Tax neutrality – taxation which does not distort the market – is a common structural reform condition of World Bank and International Monetary Fund (IMF) lending. Is it necessarily a desirable policy?
A paper from the Centre for Tax Policy and Administration of the Organisation for Economic Cooperation and Development (OECD) suggests that such policies may not be optimal in all cases. Tax neutrality is advocated on the basis of two assumptions which may not hold for low-income countries. (1) The pre-tax economy allocates resources efficiently and taxes can only reduce efficiency; (2) a wide range of policy instruments are available, including taxes on any transaction and direct payments to households (tax allowances and welfare payments). Taxation strategies are analysed with respect to the specific difficulties faced by low- income countries; recommendations include a broader tax base, modest trade taxes and land or land improvement taxes.
- Current revenue patterns show a reliance on non-tax revenues (typically from mineral deposits), trade taxes and company income tax, reflecting the difficulty of administering personal or social security taxes.
- Simplified personal income tax is recommended: a single rate with a high exemption threshold is more effective than a multi-tier system with high marginal rates.
- Market failures, especially in labour and capital, mean that the pre-tax economy is frequently not efficient, so appropriate taxation can improve efficiency.
- Uniform sales taxes combined with direct payments to households can be less distortionary and more redistributive than differential taxes, but are not optimal where direct payment mechanisms do not exist or are ineffective.
- ‘Benefit taxation’ charges landowners for government spending which increases their land value. If well-designed, these taxes encourage participation by benefiting the recipients, and are an effective means of financing infrastructural investment.
Since tax neutrality is not always the optimal solution, policy recommendations should be tailored using country-specific data. Such data are often non-existent or out of date, but the costs of collecting them are likely to be outweighed by the benefits of a better tax system.
- Trade taxes can generally be replaced by sales taxes, which remove market distortions and broaden the tax base without affecting consumer prices; however, the inability to collect taxes on agricultural transactions means that modest trade taxes may in fact be optimal.
- Value-Added Tax (VAT) can replace commodity taxes, broadening the tax base to include services; it can be difficult to administrate, but a single rate with sectoral exemptions such as small-scale agriculture can simplify administration and avoid regressivity.
- Tax incentives for inward foreign direct investment (FDI) can be effective, though it is questionable whether the increased FDI can justify the revenue foregone.
- Non-uniformities in sales taxes are recommended as pro-poor measures in the absence of mechanisms of direct payment to households, but they must be well-targeted, using reliable data on local consumption patterns.
- A differential tax regime may be abused by interest groups who lobby for their own benefit rather than for general growth and poverty alleviation; attention must be paid to issues of political economy.
- Land or benefit taxation may raise administrative difficulties as well as political opposition, but given its revenue potential and the fact that other tax instruments face similar difficulties, it is recommended for consideration.
