Reform in Developing Countries What constitutes successful ? A review of developing country experience Javad Khalilzadeh-Shirazi and Anwar Shah

Tax reform has become an increasingly im- March 1990. This article aims to highlight the development, savings, investment, employ- portant element of adjustment programs in main themes that emerged and .the conclu- ment, and promotion. A common prac- developing countries supported by the World sions of the discussions. tice is to levy preferential tax rates, or provide Bank and IMF. Balance of payments disequi- exemptions or special deductions for the pre- libria often have their origins in inappropriate Impetus for reform ferred activity. Revenue foregone to encour- fiscal policies, and there is a growing recogni- The review of tax reform experiences age specific activities is termed a "tax expen- tion that fiscal imbalances cannot be ad- indicates that tax structures in most develop- diture" in the public finance literature. For dressed simply by curtailing expenditure. ing countries are: example, to promote investment in less devel- Moreover, tax systems of many developing • complex—difficult to administer and oped regions, many countries allow an initial countries are often distortionary and also con- comply with; tax-free period (). However, given tribute significantly to distributional prob- • inelastic—unresponsive to growth and poor compliance and enforcement, such mea- lems. Restructuring tax systems is thus per- the changing structure of economic activity; sures are often ill-suited to achieving individ- ceived to be critical for the success of • inefficient—introduce serious economic ual policy objectives and simply lead to in- both macroeconomic and structural reform distortions while often raising relatively little creased inefficiency as other activities have to policies. revenues; be taxed at even higher levels. A World Bank research project, initiated in • inequitable—treat individuals and busi- In recognition of these factors, many coun- early 1988, examined the experience with tax nesses in similar circumstances differently; tries have been reforming and many more reform in ten developing countries with a and have begun to critically evaluate their tax view toward drawing lessons for other coun- • unfair—tax administration and enforce- systems. The broad goal of tax reform is to tries contemplating similar reforms. The ment are selective and favor those with the secure an efficient tax system based on countries included in the study were Bolivia, ability to defeat the system. that are politically feasible and administra- Colombia, Jamaica, Indonesia, Malawi, Most developing countries also face a com- tively practicable, and produce sufficient rev- Mexico, Morocco, the Republic of Korea, mon set of fiscal problems. There is a heavy enue with a minimum of economic distortion. Turkey, and Zimbabwe. The results of the reliance on import duties and export taxes, Although the scope for tax reform varies project, as well as of recent Bank research on which undermines their long-term interna- from country to country depending on the na- a number of specific issues, were tional competitiveness, while the potential to ture of the initial tax system, administrative reviewed at a conference held at the Bank in raise revenue through consumption taxes is constraints, and the governmenf s social and not exploited. Agricultural incomes, fringe economic priorities, some general conclusions benefits, and, in some countries, public sector about the appropriate direction of tax reform wages are not taxed, while taxes on unearned can be drawn from the experience of the ten The World Bank hosted a conference in March income, property, and wealth contribute only countries mentioned above. 1990 to review tax reform experiences in develop- a small proportion of total revenues. As a con- ing countries and to discuss a range of issues—in- sequence, personal and corporate income Lessons from tax reform cluding taxation of foreign investment, resources taxes are levied on narrow tax bases at high Broadening the tax base and and financial institutions, design of indirect taxes, rates. lowering tax rates should be the fore- , tax policy models, and tax policy and economic growth—that are expected to dominate The existing tax systems are also widely most goal of any tax reform initiative tax policy discussions in the 1990s. A conference used to advance wide ranging and often con- in developing countries. Developing volume edited by these authors wiHsoon be pub- flicting economic policy objectives, such as countries typically levy high tax rates on nar- lished by the World Bank. revenue enhancement, industrial and regional row bases, encouraging and com-

