## sdnea2023006

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### Executive Summary
- Building tax capacity—policy, institutions, and technical capabilities to collect tax revenue—is central to government role in development.
- LIDCs face large financing needs: additional average annual spending of up to 16 percent of GDP is estimated to be required to reach the SDGs by 2030.
- Key quantitative potentials:
  - LIDCs can raise their tax-to-GDP ratio by, on average, 6.7 percentage points given current institutions and economic structures.
  - Institutional reform bringing LIDCs to EME levels can raise an additional 2.3 percentage points.
  - Improving government effectiveness by one standard deviation would increase the tax frontier by 2.8 percentage points of GDP (to 22.7 percent of GDP).
  - Total potential increase of 9 percentage points of GDP would materially support sustainable, inclusive, and resilient development.
- Core policy thrust: strengthen VAT and excises, PIT and CIT, and real property taxation; professionalize and digitalize revenue administrations; build Tax Policy Units (TPUs); and strengthen legal frameworks.
- International cooperation on taxing MNE profits is helpful but insufficient for LIDCs’ revenue needs and should not distract from domestic tax-capacity building.

### Why improve tax capacity
- Rationale and impacts:
  - Achieving the SDGs, addressing climate change, and stabilizing debt in LIDCs requires significant, sustainable revenue boosts.
  - COVID-19 raised spending needs and debt; at the beginning of 2023, 11 LIDCs were in debt distress and another 28 were at high risk of debt distress.
  - Evidence: once a country crosses a tax (excluding SSCs) revenue level of 13 percent of GDP, likelihood of growth acceleration increases.
  - Tax capacity improvements support public finance management, social contract, and wider government innovation.
- Institutional prerequisites:
  - Inclusive politics and credible leadership to avoid policy capture.
  - Legal capacity (judiciary and property rights) vital for effective collection.

### Progress and potential (trends, tax potential, tax effort)
- Historical and cross-country patterns:
  - LIDCs increased tax revenues from about 10 percent of GDP in the early 1990s to 13.8 percent in 2020 (tax revenue includes SSCs).
  - Tax-to-GDP ratios have stagnated since 2010 for LIDCs and EMEs.
  - LIDCs’ tax-to-GDP distribution is tightly centered around 10 percent, with few countries collecting more than 15 percent.
  - Consumption-based taxes account for approximately 62 percent of all taxes in LIDCs (down from over 70 percent in the 1990s).
- Tax potential and effort (SFA-based):
  - LIDCs’ estimated tax potential: 19.9 percent of GDP.
  - LIDCs’ average tax effort: 0.67 (Tax effort = observed tax collection / tax potential).
  - AEs tax potential: 26 percent of GDP; tax effort: 0.94.
  - EMEs tax potential: 22.5 percent of GDP; tax effort: 0.78.
  - Regional tax-effort examples: MECA average effort: 0.55; AEs: Europe effort: 1.0; Asia-Pacific effort: 0.8; Western Hemisphere effort: 0.9.
- Simulations on government effectiveness:
  - Setting government effectiveness to EMEs average: Increase in Tax Potential: 2.3; New Tax Potential: 22.2 Percent of GDP.
  - Setting government effectiveness to LIDCs average + one SD: Increase in Tax Potential: 2.8; New Tax Potential: 22.7 Percent of GDP.

### Tax policy: strengthening the core (consumption, income, natural resources, excises)
- VAT and consumption taxes:
  - VAT raised on average 4.7 percent of GDP in 2019 in LIDCs (EMEs’ average: 6.4 percent).
  - Standard VAT rates average about 15 percent in LIDCs (EMEs: 15 percent; AEs: 18 percent).
  - VAT C-efficiency was 37 percent on average in 2020.
  - VAT tax expenditures in 2020: LIDCs: about 1.3 percent of GDP; AEs: 0.8 percent of GDP; EMEs: 0.6 percent of GDP.
  - Policy opportunity: reduce exemptions/reduced rates that erode C-efficiency; capture digitalized consumption (vendor collection model).
- Excise taxes and environmental taxation:
  - Excise tax revenues between 1.5 and 2.5 percent of GDP have been trending upward in LIDCs and EMEs.
  - Excises on petroleum, alcohol, tobacco, unhealthy foods (for example, sugary drinks), and plastic waste can raise revenue and reduce externalities.
  - Fuel excises serve as carbon pricing; aligning excise rates with carbon content and reducing implicit/explicit fuel subsidies can raise revenue and support decarbonization.
  - Carbon taxes in the form of excises and feebates on vehicles are practical options for LIDCs.
- Income, wealth, and corporate taxation:
  - PITs raised 2.5 percent of GDP in 2021, up from 1.5 percent in 2005.
  - Reforms needed: lower exempt thresholds, adjust top rates and thresholds, design simplified regimes for self-employed/micro-enterprises.
  - Recurrent real property taxes raise on average 0.25 percent of GDP (0.6 percent in EMEs).
  - Corporate income tax: pervasive investment incentives are costly and ineffective; Pillar 2 global minimum tax estimated revenue impact: 0.15 percent of GDP (potentially rising to 0.4 percent in the longer run), with LIDCs capturing a modest share.
  - Simple anti-abuse provisions and expanded source taxing rights are practical for LIDCs given capacity constraints.
- Natural resources taxation:
  - Natural resource revenue share: on average 22 percent of total revenue in LIDCs and 27 percent in EMEs.
  - Empirical substitution: a 1 percentage point of GDP increase in natural resource tax revenue is associated with a reduction of 1.06 percentage points in other tax revenue in LIDCs (0.96 points in EMEs), indicating substitution effects.
  - Recommended design: combine profit/rent taxes with royalties to capture rents while ensuring early revenue and progressive outcomes.

