Tax Base Protection in the Arab Region: New Approaches and Implications
Joosung Jun
A major fiscal challenge facing countries in the Arab region is to generate additional tax revenue so as to meet their expenditure targets, especially in the face of unstable oil revenue and deteriorating fiscal stance. Oil producing countries in the region have experienced a fiscal shock with their oil revenues dropping about 40% to 60% over the period of 2013-2016. As they accommodated the shock through deficit financing, the level of public debt has been sharply soaring. Oil-poor countries are also in need of revenue expansion as they have suffered a chronic fiscal deficit. A relatively high reliance on trade-related taxes in this group will pose a further problem as trade liberalization goes on. The objective of this research is to examine strategies for tax base protection in the Arab region, especially in the face of enforcement difficulties and international capital mobility. Policy recommendations include various base-broadening measures in the context of improving tax compliance and reforming tax structure.
The level and structure of taxes are affected by the nation’s policy objectives, economic structure and administrative capacity. Raising revenue in an efficient and equitable manner is a commonly stated goal in tax theory. Policymakers, though, need to be more specific about their priorities and constraints over a given policy horizon, often facing a trade-off between objectives. For developing countries, economic growth is a dominant objective underlying their tax systems with a primary attention paid to raising revenue to finance public infrastructure and education. However, tax enforcement is not easy because a significant portion of their economies belongs to the informal sector. Tax evasion in the formal sector is also prevalent due to limited administrative capacity. To the extent that transactions are made in cash, no paper trail remains.
Nonetheless, traditional tax analyses failed to give adequate considerations to the pressures stemming from insufficient information. This is because most tax theories were developed in the context of advanced countries where informal activity has seldom been a major concern in tax design. The optimal tax theory recognizes the second-best nature of taxation by excluding the lump-sum tax based on individuals’ earning ability and basing taxes on observables such as income and consumption. In developing countries, however, a significant portion of such ‘observables’ is not readily captured by tax nets. Taxes can be collected only to the extent that information is available on the transactions and earnings of individuals and firms.
Many of the Arab countries share the same enforcement problem. In analyzing their tax systems and suggesting directions for reform, therefore, this research adopts second-best approaches, explicitly recognizing various constraints stemming from imperfections of available information and deficiencies in the tax systems. This leads to room for “corrective taxation” in the sense that both efficiency and revenue can be increased. Many of the base-broadening measures discussed here might lead to a revenue gain without much loss of efficiency or equity. In certain situations, they can produce a double dividend by reducing existing distortions and inequities. By contrast, raising more revenue in developed countries typically involves higher distortions and a resulting efficiency loss. A revenue-neutral, ‘broad-base-low-rate’ system will increase efficiency, but often at the expense of equity.
Imperfect information and other constraints limit the scope of feasible taxes over a given policy horizon. Thus, both long-run and short-run considerations are necessary in shaping a tax policy, making some sort of ‘policy sequencing’ inevitable. This is especially important for policymakers in developing countries since many of the conventional tax advices are based on the optimal tax literature employing long-run perspectives or the experiences in developed countries where a wider set of tax tools is feasible. For example, policies to reduce the informal sector will relax constraints on available tax instruments over a longer period of time. In the short run, however, policymakers may need to rely on second-best policies to protect tax bases. As another example, many fiscal experts stress the role of investment climate in determining the efficacy of tax incentives in attracting foreign direct investment (FDI). However, policies to improve nontax factors such as the quality of labor force and infrastructure may take time and require budget while tax incentives can be a readily available tool.
Reforming tax structures in the region may well go in line with base-broadening efforts. Given market imperfections and a limited set of feasible tax tools, the conventional wisdom might not be the best solution in some cases. The value-added tax (VAT), though an important revenue raiser, might not be an “efficient” tax when the informal sector is large. Given a weak presence of progressive taxes, a VAT might also amplify distributive concerns. In this situation, well-designed excise taxes can play a complementary role on efficiency and equity grounds. The role of the corporate income tax (CIT) in preserving revenue capacity also needs to be stressed, considering the minor role of the personal income tax (PIT) in the region. Its potential as a rent tax is another point to note, particularly in oil-producing countries. Also, ‘simplicity’ needs to be counted as a major criterion for tax design because efficiency, administrative and compliance costs will likely increase as the tax system becomes more complicated. Even when some complications are inevitable on second-best grounds, they should be administratively manageable.
International capital mobility is another key factor affecting tax bases. However, some conventional recommendations on this subject appear to be overstated. For one, the best-practice suggestion of securing good investment climates for the efficacy of tax incentives in attracting FDI may have a policy-horizon mismatch as described above. In addition, the presence of nontax factors per se does not tell much about the cost-effectiveness of tax incentives at the margin. An incentive can be more effective when something is missing, and the revenue costs can possibly be large when investment climates are “too good.” Also, the prospect of a ‘race to the bottom’ type of tax competition seems unlikely, considering the complex nexus of tax and nontax factors affecting the location decision by multinationals and the differing attributes among host countries. Rather, a more worrisome base erosion threat is related to profit shifting by multinationals by means of transfer pricing or other schemes.
Political-economic factors also matter in tax design. Among various ways in which economics and politics interact in shaping a tax system, this research examines two particular issues: corruption and earmarking. Corruption and tax evasion are closely related to each other since both are essentially a problem of visibility. If more economic activities leave observable trails, corruption will be reduced. In this context, the tax system needs to be designed in a way that tax bases are more observable and readily verifiable. This research also stresses the role of earmarking in improving tax compliance. On the part of taxpayers, fiscal accountability and transparency are a key element in judging whether their money is appropriately spent. In addition, linking taxes to specific uses may increase tax efforts by government agencies, though allowing such ‘rent-seeking’ may occur at the expense of economic efficiency.
