Developing countries could be missing out on substantial tax revenues as a result of ill-suited tax policies, research from the International Growth Centre based at the London School of Economics has shown.

The IGC found that developing countries could be overlooking some of the most effective tax policies for their economies because they run counter to current ideas of sound tax policy, advocated by literature and institutions like the International Monetary Fund, and designed around conditions in advanced economies.

Adnan Khan, research and policy director at the IGC and one of the authors of the report, said that developing countries could be losing out on much-needed funds as they employ “inappropriate policies, designed for different contexts”.

He said today’s tax policies are based on the assumption that authorities face some informational and enforcement barriers to tax collection, which is true in even the top tax collectors like Denmark, which has the world’s highest tax-to-GDP ratio.

An example would be self-employed workers who report their own tax information, which is harder to verify and easier to manipulate.

However, in developing countries, where a significant portion of their economies are made up by the unregistered or informal sector, a much larger proportion of tax information is self-reported and not easily verifiable. This prevents tax authorities from comparing information to uncover discrepancies or detect evasion and represents a significant barrier to effective collection.

The IGC argues that policies that take into account such constraints on tax authorities’ enforcement capacity might be a much better fit for developing countries.

For example, IGC research found that taxing firms on turnover, rather than profit in Pakistan could reduce domestic corporate tax evasion in the country by 70%.

IMF estimates suggest that overall, Pakistan is currently only collecting half of the tax revenue it could potentially collect, losing out on approximately £22.1bn, almost 11% of its GDP. The IGC said policies that take into account Pakistan’s enforcement barriers could close that gap.

Khan explained to Public Finance International that taxing turnover would technically create an inefficiency and distort the production process. However, he continued: “That inefficiency is counterbalanced by revenue gains, which outweigh the losses from the production distortion.

“This is a very clear example of where what the literature suggests and what international institutions also advocate has not been studied in terms of the concerns actually faced by tax authorities in developing countries.”

Because of the related inefficiencies and distortions, such policies and their potential benefits are often overlooked in developing countries, not extensively studied and therefore often not recommended by institutions that guide developing countries on their tax policy, such as the IMF and World Bank.

“We’re not saying the IMF or the World Bank are wrong,” Khan stressed, noting that such policies are not effective in every circumstance.

“We come up with new insights, sometimes they go along with what we already know and show this is true. In other cases we get counterintuitive results.

“We’re saying there is not enough of an evidence base out there for anyone to base their policy advice on,” he continued, calling for “a different kind of approach to issues of taxation in developing countries” that takes their unique challenges into account and establishes the best approach for each context.

The IGC’s research also showed that in countries where enforcement capacity is weak and threats of punishment to tax evaders are less credible, there may be better approaches to encouraging tax payers to pay up.

These include leveraging social incentives and pressures. For example, an IGC study in Rwanda found that encouraging customers to request receipts from retail stores in Kigali increased their use of electronic billing machines, which in turn increased VAT receipts and reported taxable revenues.

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Taxing to develop – When ‘third-best’ is best

Taxes are a channel of reciprocal exchange between citizens and governments. Taxes increase government accountability, encourage better governance, public service delivery and enforcement of law and order for the protection of citizen rights – essential ingredients for economic growth. Without widespread monitoring and reporting systems to capture and verify financial transactions, many developing country tax systems generate low tax-to-GDP ratios. Effective tax policies must also address tax morale and administration.

Inability to tax is both a symptom and cause of underdevelopment. In countries with large informal economies, tax policies must account for gaps in monitoring, reporting, and administration to overcome barriers to tax enforcement and collection. Developing country governments are often characterised by poor public service delivery. Without the benefits of public goods and services, citizens have few incentives to pay taxes.

This brief presents a rethinking of tax policy. Traditional tax models assume a ‘second-best’ approach where, in the absence of perfect information (‘first-best’ conditions), tax authorities face some informational barriers to tax collection. Our approach, characterised as ‘third-best’, assumes that developing country tax authorities face severe informational barriers and significant enforcement constraints.

KEY MESSAGES

1. Overcoming barriers to tax policy enforcement requires greater access to information. Large informal economies with limited digital coverage of financial transactions make monitoring, verifying, and enforcing tax liabilities a challenge in developing countries. Policies must address enforcement gaps and strengthen information trails.

2. Third-best policies, inefficient in developed countries, may prove efficient in developing countries. The barriers to information and enforcement that plague developing countries require experimentation and policy innovation. Although taxes of inputs, turnover, and trade, are traditionally considered production inefficient, gains in revenue efficiency may significantly offset losses from production efficiency.

3. Harnessing social incentives may increase compliance. Non-monetary incentives affect tax morale and compliance. Harnessing social and non-monetary incentives may provide a cost-effective mechanism for raising compliance.

4. Motivating tax collectors could bridge wider enforcement gaps. Effective administration systems are crucial to tax collection. Smart interventions like pay-for-performance can incentivise better performance by tax collectors.