is extremely doubtful
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Income Distribution
Christiansen (1984) pointed out that if taxableincome is only an imperfect indicator of ability to
pay (say, because highincome individuals areable to hide some of their income), commoditytaxes on luxuries may help the government toachieve the desired distribution of income.
A commodity should be taxed if it is positivelyrelated to leisure in the sense that more of thegood is consumed if more leisure is obtained at aconstant income level (Little, 1951).
A commodity should be subsidized if it isnegatively related to leisure in the sense that lessof the good is consumed if more leisure isobtained at a constant income level (Little, 1951).
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The poor in developing countries consume verylittle of air conditioners and private cars, forexample.
Direct tax and transfer instruments are generallyweak and far from universal in such countries.
So there are strong distributional grounds for
higher taxes on the goods consumed by the rich. As far as developing countries are concerned one
problem is that the retail and wholesale networkis very informal and much of consumption is not
marketed. therefore a tax based on final consumption will
not be effective in generating much revenue.
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Conclusion A countrys tax system is a major determinant of other
macroeconomic indices such as economic growth,public debt, fiscal deficit and inflation
and therefore taxation policy plays an important role inthe efforts of many developing countries to improvetheir fiscal and economic performance.
Taxation is also an important instrument for attaining aproper pattern of resource allocation, incomedistribution and economic stability, in order that thebenefits of economic development are evenlydistributed.
However, many developing countries still face difficultyin raising tax revenue to the level required forpromoting economic growth.
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In practice, due to poor economic performance,weak economic structure and administrative andpolitical constraints, tax revenue as percentage ofGDP is very low in many developing countries ascompared to developed countries.
As a result, huge fiscal deficits are a chronic
problem in almost all developing countries. In these situations, revenue mobilization through
taxation is an important element in medium-termdevelopment plans that aim to raise domestic
investment and government savings whilereducing reliance on debt creating capital inflows.
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This review of literature regarding the role ofindirect taxes in developing countries highlights
four conclusions. Firstly, indirect taxes seem to be more
appropriate than direct taxes for developingcountries.
Secondly, the tax system should tax more heavily,goods consumed more heavily by the rich.
Thirdly, those goods which are complementary
with leisure should be taxed more heavily. Lastly, those goods which have external
diseconomies should be taxed more heavily.
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