WBI Module 1

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Introduction to Tax Policy Design and Development

Richard M. Bird and Eric M. ZoltApril !!"

This is a draft prepared for a course on Practical Issues of Tax Policy in DevelopingCountries, World Bank, April 2 !"ay #, 2$$%&

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#ontents

I& Introduction

II& An 'vervie( of the World of Taxes#& Tax levels2& Tax structure%& )ecent trends*& Conclusion

III& What Can Taxation Do+#& )aising revenue2& cono-ic efficiency%& .airness concerns*& Tax ad-inistration

/& Taxation and gro(th0& Taxation and decentrali1ation& 3sing the tax syste- for non!fiscal o45ectives

I6& Conclusion !! The Political cono-y of Taxation

)eferences

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Against this 4ackground, (e then discuss in Part III the principal policyo45ectives that different countries -ay atte-pt to achieve through 4udgetary andespecially tax policy !! such as the need to raise revenue =usually for -ore than one levelof govern-ent? the desire to raise such revenue e8uita4ly or fairly the desira4ility of-ini-i1ing the costs of raising taxes the desire to encourage econo-ic gro(th and such

related 8uestions as the desire to encourage =or discourage? particular types of activity orto help =or penali1e? particular groups or regions and the (ish to encourage and facilitatehonest and responsive govern-ent&

.inally, in Part I6, (e sketch 4riefly the 4road political econo-y context (ithin(hich tax policy design and develop-ent issues -ust 4e considered 4y practicalrefor-ers& We do not provide definitive ans(ers to -ost of the 8uestions raised in thisintroduction, -any of (hich are considered in -ore depth in later -odules, and so-e of(hich cannot 4e definitively ans(ered& 'ur ai- is rather si-ply to set out so-e of the

4asic issues facing tax policy designers in developing countries and to suggest at leastso-e of the key ele-ents that -ust 4e considered in designing the 4est feasi4le tax

structure for a particular country at a particular ti-e&

II. An $vervie% o& the 'orld o& Taxes

o single tax structure can possi4ly -eet the re8uire-ents of every country& The 4est syste- for any country should 4e deter-ined taking into account its econo-icstructure, its capacity to ad-inister taxes, its pu4lic service needs, and -any otherfactors& onetheless, one (ay to get an idea of (hat -atters in tax policy is to look at(hat taxes exist around the (orld& The level and structure of taxes, and the (ay in (hichtaxing patterns have changed in recent years are revie(ed here on the 4asis of datacollected for so-e recent years for #0 countries, representing every region of the (orld& #

# There are -any pro4le-s in asse-4ling such data& .or exa-ple, although (e shall focus herelargely on national taxes, it should 4e noted that the data coverage in this sa-ple varies& .or //countries in the sa-ple, only central govern-ent is included, (hile for 0> countries, generalgovern-ent, including regional and local govern-ent, is covered& .or # countries, the sourcesdo not -ake it clear (hich govern-ents are included& Data are analy1ed for the -ost recent yearfor (hich they are availa4le for each country !! usually #>> & The length of the ti-e series usedto investigate the changes in this pattern also varies 4y country, 4ased on data availa4ility& Thedata (ere collected for a period averaging a4out six years, usually in the -id!#>>$Es& The datareported in this section are 4ased on (ork done 4y Willia- .ox for a 4ackground report for the3nited ations& = o-e later sections of this -odule also dra( on this report, as yet unreleased,(hich (as prepared 4y )& Bird, W& .ox, and "& "cIntyre&? FDP d ata were obtained fromthe IMF World Economic Outlook Database atwww.imf.org/external/pubs/ft/weo/ !! /ol/data/index.htm . "e#enue datawere obtained from IMF $ountr% "eports atwww.imf.org/external/countr%/index.htm and OE$D "e#enue &tatistics$D"om' ()*+, !!!' dated !!(.

/

http://www.imf.org/external/pubs/ft/weo/2002/ol/data/index.htmhttp://www.imf.org/external/country/index.htmhttp://www.imf.org/external/pubs/ft/weo/2002/ol/data/index.htmhttp://www.imf.org/external/country/index.htm


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(. Tax levels

'n average, the tax ratio !! taxes as a share of FDP !! (as a 4it less than one!fifthof FDP =# & percent? for the #0 countries in the sa-ple& 2 This is a si-ple average,treating each country as a single o4servation, so that a s-all island such as t& Guciareceives the sa-e (eight as the 3nited tates or China& In fact, tax ratios in the sa-plerange fro- (ell under #$ percent in a fe( countries, -ost of (hich are s-all and all of(hich are lo( inco-e !! for exa-ple, "yan-ar, Chad, Fuate-ala, and Central African)epu4lic !! to (ell over *$ percent in a fe( high!inco-e countries in (estern uropesuch as .rance and (eden& urprisingly, ho(ever, so-e lo(er!inco-e countries,

particularly transitional countries, also had high ratios, such as Belarus, 3kraine, Algeria,and udan& i-ilarly, so-e higher!inco-e countries, such as the 3nited tates, hadconsidera4ly lo(er tax ratios than others, (ith 7ong >> (ere classified as lo(!inco-e, /# countries (here per capita FDP (as 4et(een3 D#,$$$ and 3 D# ,$$$ (ere classified as -ediu-!inco-e, and the 2* countries (ith

per capita FDP greater than 3 D# ,$$$ (ere classified as high!inco-e& As earlierstudies =Tan1i, #> ? have sho(n, in general, taxes tend to rise as per capita inco-es rise&The tax ratio rises fro- a4out # percent in the lo(!inco-e group, to 22 percent in the-ediu-!inco-e group, and 2 percent in the high!inco-e group&

everal factors could explain this relationship& The de-and for pu4lic services-ay rise faster than inco-e =the inco-e elasticity for services is greater than one?,

particularly in lo(er!inco-e countries& .or instance, ur4ani1ation tends to rise (ithinco-e, and the de-and for pu4lic services is generally higher in ur4an areas& At thesa-e ti-e, ho(ever, it is usually easier to collect taxes in ur4ani1ed areas& "oregenerally, the capacity of countries to collect taxes appears to rise as inco-e levelsincrease&

2 If social insurance contri4utions are included, the average tax ratio rises to 2#& percent& Weshall not discuss social insurance pay-ents, ho(ever, in part 4ecause it is not al(ays clear(hether they are included in the tax data for so-e countries&

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here !! have traditionally relied little on trade taxes ="artine1!6a18ue1 and "c a4,2$$$?& In general, ho(ever, trade taxes clearly decline in i-portance as inco-e rises&

The higher the level of per capita inco-e, the -ore a country relies on directtaxes, especially those on personal inco-e& i-ilarly, although they rise -ore slo(ly,

consu-ption taxes too 4eco-e relatively -ore i-portant in -ore developed countries&/

These differences in tax structure appear to reflect certain 4asic differences 4et(een lo(and high!inco-e countries& Go(!inco-e countries tend to raise -ore revenues at the

4order, (here relatively fe( collection points need to 4e controlled& .or the sa-e reason,they are -ore likely to rely -ore heavily on excise taxes on to4acco, alcohol and so on&In contrast, direct taxes =and 6AT? tend to re8uire 4oth a -ore effective taxad-inistration and taxpayers (ho are -ore sophisticated, conditions -ore likely to existin developed countries&

". Recent trends

'ver the short ti-e period covered in the data =only five or six years for -ostcountries in the sa-ple?, tax 4urdens have increased only slightly on average, fro- # &$to # & percent of FDP& Indeed, taxes actually (ent do(n a 4it in Asia in this period&Taking a longer perspective, Tan1i =#> ? reported for the late #> $s an average tax ratioof # & percent of FDP for the 0 developing countries in his sa-ple& The co-para4leratio for the / countries for (hich overlapping data are availa4le (as # &0 percent, againsuggesting a slight increase over ti-e in tax ratios&

'ne (ay to su--ari1e revenue gro(th over ti-e is in ter-s of 9tax 4uoyancy,:that is, the percent change in tax revenue divided 4y the percent change in FDP& 0 ince,as noted a4ove, on average revenues have gro(n -ore 8uickly than FDP, the overallaverage 4uoyancy (as #&$*& "oreover, 4uoyancies (ere roughly the sa-e in all threeinco-e categories, although they tended to 4e lo(er in Africa, and especially Asia, thanelse(here&

The relative i-portance of different taxes has changed in recent years& The -oststriking feature has 4een the increase in the share of revenues generated 4y consu-ptiontaxes& 'ne reason has 4een the continued -ove to the adoption of 4road!4ased 6ATs,(hich rose fro- %* to *$ percent of all consu-ption taxes even in the short periodconsidered in our sa-ple& A4out $ percent of the (orldEs population lives in the #2% or-ore countries that no( levy a 6AT = 4rill et al&, 2$$#?& 'n the other hand, there hasalso 4een so-e increase in the share of revenues raised fro- direct taxes, especially

personal inco-e taxes& In contrast, although the change is s-all, corporate taxes arerelatively less i-portant& Taxes on international trade have dropped dra-atically,decreasing 4y *&% percent of total collections in this short period !! a decline

* The coefficient in a regression of per capita FDP on international trade taxes as a share of FDPis negative and statistically significant&/ The inco-e elasticity of direct taxes is $& $, for consu-ption taxes $&0#, and for trade taxes$&$>&0 'n the relation 4et(een 94uoyancy: and 9elasticity:, see the discussion at note 4elo(&


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approxi-ately offset 4y the * percent rise in consu-ption taxes& The use of trade taxeshas dropped even -ore over the longer ter-& In #> #, for exa-ple, trade taxes accountedfor %$&0 percent of developing country revenues =Tan1i, #> ?, co-pared to only 2*&%

percent for the sa-e countries in #>> &

). #onclusion

This course focuses on developing countries, covering a (ide variety of countries,(ith very different tax levels and structures& o-e countries -ay lack effectivegovernance structures& uch countries need to develop and i-ple-ent effective andefficient tax syste-s if they are to 4e a4le to provide for the needs of their people and to

participate effectively in the (orld econo-y& Another group of countries -ay have -adesu4stantial progress in -eeting develop-ent goals& There countries -ay still facesignificant pro4le-s in tax policy due to glo4ali1ation and other factors& Although eventhe less!developed countries -ay face fiscal challenges due to heavy dependence on tradetaxes, those countries (ith a developing econo-y -ust also cope (ith potentially

trou4leso-e and i-portant pro4le-s in the inco-e tax area& While glo4ali1ation andother factors -ay lead to further convergence of tax syste-s, the evidence to datesuggests that the si1e and structure of taxation in -ost countries (ill continue to 4edo-inated largely 4y do-estic rather than glo4al factors&

