Tax reform is usually undertaken to improve tax administration or to provide economic or social benefits. This topic guide provides an overview of the limited, but growing, evidence on tax reform in developing countries.
There is increasing recognition of taxation’s role in state-building, in addition to greater understanding of its impacts on growth, inequality and the sustainability of revenues for expenditure. The key debates in tax reform centre on the trade-offs involved in achieving these sometimes incompatible objectives, and on which local, national or international tax issues reform efforts should prioritise. Specific evidence on taxation’s impact on development outcomes is as follows:
- Economic growth: There is robust evidence in high- and middle-income countries, and emerging evidence in low-income countries, that significant use of personal income taxes can dampen growth, and a shift towards the use of consumption and property taxes can in some cases be beneficial for growth. Such relationships are context-specific, modest in overall impact on growth, and mitigated by de facto implementation of tax policy. Tax incentives (i.e. tax exemptions) do not spur investment and growth, according to existing evidence.
- Sustainable revenue and reducing aid and natural resource dependence: Tax revenue (excluding that from natural resources) is arguably more sustainable, and has been more resilient during the 2008 financial crisis, than aid and natural resource tax revenue in developing countries. Though past evidence has found a negative relationship between aid and tax revenue and effort, emerging evidence, with newer data, finds no relationship.
- Statebuilding: There is some evidence to confirm taxation’s impact on statebuilding through improving state apparatus, incentivising citizen-state accountability, and providing expenditure revenue. Some local administrations that improved public administration so as to tax more, have gone on to deliver better quality public services. Increases in taxes have been linked to improvements in services or to democratic reforms; and states that tax the poor tend to prioritise basic public services over property rights, whereas states that tax the rich do the reverse.
- Inequality and redistribution: Emerging evidence finds that reducing inequality can create improved and more sustainable economic growth in the long term. However, income taxes in developing countries have been found to be relatively ineffective in reducing inequality, politically challenging to implement, and potentially harmful to growth. The poorest countries have insufficient resources to alleviate poverty through domestic income redistribution. Taxes, and in particular income and consumption taxes, can be gender-biased.
See also a visual summary in table format (PDF, 400 KB) of the evidence selected for inclusion in the Development outcomes section of this topic guide.
On approaches, interventions and tools the literature highlights the following:
- Understanding and working with the political economy context: Reform has been successful, in particular, in situations of fiscal crisis or political transition. Strategies that have helped to minimise resistance to reform and to align reform with the political economy context include: phasing in tax increases gradually; obscuring the impact of tax reforms; appealing to fairness and equity; linking reform to specific benefits; engaging with networks and institutions; building reform coalitions; and using a flexible, pragmatic approach.
- Supporting a culture of paying appropriate taxes: Tax morale, and in turn tax compliance, is linked to socioeconomic factors (e.g. age, gender, education), public perceptions of the fairness of the tax system, and the belief that tax revenue will be well spent. Efforts to support a taxpaying culture include outreach and education, improving payment and processing services, and credible measures to deter evasion and ensure payment.
- Taxing the informal sector: Taxing the informal sector, through business registration and formalisation or indirect taxation, may not increase revenues substantially. However, formalisation can encourage business growth, create a better business environment, and help build a culture of tax compliance. Firms choose to formalise largely based on cost-benefit calculations, which consider taxes and profits. Taxing firms while they remain informal can involve taxing what they buy and sell, ‘presumptive’ taxes, withholding taxes, or delegating the role of taxation to work associations.
- Local taxation (taxes, fees and charges collected to be spent locally): Local taxation can provide substantial and reliable revenue, separate from central government transfers. Local taxation has, in some cases, improved state-society relations at the local level. Suggested local taxation reforms include: simplifying processes; increasing transparency; improving payment compliance; and improving information provision.
- Aid modalities and aid-funded goods and services: No single aid modality is always most effective in shifting tax-related incentives, or in reinforcing tax systems and tax culture. Guidance suggests combining different aid modalities, adjusting them to local conditions. There is consensus that tax exemptions on aid-funded goods and services are undesirable as they can undermine tax compliance norms and systems, and increase tax administration costs.
- Capacity development for taxation: Proposals for international actors include deepening support for tax system development and for South-South cooperation on taxation issues, improving the transparency and tax compliance of multinational enterprises, and strengthening efforts to measure progress.
- Monitoring and evaluation (M&E): M&E for project evaluation and for benchmarking tax agencies tend to use ad hoc mixtures of resources and indicators. The literature suggests that indicators are best chosen in collaboration with stakeholders to ensure they are in line with tax agency priorities and are feasible to implement. Two new tools (Integrated Assessment Model for Tax Administration, IAMTAX; Tax Administration Diagnostic Assessment Tool, TADAT) provide potential indicators, as do other governance measures (e.g. OECD Tax Administration, PEFA Framework, the Diagnostic Framework for Revenue Administration).
