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An optimal tax system

Tax systems in most developing countries are far from optimal. Indeed, the need for adequate government revenues without excessive borrowing is sometimes in conflict with sound economic fundamentals. Most often these tax systems end up discouraging economic activity and distorting allocation of resources.

Developing countries face formidable challenges in their attempt to establish an efficient tax system.

First, most of the work force is employed either in agriculture or in the informal sector, including a rather large segment of the working population which is self-employed. As these economic activities are seldom documented, the base for taxation is attenuated and the possibility that the government can achieve high levels of revenues is virtually eliminated.

Second, in this day and age of computerisation, efficient tax administration requires well-educated and well-trained human resources which are typically lacking in developing countries.

Third, lack of reliable information on economic activity prevents major reforms of the tax system. Most developing countries, therefore, prefer marginal changes in their tax regime over major structural changes of the tax system.

Fourth, uneven distribution of income and wealth and the conjoining of economic and political power present a formidable barrier in the quest for a progressive tax regime. Most tax systems are regressive and are largely based on consumption rather than income. In other words, revenue generation is based mainly on indirect taxes with only a token contribution of direct taxes. Consequently, the burden of taxation falls most disproportionately on labour and not enough on capital.

The thrust of our argument is that developing countries tend to exploit whatever options are available rather than strive to establish a rational, modern and efficient tax system. The above observations notwithstanding, we should attempt to outline a tax regime which is least ‘harmful’ in the sense that it does not inhibit economic activity or cause major distortions in the allocation of resources.

Let us start by looking at the level of tax revenues. What is the optimal tax level? The measure that is generally used to determine the adequacy of the level of taxation is the tax-to-GDP ratio. This is, of course, typically low for developing countries.

However, when addressing the issue of the level of taxation, we tend to ignore the important question of what the optimal level of government spending ought to be. If, as in the case of Pakistan, revenues are used largely for non-development purposes, there is little that can be said about an optimal level of taxation. If, however, state-sponsored development is accorded any priority at all, we should recognise the fact that the process of economic development creates additional needs for public spending.

It may then be pertinent to link levels of taxation with the goals and stages of economic development. Therefore, our measure of the adequacy of the level of taxation must take into account the important issue of how revenues are to be used. It is also important to understand the flip side of this proposition, that an increase in public-sector spending which contributes to a higher level of growth also increases the economy’s ability to generate more revenues.

When we look at the composition of tax revenues with regard to economic development, we are confronted with several conflicting areas. The answer to this dilemma must come from the design of the development programme and not the other way round.

The issues involve the taxation of income relative to consumption, taxation of imports as against domestic consumption, allowable depreciation which affects the cost of capital and investment etc. Above all there is also a need to keep in mind the effect of a tax system on societal welfare and equity across various groups within society. In any case, the process of economic development should itself lead to a shift in the composition of revenues from consumption to income taxes or from a relatively regressive to a progressive taxation regime.

While on the subject of a taxation system which is least ‘harmful’, we should also address the issue of tax incentives. Most development literature contemplates some role for tax incentives in development design. However, many such incentives lead to rent-seeking activity and are prone to be misused or even abused.

Tax holidays, tax credits and investment allowances, accelerated depreciation, investment subsidies, duty drawbacks and indirect tax incentives such as exemption of raw materials and capital goods from sales tax etc., are some of the tax incentive schemes that are variously used, misused and abused in developing countries.

In addition, many of these tax incentives are instituted to attract foreign capital. But for foreign capital tax incentives are usually not as important as some other factors such as natural resources, political stability, good physical and human infrastructure etc. and are, therefore, of questionable value. The sole economic reason for such incentive schemes should be to compensate for and correct ‘market failures’.

To conclude our discussion we would suggest that keeping in mind the need for ever greater revenues and the relatively small base of taxation, developing countries should strive for tax systems which are least ‘harmful’. The need to allow the market forces to determine the allocation of resources should be tampered with only where market failures are perceived to exist. The design of the tax system should reflect this concern and minimise interference in the allocation process.

The writer is a professor of economics at a private university in Karachi.

Muzaffar A. Isani, "An optimal tax system," Dawn. 2013-04-08.