III. 'hat #an Taxation Do*

This Part exa-ines the role of taxes as (ell as so-e criteria that -ay 4e useful indesigning tax regi-es& The -ain purpose of taxation is to generate sufficient revenue tofinance pu4lic sector activities in a non!inflationary (ay& In Part II, (e sho(ed thatcountries raise revenue in different (ays& A countryEs choice on ho( to structure its taxsyste- depends upon -any factors, such as the level of develop-ent, the need and desirefor increased pu4lic services, and the capacity to levy taxes effectively& Tax policychoices also depend on a countryEs preference as to such pu4lic policy goals as attaining adesired distri4ution of inco-e and (ealth and increasing the rate of national =and perhapsregional? econo-ic gro(th&

o one likes taxes& People do not like to pay the-& Fovern-ents do not like toi-pose the-& But taxes are necessary 4oth to finance desired pu4lic spending in a non!inflationary (ay and also to ensure that the 4urden of paying for such spending is fairlydistri4uted& While necessary, taxes i-pose real costs on society& Food tax policy seeks to-ini-i1e those costs&

Tax policy is not 5ust a4out econo-ics& Tax policy also reflects political factors,including concerns a4out fairness& In -any countries, increased econo-ic gro(th hasincreased the disparity 4et(een the rich and the poor& Taxes influence the 4efore!taxdistri4ution of inco-e 4y changing econo-ic incentives& They also influence the after!tax distri4ution of inco-e through, for exa-ple, progressive inco-e taxation&

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.inally, regardless of (hat a particular country -ay want to do (ith its taxsyste-, or (hat it should do (ith respect to taxation fro- one perspective or another, it isal(ays constrained 4y (hat it can do& Tax policy choices are influenced 4y a countryEsecono-ic structure and its ad-inistrative capacity& These factors reduce the tax policyoptions availa4le to developing countries&

fficiency, e8uity and ad-inistrative feasi4ility are key criteria in designing andevaluating tax syste-s& This Part provides an overvie( of the role of taxes in part 4yfocusing on these criteria& The first section exa-ines so-e considerations in using taxesto raise revenue to fund govern-ent operations& The second section revie(s issues ofecono-ic efficiency and different costs of taxation& ext, fairness concerns areaddressed& The fourth section revie(s the interaction of tax ad-inistration and tax policy&The fifth section considers taxation and gro(th, and the sixth section touches on suchissues related to decentrali1ation& The final section exa-ines the use of taxes for non!tax

purposes&

(. Raise revenue

Tax syste-s exist pri-arily to raise revenue to fund govern-ent operations& Gackof sufficient revenue often results in large 4udget deficits& xcept (hen short!ter- fiscalsti-ulus -ay 4e considered appropriate for -acroecono-ic reasons, deficits generallyhave undesira4le -acroecono-ic conse8uences such as cro(ding out private invest-entand increasing inflation& Preventing deficits re8uires good control over 4oth theexpenditure and revenue sides of govern-ent& The legislated 4udget -ust 4e structuredeach year to operate strictly (ithin esti-ates of likely revenue receipts& While this -aysee- o4vious, even these initial conditions for good tax and 4udgetary policy are notsatisfied in a nu-4er of countries&

Tax refor-s should as a rule 4e undertaken to achieve long!ter- rather than short!ter- o45ectives& Tax syste-s should not nor-ally 4e altered on a te-porary 4asis to-eet anticipated current year shortfalls& .re8uent tax changes increase enforce-ent andco-pliance costs and -ay increase efficiency costs, especially (here 4usinesses -ake

production and location decisions on the 4asis of a particular tax structure&

3nless tax revenues gro( sufficiently 8uickly to finance desired services over thelong ter-, govern-ents -ust reduce expenditures, raise tax rates, or alter other structuralcharacteristics of the syste-& Thus, a good tax syste- -ust generate sufficient revenueto fund pro5ected govern-ent expenditures& Although countries differ in the pro5ectedrate of revenue gro(th pri-arily due to differences in pro5ected de-and for pu4licservices, usually revenue gro(th rate should 4e roughly e8ual to the overall econo-icgro(th rate, unless the country (ants to increase =or reduce? the si1e of its govern-ent&

The i--ediate revenue effects of a tax policy change need not reflect its long!ter- effects,o(ing 4oth to transitional aspects of the ne( structure and to the fact that taxpayers often changetheir 4ehavior te-porarily to take advantage of higher or lo(er tax 4urdens in the years 4efore orafter the changes&

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The rate at (hich revenues increase over ti-e differs depending on the taxstructure, the 8uality of tax ad-inistration, and the pace and nature of econo-ic gro(th&The 9inco-e elasticity: of a tax syste- -easures ho( fast revenues gro( relative to theecono-y& Tax elasticity is defined as the percentage change in tax revenues divided 4ythe percentage change in FDP =or potential tax 4ase, such as personal inco-e?& lasticity

e8ual to one, for exa-ple, -eans that tax revenues (ill re-ain a constant share of FDP&lasticity greater than one indicates that tax revenues gro( -ore rapidly than inco-e& In principle, revenues should gro( at the sa-e rate as desired expenditures =that is, theinco-e!elasticity for revenues and expenditures should 4e the sa-e?& In practice,ho(ever, -any developing and transitional countries have had great difficulty inachieving this target& This leads to fre8uent tax 9refor-s: ai-ed pri-arily at closingshort!ter- revenue gaps& Tax policies enacted in such econo-ically and politicallydifficult circu-stances often fail to resolve the underlying 4asic pro4le- of inade8uaterevenue elasticity&

The overall elasticity of any tax syste- is si-ply the average of the elasticity of

individual taxes, (eighted 4y the percentage of total taxes raised 4y the tax& Theelasticity of a tax depends on the specific characteristics of its structure& The elasticity of personal inco-e taxes generally reflects the progressivity of their rate structure and, -osti-portantly, the level of the personal exe-ptions =or 1ero 4racket? relative to averageinco-e levels& Consu-ption taxes are -ore elastic if they cover -ore rapidly gro(inggoods and services rather than 5ust -ore slo(ly gro(ing traditional goods and if they arelevied as a percentage of the price =like a 6AT? rather than on the specific nu-4er of units

purchased =as (ith -any excises?& Property tax revenue increases -ore rapidly (henreappraisals occur on a regular 4asis and (hen property is fully valued&

)evenue gro(th generally slo(s during recessions and accelerates duringexpansions& )evenue elasticity also tends to rise in expansions and fall in recessions,thus exacer4ating the volatility of revenue flo(s& The elasticity of the corporate inco-etax is particularly volatile 4ecause in a recession corporate profits fall -uch -ore

precipitously than overall econo-ic gro(th& Countries that depend heavily on taxation of natural resources such as oil or -inerals are especially vulnera4le to cyclical s(ings, (ith(ide s(ings in co--odity prices changing the level of tax revenues& Fenerally, acountry that relies on a 4alanced set of tax instru-ents rather than a single revenue source(ill have lo(er tax revenue volatility, 5ust as an individual investor can reduce thevolatility of her invest-ent portfolio 4y adopting a diversified invest-ent strategy&

. Economic e&&iciency

o-e -ay contend that econo-ists overe-phasi1e the costs of taxation and thei-portance of efficient resource allocation& Taxes do, ho(ever, i-pose real econo-ic

Tax 9elasticity: refers to revenue gro(th in the a4sence of any tax policy changes, (hile tax94uoyancy: refers to gro(th including the effects of such changes& In principle, elasticity is a

4etter -easure of the gro(th potential of the tax structure& In practice, ho(ever, as in Part II, datali-itations often force analysts to rely on 4uoyancy data&

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.inally, taxes -ay give rise to (hat econo-ists call 9dead(eight: or 9distortion:costs& Al-ost every tax -ay alter decisions -ade 4y 4usinesses and individuals as therelative prices they confront are changed $ The resulting changes in 4ehavior likelyreduce the efficiency (ith (hich resources are used and hence lo(er the output and

potential (ell 4eing of the country& o -atter ho( (ell the govern-ent uses the

resources ac8uired through taxation, govern-ents need to li-it the negativeconse8uences of tax!induced changes in 4ehavior&

Taxes on (ages =personal inco-e taxes, (age taxes, social security taxes, and soforth? reduce incentives to (ork& .or exa-ple, the higher the tax rate on (ages in thefor-al sector, the less attractive (orking in the for-al sector 4eco-es relative to (orkingin the untaxed infor-al sector& Consu-ption taxes also discourage (ork& Taxes onspending increase the a-ount of ti-e one -ust (ork to pay for goods and servicesthrough the -arketplace& As taxes are not i-posed on leisure, at the -argin, taxes likelydiscourage =taxed? (ork&

Taxes not only alter relative prices =in this case, the net =after!tax? (age?, 4ut alsoinco-e& As taxes reduce individualsE after!tax (ages, they -ay choose to (ork -ore toco-pensate for lost inco-e& The net effect on (ork of any tax change reflects 4oth thisinco-e effect and the effect of the change in relative prices =the su4stitution effect?&"any studies have exa-ined the i-pact of taxes on (ork, (ith results varying fro-country to country depending upon the structure of taxes, the nature of the (orkforce, andthe nature of the econo-y # In the present context, it is i-portant to note that thesu4stitution effect =the change in relative prices? (ill cause individuals to change their(ork decisions and, if those decisions had 4een econo-ically efficient 4efore the tax, toreduce the potential output of the nation&

