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Tax Policy for Developing Countries

Author: V Tanzi and H Zee
Date: 2001
Size: 9 pages (89 KB)

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Summary

Developing countries face great challenges when they attempt to establish efficient tax systems. Are taxes inevitable? How can governments in developing countries set up fair and efficient tax systems?

This paper from the International Monetary Fund outlines the main issues facing policy makers in the development of tax systems in developing countries. Their approach is based on a practical evaluation of difficulties encountered when applying the revenue procedures of industrialized countries to developing countries. Practical recommendations are made regarding both the macroeconomic (level and composition of tax revenue) and microeconomic (design aspects of specific taxes) elements of tax policy.

The authors note that in most developing countries ‘tax policy is the art of the possible rather than the pursuit of the optimal’ since governments tend to exploit whatever options are available rather than establishing rational, modern and efficient tax systems. This occurs for the following reasons:

• Income and consumer taxes are hard to calculate since employment and shopping occur mainly in the informal sector
• A lack of well-educated and well-trained staff and taxpayers’ limited ability to keep accounts hinders the establishment of efficient tax administration
• Marginal changes are often preferred over major structural changes since a lack of reliable statistics prevents policy-makers from assessing the potential impact of major changes
• The economic and political power of rich taxpayers often allows them to prevent fiscal reforms that would increase their tax burdens
• Because of these challenges, on average, governments in industrialised countries collect twice the revenue of their counterparts in developing countries.

The best strategy for sustained investment promotion is to provide a stable and transparent legal and regulatory framework and to put in place a tax system in line with international norms. Tax policy should be guided by the general principles of neutrality, equity, simplicity and efficiency. The following specific recommendations are made:

• The optimal tax level should be fixed in relation to optimal government expenditure. In general, developing countries need to raise their tax revenue
• Since market forces are increasingly important in allocating resources, the design of the tax system should minimize interference in the allocation process
• Tax administrations must be strengthened to accompany the necessary policy changes. The system should have simple and transparent administrative procedures so that it is clear if the system is not being enforced as designed
• Effective rate progressivity could be improved by reducing the number of rate brackets and reducing exemptions and deductions. The top personal income marginal tax rate should not be set too high and should not differ materially from the corporate income tax rate
• Tax incentives are not generally cost-effective
• Revenue from personal income tax should be increased and reliance on foreign trade taxes reduced without creating economic disincentives.

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Source: Tanzi, V. and Zee, H. 2001, 'Tax Policy for Developing Countries', Economic Issues, no. 27, International Monetary Fund, Washington, D.C.
Author: Howell Zee , publicaffairs@imf.org
International Monetary Fund, http://www.imf.org
Organisation: International Monetary Fund, http://www.imf.org