Impacts of tax capacity on development outcomes 

Question

Where has reformed tax policy had the most impact in terms of broader developmental goals?

Summary

There is increasing recognition that strong tax systems can have impacts on economic growth, the sustainability of revenues for expenditure, state-building, and inequality, although there are debates about the trade-offs to achieving these differing and sometimes incompatible objectives. Tax revenue appears to be more likely to be used to support broad development goals than revenue from grants (Gadenne, 2015) or from natural resources (Prichard et al., 2014). However, state capacity improvements and civil society engagement are important to help ensure that tax revenues improve development outcomes (Prichard, 2010).

Key findings

Evidence about the impact of tax reform on development outcomes includes:

  • Economic growth: There is robust evidence in high- and middle-income countries, and emerging evidence in low-income countries, that personal income taxes can dampen growth, and that a shift towards consumption and property taxes can in some cases be beneficial for growth. Such relationships are context-specific, modest in overall impact on growth, and depend on how tax policy is actually implemented. There is some evidence that increased effectiveness of tax systems is positively linked with GDP growth. The evidence available on tax incentives (exemptions) suggests that they fail to encourage investment and growth.
  • Sustainable revenue and reducing aid and natural resource dependence: Tax (excluding revenue derived from natural resource rents) is arguably more sustainable, and has been more resilient during the 2008 financial crisis, than aid and natural resource rents in developing countries. Though past evidence has found a negative relationship between aid and tax revenue and effort, emerging evidence, with newer data, finds no relationship.
  • Statebuilding: There is growing evidence showing that taxation has a positive impact on statebuilding by strengthening state administrative capacity, incentivising accountability, and providing revenue for state expenditure. Some local administrations that improved tax capacity have gone on to deliver better quality public services. Increases in taxes have been linked to improvements in services and with democratic reforms, and states which tax the poor tend to prioritise basic public services over property rights, whereas states that tax the rich do the reverse.
  • Inequality and redistribution: Emerging evidence finds that reducing inequality can create improved and more sustainable economic growth in the longer term. However, income taxes have been found to be relatively ineffective on redistribution, politically challenging to implement, and potentially harmful to growth. The poorest countries have demonstrably insufficient resources to alleviate poverty through domestic income redistribution. Taxes, and in particular income and consumption taxes, can be a source of gender bias.

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Suggested citation

Lucas, B. (2017). Impacts of tax capacity on development outcomes. K4D Helpdesk Report. Brighton, UK: Institute of Development Studies.