Al-ost all taxes affect resource decisions& Consu-ption taxes, such as the value!added tax, -ay discourage the consu-ption of taxed as opposed to untaxed goods =e&g&housing in so-e countries?& Taxes on gasoline, alcohol, and cigarettes can reduce the

#$ There are a fe( exceptions& Gu-p!su- taxes, (here the tax 4urden is the sa-e regardless ofany 4ehavioral responses 4y taxpayers, are one exa-ple, -uch favored 4y theorists& "orei-portantly in practice, to the extent that taxes fall on econo-ic 9rents: H pay-ents to factorsa4ove those needed to induce the- into the activity concerned !! they too -ay not affectecono-ic activity& Well!designed taxes on natural resources and land, for exa-ple, -ay thus toso-e extent produce revenue (ithout econo-ic distortion& .inally, in certain instances, taxes Hagain, if properly designed H -ay not only create distortions in econo-ic 4ehavior 4ut -ay eveninduce desira4le 4ehavior& Certain environ-ental levies, for exa-ple, or even crude proxies suchas taxes on fuel, -ay to so-e extent have such effects& uch instances of 9good: taxes H those(ith no 4ad econo-ic effects H should of course 4e exploited as fully as possi4le, 5ust as (ell!designed charges should to the extent possi4le, given pu4lic policy o45ectives, 4e used to financecertain pu4lic sector activities that specifically 4enefit identifia4le individuals& In the end,ho(ever, -ost of the taxes needed to finance govern-ent (ill have to co-e fro- other sourcesand (ill hence give rise to the efficiency costs discussed in the text&

## .or one such recent study, of Colo-4ia, for exa-ple, see Al- and G pe1!CastaJo =2$$2?&

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consu-ption of these ite-s& #2 Inco-e taxes, 4ecause they tax the return to savings, -ayalter the a-ount of savings or the for- in (hich savings are held& .or exa-ple, failure totax capital gains until they are reali1ed =(hen the asset is sold? encourages the holding ofassets =a lock!in effect?& Taxes -ay also affect invest-ent, and such effects -ay 4eespecially i-portant (hen econo-ies are -ore open to trade and invest-ent& .oreign

investors -ay choose to locate their activities in a particular country for -any reasons,such as the relative costs of production, access to -arkets, and sound infrastructure&Taxes -ay also influence their choice of location& To the extent taxes lo(er the after!taxreturn on invest-ents in a country or a region, the level of invest-ent and hence gro(th-ay 4e lo(er than it (ould other(ise 4e& Corporate inco-e taxes -ay also influencethe co-position of a fir-Es capital structure =use of de4t or e8uity financing? or dividend

policy& .or exa-ple, retained earnings are encouraged (hen dividends are su45ect to taxat the shareholder level and de4t is preferred over e8uity (here interest on de4t capital isdeducti4le and dividends paid fro- e8uity capital are not&

xactly ho( i-portant such tax effects are is a -atter of considera4le de4ate

a-ong analysts,#%

4ut the consensus is that they are -uch -ore i-portant than (asthought thirty or forty years ago& The efficiency costs of taxation are so-e -ultiple ofthe ad-inistrative and co-pliance costs -entioned a4ove& The lo(est esti-ates of theefficiency costs of taxes for developed countries are at least 2$!%$ percent of revenuescollected, and -uch higher esti-ates are co--on in the literature& If these efficiencycosts are the conse8uence of rational policy decisions =for exa-ple, to redistri4uteinco-e through the fiscal syste-?, they -ay 4e accepta4le& till, it is i-portant to designtaxes to -ini-i1e such possi4le adverse conse8uences, especially in poor countries&Although the efficiency losses are real, they are not directly visi4le& The efficiency costof taxation arises 4ecause so-ething does not happen so-e activity did not occur oroccurred in so-e other for-& 'utput that is not produced, ho(ever, is still output, and

potential (elfare, lost&

A suggested approach

Food tax policy re8uires -ini-i1ing unnecessary costs of taxation& To -ini-i1ecosts, experience suggests three general rules .irst, tax 4ases should 4e as 4road as

possi4le& A 4road!4ased consu-ption tax, for exa-ple, (ill still discourage (ork effort, 4ut such a tax (ill -ini-i1e distortions in the consu-ption of goods if all or -ost goodsand services are su45ect to tax * A fe( ite-s, such as gasoline, to4acco products andalcohol, -ay 4e taxed at a relatively higher rate, either 4ecause of regulatory reasons or#2 As noted earlier, not all such effects need 4e 4ad for instance, if to4acco consu-ption falls,

people -ay live longer, healthier and -ore productive lives&#% .or a recent survey of the effects of taxes on saving, for exa-ple, see Bernhei- =2$$2?&#* In theory, in order to -ini-i1e efficiency losses different tax rates should 4e i-posed on eachco--odity, (ith higher rates i-posed on those goods and services (here the changes in

4ehavior are the s-allest& To do so, ho(ever, re8uires -uch -ore infor-ation a4out ho( taxesalter 4ehavior than is availa4le in -ost countries& "oreover, this approach does not takead-inistrative and e8uity concerns into account& .or these reasons, in practice it see-s generallyadvisa4le to i-pose a unifor- tax rate to the extent possi4le&

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4ecause the de-and for these products is relatively unresponsive to taxation& #/ The tax 4ase for inco-e tax should also 4e as 4road as possi4le, treating all inco-es, no -atterfro- (hat source, as unifor-ly as possi4le&

econd, tax rates should 4e set as lo( as possi4le, given revenue needs to finance

govern-ent operations& The reason is si-ply 4ecause the efficiency cost of taxes arisesfro- their effect on relative prices, and the si1e of this effect is directly related to the taxrate& The distortionary effect of taxes generally increases proportionally to the s8uare ofthe tax rate, so that dou4ling the rate of a tax i-plies a fourfold increase in its efficiencycosts& .ro- an efficiency perspective, it is 4etter to raise revenue 4y i-posing a singlerate on a 4road 4ase rather than dividing that 4ase into seg-ents and i-posingdifferential rates on each seg-ent& In practice, the cost of differential treat-ent -ust 4e

4alanced against the e8uity argu-ent for i-posing graduated rate schedules&

Third, fro- an efficiency perspective, it is especially i-portant that carefulattention 4e given to taxes on production& Taxes on production affect the location of

4usinesses, alter the (ays in (hich production takes place, change the for-s in (hich 4usiness is conducted, and so forth& Developing and transitional countries generally needto i-pose taxes on production for several reasons& .irst, countries (ith li-itedad-inistrative capacity find it easier and less expensive to collect excise and sales taxesat the point of -anufacture& econd, to the extent that taxes represent the costs of pu4licservices provided to 4usinesses, the 4usinesses should 4ear the cost, via taxation, forthose services& .inally, countries need to tax corporate inco-e to prevent tax avoidance

4y individuals (ho (ould avoid shareholder level taxes 4y retaining earnings (ithin acorporation and to collect taxes fro- foreign!o(ned fir-s&

". +airness concerns

.airness or e8uity is a key issue in designing a tax regi-e& .ro- one perspective,taxes exist pri-arily to secure e8uity& ational govern-ents do not need taxes to securefunds 4ecause they can si-ply print the -oney re8uired to fund operations& The taxsyste- can 4e vie(ed as a -echanis- to take -oney a(ay fro- the private sector in asefficient, e8uita4le, and ad-inistratively inexpensive (ay as possi4le&

What is fair?

What is considered e8uita4le or fair 4y one person -ay differ fro- theconceptions held 4y others& Traditionally, tax scholars have defined fairness in ter-s ofhori1ontal and vertical e8uity& 7ori1ontal e8uity re8uires those in si-ilar circu-stancesto pay the sa-e a-ount of taxes& .or apportioning tax lia4ility, hori1ontal e8uity oftene-4races so-e notion of a4ility or capacity to pay& 6ertical e8uity re8uires 9appropriate:differences a-ong taxpayers in different econo-ic circu-stances&

#/ 3nfortunately, in -any instances this i-plies that such taxes (ill 4e highly regressive (ithrespect to inco-e&

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'n the surface, 4oth concepts have great intuitive appeal& Those (ho have thesa-e a4ility to pay should 4ear the sa-e tax lia4ility& i-ilarly, it -akes good sense forthere to 4e appropriate differences for taxpayers in different situations& 3nfortunately,

4oth concepts -ay have li-ited usefulness in tax policy de4ates&

The concept of hori1ontal e8uity has 4een challenged as 4eing inco-plete, nothelpful, and derivative& .or exa-ple, an inco-e tax can co-pletely satisfy hori1ontale8uity re8uire-ents only if (e assu-e individuals have identical tastes and a single typeof a4ility or inco-e& 'nce (e allo( preferences to vary and provide for different types of a4ility or inco-e, then only a tax 4ased on an individualEs a4ility to earn inco-e, ratherthan actual earnings, can effectively provide for e8ual taxation for those in e8ual

positions& In addition, the concept of hori1ontal e8uity -ay 4e inco-plete to the extent itfocuses only on a short ti-e period, such as one year, or fails to consider the i-pact of alltaxes or ignores the provision of govern-ent services or other 4enefits& The concept ofhori1ontal e8uity also -ay not 4e useful unless (e can deter-ine (hich differences arei-portant and (hy these differences 5ustify different tax treat-ent&

i-ilarly, -uch disagree-ent exists a4out the usefulness of the concept ofvertical e8uity and a4out (hat constitutes appropriate differences in treat-ent& Considerseveral possi4le conceptions of fairness& To so-e, fairness could re8uire that allindividuals pay the sa-e a-ount of tax& Thus, one could design a tax syste- that i-posesa head tax on each individual over the age of # years old& .airness could also re8uire alltaxpayers to pay the sa-e rate of tax on their inco-e& In so-e countries, the 9flat tax: or9single rate tax: rhetoric en5oys great popularity& While -ost flat rate proposals providefor a high threshold =1ero rate 4racket? 4efore the i-position of the flat rate, the notion ofone tax rate that fits all strikes -any as an e8uita4le -anner of deter-ining tax lia4ility&To others, ho(ever, fairness re8uires those taxpayers (ith higher inco-e to pay a higher

percentage of their inco-e in tax& Although the progressive rate structure -ay rest on ashaky theoretical foundation, it has 4een the -ost co--on inco-e tax rate structure&"any find a 4asic attraction to assessing tax on the 4asis of 9a4ility to pay: (ith theresult that the rich are 4etter a4le to contri4ute to the financing the govern-entoperations&

