The FINANCIAL — 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.
“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.
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