How can tax reform build effective states?

January 7, 2010

     By Duncan Green     

Taxation is one of those issues that usually causes the eyes of development types to glaze over. At best it’s relegated to the ‘important but braindeath’ category. When we do talk about tax, it’s often just as a way to raise money for schools and hospitals (if aid isn’t enough to do the job, that is).

This is a serious mistake. Sure, tax funds essential services, but its importance goes far beyond that, as a new paper by DFID tax wonk Max Everest-Phillips in the Development Policy Review journal argues (sorry, doesn’t seem to be any online version available – don’t you just hate that?). He starts off by quoting then South African Finance Minister Trevor Manuel:

‘Effective revenue administration contributes to a country more than simply filling its national coffers; it is an essential component of good governance. When states are obliged to bargain with their citizens over taxation, or cannot rely on coercion or external resources, then they must become more responsive to their citizens.’

States build taxation systems, but taxation also builds states (indeed modern states were largely born out of the need to create efficient tax-raising bureaucracies). So if the key to development is the combination of an effective state and active citizens, taxation is likely to play a key role, both in building the state, and in its relationship with its people.

Using DFID’s experience in promoting tax reform in Yemen, Sierra Leone and Vietnam, the paper argues that seeing taxation explicitly as an exercise in state building, rather than simply revenue raising, changes the way you do it. How taxes are raised becomes as important as how much cash the state can find.

Max E-P starts off by discussing a country’s ‘tax culture’, which in turn relies on what he calls

Low tax morale situation

Low tax morale

‘tax morale’. Between one country and another, citizens and businesses vary hugely in their attitudes to tax (just compare US and European elections….): in some they are grudgingly accepting, in others actively hostile (with the possible exception of weird bits of Scandinavia, there probably aren’t many where places where people leap out of bed in the morning actively excited at the prospect of paying their taxes).

The roots of citizens’ tax morale are pretty straightforward – is the tax system honest, fair and efficient? Does the government do good things with the money? But business tax morale is more complex, the paper argues. Often, a small formal sector bears a heavy tax burden. This creates a strong disincentive to investment and participation in the formal economy. Big companies use their political clout to carve out tax exemptions, while small ones flee the formal sector for the tax haven that is the informal economy. The result is a ‘missing middle’ – developing companies tend to have much fewer small and medium enterprises than they should. (An Oxfam paper I reviewed at the end of last year showed how this ‘missing middle’ is also starved of credit  – small business life is tough!)

This matters economically because small businesses in the formal sector tend to grow faster and employ more people than if they remain informal. And politically because it is the small business sector whose political voice is often central in moving a political system from oligarchy to something resembling democracy, but being outside the tax system means that voice is muted. In Bangladesh, less than 1% of the population pay taxes – that’s not good news for the social contract.

Early tax activist

Early tax activist

Another mess that needs sorting out is local taxation. Many developing countries have a chaotic system of local levies and taxes, many of which are coercive and hated by the population (remember Robin Hood‘s fight against the anti-poor taxes of the Sheriff of Nottingham?). Replacing detested local taxes with marginally more respected national ones can rebuild tax morale.

Overall, the key question becomes ‘how a weak state dominated by vested interests with limited tax morale and funded by a narrow tax base evolves into a liberal democracy of citizen-taxpayers with a high tax morale.’

Max E-P argues that this can be done, but only if those in charge

a) see state building as an essential part of tax reform, and so are prepared to do things that may not maximize revenue in the short term (like taxing small firms rather than keep stinging the big guys)

b) think about carrots as well as sticks. In Mauritius, the government has been successful in bringing small businesses into the tax net by offering targeted access to finance; in China, larger firms may be willing to pay higher rates of local taxation in return for more secure property rights, which allow the business to develop securely; in Liberia, over 60% of respondents who had begun to formalise were driven by the desire to avoid rampant corruption and the high unofficial ‘payments’ needed to maintain their informal status, (which also undermine the effectiveness and legitimacy of the state).

Finally, my favourite corruption stat: In Yemen a ‘taxpayer survey suggests that, while the bribe ranges between 25% and 40% of the total assessed tax amount, paying a bribe can lower the assessment by 50%.’ So at an individual level, firms keep on paying bribes even though it diverts money from government, and is disastrous for both tax morale and state building.

January 7, 2010
Duncan Green