Kuestions -ay also 4e raised a4out the relative fairness of consu-ption taxesversus inco-e taxes& Consu-ption tax proponents 8uestion (hether any inco-e taxsyste- can 4e fair& There are several, so-e(hat related, strands to their positions& 'neapproach takes a societal vie(& Inco-e is (hat individuals contri4ute to societyconsu-ption is (hat they take a(ay fro- the pot& Therefore, if (e (ant a society that(ill continue to gro( and prosper, (e are 4etter off taxing consu-ption rather thaninco-e& A second approach considers consu-ption as a 4etter -easure of a householdEsa4ility to pay& Because of the greater variations in inco-e over a personEs or householdEslifeti-e, it -ay 4e 4etter to use consu-ption as the 4ase for taxation rather than inco-e&.inally, inco-e taxes i-pose higher taxes on households (ith higher savings& As such,the inco-e tax syste- penali1es savers over those (ho consu-e currently&

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Proponents of inco-e tax clai- that a personLs net increase in econo-ic (ealth isa 4etter -easure-ent of a4ility to pay than the use of their inco-e& That is, an inco-etax proponent (ould say the person (ho earns M# -illion and spends M#$ has a greatera4ility to pay than the person (ho earns M#$ and spends M#$& 3nder a consu-ption tax,

4oth (ould 4ear the sa-e tax 4urden (hile under an inco-e tax, the first person (ould

4ear a -uch greater tax 4urden& o-e consu-ption tax advocates concede theconsu-ption tax alone (ould not 4e appropriate if it failed to tax a personLs savings as(ell as consu-ption& It is argued, ho(ever, that the inco-e tax is not an appropriate toolto tax savings& 'ne alternative (ould 4e to use a consu-ption tax to tax spending and a(ealth tax to tax savings&

As these 4rief co--ents suggest, discussions of fairness in general, or ofhori1ontal and vertical e8uity in particular, are, 4y the-selves, of li-ited usefulness&

i-ply saying (e should accord e8ual treat-ent to e8uals adds little to tax policydiscussions& We need to choose an ethical fra-e(ork 4efore -aking any co-parisonsN (hether co-paring e8uals or -aking 9appropriate: co-parisons a-ong une8uals&

Without such a funda-ental fra-e(ork one cannot evaluate the relative fairness ofdifferent proposals or different tax regi-es& Perhaps the 4est (e can do nor-atively is todeter-ine the conse8uences of a proposal or regi-e, and then evaluate the- in thecontext of different ethical structures& In the end, only through its political institutionscan any country really define and i-ple-ent its vie( of (hat is an accepta4ly fair taxsyste-&

A possible approach

.airness -ay 4e approached in various (ays& As discussed a4ove, one -ayconsider the relative tax 4urdens i-posed on taxpayers (ho are in the sa-e or in differentecono-ic circu-stances& Alternatively, one -ay consider the overall effects of taxationon inco-e and level of (ell!4eing& The policy i-plications of these t(o approaches -ay

4e 8uite different& The first approach focuses on the distri4utional conse8uences of a particular refor- proposal to change a particular provision or series of provisions&3nfortunately, although proposals to refor- taxes 4ased on such analysis -ay indeedi-prove particular -easures of hori1ontal and vertical e8uity (ithin the li-ited groupactually su45ect to the full legal 4urden of the tax in 8uestion, they -ay also havei-plications for others that -ay in so-e instance -ake the syste- as a (hole less fair&

.ro- the perspective of social and econo-ic ine8uality, (hat -atters in the end isthe overall i-pact of the 4udgetary syste- on the distri4ution of (ealth and inco-e&Both expenditures and taxes should therefore 4e taken into account in considering ho(govern-ent policy affects the distri4ution of inco-e, as (ell as the overall e8uityi-plications of any tax change&

Taxes affect e8uity in -any and co-plex (ays& They -ay treat people (ho are inessentially the sa-e econo-ic position differently =hori1ontal e8uity?& Taxes -ay fall-ore heavily on those (ho consu-e alcohol than on those (ho consu-e housing, or onthose (ho get their inco-e in the for- of (ages rather than fro- far-s or dividends&

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Taxes -ay also differ in their effects on inco-e distri4ution =vertical e8uity?& They -aytax the rich relatively -ore =progressivity? or less =regressivity? than the poor&

o-e countries -ay (ish to favor cities, other countries -ay favor rural areas&o-e -ay choose to favor rich savers in the na-e of gro(th, others the poor, in the na-e

of redistri4ution& Gike -ost policy instru-ents, tax policy can play -any tunes& What iscritical fro- an e8uity perspective is, first, to 4e a(are of the e8uity i-plications of taxrefor-s for different groups, and, second, to ensure that the actual outco-e of suchrefor-s is consistent (ith the intended outco-e&

Consider, for exa-ple, the case of a transitional country like the )ussian.ederation, in (hich the 4ig 9untaxed: sector is not traditional agriculture =as in -anylo(!inco-e countries? 4ut rather the relatively large 9shado(: econo-y& The existenceof such a sector -ay have i-portant i-plications for the effects of particular tax policy&.or exa-ple, to the extent the 6AT functions properly, it (ill to so-e extent serveessentially the sa-e function as a presu-ptive tax on the infor-al sector =since credits

are only availa4le for fir-s that are registered as taxpayers and those earning inco-e inthe shado( sector are taxed (hen they purchase co--odities through the for-al sector?&'n the other hand, if -any high!inco-e recipients operate through the shado( econo-y,the effects on e8uity of increasing the progressivity of the personal inco-e tax are notal(ays o4vious& Fovern-ent e-ployees and e-ployees of large, for-al -arket fir-s-ay 4e the pri-ary personal inco-e taxpayers and hence 4ear the 4runt of such changes&

In such circu-stances, it is not inconceiva4le that indirect taxes such as a 6AT andespecially certain excises in 9higher!inco-e: consu-ption goods such as -otor vehicles-ay 4e -ore progressive than a personal inco-e tax that in reality falls largely on ali-ited group of (age earners& #0 In short, it is i-portant in thinking a4out taxation ande8uity to focus not on preconceived notions a4out la4els !! for exa-ple, that anythingcalled a personal inco-e tax is, 4y definition, progressive, (hile anything called a 6ATis, 4y definition, regressive H 4ut rather on the reality of ho( taxes (ork in practice&

uch argu-ents do not -ean that corporate and personal inco-e taxes do not servean i-portant role in developing and transitional countries& uch taxes are often thelargest tax source for high!inco-e countries, and the sa-e -ay 4eco-e true in othercountries as their econo-ies develop, -ore 4usinesses and individuals 4eco-e part of thefor-al econo-y, and infor-ation and tax ad-inistration i-proves& Currently, ho(ever,

particularly in the least developed countries, revenue syste-s rely heavily onconsu-ption taxes and are likely to continue to do so for so-e years to co-e&

#0 A tax is considered progressive (hen the tax 4urden as a percent of inco-e is greater for higherinco-e households than for lo(er inco-e households, proportional if the percentage of inco-e

paid in taxes stays constant as inco-e rises, and regressive if the percentage paid in taxes falls asinco-e rises& A higher inco-e taxpayer (ill nor-ally 4ear a larger a4solute tax lia4ility than alo(er inco-e taxpayer, regardless of (hether the tax is progressive, proportional or regressive, sothe difference 4et(een the three concepts is ho( rapidly taxes rise (ith inco-e, not (hethertaxes rise (ith inco-e&

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Taxes -ay not -ake the poor richer, 4ut they can certainly -ake the- poorer& # .iscal atte-pts at poverty alleviation in developing countries -ust therefore 4eundertaken pri-arily on the expenditure side of the 4udget& onetheless, the poor shouldnot 4e -ade even poorer through taxes& It -ay therefore 4e desira4le to exe-pt certain94asic needs: ite-s fro- even the 4roadest!4ased consu-ption tax& Certainly, heavy

taxes on ite-s that constitute -a5or consu-ption expenditures for poor people shouldgenerally 4e avoided&

Taxation is one of the fe( (ays in (hich the (ealthy -ay 4e -ade less (ealthy,short of outright confiscation& But taxes have likely had only -oderate success inreducing inco-e ine8uality in developed countries and appear to have had even lesssuccess in reducing inco-e ine8uality in developing countries& The -a5or tax instru-entsfor achieving progressivity are the individual inco-e tax and various (ealth taxes =suchas taxes on real property, taxes on personal assets, and inheritance taxes?& one of thesetaxes has 4een particularly effective in developing countries in reducing inco-eine8uality&

Although atte-pts to redistri4ute inco-e through taxation have generally not 4eeneffective in -ost developing and transitional countries =Chu, Davoodi, and Fupta, 2$$$?,it -ay often 4e politically necessary and desira4le to tax those (ho gain the -ost fro-econo-ic develop-ent, 4earing in -ind the need at the sa-e ti-e to -ini-i1e theefficiency costs of unduly high tax rates& ustaina4le tax policy needs to 4e accepted asfair 4y those affected& ven in the poorest countries, auto-o4iles and other luxury

products are -ore visi4le than inco-e, so that it should 4e feasi4le to collect progressivetaxes on these ite-s& #

Tax incidence

To deter-ine the fairness of a tax regi-e, one -ust consider the econo-icincidence of taxation& It is i-portant to distinguish 4et(een those (ho have the lia4ilityto pay a particular tax and those (ho suffer the econo-ic incidence or 4urden of the tax&Tax 4urdens fall on individuals in their roles as consu-ers, producers and factorsuppliers, not on corporations or other institutions& .or exa-ple, although the 6AT la(-ay re8uire fir-s to pay 6AT to the govern-ent, it is likely that the real econo-icincidence of the 6AT falls on the ulti-ate consu-er& i-ilarly, although -otor fuel taxesare al-ost al(ays collected high in the distri4ution chain =for exa-ple, at i-port or fro--a5or distri4utors?, the cost of the tax is likely 4orne 4y consu-ers& In other instances, itis unclear (ho actually 4ears the econo-ic costs of taxation& .or exa-ple, the econo-ic

