Personal Income Tax Has Untapped Potential in Poorer Countries

IMF Blog, March 24, 2022

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Developing countries have shown remarkable progress in using the personal income tax.
The personal income tax is levied on wages, salaries, and other income and is described as a suitable instrument for raising significant amounts of revenue in the fairest way possible.
The research examines the scope for greater use of personal income tax in developing countries, focusing on what drives growth, how increases affect total revenue performance, and how these levies influence income redistribution.

In many advanced economies the personal income tax now raises approximately 9 percent of gross domestic product.
In most emerging market and low-income countries, revenue from personal income tax averages only 2.5 percent of GDP.
In the two decades preceding the pandemic:
- Low-income countries: income tax revenue rose from the equivalent of 1 percent of GDP to 2.1 percent.
- Emerging markets: income tax revenue rose from 2.1 percent to 3.1 percent.
- Share of the tax in overall tax intake:
- Low-income countries: went from 5 percent to 8 percent of total tax revenue.
- Emerging markets: went from 9 percent to 11 percent of total tax revenue.

The research distinguishes between observable tax policy changes and broader economic changes.
Policy changes examined include adjustments to top and bottom statutory rates and the level of exempt income.
- Finding: These policy changes haven’t contributed much to the increase in revenue in low-income countries.
- In emerging market economies, some policy shifts have sometimes actually reduced revenue, in part because many emerging markets have introduced flat tax systems with low rates and those with progressive schedules have reduced rates over the last two decades.
Economic variables played a very important role:
- Factors considered: increases in per capita incomes, the size of the public-sector wage bill, and the reduction in the size of the informal sector (measured by the share of self-employed workers in the labor force and the share of agriculture in the economy).
- Finding: These developments have clearly been the driving force behind the growth in personal income tax revenues.
- Implication: As economies develop, the personal income tax can be expected to take on greater importance.
Improvements in tax administration potentially play a role in boosting revenues, though that also extends to other taxes.
The accelerated shift into digitalized services because of the pandemic can pave the way for better income tax design and enforcement.

The research separates the effects of policy design from the size of the population covered by the tax.
Low-income countries:
- The design of the personal income tax is typically progressive.
- Narrow coverage makes the overall contribution to redistribution very small compared to that seen in advanced economies.
Emerging markets:
- The personal income tax is not progressive.
- Several emerging markets have a flat income tax, suggesting significant potential to improve inclusion in this group of countries.

Advanced economies: additional revenue is predominantly sourced from the income tax.
Low-income countries: the personal income tax plays a much more modest role in raising additional revenue.
Other taxes will likely have to play a significant role in raising revenue over the medium term in developing countries, with the value-added tax and other indirect taxes remaining the main contributors.
Nonetheless, income taxes can be important for inclusive growth if properly designed and revenues well spent.
Historical evidence and the research indicate the personal income tax should evolve into a more significant source of revenue as countries develop.

IMF Blog — Personal Income Tax Has Untapped Potential in Poorer Countries (Dora Benedek, Juan Carlos Benítez, Charles Vellutini), March 24, 2022