## Enhancing domestic tax capacity is essential for strengthening social protection and developing human capital

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**Canonical URL:** [Enhancing domestic tax capacity is essential for strengthening social protection and developing human capital](https://www.imf.org/-/media/files/publications/fandd/article/2018/december/taxes-and-social-protection-coady.pdf)

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### Key challenge: large informal sector and revenue mobilization
- The informal sector is typically characterized by high levels of self-employment, low skill levels, and often multiple and volatile sources of income, which limits the potential to raise revenue by taxing income—especially from lower-income groups—and increases reliance on general government revenue for social insurance.
- Recent research finds that countries move to a higher growth path once tax revenue reaches about 15 percent of GDP (Gaspar, Jaramillo, and Wingender 2016).
- About half of low-income countries—and a third of emerging market economies—have tax ratios below this 15 percent threshold.
- Low tax ratios result in low levels of social spending.

### Evidence of revenue gains achieved by countries
- Countries that have significantly increased tax revenue in recent years (examples with exact reported increases and periods):
  - Georgia: increased tax revenue by 12.9 percent of GDP during 2004–08.
  - Maldives: raised revenue by 11 percent of GDP during 2011–15.
  - Dominica: 7.5 percent during 2002–06.
  - Ghana: 7.3 percent during 2000–04.
  - Mauritania: 6.1 percent during 2010–14.
  - Mozambique: 6.1 percent during 2007–11.
  - Guinea: 5.8 percent during 2008–12.
  - Malawi: 5.7 percent during 2003–07.
  - Cambodia: 5.0 percent during 2012–16.

### Typical tax reforms and instruments
- As countries modernize tax systems, they typically:
  - Expand broad-based consumption taxes and selective excise taxes.
  - Prioritize the development of progressive income tax systems.
- Broad-based consumption taxes:
  - Increased revenue from consumption taxes, especially value-added tax (VAT), has been the main driver for most countries that significantly increased tax ratios.
  - C-efficiency (ratio of actual VAT revenue to potential revenue if all consumption were taxed at the standard rate) measures how close a government comes to collecting tax on all consumption; recent VAT revenue rises have been driven primarily by improvements in C-efficiency rather than by increasing tax rates (Keen 2013).
- Greater reliance on excise taxes:
  - “Corrective” excise taxes on energy, alcohol, tobacco, and sugar-sweetened beverages—levied on top of VAT—can be efficient revenue sources and reduce negative health impacts.
  - Excise taxes provide an administratively feasible way of increasing revenues over the short term.
- Progressive personal income taxes:
  - Progressive personal income tax systems are important for revenue and redistribution, but high levels of tax exemption or tax evasion in emerging market and developing economies limit short-term potential.
  - Experience shows countries can still raise sizable additional revenue through stronger personal income tax systems.
- Additional tax measures:
  - Reforms to address corporate income tax avoidance and reduce mutually destructive international tax competition are options but may need stronger international cooperation to be effective.
  - Average effective corporate tax rates have declined significantly and are typically lower than statutory rates due to exemptions, deductions, and tax planning.
  - Recent estimates put the long-term costs from profit shifting to lower-tax countries at about 1 to 1.5 percent of GDP for developing economies (Crivelli, de Mooij, and Keen 2016).
  - Removing tax incentives (tax-free zones, exemptions, tax holidays) can lead to sizable revenue gains.
  - There is room in most emerging market and developing economies to expand revenue from property taxes (efficient and equitable, but relatively modest potential).
  - Natural resource revenue is often an equitable and efficient revenue source that is frequently inadequately tapped.

### Spending efficiency and fiscal safeguards
- There is large variation in social outcomes across countries with similar spending levels, indicating substantial room to improve spending efficiency.
- Estimates in the health care sector suggest that as much as 40 percent of spending may be wasted across all country income groups.
- Many countries spend significant amounts on inefficient and inequitable energy subsidies aimed at protecting domestic consumers from volatile international oil prices.
- A key barrier to reforming energy subsidies is the absence of a strong safety net to adequately protect the poor from rising energy prices.

### Protecting the poor while raising revenue
- While broad-based consumption and selective excise taxes are efficient revenue sources, it is important to ensure access to strong safety nets to protect the poor and vulnerable from associated price increases.
- Options to mitigate harm to the poor from VAT or excise increases include:
  - Raising the VAT registration threshold (determines when a firm is large enough, based on sales, to be required to charge VAT).
  - Reducing the VAT rate for goods consumed disproportionately by the poor.
  - Focusing excise increases first on goods consumed disproportionately by higher-income households (for example, gasoline and high-end alcohol, and possibly tobacco).
  - Phasing in and sequencing tax increases across products so some revenue gains can be allocated to strengthening safety nets in the short term.

### Institutional and governance measures
- Policy and institutional reforms must accompany tax reforms:
  - Strengthen administrative capacity so VAT and income tax thresholds can be lowered and risk-based tax audit systems can enhance compliance and fairness.
  - Frame tax capacity strengthening within a broader whole-of-government process involving line ministries, the Ministry of Finance, citizen participation, and good governance.
  - Embed tax reform plans within national development plans that identify priority spending needs, often anchored in national strategies for attaining the United Nations Sustainable Development Goals.
  - Effective consultation and communication on comprehensive spending and tax plans are necessary to strengthen the social contract with civil society and could lead to a consensus-based medium-term revenue strategy (Platform for Collaboration on Tax).
  - Transparent and effective public financial management systems are essential to ensure and demonstrate that tax revenues are spent efficiently and not wasted or fraudulently used.
- Political economy note: “Nobody votes for a tax hike in isolation!”

### Author
- DAVID COADY is division chief of the Expenditure Policy Division in the IMF’s Fiscal Affairs Department.

*Source: taxes-and-social-protection-coady (PDF chapter).*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2018/december/taxes-and-social-protection-coady.pdf_