# o-e developed countries, such as Canada and the 3nited tates, use their inco-e tax syste-sto provide inco-e support to certain lo(!inco-e people& 3sing the tax syste- to -ake suchtransfers re8uires 4oth that the tax ad-inistration is efficient and that -ost people file tax returns&

either condition is satisfied in -ost developing countries&# As 7ughes =#> ? notes, taxing fuel correctly can 4e especially difficult in countries

like Indonesia in (hich petroleu- products =in this case, kerosene? are an essential consu-ptionite- for the poorest people& Bosnia seeks to i-pose differential rates on fuel for ho-e heatingversus for other purposes =such as transportation?, 4ut this has proven to 4e very difficult toenforce and is su45ect to significant evasion&

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incidence of property taxes -ay 4e 4orne either 4y the o(ners of land and capital =(hoalso 4ear the legal incidence? or 4y the users or renters of the property, depending upon-arket conditions&

Deter-ining tax incidence re8uires a good understanding of ho( various -arkets

operate in an econo-y, particularly the a4ility of different types of taxpayers to shift thecost of the tax to other econo-ic actors& Who actually 4ears taxes depends on the relativesupply and de-and elasticities of consu-ers and suppliers and other factors& Whileecono-ists have -ade i-portant advances in esti-ating tax incidence, -uch (orkre-ains, particularly in deter-ining tax incidence in developing countries&

.or exa-ple, it is still not clear (ho 4ears the cost of the corporate inco-e tax& Ascorporations are 5ust legal constructs, the tax cost -ust fall on individuals& As a result ofthe corporate tax, shareholders =or all o(ners of capital? could receive lo(er returns,consu-ers could pay higher prices, or (orkers could receive lo(er (ages, or so-eco-4ination thereof& In addition, the tax conse8uences in the short!run could differ fro-

long!run conse8uences& The incidence of a corporate inco-e tax thus depends on suchfactors as the openness of the overall econo-y in ter-s of the inflo(s and outflo(s ofcapital invest-ent, as (ell as on the extent to (hich capital -oves 4et(een the corporateand unincorporated sectors, the relative capital!intensity of corporations, and theelasticity of de-and for goods produced 4y corporations and other 4usinesses& Thesefactors are not easy to -easure& As econo-ic conditions vary a-ong different countries,taxes that have the sa-e legal incidence -ay have different econo-ic incidence indifferent countries = hah and Whalley, #>>$?&

Consider also the payroll tax& cono-ists generally assu-e the payroll tax isactually 4orne 4y (orkers in the long run, regardless of the actual division 4et(eene-ployers and (orkers on the o4ligation to pay the tax& Again, the incidence depends onthe elasticities of supply and de-and& Because the supply of la4or is relatively inelastic,-ost or the entire tax 4urden falls on (orkers& In so-e instances, the i-position of a

payroll tax -ay have additional effects& The change in the after!tax (age (ill have 4othinco-e and su4stitution effects on (orkers& It is possi4le that the la4or supply couldcurve 4ack(ards such that the (age rate could fall 4y -ore than the a-ount of the tax& Inthis case, 4ecause of the additional supply response, the e-ployers could actually 4enefitfro- the i-position of a tax on la4or&

Chu, Davoodi, and Fupta =2$$$? find that for %0 studies of overall tax syste-s in#> different developing countries, #% studies found the tax syste- progressive, studiesfound the tax syste- proportional, studies found the tax syste- regressive, and there-ainder of the studies had -ixed findings or insignificant effects& .or inco-e taxsyste-s, #2 of the #* studies (ere progressive, one study (as regressive, and one had a-ixed finding&

T(o other considerations add to the difficulty of trying to deter-ine the tax 4urden of 4oth individuals and groups of individuals in different inco-e classes& The firstfactor is the necessity to consider the tax incidence of a group of taxes& The -ore

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a4ility of the individual inco-e tax to tax effectively inco-e fro- -ost for-s of capital-eans that it is unlikely that the very rich 4ear significant tax lia4ility&

Third, it -ay of course 4e politically difficult to i-pose effective inco-e tax and(ealth taxes in -any countries& It -ay 4e accepta4le to pass tax legislation that is in

theory progressive 4ut in practice does not i-pose significant tax lia4ility on the upperclasses& The appearance of progressivity -ay 4e necessary for the tax syste- to 4e politically accepta4le even if the reality of effective progressivity is not, in the end,accepta4le&

Taking all these factors into account, (hat can 4e said a4out the role of inco-etaxes in developing and transitional countries+ .irst, even if a countryEs sole o45ective isecono-ic gro(th, a clear case exists for taxing corporate inco-e, if only to collect a fairshare of the revenue that -ultinational and large do-estic 4usinesses derive fro-econo-ic activities in that country& It is of course true that 4y taxing corporationsdifferently, and usually -ore heavily than other for-s of 4usiness, govern-ents tend to

discourage, at least in principle, the operation of 4usinesses in corporate for-& till, thefact that -ost -a5or 4usinesses all over the (orld operate in corporate for- despite the prevalence of corporate inco-e taxes suggests that the corporation re-ains in general the 4est availa4le vehicle for -o4ili1ing large a-ounts of capital for 4usiness purposes&

ince corporations are the engine of develop-ent in all -odern societies, a tax oncorporations is in effect a tax on the -odern, gro(ing sector of the econo-y& #> Countriesneed to tax that sector 4oth to secure the revenue they need to -eet expandingexpenditure de-ands and also to ensure that those (ho 4enefit -ost fro- develop-ent

pay their fair share& But they -ust also ensure that corporate taxes are not so high as todiscourage gro(th& In general, the 4est approach for developing or transitional countriesis thus to i-pose a -oderate, sta4le tax on all corporations&

Personal inco-e taxes =as distinguished fro- general (age levies such as thosei-posed in -any countries for social security purposes? serve to -itigate, at least to a-oderate degree, the ine8ualities in inco-e and (ealth that al-ost invaria4ly acco-panygro(th& Care -ust, ho(ever, 4e taken not to co-plicate such taxes unduly, thus raisingtheir costs to too high a level& ven if a country could change its individual inco-e taxesand (ealth taxes to -ake the- -ore effective, it is not clear the 4enefits of increased

progressivity (ould 4e (orth the econo-ic costs& As discussed else(here, it is difficult todeter-ine the effects of taxes on econo-ic 4ehavior& It is also likely that theconse8uences are 8uite different in developed versus developing countries& .or exa-ple,taxes -ay play a lesser role in influencing decisions a4out (ork vs& leisure in developingcountries, 4ut a greater role in influencing decisions regarding operating in the for-al vs&grey or 4lack econo-y, or in saving at ho-e vs& portfolio invest-ent outside the country&

#> In -any developing countries, the corporate sector -ay 4e 8uite s-all to 4egin (ith& onetheless, corporate taxes -ay have an i-portance 4eyond the revenue they yield& To theextent a corporate tax falls on foreign!4ased corporations, for exa-ple, it -ay 4oth yieldrevenues that are paid in effect 4y foreigners and also provide a useful (indo( to the (ay

4usiness is conducted in developed countries&

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In principle, it is also desira4le to expand the 4ase of consu-ption tax toenco-pass -ore services in part to reduce regressivity& 3nfortunately, it has often

proved exceedingly difficult to include -any services, especially those that -ay 4econsu-ed disproportionately 4y the rich, in the 4ase of taxes such as the 6AT, so that

even the 4est!designed consu-ption taxes are unlikely to 4e very progressive, at least(ithin the -arket sector of the econo-y& 2$ Progressivity in the personal inco-e tax -aythus provide a useful offset to the likely regressive i-pact of the consu-ption taxes on(hich the revenue syste-s in -ost lo(er and -iddle!inco-e countries depend& In suchcountries, for the -ost part personal inco-e taxation should likely have a 9threshold: Hthe level of inco-e at (hich the tax 4egins to apply H (ell a4ove average inco-e levels&"oreover, to check tax avoidance, it (ould likely also 4e (ise to keep the top -arginalrate of the personal inco-e tax fairly close to the rate of the corporate inco-e tax&

Both corporate and personal inco-e taxes -ay thus play an i-portant role indeveloping and transitional countries& 7o(ever, given the current econo-ic context in

-any countries, the -ost i-portant part of the tax regi-e in such countries is likely to 4ea 4road!4ased value!added tax, pro4a4ly supple-ented 4y a fe( high!rate excise taxes onselected ite-s&

In the end, the -ost effective (ay to reduce ine8uality in -any countries see-slikely to 4e through spending progra-s targeted at the poor& .or exa-ple, expendituresai-ed at i-proving pri-ary education or pri-ary health services -ay prove -oreeffective at reducing ine8uality than trying to change the tax syste- to tax the rich& 3nder this approach, it -ay 4e 4etter to use the tax syste- to raise as -uch revenue as possi4le(ithout regard to distri4utional concerns and use expenditure progra-s to transferresources&

). Tax administration

The 4est tax policy in the (orld is (orth little if it cannot 4e i-ple-entedeffectively& Tax policy design -ust take into account the ad-inistrative di-ension oftaxation& What can 4e done -ay to a considera4le extent deter-ine (hat is done in anycountry&

Tax design in developing countries is strongly influenced 4y econo-ic structure& 2#

"any developing countries have a large traditional agricultural sector that is not easilytaxed& "any transitional and developing countries have a significant infor-al =shado(?econo-y that also is largely outside the for-al tax structure& The potentially reacha4letax 4ase thus constitutes a s-aller portion of total econo-ic activity than in developed

2$ ee the exa-ple cited in note 2/ 4elo(& To the extent the poorest sectors of society re-ainlargely outside the -arket econo-y, a 6AT -ay, of course, nonetheless 4e 4roadly progressive inits incidence&2# A century ago, for exa-ple, the no( developed countries also relied heavily on excises andtrade taxes, in part reflecting the nature of their econo-ies at that ti-e&