### Institutions: TPUs, revenue administration modernization, legal frameworks
- Tax Policy Units (TPUs):
  - Functions: objective analyses of reform options, tax expenditure reports, baseline revenue forecasts, communication materials, coordination across agencies.
  - Evidence: TPUs present in most AEs, increasingly in EMEs, but lacking in many LIDCs; at least 17 EMEs and LIDCs created TPUs in the past decade.
  - Challenges: staffing with quantitative skills and ICT capacity for micro-simulation.
- Modernizing and digitalizing revenue administrations:
  - Staffing and governance:
    - Allocation to audit: AEs allocate over 30 percent of staff to audit; LIDCs allocate about 20 percent.
    - Share of experienced staff is smaller in EMEs and LIDCs compared with AEs.
    - Integration of tax and customs exists in 40 percent of 166 ISORA countries (34 percent of LIDCs, 44 percent of AEs).
  - Compliance risk management and segmentation:
    - Segmenting taxpayer populations and risk-based approaches support targeted services and enforcement; LIDCs lag on TADAT indicators.
  - Digitalization and analytics:
    - LIDCs lag in electronic filing and use of third-party data, though gaps have shrunk; pre-filling and e-filing rose between 2016 and 2020.
    - Greater digital adoption is associated with higher domestic tax revenue and reduced VAT compliance gaps.
    - GovTech and transaction-level data (EFDs, real-time invoicing) are important; automatic exchange of information benefits for LIDCs remain unclear.
- Legal and procedural frameworks:
  - Design principles: balance simplicity and comprehensiveness; preliminary clauses for principles; implementation rules in supplementary regulations.
  - Credible legislative process: tri-partite model (ministry of finance, revenue administration, non-government stakeholders), consultation, legislative approval before effect, monitoring, and minimizing frequency of changes.
  - Tax procedure laws (separate from tax laws) are emerging but not yet widespread among LIDCs.

### Medium-Term Revenue Strategy (MTRS) and reform sequencing
- MTRS components:
  - A revenue target to support economic and social development.
  - Comprehensive approach addressing policy, administration, and legal interlinkages.
  - Sustained political commitment from formulation to implementation.
  - Coordinated support among capacity development partners aligned with government leadership.
- Usage and case evidence:
  - MTRS used in 24 countries, including eight LIDCs (PCT 2022).
  - Morocco example: coordinated multi-decade reforms (VAT, CIT, PIT, tax dialogues, tax expenditures reporting, administrative reorganization) improved tax effort; remaining priorities include wider bases and convergence of multiple rates.
- Sequencing and coordination:
  - Recommended sequencing includes legal framework first, simplification of tax system, and adoption of MTRS to enhance feasibility and political buy-in.

### Conclusions, priority actions, and key aggregate figures
- Aggregate needs and potentials:
  - Additional spending to meet SDGs: nearly 16 percent of GDP per year in LIDCs.
  - LIDCs’ observed tax revenues average about 13.2 percent of GDP, below a tax potential of 19.9 percent of GDP (holding economic structure and institutional quality constant).
  - Realistic pathway: raise tax-to-GDP by 6.7 percentage points given current structures; achieve further 2.3 percentage points through institutional reforms to EME levels; total potential increase of 9 percentage points of GDP.
- Priority actions:
  - Strengthen design of VAT, excises, PIT, CIT, and property taxes focusing on base broadening, reforming ineffective tax expenditures, and more neutral taxation of capital income.
  - Build TPUs; professionalize and digitalize revenue administration staff; implement digital services, taxpayer segmentation, and risk-based compliance management.
  - Strengthen legal frameworks for tax certainty and minimize frequent legislative changes.
  - Adopt a holistic, politically informed Medium-Term Revenue Strategy and coordinate capacity development support.
- Expected outcomes:
  - When reforms are supported by political buy-in and coordinated across complementary policies and institutions, they can deliver quick and meaningful revenue gains, greater progressivity, and better incentives.
  - Successful tax policy and administration reforms create a virtuous circle: improved tax capacity and state capacity reinforce each other.

