Sources of Taxes in Less and More Developed Countries

Article by Rashid Javed

Personal Income and Property Taxes: Personal income taxes yield much less revenue as a proportion of GDP in-less developed than more developed nations. People with higher incomes theoretically pay a larger percentage of that income in taxes. It would be administratively too costly and economically regressive to attempt to collect substantial income taxes from the poor. But the fact remains that most LDC governments have not been persistent enough in collecting taxes owed by the very wealthy. Moreover, in countries where the ownership of property is heavily concentrated and therefore represents the major determinant of unequal incomes (e.g., most of Asia and Latin America), property taxes can be an efficient and administratively simple mechanism both for generating public revenues and for correcting gross inequalities in income distribution. But in a World Bank survey, in only one of the 22 countries surveyed did the property tax constitute more than 4.2% of total public revenues. Moreover, in spite of much public rhetoric about reducing income inequalities, the share of property taxes as well as overall direct taxation has remained roughly the same for the majority of developing countries over the past two decades. Clearly, this phenomenon cannot be attributed to government tax-collecting inefficiencies as much as to the political and economic power and influence of the large landowning and other dominant classes in many Asian and Latin American countries. The political will to carry out development plans must therefore include the will to extract public revenue from the most accessible sources to finance development projects. If the former is absent, the latter will be too.

Corporate Income Taxes: Taxes on corporate profits, of both domestically and foreign-owned companies, amount to less than 3% of GDP in most developing countries, compared with more than 6% in developed nations. LDC governments tend to offer all sorts of tax incentives and concessions to manufacturing and commercial enterprises. Typically, new and foreign enterprises are offered long periods (sometimes up to 15 years) of tax exemption and thereafter take advantage of generous investment depreciation allowances, special tax write-offs, and other measures to lessen their tax burden. In the case of multinational foreign enterprises, the ability of LDC governments to collect substantial taxes is often frustrated. These locally run enterprises are frequently able to shift profits to partner companies in countries offering the lowest levels of taxation through transfer pricing.

Indirect Taxes on Commodities: The largest single source of public revenue in developing countries is the taxation of commodities in the form of import, export, and excise duties. These taxes, which individuals and corporations pay indirectly through their purchase of commodities, are relatively easy to assess and collect. This is especially true in the case of foreign-traded commodities, which must pass through a limited number of frontier ports and are usually handled by a few wholesalers. The ease of collecting such taxes is one reason why countries with extensive foreign trade typically collect a greater proportion of public revenues in the form of import and export duties than countries with limited external trade. For example, in open economies with up to 40% of gross national income (GNI) derived from foreign trade, an average import duty of 25% will yield a tax revenue equivalent of 10% of GNI. By contrast, in countries like India and Brazil with only about 7% of GNI derived from exports, the same tariff rate would yield only 2% of GNI in equivalent tax revenues. One further point about these taxes, often overlooked, must be mentioned. Import and export duties, in addition to representing a major source of public revenue in many LDCs can also be a substitute for the corporate income tax. To the extent that importers are unable to pass on to local consumers the full costs of the tax, an import duty can serve as a proxy tax on the profits of the importer (often a foreign company) and only parity a tax on the local consumer. Similarly, an export duty can be an effective way of taxing the profits of producing companies, including locally based multinational firms that practice transfer pricing. But export duties designed to generate revenue should not be raised to the point of discouraging local producers from expanding their export production to any significant extent.

In selecting commodities to be taxed, whether in the form of duties on imports and exports or excise taxes on local commodities, certain general economic and administrative principles must be followed to minimize the cost of securing maximum revenue. First, the commodity should be imported or produced by a relatively small number of licensed firms so that evasion can be controlled: Second, the price elasticity of demand for the commodity should be low so that total demand is not choked by the rise in consumer prices that results from the tax. Third, the commodity should have a high income elasticity of demand so that as incomes rise, more tax revenue will be collected. Fourth, for equity purposes, it is best to tax commodities like cars, refrigerators, imported fancy foods, and household appliances, which are consumed largely by the upper-income groups, while forgoing taxation on items of mass consumption such as basic foods, simple clothing, and household utensils, even though these may satisfy the first three criteria. The conventional wisdom in recent years has been that switching to a broad-based value-added tax (VAT) would improve economic efficiency; encouraged by development agencies, such tax reforms have accordingly been undertaken in several LDCs. However, this approach has been challenged recently. In particular, welfare may be worsened when the ability of the informal economy to remain effectively untaxed introduces new distortions in the economy. The impact on human capital accumulation raises further complexities.

About the Author

Rashid Javed writes articles about economics and accounting such as national debt and income determination and final accounts.

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