PRESENTATION ON TAX AND POVERTY WORK

Introduction

Using tax analysis:  In many countries, the focus of budget analysts working on poverty issues has traditionally been on expenditure issues rather than on tax issues.  Expenditure, particularly on anti-poverty programs, can have a direct impact on the poor.  The goal of this session is not to question the importance of expenditure analysis for poverty work, but to highlight the potential of tax analysis.  Important concerns include:

• tax burden:  whether the burden of taxation is being distributed appropriately.

• revenue adequacy:  whether revenues are sufficient, as this affects the funding available for important programs.

• fairness and transparency:  whether tax policy and tax administration are fair and transparent; in part, because these issues that go beyond taxes and are part of the key characteristics that define a government.

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Equity:  The link between tax burdens and fairness is clear.  Everyone believes that the tax code should be fair; the problem is that not everyone agrees on what is fair. 

• Vertical equity:  how does the tax system treat people with different incomes?

• Horizontal equity:  how does the tax system treat people with the same income?

Vertical equity:  For our purposes, horizontal equity is primarily about tax breaks and tax avoidance, which are addressed later.  Here are three concepts related to vertical equity:

• Proportional:  everyone pays the same percentage of income in tax

• Progressive:  pay a larger percentage of income in tax as income increases

• Regressive:  pay a smaller percentage of income in tax as income increases

Taxing principles:  Governments rely on a variety of tax instruments, some of which may be progressive (e.g. income tax) or regressive (e.g. consumption taxes, user fees).  The goal is therefore to look at the combination of all taxes government imposes and see how the burden is distributed.  Rationales for different types of taxes are often based on the following two principles:

• benefit principle:  pay taxes commensurate with the benefits received from government programs

• ability-to-pay principle:  pay taxes in relation to one’s economic well-being

Limits to progressivity:  The ability-to-pay principle clearly supports progressive taxation.  If one accepts the ability-to-pay principle, then more income inequality suggests a need for greater tax progressivity.  However, economists argue that there are limits to how progressive the tax system can be:  if marginal tax rates become too high (and, of course, nobody knows where that point is) they create disincentives for folks to work or start new businesses and create more jobs.

Initial vs. economic incidence:  It is frequently difficult to distinguish between the initial incidence and the economic incidence of a tax — in short, who really pays the tax?  Paying a tax is not necessarily the same as bearing the burden.  The burden can be shifted onto others.  For instance, who pays business taxes?  Is it the company, or does it pass them on to employees or consumers?  There are a number of factors that affect the outcome, including what is being taxed (e.g. profits or property).  For policy purposes, an issue is whether the tax burden is being borne by the group intended. 

US federal and state and local taxes:  These analyses were undertaken by organizations that made explicit assumptions about tax incidence (see charts at end of handout).  US federal government has overall progressive tax structure.  US state and local taxes are regressive overall.  These charts also highlight the need to look at all taxes imposed at all levels of  government to determine the overall tax burden on individuals.

Developing countries:  Developing countries tend to rely on revenue sources more similar to US states, with a heavier reliance on consumption taxes, such as VAT, sales taxes, and excise taxes, than on income taxes.  In terms of income taxes, developing countries tend to rely more on corporate income taxes than personal income taxes. 

Conclusion:  Measuring tax burdens in a precise way is difficult.  But there are some general rules that one can apply based on the type of tax instruments used and the share of total revenue generated by each instrument.  A government that relies more on consumption taxes (VAT, sales or excises) will generally place a heavier tax burden on those with lower incomes than a government that relies more on income taxes.  Tax systems are not static, and the importance of various tax instruments can change over time.  An important analysis is to track the composition of government revenues over time and to see whether they have become more or less progressive.

Taxes as source of funds:  An analysis of tax burdens, though important, is necessarily incomplete, particularly when it comes to low-income groups.  One must look at whether the budget as a whole – both revenue and expenditure – is redistributive.  Revenues are an important, generally the most important, source of funding for expenditure, and government’s ability to spend money is linked to its ability to raise revenues.  Inadequate revenues means that government will have to rely more on borrowing or grants to fund expenditure, and neither are as sustainable over the long term.  Setting aside the issue of the desired level of expenditure, a key issue is whether the revenues are stable over time and grow fast enough to cover rising spending needs.

Stability:  An ideal tax system would minimize revenue fluctuations that occur with the business cycle.  No individual tax source is completely stable.  Thus a more broad-based tax system – one that relies on a range of tax instruments – is likely to be the most stable.  Along with stability comes predictability.  Predictability is important because it allows for better revenue projections and thus expenditure planning.  Over- or under-estimates of revenue can undermine expenditure planning, particularly over a multi-year framework.

Growth:  Revenues need to keep pace with expenditure.  Spending tends to grow as the economy grows.  Inflation pushes up the cost of providing services.  Population growth means that government must serve more people.  Rising wages, particularly if government spends a large share of its budget on personnel, can push up expenditure.  Increasing needs will also create more demand for expenditure.  Sometimes increasing needs are a function of politics; for instance, when there is agreement that government must address an existing problem.  Other times economic or other circumstances, such as a recession or the rise of HIV/AIDS, increase demand for government services.