### Methodology, data, and selected empirical estimates
- Methodology:
  - Stochastic Frontier Analysis (SFA) with time-varying inefficiency and “true random effects” (Greene 2005).
  - Model: ln(TR_it) = α + Σβ ln(X_it) + ν_it - u_it, where u_it = -ln(E_it).
- Data:
  - Longitudinal dataset with 157 countries spanning 1990–2021.
  - Dependent variable: tax revenue excluding social security contributions.
  - Explanatory variables: GDP per capita (constant USD), GDP per capita squared, agriculture % of GDP, trade openness, government effectiveness, perception of public-sector corruption.
- Selected SFA coefficients (preferred specification, standard errors in parentheses):
  - ln_GDP per capita: 2.418*** (0.0609)
  - ln_GDP per capita squared: –0.127*** (0.00346)
  - ln_agriculture: –0.0583*** (0.00822)
  - ln_trade_gdp: 0.148*** (0.0102)
  - ln_public sector corruption: –0.0707*** (0.00530)
  - Constant: –9.334*** (0.266)
  - Usigma: –3.318*** (0.0446)
  - Vsigma: –5.179*** (0.0682)
  - Number of observations: 4,146; Number of countries: 157
- Selected sample statistics:
  - Entire sample tax revenue: Obs 5,401; Mean 16.9; Standard Deviation 10.8; Minimum 0.0; Maximum 53.4.
  - LIDCs tax revenue: Obs 1,604; Mean 12.1; Standard Deviation 7.3; Minimum 0.4; Maximum 53.4.
  - Government effectiveness: Obs 4,296; Mean 0.0; Standard Deviation 1.0; Minimum –2.5; Maximum 2.4.

*International Monetary Fund, Staff Discussion Note "Building Tax Capacity in Developing Countries" (Executive Summary).*

### Executive Summary ......................................................................................................

### sdnea2023006 - Executive Summary

### Executive Summary
- Building tax capacity—the policy, institutions, and technical capabilities to collect tax revenue—is central to the role of government in development.
- The COVID-19 pandemic, the global energy crisis, and Russia’s war in Ukraine highlighted the importance of domestic public revenue levers to fund policy responses.
- Tax capacity is integral to achieving the Sustainable Development Goals (SDGs), addressing climate change, and ensuring debt sustainability.
- Estimates suggest additional average annual spending of up to 16 percent of GDP is needed in low-income developing countries (LIDCs) to reach the SDGs by 2030.
- Key empirical findings and guidance:
  - LIDCs can raise their tax-to-GDP ratio by, on average, 6.7 percentage points to achieve their full potential, given current institutions and economic structures.
  - Institutional reform, by bringing LIDCs to the level of emerging market economies (EMEs), can raise an additional 2.3 points.
  - The total potential increase of 9 percentage points of GDP would materially support sustainable, inclusive, and resilient development.
  - Revenue gains require strengthening the design of core taxes—VAT and excises and personal and corporate income taxes—with emphasis on base broadening, reforming ineffective tax expenditures, more neutral taxation of capital income, and better use of real property taxes.
  - Improvement in institutions is essential: adequate tax policy units, greater professionalization of tax officials, digital technologies for revenue administrations, and transparency and certainty in translating policy into legislation.
  - Ongoing international cooperation on taxing multinational enterprises (MNEs) profits is important but insufficient for LIDCs’ revenue needs and should not distract from broader domestic tax-capacity building.

### I. Why Improve Tax Capacity?
- Achieving the SDGs, addressing climate change, and stabilizing debt in LIDCs requires a significant and sustainable boost in tax revenue.
- Example: Gaspar and others (2019) estimate additional spending in LIDCs averaging nearly 16 percent of GDP per year to achieve the SDGs by 2030.
- COVID-19 increased spending needs and debt levels; at the beginning of 2023, 11 LIDCs were in debt distress and another 28 were at high risk of debt distress (IMF 2023b).
- Beyond revenue, tax capacity is associated with accelerated growth and better institutions:
  - Once a country crosses a tax (excluding Social Security Contributions—SSCs) revenue level of 13 percent of GDP, the likelihood of an acceleration of growth increases significantly (Gaspar, Jaramillo, and Wingender 2016).
  - A simple and fair tax system can improve public finance management and the social contract.
  - A modern revenue administration can spur wider government innovation.
- Extending taxation scope requires forward-looking investments in institutions tailored to country circumstances:
  - Inclusive politics and credible leadership are essential to avoid policy capture and enable socially sensitive reforms (for example, streamlining VAT exemptions).
  - Legal capacity (judiciary and property rights) is vital to effective tax collection.

### II. Progress and Potential
#### A. Trends in Revenue Mobilization
- LIDCs have increased tax revenues from about 10 percent of GDP in the early 1990s to 13.8 percent in 2020 (tax revenue includes SSCs).
- Tax-to-GDP ratios have stagnated since 2010 for LIDCs and EMEs.
- Country distributions:
  - LIDCs’ tax-to-GDP distribution is tightly centered around 10 percent, with few countries collecting more than 15 percent.
  - EMEs and AEs distributions center around 20 and 30 percent of GDP respectively.
- Tax composition and evolution:
  - Consumption-based taxes are the main source of revenue in LIDCs; consumption taxes represented approximately 62 percent of all taxes (down from over 70 percent in the 1990s when they tallied 8.0 percent of GDP).
  - Income-based taxes rose from 24 percent of total tax revenue in the 1990s to 34 percent in the 2010s.
  - VAT growth during 1990–99 and 2000–09 increased total tax revenue by 1.9 percentage points of GDP, offsetting losses from taxes on international trade (1.2 percent of GDP) and other taxes (0.8 percent of GDP).
  - From 2000–20, increases in CIT accounted for 1.0 percentage point of GDP and PIT for 0.8 percentage point of GDP.
- COVID-19 impacts:
  - Temporary sharp decline in tax revenue in LIDCs due to local restrictions and global slowdown, with revenues rebounding during 2021–22 to pre-COVID-19 levels in most countries.
  - The pandemic accelerated digitalization of revenue administrations and investment in ICT.