Tax Base Protection in the Arab Region: New Approaches and Implications
Joosung Jun
A major fiscal challenge facing countries in the Arab region is to generate additional tax revenue so as to meet their expenditure targets, especially in the face of unstable oil revenue and deteriorating fiscal stance. Oil producing countries in the region have experienced a fiscal shock with their oil revenues dropping about 40% to 60% over the period of 2013-2016. As they accommodated the shock through deficit financing, the level of public debt has been sharply soaring. Oil-poor countries are also in need of revenue expansion as they have suffered a chronic fiscal deficit. A relatively high reliance on trade-related taxes in this group will pose a further problem as trade liberalization goes on. The objective of this research is to examine strategies for tax base protection in the Arab region, especially in the face of enforcement difficulties and international capital mobility. Policy recommendations include various base-broadening measures in the context of improving tax compliance and reforming tax structure.
The level and structure of taxes are affected by the nation’s policy objectives, economic structure and administrative capacity. Raising revenue in an efficient and equitable manner is a commonly stated goal in tax theory. Policymakers, though, need to be more specific about their priorities and constraints over a given policy horizon, often facing a trade-off between objectives. For developing countries, economic growth is a dominant objective underlying their tax systems with a primary attention paid to raising revenue to finance public infrastructure and education. However, tax enforcement is not easy because a significant portion of their economies belongs to the informal sector. Tax evasion in the formal sector is also prevalent due to limited administrative capacity. To the extent that transactions are made in cash, no paper trail remains.
Nonetheless, traditional tax analyses failed to give adequate considerations to the pressures stemming from insufficient information. This is because most tax theories were developed in the context of advanced countries where informal activity has seldom been a major concern in tax design. The optimal tax theory recognizes the second-best nature of taxation by excluding the lump-sum tax based on individuals’ earning ability and basing taxes on observables such as income and consumption. In developing countries, however, a significant portion of such ‘observables’ is not readily captured by tax nets. Taxes can be collected only to the extent that information is available on the transactions and earnings of individuals and firms.
Many of the Arab countries share the same enforcement problem. In analyzing their tax systems and suggesting directions for reform, therefore, this research adopts second-best approaches, explicitly recognizing various constraints stemming from imperfections of available information and deficiencies in the tax systems. This leads to room for “corrective taxation” in the sense that both efficiency and revenue can be increased. Many of the base-broadening measures discussed here might lead to a revenue gain without much loss of efficiency or equity. In certain situations, they can produce a double dividend by reducing existing distortions and inequities. By contrast, raising more revenue in developed countries typically involves higher distortions and a resulting efficiency loss. A revenue-neutral, ‘broad-base-low-rate’ system will increase efficiency, but often at the expense of equity.
Imperfect information and other constraints limit the scope of feasible taxes over a given policy horizon. Thus, both long-run and short-run considerations are necessary in shaping a tax policy, making some sort of ‘policy sequencing’ inevitable. This is especially important for policymakers in developing countries since many of the conventional tax advices are based on the optimal tax literature employing long-run perspectives or the experiences in developed countries where a wider set of tax tools is feasible. For example, policies to reduce the informal sector will relax constraints on available tax instruments over a longer period of time. In the short run, however, policymakers may need to rely on second-best policies to protect tax bases. As another example, many fiscal experts stress the role of investment climate in determining the efficacy of tax incentives in attracting foreign direct investment (FDI). However, policies to improve nontax factors such as the quality of labor force and infrastructure may take time and require budget while tax incentives can be a readily available tool.
Reforming tax structures in the region may well go in line with base-broadening efforts. Given market imperfections and a limited set of feasible tax tools, the conventional wisdom might not be the best solution in some cases. The value-added tax (VAT), though an important revenue raiser, might not be an “efficient” tax when the informal sector is large. Given a weak presence of progressive taxes, a VAT might also amplify distributive concerns. In this situation, well-designed excise taxes can play a complementary role on efficiency and equity grounds. The role of the corporate income tax (CIT) in preserving revenue capacity also needs to be stressed, considering the minor role of the personal income tax (PIT) in the region. Its potential as a rent tax is another point to note, particularly in oil-producing countries. Also, ‘simplicity’ needs to be counted as a major criterion for tax design because efficiency, administrative and compliance costs will likely increase as the tax system becomes more complicated. Even when some complications are inevitable on second-best grounds, they should be administratively manageable.
International capital mobility is another key factor affecting tax bases. However, some conventional recommendations on this subject appear to be overstated. For one, the best-practice suggestion of securing good investment climates for the efficacy of tax incentives in attracting FDI may have a policy-horizon mismatch as described above. In addition, the presence of nontax factors per se does not tell much about the cost-effectiveness of tax incentives at the margin. An incentive can be more effective when something is missing, and the revenue costs can possibly be large when investment climates are “too good.” Also, the prospect of a ‘race to the bottom’ type of tax competition seems unlikely, considering the complex nexus of tax and nontax factors affecting the location decision by multinationals and the differing attributes among host countries. Rather, a more worrisome base erosion threat is related to profit shifting by multinationals by means of transfer pricing or other schemes.
Political-economic factors also matter in tax design. Among various ways in which economics and politics interact in shaping a tax system, this research examines two particular issues: corruption and earmarking. Corruption and tax evasion are closely related to each other since both are essentially a problem of visibility. If more economic activities leave observable trails, corruption will be reduced. In this context, the tax system needs to be designed in a way that tax bases are more observable and readily verifiable. This research also stresses the role of earmarking in improving tax compliance. On the part of taxpayers, fiscal accountability and transparency are a key element in judging whether their money is appropriately spent. In addition, linking taxes to specific uses may increase tax efforts by government agencies, though allowing such ‘rent-seeking’ may occur at the expense of economic efficiency.