44 Finance & Development /June 1991

©International Monetary Fund. Not for Redistribution promising the fairness of the tax system. ports. Further, to enhance overall economic shift of resources to tax preferred activities, Broadening the tax base can generate higher performance, tax reform should be integrated thus ultimately reducing the tax base. Thus, revenues, while also providing similar tax closely with overall structural adjustment in devising tax policies to meet economic and treatment to various activities and individuals measures. social objectives, potential gains must be in similar economic circumstances. The distri- Improved tax administration is a weighed against the potential losses in effi- bution of tax burden among income classes is prerequisite for the success of tax re- ciency and revenues that might be associated also improved by curtailing tax preferences form. In developing countries, the success in with these measures. Recently, Colombia, that, for the most part, benefit the rich. broadening the bases of existing taxes and Mexico, Indonesia, and Jamaica have intro- Lowering tax rates mitigates the disincentive having lower tax rates continues to be com- duced reforms to curtail the use of the tax sys- effects of taxation. promised by tax administration difficulties. tem for nonrevenue goals. The value-added tax (VAT) should The apparent lack of success in this area is at- Tax reform must take into account form an important element of an tributable to several factors: selective and lax initial conditions at home and abroad. agenda for reform in devel- enforcement practices; ineffective tax admin- In reforming their tax systems, developing oping countries. A broadly based sales istration, in part, due to political inertia; insti- countries are severely constrained not only by (consumption) tax of the value-added type can tutional and political difficulties associated their own institutional settings but also by the raise a significant amount of public revenues with bringing agricultural income into the tax tax structure in capital-exporting countries. in a nondistorting manner. The tax also pro- net; and a disenchantment with income taxes For example, the US foreign regime vides an impetus for higher savings. While as revenue instruments in an environment impedes the adoption of a cash-flow system of the overall distributional implications of such where tax evasive behavior is the rule rather taxation (a system where all expenditures are a tax are not clear, the component of VAT than the exception. Thus, it is important to deducted from the income base in the same that falls on imports is expected to reduce concurrently reform tax administration while year they are incurred) in developing coun- rents accruing to the wealthy recipients of im- attempting to restructure the tax system. tries. This is because, under such a system, port and foreign exchange licenses. A VAT The use of the tax system for nonrev- taxes paid to developing nations by US in- can further assist in improving the collection enue objectives (e.g., tax preferences vestors cannot be credited against their home of other taxes by creating a verifiable record for specific investments) should be tax liabilities. Notwithstanding this, domestic of transactions through production and distri- curtailed. While the tax system can legiti- circumstances may be such that a complete bution channels. This potential, though, has mately be used to further social and economic redesign of tax systems could lead to serious yet to be exploited by a developing country. goals, such a use often leads to a major drain transition difficulties. Developing countries The adoption of a VAT has been successful in on the national treasury by conferring wind- must, therefore, take initial conditions at raising additional revenues and reducing the fall gains on existing activities or through a home and abroad into account to ensure that efficiency costs of taxation in Indonesia, Turkey, Brazil, Colombia, Mexico, Korea, and Malawi. Of course, the implementation of a VAT in developing countries raises special difficulties. A VAT is unable to encompass Indonesia's tax reform experience the large number of economic activities that are carried out in the informal sector in a typi- cal developing country. Further, to keep the Prior to 1983, Indonesia derived less than one third of its revenues from non-oil sources. Over the poor out of the tax net, basic foods and neces- years, the tax system was unsuccessfully used to accomplish nonrevenue objectives, such as re- sities are usually exempted, creating adminis- gional and industrial development and developing an egalitarian society. In the process, most rev- trative complexities. Inter-regional cre- enue sources, especially income and sales taxes, were subject to multiple rates on narrow bases. A ates its own special problems for VAT lax tax administration compounded these problems further. While the inadequacies of the lax sys- administration. Simple alternative rules are tem were recognized, growing oil revenues served to detract attention from the urgent need for re- form. The oil crisis of the early 1980s, however, provided an impetus for diversifying revenue adopted to provide interstate tax credits on sources. Against this backdrop, the tax reform measures introduced in 1983 emphasized raising rev- such trade. A VAT is also not considered su- enues through broad-based consumption taxes and improvements in tax administration. This was perior to a well-functioning retail sales tax in to be achieved, however, by minimizing tax induced distortions in resource allocation and protect- small island-type economies that have a nar- ing the poorest of the poor from the tax net row manufacturing base and depend heavily A value-added tax was introduced along with a luxury sales tax. Personal and on cross-border trade. bases were broadened and subjected to lower nominal tax rates. A three-rate structure (15 percent, Coordinated tax reform offers sig- 25 percent, and 35 percent) applicable to income from all sources replaced 17 personal nificant advantages over isolated rates and 3 business income tax rates. Most special tax preferences were eliminated, but the basic piecemeal tinkering with the tax sys- exemption level for personal income laxes was increased to remove nearly 90 percent of the popula- tem. A coordinated reform ensures consis- tion from the reach of the income tax. Indonesia's tax reform strategy had a measurable degree of success in meeting its stated objec tency of individual tax changes with the over- rives. In just three years, non-oil revenues as a share of GDP rose nearly 50 percent. This success is all objectives. For example, a reduction in largely attributable to the introduction of a VAT. The VAT also eliminated the cascading effects of tariffs without a corresponding increase in earlier sales taxes and preferential tax treatment of imports over domestically manufactured goods. other taxes can increase the fiscal deficit and Further, business inputs and were spared from taxation. exacerbate macroeconomic difficulties. A co- Indonesia carried out major changes in its tax system over a three-year period. Its experience ordinated reform of these taxes would com- demonstrates that a developing country with the political will to undertake a major overhaul of its bine reductions in tariffs with an offsetting in- tax system can succeed in reaping significant economic benefits from such an initiative. crease in consumption taxes that would apply equally to both domestic production and im-