#### B. Tax Potential and Tax Effort
- Tax potential is estimated as the highest level of tax revenue (excluding SSCs) a country can mobilize under comparable situations, controlling for country characteristics including GDP per capita, size of agriculture, government effectiveness, and perceived public-sector corruption (see Annex 1 for technical details).
- LIDCs’ estimated tax potential amounts to 19.9 percent of GDP, and their average tax effort is 0.67.
  - Tax effort = observed tax collection / tax potential.
  - Differences in tax effort reflect variations in tax policy, tax compliance, and their interactions.
- Policy implication: LIDCs have substantial unmet tax potential even given current institutions and economic structures; institutional improvements could unlock further revenue.

### III. Tax Policy: Strengthening the Core
- Tax capacity must rest primarily on improving design and administration of core domestic taxes.
- Key areas of focus:
  - Taxing Consumption:
    - Strengthen VAT and excise design and administration to broaden bases and improve C-efficiency (see figures on VAT revenue and C-efficiency, 2005–20).
    - Use excise taxes effectively; monitor explicit and implicit fuel subsidies (average 2015–20) which affect excise outcomes.
  - Taxing Income and Wealth:
    - Improve PIT and CIT design to reduce distortions, address ineffective tax expenditures, and achieve more neutral taxation of capital income.
    - Address equity and distributional consequences of tax design; leverage rising PIT and CIT shares observed between 2005–20 and 2005–21 respectively.
  - Taxing Natural Resources:
    - Design natural resource taxation mindful of its marginal effect on overall tax revenue and interactions with other tax bases (see figure on marginal effect of natural resource revenue on tax revenue).

### IV. The Role of Supporting Institutions
#### A. Building Tax Analysis Capacity: Tax Policy Units
- Establish and strengthen Tax Policy Units (TPUs) to forecast and analyze tax policy impacts across economic dimensions.
- TPUs should integrate policy analysis, monitoring, and evaluation to align tax design with macro-fiscal and distributional objectives.

#### B. Modernizing and Digitalizing Revenue Administrations
- Professionalization and staff capacity:
  - Average staff tenure in revenue administrations and allocation of staff (average 2018–21) show capacity and resourcing patterns requiring attention.
  - Emphasize greater professionalization of public officials working on tax design and implementation.
- Digitalization and taxpayer services:
  - Expand electronic filing and pre-filling of PIT returns—documented increases between 2016 and 2020.
  - Improve on-time filing rates of tax returns (2016–20) via digital tools and service improvements.
  - Use ICT investments to enhance compliance, taxpayer services, and administrative resilience.

#### C. Ensuring a Sound Legal Framework
- Ensure certainty and transparency in how policy and administration are translated into legislation.
- Strengthen legal capacity, judicial processes, and property rights to support effective tax collection and enforcement.

### V. Conclusions
- There is a large unmet tax potential in LIDCs; closing the gap requires both policy design and institutional improvements.
- A realistic pathway for LIDCs:
  - Raise tax-to-GDP by, on average, 6.7 percentage points given current structures.
  - Achieve a further 2.3 percentage points through institutional reforms to EME levels.
  - Total potential increase of 9 percentage points of GDP would significantly support SDGs, climate action, and debt sustainability.
- Priority actions:
  - Strengthen design of VAT, excises, PIT, CIT, and property taxes with focus on base broadening and neutral capital taxation.
  - Build TPUs, professionalize revenue administration staff, digitalize tax administration, and strengthen legal frameworks.
  - Continue engaging in international tax cooperation but maintain emphasis on domestic tax capacity as the primary revenue mobilization strategy.

*International Monetary Fund, Staff Discussion Note "Building Tax Capacity in Developing Countries" (Executive Summary).*

### 6.7  percentage points of GDP of additional tax

### 6.7  percentage points of GDP of additional tax 

### Key findings on tax potential and tax effort
- LIDCs have an estimated additional tax revenue potential of 6.7 percentage points of GDP.
- Tax potentials and efforts in other country groups:
  - AEs tax potential: 26 percent of GDP; tax effort: 0.94.
  - EMEs tax potential: 22.5 percent of GDP; tax effort: 0.78.
- VAT accounts for about one third of tax revenue; microdata-based studies decompose the VAT tax gap into a compliance gap and a policy gap, with the compliance gap markedly higher in LIDCs than in other country groups.
- Regional variations in tax effort:
  - MECA (Middle East and Central Asia) average effort: 0.55.
  - Other regional groups: range from 0.67 to 0.98.
  - AEs: Europe effort: 1.0; Asia-Pacific effort: 0.8; Western Hemisphere effort: 0.9.
  - LIDCs in sub-Saharan Africa (SSA) have a similar tax effort to those in other regions; EMEs in SSA fare better than other regions.

