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New approach needed to maximise tax take in low-income countries

“Third-best” tax policies could be best to support development, IGC claims 

Developing country policymakers and the international institutions that advise them should not default to using the same tax policies that work in high-income countries but instead consider alternative approaches that work better in their contexts and that could generate more revenue, according to a new paper from the International Growth Centre (IGC), based at LSE.

Instead of taxing company profits, for example, developing country governments could consider a tax on turnover, on the grounds that it is harder to disguise total revenue and thereby evade tax. IGC research in Pakistan suggested that this approach could reduce corporate tax evasion by 70%.[i] Similarly, IGC research shows that rewarding tax collectors for bringing in more taxes, something not done in high-income countries, can significantly increase tax revenues without negatively affecting taxpayers in developing countries.[ii]

Pakistan - Tax - Currency Credit - Spencer Platt“Tax is critical for economic growth and to pay for public services. If a country wants to develop and reduce poverty, there is no viable, long-term alternative to taxation”, said Adnan Khan, research and policy director at the IGC and one of the authors of the paper, Taxing to Develop. “However, because many are using inappropriate policies, designed for different contexts, developing countries are losing out on much-needed funds.”

Tax policies used in developed countries are known by economists as ‘second-best’ because they take into account the barriers to information faced by governments in the real world, and are therefore different from the ‘first-best’ policies that would be used if policymakers had perfect information.

Over time, the implementation of these ‘second-best’ policies has enabled states with strong enforcement capacities to gather large public revenue resources. However, the same policies have fallen far short of revenue targets in developing countries where governments are not able to collect taxpayer information as effectively and face significant enforcement challenges. International Monetary Fund estimates suggest that Pakistan is only collecting half of the tax revenue it could potentially collect – losing out on approximately £22.1 billion, almost 11% of its GDP.[iii] ‘Third-best’ tax policies could help close that gap.

“In most developed countries, tax revenue makes up between 30 and 40% of GDP, while in developing countries it’s closer to 10 to 15%. So-called ‘third-best’ tax policies are generally considered inefficient by economists, but they could actually be much more appropriate for developing country contexts and raise more money to promote development,” said Khan.  

Posted 14 April 2016

Notes to Editors

[i]Production vs. Revenue Efficiency with Limited Tax Capacity: Theory and Evidence from Pakistan” (Best, Brockmeyer, Kleven, Spinnewijn, Waseem). Journal of Political Economy 123(6), 1311-1355. December 2015.

[ii] Tax Farming Redux: Experimental Evidence on Performance Pay for Tax Collectors (Khan, Khwaja, Olken). The Quarterly Journal of Economics first published online November 1, 2015 doi:10.1093/qje/qjv042.

[iii] Fenochietto, Ricardo and Pessino, Carola, Understanding Countries’ Tax Effort (December 2013). IMF Working Paper No. 13/244.

The International Growth Centre:

The International Growth Centre (IGC – www.theigc.org) aims to promote sustainable growth in developing countries by providing demand-led policy advice based on frontier research. Based at the London School of Economics and Political Science and partnership with the University of Oxford, the IGC is funded by the UK Department of International Development (DFID). 

For more information, contact:

Emilie Yam, IGC Policy Communications Manager, +44 (0) 203 486 2611, e.yam@lse.ac.uk