Introduction to Tax Policy Design and Development

Richard M. Bird and Arindam Das-Gupta

March 2004

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

Tax revenue (% of GDP)

0

5

10

15

20

25

30

35

40

45

50

0 5000 10000 15000 20000 25000 30000 35000 40000

Per capita GDP (PPP)

Relative Use of Different Tax Instruments...

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

…and Non-Tax Instruments

Includes royalties, user charges, sale of goods and services, fees, penalties

Relatively neglected (15% except oil producers and Singapore: 40%)

Great potential Potentially fairer than broad based

taxes

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

Tax-GSDP ratios and Per Capita GSDP: c: 2001

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40%

60%

80%

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Social securitytaxes

Taxes on goods andservices

Taxes on income,profits and capitalgainsTaxes oninternational trade

Nontax revenue

Taxes as a % of Current Revenue by Region

Revenue Structures in SAR and EAP Countries

Revenue (% of GDP) in SAR and EAP Countries

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Other taxes

Taxes on internationaltrade

Taxes on income,profits and capital gains

Taxes on goods andservices

Social security taxes

Nontax revenue

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

Other revenue sources

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

What Can Taxes Do?

Raise revenue to fund government operations

Assist in redistribution of wealth or income

Encourage or discourage certain activities

At a cost in terms of efficiency and growth

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

Revenue productivity Efficiency Fairness Administrative feasibility

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

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 To Choose Among Competing Criteria?

What factors to consider in choosing among the different criteria?

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

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; unclear whether good tax systems can substantially increase economic growth

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

India: Centre vs state revenues 2001-2 vs 1990-1

Centre 2001-02

Capital Receipts

44%

Tax Revenue

37%

Non-tax Revenue

19%

Centre 1990-91

Non-tax Revenue

13%

Tax Revenue

45%

Capital Receipts

42%

States 2001-02Capital

Receipts32%

Non-tax Revenue

6%

Tax Revenue

62%

States 1990-91

Tax Revenue

76%

Capital Receipts

13%Non-tax Revenue

11%

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

Predictions for Future

Tax design will still be largely dictated by domestic considerations

However, increased cross-border activity means tax system can no longer be designed 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

Conclusion

‘To tax and be loved is not possible’ ‘‘Taxes are the price we pay for

civilized society’ Above all, do no harm – or at least

as little as possible’