### Institutional capacity and simulation results
- Empirical results indicate tax potential critically depends on indicators of state capacity, proxied by government effectiveness.
- Simulations for LIDCs where government effectiveness scores are set aspirationally:
  - Government effectiveness set to EMEs average:
    - Increase in Tax Potential: 2.3
    - New Tax Potential: 22.2 Percent of GDP
  - Government effectiveness set to LIDCs average + one SD:
    - Increase in Tax Potential: 2.8
    - New Tax Potential: 22.7 Percent of GDP
- Improving government effectiveness by one standard deviation would increase the tax frontier by 2.8 percentage point of GDP (to 22.7 percent of GDP).
- Joint interpretation: meaningful additional tax revenue in LIDCs could accrue from improved institutions; a holistic approach to government reform is more likely to succeed than a piecemeal approach.

### Medium-Term Revenue Strategy (MTRS) — design and role
- MTRS frames tax system reform holistically over the medium term with four interdependent components:
  - A revenue target to support economic and social development.
  - A comprehensive approach addressing policy, administration, and legal framework interlinkages.
  - A sustained political commitment from formulation to implementation.
  - A coordinated support among capacity development partners to align with government leadership and priorities.
- The MTRS has been used in 24 countries, including eight LIDCs (PCT 2022).
- Morocco case example: coordinated, sustained reform efforts (VAT, CIT, PIT changes, tax dialogues, tax expenditures reporting, administrative reorganization) improved tax effort and capacity over multi-decade reforms; remaining priorities include wider tax bases, fewer preferential regimes, and convergence of multiple tax rates.

### VAT performance and opportunities
- VAT performance in LIDCs:
  - VAT raised on average 4.7 percent of GDP in 2019 (EMEs’ average: 6.4 percent).
  - Standard VAT rates average about 15 percent (the same in EMEs and 18 percent in AEs).
  - C-efficiency was 37 percent on average in 2020.
  - VAT tax expenditures (revenue cost of exemptions and reduced rates) in 2020:
    - LIDCs: about 1.3 percent of GDP.
    - AEs: 0.8 percent of GDP.
    - EMEs: 0.6 percent of GDP.
- Drivers of low VAT C-efficiency: exemptions to final consumers, reduced rates, and relatively high revenue administration gaps; common reduced rates/exemptions include staple foods, transportation, electricity, gas.
- Policy opportunity: align VAT with changing consumption patterns due to digitalization to broaden the taxable base by effectively levying VAT on import of digital services and parcels bought online; this protects the taxable base as consumers shift to online services and direct purchases from foreign vendors and helps ensure a level playing field for domestic businesses.
- Emerging international norm: allocate taxing rights under the VAT to the jurisdiction in which consumption occurs and implement a vendor collection model.

### Excise taxes as a complementary tool
- Excise taxes on petroleum products, alcoholic beverages, tobacco products and equivalents, unhealthy foods (for example, sugary drinks), and plastic waste:
  - Can raise more revenue and reduce externalities and internalities through changes in consumer behavior.
  - Appeal: widely consumed but relatively easy to collect from a limited number of producers or at the border.

### Policy implications and priorities
- Strengthen institutions and government effectiveness to unlock tax potential in LIDCs (quantified increases of 2.3 and 2.8 percentage points of GDP under government effectiveness improvements).
- Adopt a holistic reform agenda—such as a Medium-Term Revenue Strategy—to coordinate tax policy, administration, legal frameworks, political commitment, and external support.
- Reform VAT design and administration to reduce exemptions and reduced rates eroding C-efficiency and to capture digitalized consumption, including applying vendor collection models where appropriate.
- Use excises strategically to raise revenue and address externalities, leveraging their administrative simplicity at limited collection points.

*Source: STAFF DISCUSSION NOTES Building Tax Capacity in Developing Countries — INTERNATIONAL MONETARY FUND (excerpts).*

### 1.5 and 2.5 percent of GDP,  has been trending

### sdnea2023006 - 1.5 and 2.5 percent of GDP,  has been trending

### Excises and environmental taxation
- Excise tax revenues, between 1.5 and 2.5 percent of GDP, has been trending upward in LIDCs and EMEs.
- There is scope to increase excise revenues through better design and consistent application across taxpayers—especially importers vs. domestic producers, and state-owned vs private enterprises.
- Excises are potentially significant as mitigation tools for climate-related risks:
  - Fuel excises are a form of carbon pricing; historically used in LIDCs primarily as a revenue instrument with relatively low rates and product differentiation that does not reflect carbon content or environmental externalities.
  - Reducing implicit and explicit fuel subsidies and promoting decarbonization (with excise rates reflecting carbon content) could raise additional revenues and help achieve climate objectives.
  - Carbon taxes in the form of excises on fuel and motor vehicles have practical, environmental, and economic advantages for LIDCs, including ease of administration, price certainty, potential to raise significant revenues, and coverage of broader emissions sources.
  - Carbon taxes can be combined with feebates to promote vehicle decarbonization and gain broader acceptability.