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countries& The si1e of the untaxed econo-y is in part a function of tax policy& .orexa-ple, the high social insurance tax rates levied in transition countries such as Croatiacreate an incentive for a large infor-al econo-y 4y discouraging e-ployers fro-treating -any service providers as e-ployees or encouraging the under!reporting of (agelevels&22 The resulting lo(er tax revenues often lead govern-ents to raise tax rates,

further exacer4ating incentives to evade taxes& I-proving tax ad-inistration is thuscentral to the choice of tax structures and to i-proving taxation in developing andtransitional countries&

The resources used in ad-inistering and co-plying (ith taxes =or, for that -atter,evading the-? are real econo-ic costs, in ter-s of the a4ility of the econo-y to providegoods and services& Food tax policy re8uires keeping such costs as lo( as possi4le (hilealso achieving revenue, gro(th, and distri4utional goals as effectively as possi4le& Thisis no s-all task& Three ingredients see- essential to effective tax ad-inistration the

political (ill to ad-inister the tax syste- effectively, a clear strategy for achieving thisgoal and ade8uate resources for the task& It helps, of course, if the tax syste- is (ell

designed, appropriate for the country in 8uestion, and relatively si-ple, 4ut even the 4estdesigned tax syste- (ill not 4e properly i-ple-ented unless these three conditions arefulfilled& "ost attention is often paid to the resource pro4le- !! the need to havesufficient trained officials, ade8uate infor-ation technology and so on& 7o(ever,(ithout a sound i-ple-entation strategy, even ade8uate resources (ill not ensuresuccess& And (ithout sufficient political support, even the 4est strategy cannot 4eeffectively i-ple-ented&

3nfortunately, 4ut unsurprisingly, fe( countries at any inco-e level have seniorgovern-ent officials (ho are eager to incur the econo-ic and political costs of -a5or tax

policy and tax ad-inistrative refor-s& .re8uently, international agencies re8uire such taxrefor-s as a condition for loans& Countries, desperate for revenues, launch frantic effortsto raise revenue (ithout hurting politically po(erful interests or (ithout providing theti-e, resources and consistent long!ter- political support needed for effective taxad-inistration& This reluctance to collect taxes efficiently and effectively (ithout fear orfavor is understanda4le in those countries (ith a fragile political foundation& But no-agic (ay exists to o4tain a via4le long!ter- tax syste- (ithout -a5or changes in taxad-inistration and often in tax policy also&

If the political (ill exists, the 4lueprint for effective tax ad-inistration is relativelystraightfor(ard& The tax ad-inistration -ust 4e given an appropriate institutional for-,(hich -ay -ean a separate revenue authority& It -ust 4e ade8uately staffed (ith trainedofficials& It should 4e properly organi1ed, (hich generally -eans an organi1ationalstructure 4ased on a function rather than on a tax!4y!tax 4asis& 2% Co-puteri1ation and22 A nu-4er of agencies in addition to the tax ad-inistration, such as social securityad-inistration and the custo-s ad-inistration and in so-e countries the financial police =forexa-ple, in the countries of the for-er Ougoslavia?, are often involved in revenuead-inistration&&

2% Alternatively, organi1ation 4y client groups -ay so-eti-es 4e sensi4le& But (hat isnever sensi4le is to assign specific taxpayers to specific officials for prolonged periods of ti-e, a

practice still co--on in so-e countries&

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appropriate use of -odern infor-ation technology is i-portant, 4ut technology alone isnot sufficient and these i-prove-ents -ust 4e carefully integrated into the taxad-inistration& e( co-puter syste-s have often developed parallel to the existingstructure =in the Philippines, for exa-ple?, 4ut little can 4e gained fro- a syste- thatdoes not recogni1e the skills and needs of tax officials&

ffective tax ad-inistration re8uires 8ualified tax officials& Tax authorities -ust provide for training and retraining staff as needed& The tax authorities need to collect theinfor-ation needed for effective ad-inistration fro- taxpayers, relevant third parties, andother govern-ent agencies& The infor-ation -ust 4e stored in an accessi4le and usefulfashion and, -ost i-portantly, it -ust then 4e used to ensure that those (ho should 4eon the tax rolls, are, that those (ho should file returns, do, that those (ho should pay onti-e, do, and that those (ho do not co-ply are identified, prosecuted and punished asappropriate& All this is easy to say and hard to do !! 4ut it is not an i-possi4le task&Countries such as ingapore are -odels of (hat can and should 4e done, and such-odels should 4e studied closely and, once adapted as necessary, i-ple-ented&

The first task of any tax ad-inistration is to facilitate co-pliance& This re8uires-aking sure that those (ho should 4e in the syste- are in the syste- and that theyco-ply (ith the rules&

.irst, taxpayers -ust 4e found& If taxpayers are re8uired to register, the registration process should 4e as easy as possi4le& yste-s -ust 4e in place to identify those(ho do not register voluntarily& Tax authorities should adopt an appropriate uni8uetaxpayer identification syste- to facilitate co-pliance and enforce-ent&

econd, tax authorities need a process for deter-ining tax lia4ilities& This -ay 4edone ad-inistratively =as (ith -ost property taxes? or 4y so-e self!assess-ent

procedure =as (ith -ost inco-e taxes and 6ATs?& 2*

Third, the taxes due -ust 4e collected& In -any countries, this is 4est done throughthe 4anking syste-& It is seldo- appropriate for tax ad-inistration officials tohandle -oney directly&

.inally, tax authorities should provide ade8uate taxpayer service in the for- ofinfor-ation, pa-phlets, for-s, advice agencies, pay-ent facilities, telephone andelectronic filing, and so on, to -ake taxpayer co-pliance (ith the syste- as easyas possi4le&

2* Flo4ali1ation confronts tax ad-inistrations (ith so-e special pro4le-s& .or exa-ple, taxad-inistrations -ust ensure that revenues and expenses are properly calculated in deter-iningtaxa4le profits for the corporate inco-e tax, and that export credits and refunds are properlyhandled under the 6AT& A nu-4er of countries =e&g& 3kraine? have failed to provide the ti-elyre4ates provided 4y the 6AT legislation for exported goods& Taxpayers cannot 4e expected torespect tax la(s (hen the govern-ent does not&

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This approach rests on treating the taxpayer as a client =al4eit not a (illing one? to 4eserved and not a thief to 4e caught& 3nfortunately, the latter attitude see-s to prevail in-any developing countries&

'f course, so-e taxpayers are not honest, so the second i-portant task of any tax

ad-inistration is to reduce tax evasion& Tax authorities re8uire esti-ates of the extent andnature of the potential tax 4ase, for exa-ple, 4y esti-ating (hat is so-eti-es called the9tax gap&: o-e esti-ate of the nu-4er and type of individuals and fir-s not registered(ith tax authorities is needed to devise strategies to 4ring the- into the tax syste-& Inso-e countries the -a5or tax pro4le- -ay 4e that -any taxpayers (ho are in the syste-are su4stantially under!reporting their tax 4ase& Without so-e kno(ledge of theunreported 4ase, and its deter-inants, no ad-inistration can properly allocate itsresources to i-prove tax collection and to ensure all parts of society 4ear their fair shareof the tax 4urden&

In addition to exploring the nature of the tax gap and undertaking the often difficult

tasks involved in extending the reach of the tax syste- into the infor-al econo-y to theextent feasi4le, close attention -ust also 4e paid to the si-ple task of ensuring that those(ho are in the syste- file on ti-e and pay the a-ounts due& I--ediate follo(!up ofnon!filers and those (hose pay-ents do not -atch their lia4ilities is a too often neglectedaspect of good tax ad-inistration& Ade8uate interest charges -ust 4e i-posed on late

pay-ents to ensure that non!pay-ent of taxes does not 4eco-e a cheap source offinance& i-ilarly, an ade8uate penalty structure is needed to ensure that those (hoshould register do so, that those (ho should file do so, and that those (ho under!reporttheir tax 4ases are sufficiently penali1ed to increase the costs of evading tax&

nforcing a tax syste- is neither an easy nor a static task in any country& It isespecially difficult in the changing conditions of developing countries& 3nless this task istackled (ith seriousness and consistency, ho(ever, even the 4est designed tax syste- (illfail to produce good results&

A third -a5or task is keeping the tax ad-inistration honest& o govern-ent canexpect taxpayers to co-ply (illingly if taxpayers 4elieve the tax structure is unfair or thatthe revenue collected is not effectively used& But even a sound tax structure and soundexpenditure policy can 4e vitiated 4y a capricious and corrupt tax ad-inistration&Developed countries took centuries to develop and i-ple-ent sound tax ad-inistration

practices ai-ed at preventing dishonest tax officials fro- succu-4ing to o4viouste-ptations =and even then, not (ithout regular e-4arrassing lapses?& 3nfortunately,-ost developing countries are trying to -aintain large govern-ent operations on a

precarious fiscal foundation (ithout su4stantial ti-e to solve the corruption pro4le-&

Tax officials -ust 4e ade8uately co-pensated, so that they do not need to steal tolive& They should 4e professionally trained, pro-oted on the 4asis of -erit, and 5udged

4y their adherence to the strictest standards of legality and -orality& Tax officials shouldhave relatively little direct contact (ith taxpayers and even less discretion in decidingho( to treat the-&

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The failure to develop good tax ad-inistration and good tax policy together has 4een a particular pro4le- in so-e transitional countries& In )ussia, for exa-ple, serious pro4le-s existed (ith 4oth the structure of the 6AT and the lack of ad-inistrativeexperience and capacity& A si-ple exa-ple is that under the initial 6AT legislation, no

tax lia4ility (as due (hen loans (ere -ade fro- one 4usiness to another& Thus, a 4uyer(ould clai- to have -ade a loan that (as never repaid =and (as in fact pay-ent forgoods? to a supplier and no tax (as due& The result (as a significant loss of revenue& A-ore capa4le ad-inistration (ould have foiled this si-ple evasion techni8ue, 4ut 4etterlegislation (as also needed&

ven if policies are good, the (ay in (hich they are ad-inistered can yield verydifferent outco-es than those intended& Ad-inistration that is seen as unfair andcapricious -ay 4ring the tax syste- as a (hole into disrepute& The initial failure oftransitional countries to develop their tax ad-inistrations (hen introducing ne( taxstructures resulted in very uneven tax i-position, lo(er than anticipated revenue, and

