Taxing times in development

15 Jan 13
While there are many ways to help developing countries move forward, building taxation capacity is crucial in maximizing the available funds for sustainable economic progress, suggest Jeffrey Owens and Petr Medvedev

By Jeffrey Owens and Petr Medvedev | 15 January 2013

While there are many ways to help developing countries move forward, building taxation capacity is crucial in maximizing the available funds for sustainable economic progress, suggest Jeffrey Owens and Petr Medvedev

The global financial crisis has changed the landscape for us all. Developed and developing economies alike are struggling to close widening deficits. But for developing countries, even in good times, dealing with fiscal challenges is an ordeal and the crisis, which has resulted in the near stagnation of investment flows, has brought the issue of domestic resource mobilization into sharp focus.

Increasing domestic resource mobilization

Developing countries need to examine forthcoming changes in the structure of development funding and look, with international help, toward viable domestic solutions. This new approach to development focuses on increasing domestic revenue mobilization, in particular by improving tax administrations. Increased revenues put economic control back into the hands of developing country states themselves, allowing them to determine and fund their own priorities.

Effective taxation achieves two objectives. Firstly, it improves the investment climate by creating a level field for all market players and secondly, it increases the revenue flow. Both of these factors provide a stable and predictable fiscal environment to promote growth and, in the longer term, reduce dependence on development aid. But taxation can also serve as a vehicle for enhancing state-society relations at the heart of a new governance contract by making the state accountable to its citizens. So how taxes are raised matters as much as how much they are raised by, and reforms which begin in tax administration may kick-start the reform process in other parts of the public sector.

This requires action on a number of fronts. On a basic level, poor countries simply lack the resources and capacity to build effective tax collection systems by themselves. Despite recent improvements in revenue-raising efforts, half of sub-Saharan Africa countries still mobilize less than 15% of their GDP in tax revenues, as against an average of around 35% in OECD countries and 23% in Latin America. This makes it difficult for the state to function properly, let alone perform wider roles such as providing social services or a better business environment.

The UN Millennium Project (2005) stated that developing countries have the potential for greater domestic resource mobilization, estimating a potential increase of about 4% over the next 10 years. But making tax systems work is easier said than done. Attitudes have to be changed. Ordinary people may be unwilling to pay tax, frequently perceiving that officials may be corrupt, and that governments consistently misuse public funds. Elites are equally hard to tax and may be able to use havens to evade taxation. It is also difficult to collect tax from low-income, agrarian economies with large informal sectors, or to avoid coercion to raise those taxes by local officials. Add to this the fact that quite a few developing countries are natural resources-dependent and more often than not do not have a proper subsoil-user taxation system and the picture is far from rosy.

International dimension

The external environment also poses new challenges. There has been an international shift away from taxes on trade, and this has added to the problems of domestic revenue-raising (African countries typically rely on trade taxes for more than 40% of their revenue). Striking the right balance between an attractive tax regime for investment and growth, and securing the necessary revenues for public spending, is a key policy dilemma.

Globalization may also exacerbate fiscal problems, as internationally mobile capital becomes more difficult to tax. Large firms and investors have increased their bargaining power over governments, forcing a “race to the bottom” among some of the most vulnerable developing countries competing to provide the most attractive tax incentives. At the same time, governments are under pressure from trading partners and local citizens to ensure their tax systems are transparent and fair.

Action by the development community

These challenges have created major new capacity needs in developing countries, which the development community has started to recognize but not to the full extent yet. Until now, support for revenue and customs sectors has attracted a relatively minimal share of aid (compared, for example, to infrastructure). Development organizations should now focus more directly in this area, seeing aid as a catalyst to the development of sustainable tax and overall public finance management systems. Assistance on taxation should be seen as an investment in the future of countries with capacity needs.

There is good evidence from Rwanda, Ghana, Georgia and elsewhere to show that aid directed at capacity development in the revenue and customs sectors in the developing world is money well spent — an important consideration given the mixed record of technical assistance in many other areas. The call for action is increasingly coming from developing countries themselves. In Africa, the creation of the African Tax Administration Forum (ATAF), driven, managed, and over time operationally funded by the Africans themselves, provides a key platform for peer learning, capacity development and dialogue on domestic and international tax issues. Launched in 2009, ATAF is already bearing fruit — expressing African needs, supporting African administrations and providing a single African voice in the global debate.

From an international standpoint, we cannot ignore the billions of dollars in tax revenues lost by developing countries through capital flight and the use of basic tax structures that are not captured by underdeveloped domestic laws. But again, there is some good news. With

the support of the G20, more progress has been made in the last few years in combating bank secrecy as the shield for offshore non-compliance than in the previous decade. This provides a basis for addressing illicit flow, tax evasion, avoidance and tax havens. Over 100 countries have committed to transparency and exchange of information standards and are in the process of implementing them.

Tax information exchange agreements are a necessary step forward, and over 700 of these have now been signed. The same applies (albeit on a smaller s cale) to new double tax treaties that developing countries are signing with the developed world.

The development community needs to act to ensure all developing countries are better integrated in global trade and can take advantage of the more transparent international environment. Strengthening their tax systems, supporting them in their development of tax policies and reforms of tax administration should be key priorities going forward.

Jeffrey Owens is Senior Policy Advisor to Ernst & Young’s Vice Chair-Tax. Petr Medvedev is Emerging Markets Tax Leader, EMEIA, and serves as Global Tax Account Leader to the World Bank Group at Ernst & Young.

This article first appeared in the December issue of Ernst & Young's Dynamics magazine

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