### Consumption taxes and equity
- A well-designed VAT is an efficient revenue instrument but exemptions and low rates commonly used in LIDCs perform poorly in addressing regressivity.
- The revenue loss from VAT exemptions and low rates tends to be high relative to the benefit to low-income individuals; high-income individuals often benefit more in absolute terms.
- Greater impact on poverty reduction can be made by transfers to low-income households.
- Carbon taxation tends to be moderately regressive in advanced economies but can be progressive in LIDCs (example: India, where poorer households spend a smaller share of their budget on electricity than richer households).
- Corrective excise taxes on goods that generate pollution can offer redistribution benefits while reducing tax inefficiencies.

### Taxing income and wealth
- Personal income taxes (PITs):
  - PITs raised 2.5 percent of GDP in 2021, up from 1.5 percent in 2005.
  - Design weaknesses in many LIDCs include a high exempt threshold, a relatively low top rate, and a relatively high top income threshold above which the top rate applies.
  - Simplified regimes for the self-employed and micro-enterprises can improve compliance where labor formalization is an issue.
- Taxing wealth and capital income:
  - Reinforce taxation of returns on wealth or capital income (interest, dividends, capital gains) often absent or levied at lower rates; collection could be through final withholding.
  - Inheritance taxes may be considered where PITs are well developed and effectively implemented.
  - Recurrent taxes on real property raise on average 0.25 percent of GDP (0.6 percent in EMEs) and can be effective, redistributive, and relatively easy to collect once administrative infrastructure (cadaster, valuation) is in place.
  - Taxing net wealth is least feasible in LIDCs given information and capacity constraints.

### Corporate income tax and international developments
- The CIT is an important source of revenue in low-income countries and tends to be relatively effective where corporations are fewer and better organized informationally.
- Pervasive investment incentives (CIT exemptions and tax holidays) are generally costly, ineffective, inefficient, and prone to abuse.
- The proposed global minimum tax under Pillar 2:
  - Is an opportunity for LIDCs to re-design investment tax incentives.
  - Would likely dampen the effectiveness of tax incentives, allowing reform to reduce CIT distortions (for example, full expensing for some capital goods, cost for equity to neutralize debt bias).
  - The revenue impact of the global minimum tax has been estimated at 0.15 percent of GDP, potentially rising to 0.4 percent in the longer run once second-round effects from reduced tax competition are accounted for.
  - LIDCs stand to gain a modest share of this global impact.
- Simple anti-abuse provisions and expanding source taxing rights can be effective ways to manage the risk to the tax base from MNE cross-border transactions, given limited capacity to implement complex transfer pricing regimes.

### Taxing natural resources
- Nonrenewable natural resources (oil, gas, mining) are important sources of revenue in LIDCs.
- Developing countries have relied considerably on natural resources to generate revenue: the share of natural resource revenue represented, on average, 27 and 22 percent of total revenue in EMEs and LIDCs, respectively.
- Reliance on natural resource revenue exhibits a negative relationship with tax effort in LIDCs:
  - An increase in one percentage point of GDP in natural resource tax revenue is associated with a statistically significant reduction of 1.06 percentage points in other tax revenue in LIDCs, and 0.96 points in EMEs.
  - This suggests substitution away from mobilizing non-resource tax revenue and calls for balanced tax reforms.
- A well-designed natural resource fiscal regime combines profit/rent taxes with royalties to capture rents while ensuring early and dependable revenue and progressive outcomes relative to profitability.

### Building institutional capacity: tax policy units
- Tax policy units (TPUs) support evidence-based, data-driven policymaking and are present in most AEs and increasingly in EMEs but lacking in many LIDCs.
- Primary TPU functions include:
  - Producing objective analyses of tax reform options (revenue, distributional, behavioral impacts).
  - Producing regular tax expenditures reports and assessments.
  - Building baseline tax revenue forecasts and monitoring deviations over the budget cycle.
  - Producing communication material explaining tax policy changes.
  - Coordinating with other government agencies and external partners.
- Over the past decade, at least 17 EMEs and LIDCs created TPUs; challenges include staffing (quantitative skills) and ICT capacity for micro-simulation models.
- TPUs are ideally placed in ministries of finance to coordinate across central agencies and revenue collection entities; internal capacity building is emphasized over reliance on external consultants.
- Evidence shows TPUs have had a positive impact on fiscal management and tax transparency, producing tax expenditure reports, granular forecasts, revenue cost estimates, and distributional analyses.