Finance & Development /June 1991 45

©International Monetary Fund. Not for Redistribution the reform effort will succeed. wholesale reform. The pragmatic course is of- newly industrialized countries such as Korea, The impact of tax policy on international ten to strive for incremental reforms in a con- there is considerable potential for revenue en- competitiveness has not received much atten- sistent manner over time. Historical consis- hancement from the broadening of bases. In a tion in tax reform analysis. It appears that de- tency of tax reform, while desirable, is federal country, the way powers of taxation veloping countries are often engaged in difficult to attain in practice. In Colombia, for are assigned among levels of government typ- wasteful by offering an in- instance, a net was considered an ically constrains tax reform choices. For ex- creasing array of incentives to foreign in- important progressive element of taxation in ample, in India, the introduction of a federal vestors, while not paying adequate attention the 1974,1986, and 1988 reform episodes, but VAT is being constrained by state level oppo- to the tax regime that a potential investor it was repealed in 1989. Similarly, broadening sition. States are worried that a federal VAT faces in his home country. An investor from a the income tax base, when accompanied by would leave them less discretion to set state country with a worldwide system of taxation the lowering of tax rates, does not invite sig- and local sales taxes. In Pakistan, the octroi can be taxed by the host country at the home nificant opposition to forestall reform. If, how- tax, which is a tax on inter-regional trade, country , for instance, the US tax rate, ever, after introducing these changes, tax could not be repealed as it is a significant without adverse incentive effects. Further, the preferences are later restored to appease spe- source of local revenues. Land taxation is no host country must ensure that income is not cial interests, the initial tax reform effort longer an important source of revenue for de- shifted to low-tax countries or to tax havens would have contributed to a deterioration in veloping countries. This need not be the case through (i.e., pricing intracor- the budget as, in the final analysis, lower if local governments are given access to this porate transactions in such a way so as to rates would be applicable to a still narrower revenue source. A local land tax would be attribute most of the profit to a low-tax base. seen as a user charge for local public services location). Tax changes also create winners and and, therefore, offers potential for raising sub- The credibility of the tax regime is losers. Each tax change introduces some effi- stantial amounts of revenue in a nondistort- the key to the success of any tax re- ciency and vertical equity (i.e., a relatively ing manner. form. A stable tax policy environment en- higher tax burden on higher income classes) Tax administration plays a key role and, courages businesses to take a longer-term tradeoffs that must be recognized and appro- therefore, tax policy advice must consider perspective in their finance and investment priately addressed. In developing countries, current administrative practices and what po- decisions. Making tax changes without giv- this situation is dealt with by using exemp- tential there may be for improvement. ing adequate consideration to transitional ar- tions. It is important to identify gains and Experience suggests that compartmentalizing rangements can undermine the credibility of a losses by income class, by geographic region, public policy in various departments (or even tax regime. Therefore, transitional arrange- and by political affiliation so that the long- various branches of the same departments) ments require much more careful analysis run viability and sustainability of reform limits tax reform options. For example, in than they have hitherto been given in devel- measures can be objectively evaluated. Short- none of the countries studied were tax and oping countries. Greater attention to prepara- term tax measures to meet nonrevenue objec- transfer options considered simultaneously. tion, analysis of reforms, advance consulta- tives should be avoided, as they create strong The range of choices was restricted to alter- tion, as well as providing a reasonable period political constituencies wedded to these mea- native tax instruments, and direct expendi- of adjustment prior to implementation, grand- sures. A comprehensive reform offers some ture options were excluded. fathering provisions, and historical consis- possibility of balancing the gains and losses The local political and civil service elite in tency of tax reform would establish business of various groups, an opportunity that does the country must assume the "ownership" of confidence in the credibility of the tax regime. not usually arise in piecemeal reform. the proposals if the reforms are to succeed. In general, a stable tax regime should be the Country experiences suggest that tax re- Further, participation by local experts in the goal, and frequent tax changes should be form proposals must be viewed in the context design of the reform enhances chances for its avoided. of the economic and institutional setting of success as they are a better judge of the polit- the country in question. For example, in low- ical pulse of the country. The success of tax Political economy of tax reform to middle-income countries, such as reform in Colombia and Malawi can partly be Tax reform is often a sensitive and difficult Colombia, Indonesia, and Malawi, revenue attributed to the trained core of local experts process. Since the gains from comprehensive gains from the broadening of income taxes that worked closely with foreign advisors. reform often become visible only in the are expected to be modest, and VAT is there- The way to increase compliance is to make medium to long term, it is a major challenge fore expected to be the mainstay of the rev- sure not only that the people are consulted on to form a political coalition to carry through a enue raising effort. On the other hand, in the reform proposals but also that they are given a clear idea about how—and on what—the money will be spent. In Malawi, there was a wide consultation process on in- Javad Khalilzadeh- Anwar Shah come tax changes to gauge taxpayer reaction Shirazi/ro»z Iran, is cur- from Pakistan, is a Senior rently Chief of the Bank's Economist with the Bank's before the proposals were finalized. This India Country Operations Public Economics Division. helped to ensure that the final reforms were Division and was formerly He has published widely on acceptable to a majority of the affected popu- Chief of the Bank's Public tax and expenditure analy- lation. Economics Division. sis and environment and Finally, whatever choices may be made on macroeconomic policy the path to reform, it helps to have a coherent issues. overall plan in place before implementation begins. Further tax reforms must be re- sponsive to changing economic and social conditions.

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©International Monetary Fund. Not for Redistribution