Tax system design:  The combination of tax instruments affects the stability and growth of revenues.  There is some trade-off between these two goals.  Excise taxes on cigarettes, for example, are fairly stable over the economic cycle, as demand for cigarettes is relatively inelastic.  Income taxes, on the other hand, will fluctuate over the economic cycle.  But this revenue source tends to grow at least as fast as the economy.

External factors affect revenue growth:  As with expenditure growth, some factors affecting revenue growth reflect political choices and some reflect economic or other exogenous factors.  For instance, the same HIV/AIDS problem that will increase demand for health and welfare services may also depress revenues, because the disease takes a heavy toll on the working-age population.  Other factors affecting developing countries can be falling revenues from natural resource taxes (e.g. mining) or import duties.

Cannot ignore burden:  Particularly concerning political choices that change revenues, tax burdens — as well as revenue adequacy — have to be part of the discussion. Questions of equity tend to be even more pointed when dealing with tax cuts.  Particularly with targeted (“special interest”) tax cuts, tough questions need to be asked.  Transparency around these types of tax breaks is generally problematic. 

Tax expenditures:  Tax preferences (or tax expenditures, as they are called) can come in the form of tax deductions, exemptions, credits or preferential rates.  These tax breaks tend not to undergo the same cost-benefit scrutiny that programs on the spending side of the budget receive.  Once given, they tend to be enjoyed by the beneficiaries, but few go back to see if the intended social benefits have been achieved.  Eliminating such tax breaks may be politically difficult to do, as it may be labeled as a tax increase.  As part of the debate on tax expenditures, the following issues can be raised:

• Transparency – Establish cost of tax expenditures and determine who benefits

• Targeting – Focus tax expenditures on those taxpayers who most need them

• Performance standards – Require that tax breaks for business provide a clear public benefit and hold recipients to standards

Conclusion:  Government raises revenue so that it can be spent on programs to address social needs.  Revenue should be stable enough and grow enough to cover expenditure demands.  No one tax can fulfill these goals.  Tax experts advocate a broad-based tax system.  Countries face pressures to raise and lower taxes.  Sometimes these pressures arise from factors outside their control, such as changes in the economy, and other times they reflect political decisions to change the size or scope of government.  In response to these pressures, there should be an open discussion of the options.  As tax analysts, we can highlight some of the features of a particular tax and whether, given its role in the budget, it is an appropriate revenue source or designed in an appropriate manner. 

Tax gap:  First, a weak tax administration and low compliance means that all the taxes that could be collected are not being collected — the so-called tax gap.  This results in less revenue available to finance expenditure needs.  Or it requires higher tax rates on those who do pay their taxes to ensure the desired level of revenue and expenditure. 

Fewer options:  Second, a weak tax administration limits a country’s options with regard to tax policy.  With fewer tax instruments available, it becomes harder to craft a tax regime with the appropriate mix of tax instruments.  These issues are particularly true in developing countries, where tax administrators lack needed capacity, ranging from computer systems to skilled employees.

High visibility:  A third issue deals with the visible nature of tax administration.  How tax administrators operate is an important reflection of the character of government.  Is the tax collector seen as fair, enforcing a fair tax system in an even-handed manner?  Or is it seen as unfair and corrupt?  Failure to enforce the tax laws appropriately, resulting in widespread tax evasion, not only undermines the integrity of the tax system but it also reduces the credibility of the government as a whole, potentially undermining its ability to carry out positive policies in other areas.

Increase transparency:  Tax administrations can pursue an number of strategies to improve compliance, but improving transparency can be an important part of these strategies.  Tax administration’s audit function is one of its most potent; raising its visibility (along with sanctions and penalties) can have positive effects on voluntary compliance.  This can also be coupled with targeting “superrich” taxpayers, for instance.  Another facet of transparency can be taxpayer education efforts and campaigns to highlight the services being paid for with tax revenues.

Conclusion:  Tax administration has an impact on the issues raised earlier, namely the distribution of tax burdens and the adequacy of revenue to support expenditure.  Tax administration, particularly in developing countries, is likely to be an integral part of the tax policy debate, as it is frequently a constraining factor.  Improved transparency can be part of the reforms that helps boost compliance and improve the effectiveness of tax administration.

Quality of information:  The quality of information on taxes is often not good, making it difficult to undertake detailed tax analyses.  Where detailed analyses exist, they can be  complicated and technical, making them beyond the grasp of most policy makers.  We can use these information problems to our advantage.  Experience has shown that, because of this information shortage, there is considerable interest in analyses that discuss tax issues in a straightforward and accessible manner.

Initial project ideas:  Following are some possible ideas for initial tax analysis projects:

Assess, in general terms, the nature of the burdens of the country and how they have changed over time

• Create a primer on existing tax structure for other NGOs, public, media

• Publicize the costs of existing tax breaks (tax expenditures)

• Assess proposed changes to the tax system for fairness and revenue adequacy

• Put results of government reports or academic reports in plain language

• Highlight important tax issues (e.g. tax burden) that cannot be adequately analyzed due to a lack of quality information

•  Develop tax relief package that is targeted at the low-income population

• Develop and disseminate principles for improving the tax structure, or for a more transparent and effective tax administration

•  Highlight information on regional differences in tax burdens