Among development interventions, tax reform has been widely regarded as a technical matter. Yet it can have a wider impact on development goals, improving governance and reducing poverty. This paper from the Institute of Development Studies argues that middle income countries can achieve significant results by pursuing tax reform, which could also bring indirect benefits for poorer countries.
Tax reforms can contribute to better governance and poverty alleviation if they aim to redistribute income and establish a stronger ‘fiscal social contract’ under which citizens participate in decision-making and commit to paying taxes. Such reforms could be particularly effective in middle income countries because they tend to have high levels of income inequality and unjust tax systems. They also have greater capacity than low income countries to design appropriate tax reforms that command political support. It is expected that changes in the fiscal environment and tax policies will stimulate more public debate around tax and public spending in these countries. This presents an opportunity to promote constructive tax reform, which could have an indirect effect on poorer states whose development policies are increasingly influenced by middle income countries. Aid donors could continue to play a positive role in the process.
Middle income countries are divided into three categories: former communist countries, those rich in energy and mineral resources, and ‘others’, which includes many Latin American states. While fiscal social contracts tend to be weak in all three, it is argued that circumstances for strengthening them are now more favourable, partly due to democratisation. The outlook for each is as follows:
- It is the least optimistic for resource-rich countries. Despite international initiatives to earmark revenues and improve transparency, it is difficult to prevent abuses and corruption amid the uncertainties of energy markets.
- Among former communist countries, there are two distinct groups. Those who have entered or aim to enter the European Union have little choice but to continue modernising their tax systems.
- However, in Russia, the government has not yet broadened its tax base and continues to target corporations, as under communism. The outcome is uncertain but important as it will influence neighbouring countries.
- In ‘other’ middle income countries, the picture is more encouraging. Democracy has led to greater debate around tax issues and budgets, which should strengthen the fiscal social contract.
How can international financial institutions and other aid donors support further reform? Their engagement so far has focused on relatively uncontroversial measures such as tax administration, simplifying systems and introducing value-added tax. However, for deeper reform to occur, it is necessary to:
- Address the inequitable nature of taxation in middle income countries.
- Recognise that more fundamental reform must be rooted in local politics.
- Avoid over-reliance on Western institutional and ideological positions. This has led to excessive interventionism and efforts to apply a standard set of policies that may not suit developing countries.
- Support the improvement of urban property taxation systems – hitherto neglected by donors – to raise more revenue.
- Be aware of the domestic political implications of tax and revenue prescriptions and avoid setting heavy-handed targets.
- Recognise that ‘autonomous revenue agencies’ may not be a quick-fix route to improve tax collection. They need to interact effectively with other government organisations.