(idespread tax evasion& i-ilarly, in so-e developing countries, corporate tax lia4ilitiesare often negotiated rather than calculated as set out in the la(& Bri4ery is so-eti-es soco--on that it is considered a regular part of the co-pensation of tax officials& uchcorruption under-ines confidence in the tax syste-, negatively affects (illingness to paytaxes, and reduces a countryEs capacity to finance govern-ent expenditures&

.inally, so-e have argued that i-proved tax ad-inistration alone can generate therevenues re8uired to 4alance the 4udget or to finance tax policy changes that (ill narro(the tax 4ase through concessions or lo(er tax rates& Although 4etter tax ad-inistration(ill generally enhance tax collection, increased revenue -ay not 4e the only goal ofi-proved ad-inistration, (hich is needed also to i-prove fairness, for exa-ple&"oreover, since i-proving ad-inistration takes ti-e, any additional revenues -ay onlyaccrue over a nu-4er of years& Cutting tax rates or granting additional concessions in thehope that i-proved ad-inistration (ill 8uickly -ake up any revenue losses is never agood idea&

,. Taxation and gro%th

"uch has 4een (ritten a4out the effects of taxation on gro(th and e8uity&7o(ever, even in developed countries (ith sta4le, long!esta4lished tax syste-s andexcellent data, there is still -uch (e do not understand a4out this co-plex su45ect& 'urunderstanding of the relationship of tax on gro(th in developing countries is even lessco-plete& Consider, for exa-ple, the trade!off 4et(een gro(th and e8uity& "ostsocieties (ant to 4e richer& "ost also (ant the increased (ealth to 4e distri4uted fairly&Are these o45ectives co-pati4le+ Despite -uch theoretical and e-pirical in8uiry as (ellas political and policy controversy, no si-ple ans(er exists&

o-e contend that 4ecause gro(th never occurs across econo-ic sectors evenly, itis inevita4le that increased ine8uality (ill result& 'thers contend that societies in (hich

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resources are distri4uted -ore e8ually (ill do 4etter in the long ter-& till others suggestthat, (hatever the ans(er -ay 4e, countries can devise policy -easures that are fullyco-pati4le (ith achieving 4oth -ore gro(th and -ore e8uity& While the ans(er likelydepends on a countryEs specific circu-stances, the current situation in -any developingcountries offers !! at least in principle !! so -any opportunities for i-prove-ent that

so-e countries -ay 4e a4le to have their fiscal cake =gro(th? and eat it too=redistri4ution?&

'ver the past /$ years, there have 4een -any policy prescriptions for econo-icgro(th = asterly 2$$2?& Policy advisors have, in rough chronological order, called in turnfor increased capital invest-ent, i-prove-ents in education, population control,reduction of govern-ent controls on -arket activities, and loan forgiveness progra-s as9silver 4ullets: that (ould result in i-proved econo-ic perfor-ance in developingcountries& 3nfortunately, none of these cures (orked as advertised&

i-ilarly, there is no -agic tax strategy to encourage econo-ic gro(th& o-e

countries (ith high tax 4urdens have high gro(th rates and so-e countries (ith lo( tax 4urdens have lo( gro(th rates& Gooking at the relationship 4et(een gro(th rates and taxrates in the 3nited tates over the last /$ years reveals that the 3& & has had its greatest

periods of econo-ic gro(th during those years (here the tax rates (ere the highest= le-rod and Baki5a #>>0?& 'f course, this does not -ean that high tax rates are the keyto econo-ic gro(th& It -ay 4e that gro(th rates in the 3& & -ight have 4een even higherin those years (ith high tax rates if the rates had 4een lo(er& The point is that therelationship 4et(een taxes and gro(th is co-plex& ;ust looking at the no-inal tax rates

provides little infor-ation as to the real effective tax rates on different individuals anddifferent activities, the level of govern-ent infrastructure and services that are9purchased: (ith those tax dollars, and other govern-ent policies that -ay help or hinder econo-ic activity&

Tax incentives

"any countries have sought to i-prove their econo-y 4y introducing a variety oftax incentives for invest-ent, for savings, for exports, for e-ploy-ent, for regionaldevelop-ent, and so on = hah, #>>/?& 'ften, such incentives are redundant andineffective, giving up revenue and co-plicating the fiscal syste- (ithout achieving theirstated o45ectives& ven to the extent that incentives -ay 4e effective in inducinginvestors to 4ehave differently than they (ould have done in response to -arket signals,the result is often distorting and inefficient, diverting scarce resources into less thanopti-al uses& ssentially, tax incentives i-prove econo-ic perfor-ance only ifgovern-ent officials are 4etter a4le to decide the 4est types and -eans of production thanare private investors& Tax incentives also result in very uneven tax 4urdens, (ithdo-estic co-panies often su45ect to full taxation =at least in theory?, (hile other fir-s,often foreign investors, 4enefit fro- tax incentives that reduce their effective tax rates&

Despite such strictures, -any developing and transitional countries continue tointroduce and extend a variety of special tax incentives, partly in co-petition (ith one

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another for increased foreign direct invest-ent& xperience suggests, ho(ever, that non!tax factors, such as a sound -acroecono-ic policy, good infrastructure and a sta4legovernance syste- are -ore i-portant factors in locational decision than tax 4enefits&Although a li-ited role for certain si-ple incentives -ay exist as part of a gro(th!oriented fiscal policy, as so-e ast Asian experience suggests, tax incentives cannot

co-pensate for the a4sence of such critical factors& hould a country decide to introducea fe( li-ited incentives, these tax incentives should 4e (ell!designed, properlyi-ple-ented, and periodically evaluated if they are to do -ore good than har-&

It is i-portant to understand ho( particular tax instru-ents (ork in particularenviron-ents& o-e taxes that appear to 4e anti!gro(th and pro!redistri4ution =such as

personal inco-e taxes (ith highly progressive no-inal rate structures? -ay, at ti-es,have neither of these characteristics, (hile other taxes, such as the 6AT, -ay see-regressive co-pared to other tax alternatives, 4ut actually -ay 4e -ildly progressive =atleast 4et(een lo(er and -iddle inco-e groups?& As noted earlier, ho(ever, one cannot

5udge the effects of a tax 4y its na-e, 4ut only 4y close exa-ination of the details of its

design, i-ple-entation and econo-ic conse8uences& A “pro-growth” (and nothing else! tax s stem

Consider a country that (as concerned only (ith econo-ic gro(th and therefore(ishes to design a 9pro!gro(th: tax syste-& What -ight such a syste- look like+

everal characteristics co-e to -ind&

.irst, there (ould 4e little or no taxation of profits, to avoid discouragingentrepreneurship and risk!taking& Taxing profits reduces the return fro- entrepreneurshipand risk!taking& Conse8uently, under a pro!gro(th tax syste-, no good case exists fortaxing nor-al profits& 2/ "ost countries, ho(ever, do tax profits, and properly so H forexa-ple, to prevent people fro- placing assets in a corporation to avoid personal inco-etaxes and to o4tain a share for the host country of profits earned 4y foreign investors&

onetheless, high taxes on profits are unlikely to for- part of a gro(th!oriented taxstrategy& Instead, at -ost a reasona4ly lo( and sta4le 4road!4ased profits tax see-scalled for&

A purely gro(th!oriented tax strategy (ould also likely tax consu-ption -ore thaninco-e& The difference 4et(een consu-ption and inco-e is saving, and fro- a strictgro(th perspective, -ore saving is 4etter than less& o if do-estic savings are essentialto financing do-estic invest-ent, there is a 9gro(th: argu-ent for taxing inco-e fro-savings -ore lightly&

ven in the -ost gro(th!oriented tax syste-, ho(ever, taxes should kept 4e as lo(as possi4le on the poorest people si-ply 4ecause they -ust consu-e to 4e productive&;ust as so-e so!called 9invest-ent: =for exa-ple, in luxury ho-es or ela4orate office

2/ 'n the other hand, there is an excellent case for taxing so!called supra!nor-al profits=econo-ic rent? as heavily as possi4le& 3nfortunately, it is not easy in practice to tell 9nor-al:fro- an 9excess: profit&

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4uildings? -ay not 4e conducive to productivity, so so-e 9consu-ption: is productive&If people lack food to eat or lack 4asic clothing and shelter, or if they are not healthy andsufficiently educated to engage in -eaningful (ork, they are unlikely to 4e econo-ically

productive& 8uity =in the sense of not taxing the poor? and gro(th =in the sense ofenhancing the productivity of the la4or force? are thus 8uite co-pati4le o45ectives& A

9good: 6AT in such a syste-, for exa-ple, -ight exe-pt certain specific ite-s thatconstituted a significant fraction of the consu-ption of poor people &20

.inally, a gro(th!oriented tax syste- in developing countries -ay seek to increasethe cost of operating in the non!-oneti1ed traditional sector =through tax or other-easures? to encourage -ove-ent into the -onetary =-odern? sector& I-posing highertaxes on traditional agriculture -ay 4e difficulty politically and ad-inistratively, and it-ay not necessarily 4e e8uita4le, 4ut it is likely conducive to gro(th 4y shiftingresources a(ay fro- the traditional agriculture sector& Taxation of the -odern sectorthrough levies such as 6AT and inco-e taxes thus often needs to 4e supple-ented 4ytaxes on agricultural land and =especially (ith respect to the 9infor-al: or 9shado(:

sector of the econo-y? presu-ptive taxes&2

In short, a purely gro(th!oriented tax syste- (ould see- to 4e one that has a

relatively lo( and sta4le tax on profits and so-e taxation of the traditional agriculturaland infor-al sectors, 4ut (ith -a5or fiscal reliance 4eing placed on a 4road!4asedconsu-ption tax that -akes so-e allo(ance for exe-ptions of necessary consu-ption&What is conspicuously -issing in this picture, of course, is any explicit -ention of a

personal inco-e tax or any concern for fairness in taxation& As noted in section % a4ove,and reiterated in Part I6, ho(ever, one si-ply cannot leave this issue out of account indesigning and i-ple-enting a tax syste-&

