Tax Reform in Developing Countries What Constitutes Successful Tax Reform? a Review of Developing Country Experience Javad Khalilzadeh-Shirazi and Anwar Shah

Tax Reform in Developing Countries What constitutes successful tax reform? 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 export 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 (tax holiday). 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 taxes 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 tax policy 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 incidence, 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 tax evasion 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 sales tax 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 tax credit 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,

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