### Modernizing and digitalizing revenue administrations
- Strengthening revenue administrations is vital for tax capacity; improving practices, compliance risk management, and use of third-party data is associated with growth in revenue collected.
- Resources and governance:
  - Revenue administrations need sufficient funding for professional human and ICT resources.
  - Better human resource management correlates with higher on-time filing rates and lower collection costs.
  - The share of experienced staff is smaller in EMEs and LIDCs compared with AEs.
  - Allocation of staff to audit differs: AEs allocate over 30 percent to audit while LIDCs allocate about 20 percent.
  - Ensuring arm’s-length operation from political interference (for example, independent governing boards) reduces rent-seeking; LIDCs lag in accountability.
  - Cooperation or integration of tax and customs administrations can leverage data use; among 166 countries in ISORA, 40 percent have integrated administrations (34 percent of LIDCs, 44 percent of AEs).
- Compliance risk management:
  - Segmenting the taxpayer population and organizing administration around segments supports targeted taxpayer services and enforcement.
  - LIDCs lag in implementing risk management and promoting voluntary compliance (TADAT indicators).
- Digitalization and analytics:
  - LIDCs face lower levels of digitalization of core operations (notifying, invoicing, pre-filling, filing, payment, assessments).
  - On-time filing rates in LIDCs lag AEs but are close to EMEs, especially for the PIT.
  - LIDCs lag in electronic filing and use of third-party data for pre-filling returns, though the gap has shrunk.
  - Greater digital adoption is associated with higher domestic tax revenue collection and reduction in VAT compliance gaps.
  - GovTech (beyond automation) and transaction-level data (Electronic Fiscal Devices, real-time invoicing) are important; automatic exchange of information is potentially important but its benefits for LIDCs remain unclear.

### Legal and procedural frameworks
- A clear legal framework and tax certainty influence investment decisions and growth; tax legislation is critical in LIDCs with relatively weaker institutions.
- Design principles for tax laws include balancing simplicity and comprehensiveness, using preliminary clauses for overarching principles, and housing implementation rules in supplementary regulations.
- Features of a credible legislative process:
  - Tri-partite tax law design model: ministry of finance, revenue administration agencies, and non-government stakeholders.
  - Internal and public consultation on draft legislation where possible.
  - Debate, review, and legislative approval of tax laws before taking effect, with monitoring of impacts.
  - All tax policies, including incentives and allowances, should be in legislation.
  - Frequency of changes in tax legislation should be minimized with timely communication.
- Many countries are introducing tax procedure laws separate from tax laws to simplify compliance and keep tax laws stable; this practice is not yet widespread among LIDCs.

### Conclusions and key aggregate figures
- LIDCs need revenue to pursue SDGs and manage debt sustainability:
  - Additional spending of 16 percent of GDP is estimated to be required in LIDCs to meet SDGs.
- There is considerable scope to collect more revenues in LIDCs measured by tax potential:
  - Tax revenues in LIDCs average about 13.2 percent of GDP, well below their 19.9 percent potential, holding economic structure and institutional quality constant.
  - If governmental effectiveness improves to that of EMEs, that potential increases by another 2.3 percentage points of GDP.
- When reforms are supported by political buy-in and coordinated across complementary policies and institutions, they can deliver quick and meaningful revenue gains, greater progressivity, and better incentives.
- Capacity development priorities:
  - Invest in tax policy units for country-specific analyses and cross-cutting policy design (climate, industrial policy).
  - Strengthen and digitalize revenue administrations; ensure autonomy from political influence and adequate funding.
  - Implement digital services, taxpayer segmentation, and risk-based compliance management to sustain revenue improvements.
  - Maintain a transparent and robust legal framework for tax certainty.
- Coordination across government agencies is critical; sequencing and integration of reforms (for example, legal framework first, simplification of tax system, MTRS) enhances feasibility.
- Successful tax policy and administration reforms create a virtuous circle: improved tax capacity and state capacity reinforce each other, generating additional revenue and improved public goods that strengthen policies, institutions, and public acceptance.

*International Monetary Fund — Staff Discussion Notes, Building Tax Capacity in Developing Countries*

### References

### sdnea2023006 - References

### Bibliographic scope
- Comprehensive list of works cited related to tax capacity, tax effort, revenue mobilization, tax policy design, tax administration, and digitalization in taxation from 2005–2023.
- Contributors include International Monetary Fund (IMF) working papers, Staff Discussion Notes, How-to Notes, Technical Notes, World Bank, OECD, UN-WIDER, MIT Press, and other academic and policy outlets.

### Annex 1 — Methodology: Stochastic Frontier Analysis (SFA)
- Model formulation:
  - TR_it = f(X_it, β). Ε_it. expV_it
  - ln(TR_it) = ln[f(X_it, β)] + ln(Ε_it) + ν_it
  - With inefficiency u_it = -ln(E_it): ln(TR_it) = α + Σβ ln(X_it) + ν_it - u_it
- Key modeling assumptions:
  - SFA assumes a one-sided error for inefficiency (Ε_it between 0 and 1) and a two-sided random shock ν_it.
  - Time-varying inefficiency model for panel data is used, with simultaneous estimation of frontier and inefficiency.
  - Unobserved time-invariant heterogeneity captured via a “true random effects” model (Greene 2005).
- Interpretation:
  - Unobserved heterogeneity is interpreted as lack of tax effort; inefficiency u_it is modeled as a positive random variable.