-. Taxation and Decentrali ation

20 In the case of ;a-aica, for exa-ple, one study found that exe-pting only five narro(ly!definedite-s (ould cut the 6AT 4urden on the lo(est *$ percent of the inco-e distri4ution in half =Birdand "iller, #> >?& 'f course, since all such exe-ptions 4oth co-plicate ad-inistration and areal-ost inevita4ly poorly targeted =in the sense that -uch of the 4enefit goes to the non!poor? theyshould 4e kept to a -ini-u-&

2 Presu-ptive taxes are taxes that 9presu-e: a certain taxa4le capacity 4ased on o45ective=-easura4le, visi4le? indicators of production or consu-ption such as land, electricity used,e-ployees, -achines, vehicles, and so on& uch taxes, in -any different for-s, have a longhistory in -any countries& They seldo- produce -uch revenue and often suffer fro- -anydefects of design and ad-inistration& onetheless, despite such pro4le-s, presu-ptive taxes -ayin principle play t(o vitally i-portant roles in developing countries& .irst, such taxes are oftenthe only levies effectively i-posed on the often large non!-odern =or at least 9non!official:?sector of the econo-y& econdly, presu-ptive taxes can so-eti-es serve as a 4ackstop for9nor-al: taxes in the for-al sector& .or exa-ple, "exico i-poses a -ini-u- tax on the grossassets of a 4usiness if the profits reported for tax purposes exceed a certain -ini-u- rate ofreturn on the assets, the profits tax is applied as usual, 4ut if the reported rate of profits is 4elo(the -ini-al return, the 4usiness is instead su45ect to a tax 4ased on assets&

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)efor-ing tax structures is generally difficult in any country& )efor-ing taxad-inistrations is often even -ore difficult, and certainly takes longer& ven countriesthat succeed in refor-ing tax structures and ad-inistrations -ay still fail to reap theexpected 4enefits unless they pay close attention to the often trou4ling pro4le-s arisingfro- the finance of state and local govern-ents& uch pro4le-s are 4y no -eans

restricted to the relatively fe( =though i-portant? federal countries such as Bra1il, India,and igeria& )ather, they are arising (ith increasing fre8uency around the (orld incountries as diverse as China, Colo-4ia, and 3ganda&

'ne reason for the increased i-portance of intergovern-ental fiscal relations issi-ply 4ecause decentrali1ation is increasingly i-portant in -any countries, not least infiscal ter-s =Gitvack, Ah-ad, and Bird, #>> ?& Decentrali1ation is occurring in -anycountries around the (orld, (ith the expected 4enefits varying to so-e extent& o-ecountries anticipate that 4etter service delivery (ill result 4ecause the diverse de-andsand needs of the population can 4e served -ore effectively 4y local officials (ho have

4etter infor-ation on (hat people (ant& Gocal officials often can 4e held -ore

accounta4le than national officials, and particularly 4y the local population (ho have 4etter access to the -ayor than to -e-4ers of parlia-ent& This allo(s i-proved localvoice in deciding the level and 8uality of services and in de-anding i-prove-ents (herethey are needed& Decentrali1ation -ay 4e seen as a -eans of acco--odating the varyinginterests of different ethnic groups 4y reducing the potential nu-4er of points of friction&This has the potential to allo( nation 4uilding& There -ay also 4e disecono-ies ofdelivering so-e services at the national or even regional level, (hich -eans that localservice delivery can 4e less expensive& The capacity to generate sufficient revenues isoften a disadvantage of decentrali1ation& The difficulties of taxing econo-ic activity thatcan flee or 4e easily hidden is one of the reasons for pro4le-s in collecting tax revenuesat the local level& While there are =as usual? considera4le variations fro- country tocountry, in -any developing and transitional countries, it is 4eco-ing increasinglyi-portant to ensure that local and regional govern-ents, like national govern-ents, havean ade8uate resource 4ase& 3nfortunately, this again is an area in (hich practice falls farshort of (hat is needed, particularly (hen countries are really atte-pting to devolvesignificant pu4lic sector responsi4ilities to su4!national levels of govern-ent&

There is no single definition of decentrali1ation of tax revenues& The extent ofdecentrali1ation can 4e su--ari1ed in ter-s of the degree of local =or regional? controlover four factors o(nership of tax revenue, choice of tax 4ase, choice of tax rate, and taxad-inistration& )evenue o(nership is re8uired if tax revenues are to 4e seen asdecentrali1ed, 4ut o(nership is nor-ally not sufficient to vie( taxes as decentrali1ed&The revenues are 4est seen as a grant if local govern-ents only have revenue o(nership,since the rate, 4ase and ad-inistration are at the national level& In this case localgovern-ents cannot control the a-ount of revenues raised or the -eans through (hichthe revenues are raised& "any of the local revenues in "iddle astern countries like

gypt are 4est thought of as part of a grant syste- rather than as local taxes& Transfersfro- higher!level govern-ents -ay in -any instances 4e sensi4le 4oth to close the gap

4et(een (hat reasona4le tax rates can raise fro- a regionEs tax 4ase and to furthernational interests in the provision of services (ith inter5urisdictional spillovers& But

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grants should nor-ally provide only part of local revenue 4ecause govern-ents arenor-ally -ore accounta4le for revenues that they raise directly and 4ecause taxpayers are

4etter a4le to link the receipt of pu4lic services and the pay-ent of the taxes if 4oth arehoused (ithin a single govern-ent&

.ro- the perspective of econo-ic and political accounta4ility, the -ost essentialele-ent of fiscal decentrali1ation is that local or regional govern-ents are allo(ed todeter-ine the rates of taxes for (hich they are politically responsi4le, and that these taxesare sufficiently i-portant in ter-s of the revenues generated to ensure that the setting ofrates can affect expenditures in so-e noticea4le (ays& Control over the tax rate giveslocal officials the a4ility to influence the level of services provided =(hich is necessary ifgovern-ents are to 4e devolved? and -akes the- -ore accounta4le to local citi1ens (hoare 4etter a4le to see the extent of revenues going to the local govern-ents& Thus, it isi-portant that so-e taxes, and hopefully representing a significant a-ount of revenue, 4edecentrali1ed to every devolved local govern-ent& But, decentrali1ation of taxes does notnecessarily re8uire that local govern-ents -ust finance all their expenditures, and a large

role for grants and intergovern-ental transfers (ill exist in -ost developing andtransition countries&

Gocal control over tax 4ases is inappropriate in -any cases 4ecausead-inistration and co-pliance costs can often 4e reduced if the sa-e tax 4ases existacross the country& A constant 4ase -eans that 4usinesses operating across the country arenot su45ected to -ultiple tax structures& There are also lo(er ad-inistration costs if thetaxes are ad-inistered at the national level& 7o(ever, the political incentive exists forhigher!level govern-ents to give a(ay the tax 4ase of a lo(er govern-ent =for (hich thehigher govern-ent gets no revenue?, as has occurred in Bosnia and 7er1egovina, 4ecausethe higher govern-ent receives all of the political 4enefits fro- the tax incentives(ithout confronting the lost revenues& The perverse incentives are a disadvantage of localofficials not having control over their 4ase& An in!4et(een ground can 4e found 4yhaving national control over tax 4ases, 4ut (ith significant local input =even to the pointof re8uiring local agree-ent for any changes?, as exists to varying degrees in Canada,Australia, and Papua e( Fuinea&

Gocal control over the tax ad-inistration is often not necessary 4ecause in -anyinstances national collection of local and regional taxes -ay 4e -ore efficient thanesta4lishing nu-erous s-all and likely inefficient local collection agencies& There can 4eecono-ies of scale in a single ad-inistration& Co-panies operating across the countryare 4etter controlled 4y a national ad-inistration& Also, a national tax ad-inistrationallo(s for the a4ility to -ove revenue agents fro- ti-e to ti-e in order to li-it thelikelihood of fraud& Again, the potential pro4le- is that national tax ad-inistrations -aydo a poor 5o4 of collecting local taxes& The national tax ad-inistration does not have thesa-e incentives to collect local taxes and to respond to local officials as it does to theParlia-ent and the Pri-e "inister& The result can 4e that the ad-inistration puts verylittle effort into ensuring that local taxes are collected (ell& Food incentives for effectivecollection of local taxes -ust 4e esta4lished if the national ad-inistration is to collect

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local taxes& A regional tax ad-inistration -ay 4e a4le to collect so-e local taxes as (ell,given the sa-e caveats&

While the design of a good su4!national tax syste- is even -ore country!specificthan the design of a good tax ad-inistration, like the latter this task lends itself to so-e

generali1ations& .irst, at the local level, in al-ost all countries -ore use can and should 4e -ade 4oth of user charges and especially of a si-ple property tax& 3ser fees should 4e i-posed (herever possi4le to finance services& They can nor-ally 4e effectivelyi-posed (hen the recipients of services are easily identifia4le and receipt of the servicecan 4e separately identified for individuals or households& '4vious exa-ples includeutility services, (hich should 4e fully priced, and any su4sidies desired for e8uity reasons-ade explicit as pu4lic expenditures& ervices such as utilities should 4e considered for

privati1ation as (ell& Gocal property taxes should also provide a significant revenuesource& Central or regional govern-ents -ay play an i-portant role in setting up astandard tax la( and in undertaking the technical tasks of valuing property and trainingstaff, 4ut collection and enforce-ent of property taxes should likely 4e at the local level

-aking this an exa-ple of a tax that is 4est ad-inistered at the local level& In all cases,the deter-ination of the tax rate should definitely 4e at the local level, al4eit (ithin so-especified range that could 4e esta4lished 4y either the national or regional govern-ent&"axi-u- rates are particularly i-portant for non!residential property, to cur4 9taxexporting: and si-ilar (ays of 4reaking the essential connection 4et(een those (ho-ake the policy decision (ith respect to rates and those (ho 4enefit fro- the expenditureof the revenues collected& The property tax, like us

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