Taxing Times

Benjamin Franklin very famously wrote that ‘in this world nothing can be said to be certain, except death and taxes’.

I love a pithy turn of phrase but Franklin clearly wasn’t talking about Africa. Matt’s recent post about using revenue distribution and taxation to avoid the natural resource curse in Ghana turned me to think about taxation systems.

Let’s start from a simple premise. My vision of aid for development is not that it should ultimately provide the basics of a good life to all the world’s poor. Rather, it should help their Governments, private sectors, civil societies and private individuals develop their own capacity to provide, sustain and improve these basics.

For the institutions mentioned above to perform functions themselves they must have a revenue source with an inherent logic and sustainability. For private individuals this means a wage or ownership of resources that generate a rent. For private industry and business, this means revenues and profit from the undertaking of business.

For a Government it means tax revenue. And taxes are a very good thing, not just because they give the Government room to spend:

  • Eventually, everything aid currently does for or with Governments should be undertaken through domestically generated revenue, largely tax; this revenue gives full flexibility for locally constructed and executed policies
  • It stimulates accountability. Accountability in a Government powered by aid runs to donors. In a country run through taxation it goes from Government to the taxed: i.e. the general population – hence, ‘no taxation without representation’.
  • Taking this argument further, others suggest taxation is an essential component of state building
  • A bad taxation system, one that depends disproportionately on taxes that are easy to collect, is often regressive. This means the poor suffer more, and it is inefficient at raising revenue. Taxation systems in Africa typically depend heavily on Value Added Tax – a regressive tax.
  • A good tax system can be a tool in incorporating into the legal framework the vast ‘informal’ economic activities that characterize developing countries: activities that have assets but no capital because they are not part of a formal property system. De Soto marks this as the greatest problem in development.

Unfortunately, many African countries have poor or ineffective taxation systems, which are so partly because of their structure, partly because much of the economy is hidden (in a legal sense) from the state, and partly because the structures that do exist have a fair few holes through which revenue slips. Aid is also culpable. Governments rely less on tax than they should because aid fulfills the most important functions of tax from a Government (but not civil society) perspective, weakening the incentives for creating a strong tax structure.

Despite this, tax structure is not high on the donor agenda. It’s avoided partly because it is not an easy sell. The revenue collection agent will never knock the cute child in a classroom off the front cover of a development report. It is also partly because the incentives for Government are weak: they get some tax from the ‘easy’ taxes such as VAT. This finances a fairly large chunk of their activities. The rest comes from aid. Why introduce unpopular taxes when aid will come to the rescue?

Donors do get more heavily involved in tax collection issues, sometimes through the setting of targets. In countries where regressive taxes are more important than progressive income taxes, as in much of low-income Africa, this may actually harm the poor.

Newer donor practices do look a bit at tax structure, but from my experience, it is not given enough importance: rarely, for example, is reform of the tax structure a General Budget Support conditionality (I’m not advocating for greater conditionality, but simply pointing out an indicator of its relative importance). We can argue it should be a purely domestic debate, but really, it’s an economic and distributional issue, just like a lot of other things donors get involved in.

And what is a strong tax structure? One with clear rules, clearly articulated, which are progressive and incorporate all or almost all of the population in the tax structure (though not all will be taxed); which is based on sound information on the tax base; one which is backed by a culture of taxation and trust in the system which is built over time from the rules; one which is enforced transparently and without undue bureaucratic discretion; and which has a coercive (legal) fall-back in cases of evasion. Unfortunately, these things will all require time and support to put in place: little of either has been granted to developing countries.

The upshot of this is tax systems that continue to face serious challenges. Chief among these are:

  • The vast unenumerated economy, which is invisible to the legal system. These are the businesses that we who live in the developing world use and see every day: newspaper vendors on the street, fundi’s in Tanzania and Zanzibar who do all kinds of odd-jobs, even some construction companies, garages and manufacturers. Some are part of complex and high-revenue businesses. All choose retreat from the legal structure, sometimes because it is too cumbersome to formally register a business, sometimes to avoid taxation
  • The amount of informal and piece-work that is done in developing countries means much of the labour force is untaxed. I’m not saying we should bleed them dry, but some earn enough to justify low taxation – and this will increase their stake in demanding accountability from their Government
  • As mentioned, in response to these issues Governments aim to collect the easiest tax to gather: the flat rate VAT, with regressive results
  • Creative accounting (or non accounting). Some businesses offer you the chance to avoid VAT by saying ‘you get a lower price if you don’t want a receipt.’
  • Capital flight and tax evasion by large businesses. In 2008, a press release from the African Tax Justice Network claimed “Since the 1970’s … Zambia has lost 19.8 billion dollars in capital flight representing 272% of the debt stock as at 2004.” (I haven’t checked these figures, but it seems the volume of lost revenue is high, even if we account for press-release exaggeration)
  • Donor tax practices: It baffles me why extremely well-paid donor officers also get duty-free cars. I’ve had this option twice in my contracts but have not taken it. It creates a parallel market in cars for expats, and there’s no logic to it – maybe for projects it makes sense, but I’ll sell my car at the end of my contract at a price reflecting the duty paid. Why create the parallel market and deny the Government legitimate revenue? This effect is probably small, but infuriating.

There is a great deal of interesting literature out there about the social constructions, technical structures and practical problems of tax collection in Africa. If you’re interested, two reports from 2003 and 2004 were produced by the Christian Michelsen Institute, based on a research project. Both are worth reading. Also in 2003, the IDS looked at the interplay between culture and tax collection efficiency. You can find others online.

Taxation isn’t exactly a hot issue in development, but if we’re serious about being sustainable with our aid programmes, and about stimulating democratic accountability in Africa, then it really should be. The next time you’re in a meeting about economic policy, an IMF Programme meeting, a Budget Support governance meeting, or a national planning retreat, ask some questions about the tax structure. Remind people that ultimately, that’s where the money for Government work should be coming from.

2 thoughts on “Taxing Times

  1. Ryan

    October 23, 2009 at 6:45pm

    I am very glad to see someone writing about this. I can’t help but think that there are a lot of ways that aid can be used to incentivize tax collection. The best example off the top of my head is a system where aid to a government is pegged to the amount of tax that the government raises.

    Aid can obviously replace taxation in some cases, but I imagine that this is partially a product of how aid is given and that it is not simply the result of external funding.

  2. Ranil Dissanayake

    October 24, 2009 at 9:45am

    Hi Ryan, thanks for the comment.

    While I agree that aid is not necessarily bad for taxation (we should bear in mind that for the most recent year the full data is available via WDI, very few African countries had more aid than taxation revenue), I don’t think that linking aid to tax revenues is the best way forward.

    This kind of approach (tax revenue targets) has been tried before, and research seems to suggest it may have an ultimately negative effect: because tax *structures* are still quite poor, and heavily skewed towards VAT, such targets may actually be especially anti-poor.

    where I think aid and donors can help is in reforming the tax structure along side the information base and revenue collection and enforcement systems. Just changing the tax structure won’t help, because of the unenumerated economy. You also need to somehow codify and legalise all of that activity. Then you have the basis for a true system of taxation which can stimulate accountability.

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