### Data used
- Longitudinal dataset with 157 countries spanning 1990–2021.
- Dependent variable: tax revenue excluding social security contributions.
- Main explanatory variables (in natural logarithms): GDP per capita in constant USD, GDP per capita squared, agriculture % of GDP, trade openness (imports + exports % of GDP), government effectiveness, perception of corruption in public sector.
- Primary sources: WoRLD dataset (tax revenue), IMF World Economic Outlook, World Bank World Development Indicators, World Bank Worldwide Governance Indicators.

### Expected relationships (as specified)
- GDP per capita: positive relationship with tax revenue.
- GDP per capita squared: negative sign expected (diminishing increases).
- Agriculture % of GDP: negative relationship (hard-to-tax sector; proxy for informality).
- Trade openness: positive relationship expected (taxes on trade concentrated and easy to collect).
- Corruption perception: negative relationship with tax revenue collection.

### Empirical results and robustness notes
- Findings from the preferred SFA model are consistent with existing empirical work.
- Inclusion of oil-producing country dummy tended to be detrimental to the tax frontier.
- Inclusion of grants produced a positive and statistically significant coefficient in one specification, but its confidence interval spans into negative values.
- Government effectiveness variable produced unexpected signs when included with GDP per capita due to high correlation; when GDP per capita was excluded, government effectiveness exhibited expected signs.

### Annex Table 1 — Selected summary statistics (Entire sample and groups; means and ranges)
- Entire Sample:
  - Tax revenue: Obs 5,401; Mean 16.9; Standard Deviation 10.8; Minimum 0.0; Maximum 53.4 (Source: WoRLD)
  - Constant GDP per capita in PPP: Obs 5,721; Mean 17,595.4; Standard Deviation 19,987.3; Minimum 436.7; Maximum 161,971.5 (Source: WEO)
  - Agriculture % of GDP: Obs 5,415; Mean 13.2; Standard Deviation 12.4; Minimum 0.0; Maximum 79.0 (Source: WDI)
  - Trade as percentage of GDP: Obs 5,195; Mean 85.5; Standard Deviation 53.1; Minimum 0.0; Maximum 442.6 (Source: WDI)
  - Corruption perception index: Obs 5,189; Mean 0.5; Standard Deviation 0.3; Minimum 0.0; Maximum 1.0 (Source: QOG)
  - Government effectiveness: Obs 4,296; Mean 0.0; Standard Deviation 1.0; Minimum –2.5; Maximum 2.4 (Source: WDI)
- Advanced Economies:
  - Tax revenue: Obs 1,082; Mean 24.6; Standard Deviation 8.3; Minimum 9.0; Maximum 50.3 (Source: WoRLD)
  - Constant GDP per capita in PPP: Obs 1,137; Mean 44,005.6; Standard Deviation 19,656.6; Minimum 9,600.9; Maximum 161,971.5 (Source: WEO)
- Emerging Market Economies:
  - Tax revenue: Obs 2,715; Mean 16.6; Standard Deviation 8.9; Minimum 0.0; Maximum 48.4 (Source: WoRLD)
- Low-Income Developing Countries:
  - Tax revenue: Obs 1,604; Mean 12.1; Standard Deviation 7.3; Minimum 0.4; Maximum 53.4 (Source: WoRLD)
  - Constant GDP per capita in PPP: Obs 1,692; Mean 2,773.7; Standard Deviation 1,739.3; Minimum 436.7; Maximum 14,233.9 (Source: WEO)

### Annex Table 2 — Stochastic Frontier Analysis coefficients (selected specification notes)
- Estimation fitted using Stata’s sfpanel command with the True Random Effect option.
- Usigma is the mean of u_it; Vsigma is the mean of v_it.
- Significance indicators: ***p <0.01, **p <0.05, *p <0.1.
- Column (1) (preferred specification) key coefficients (standard errors in parentheses):
  - ln_GDP per capita: 2.418*** (0.0609)
  - ln_GDP per capita squared: –0.127*** (0.00346)
  - ln_agriculture: –0.0583*** (0.00822)
  - ln_trade_gdp: 0.148*** (0.0102)
  - ln_public sector corruption: –0.0707*** (0.00530)
  - Constant: –9.334*** (0.266)
  - Usigma: –3.318*** (0.0446)
  - Vsigma: –5.179*** (0.0682)
  - Number of observations: 4,146; Number of countries: 157
- Notable variations across other columns:
  - Inclusion of ln_grants (column 2): ln_grants 0.00542*** (0.00159) with fewer observations (2,822) and countries (144).
  - Oil dummy (columns 3 and 4) shows negative coefficients: –0.842*** (0.0181) and –0.282*** (0.0219) in respective specifications.
  - Government effectiveness appears with divergent signs depending on inclusion/exclusion of ln_GDP per capita (column 5: 0.1340** (0.0646); column 6: –0.151*** (0.0492)).

*Source: Building Tax Capacity in Developing Countries, Staff Discussion Note No. SDN/2023/006 (References and Annex material).*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2023/english/sdnea2023006.pdf_