Tax in Developing Countries: Increasing Resources for Development

Written evidence submitted by Adam Smith International

1. Introduction

Our company, Adam Smith International, has had extensive experience of delivering technical assistance relating to tax policy and administration in developing countries, financed by a variety of donors and countries. This work has ranged across a variety of countries, including Afghanistan, Burundi, Tuvalu, Nigeria, Zambia, Romania, Bulgaria, Turkey, Palestine, Sierra Leone, Oman, South Sudan, India, Mongolia, Zambia, and Uganda. We welcome this opportunity to provide input to this inquiry into this very important subject.

2. The importance of revenue reform for development

Increased support to revenue reform is one of the most valuable forms of development assistance. By enabling countries to develop the revenue base to finance their own public services a sustainable source of funding is created, and one that helps improve the accountability of governments to their citizens.

Assistance to revenue reform may be contrasted with budget support, which involves the direct transfer of funds to a developing country’s budget from developed country aid budgets on an annual basis. It is not a reliable source of income for the recipient countries. Moreover, given the absence of effective accountability systems in almost all of the countries which receive budget support, it is not possible for developed country taxpayers to know that their money has been spent properly.

A greater focus on support to revenue reform is thus an extremely cost-effective means of enabling countries to improve public services on a sustainable basis. It is very high value aid.

The following are some of the primary reasons why revenue reform is so important for developing countries.

· Public services can be financed in a sustainable way, independent of donor financing, enabling governments to provide essential services for the population without recourse to external assistance.

· A transparent, fair and efficient revenue system provides certainty and confidence for the private sector, thereby facilitating private sector development and increasing employment and income. This is especially important when effective and fair development of a particular sector is considered crucial to poverty alleviation, e.g. the extractives sector.

· A reformed revenue system can be used directly and indirectly to allocate resources to the poorest people in society.

· The impact of donor financing is multiplied many times in that it helps developing country governments help themselves in way that no other donor support can, i.e. with their own finances, raised on their own account, developing country governments are in position to support the full range of development initiatives, in e.g. health, education, private sector development etc. While other forms of donor support can lead to donor dependency and short-termism, revenue reform supports sustainability and long-termism.

· More robust and transparent revenue systems reduce corruption and there is often a knock-on effect whereby the level of corruption falls across government and society.

· Interaction with revenue systems

· leads to more open, transparent and accountable government and politics, and educates society about its rights and obligations in relation to government. Businesses and individuals who pay taxes, customs and fees/charges are financing the government/political system and feel an increased need to hold it accountable.

· The need to understand and comply with the reformed revenue system can kick-start the development of more sophisticated accountancy, legal and consultancy skills in the economy, which are widely beneficial in the long-term.

Despite this long list of reasons why increased revenue is so important for developing countries, the revenue performance of these countries stands in stark contrast to that of developed countries. In high income countries, including non-OECD countries, average revenue as a proportion of GDP is over 40%, whereas in low income countries it is around 18% and below 10% in the worst performing countries.

There is, however, clear evidence that appropriate revenue reforms in developing countries can improve this situation.

3. Some examples of success in revenue reform

3.1 Case study 1: Tax reform in Afghanistan since 2004

ASI has been engaged in supporting tax reform in Afghanistan since 2004, in programmes financed by DFID. Initially we helped develop a comprehensive tax policy and a modern, consolidated legal regime to reflect that policy. The bulk of the subsequent work was to design and implement a modern tax administration. The tax administration work involved setting up an Afghanistan Revenue Department (ARD) Large Taxpayer Office and Medium Taxpayer Office in Kabul and establishing/developing the tax administration along functional lines in accordance with a new, comprehensive self-assessment approach. This entailed putting in place HRM systems and supporting the recruitment/training/on the job development of a large cadre of tax officials in each functional area.

We also supported ARD to understand where Afghanistan’s revenue was coming from both geographically and in terms of legal/administrative basis, and developing systems and capability to report and analyse revenue effectively. We developed the Revenue Trend Analysis System (RTAS), which tracks historical revenue by type and location over time. This is an invaluable planning tool that we have used to help the Afghanistan Government develop evidence based revenue policy.

In recent years, with the tax base and the number of taxpayer cases expanding dramatically, both the international community and the Afghanistan Government has set increasingly ambitious revenue collection targets and it has been ASI’s job to support ARD to meet these targets while also continuing to lay the foundations for ARD’s sustainable future development as an organisation that can operate effectively without international support.

More recently ARD has also taken forward new areas of modernisation, e.g. the project was rolled out successfully to the priority provinces of Herat, Balkh, Nangarhar, Kunduz and Kandahar and a nationwide tax administration computerisation system, SIGTAS, is being implemented.

ARD reported revenue collection of US$ 1.77 billion for the 2010/11 fiscal year, a 26% increase year-on-year and more than six times the level of revenue collected in 2004/5, when ASI started working with ARD. By comparison, GDP grew 16% year-on-year in 2010/11, implying revenue as a proportion of GDP in excess of 11%, up from 9.7% in 2009/10. Revenue as a proportion of GDP was approximately 4% when ASI started working with ARD on tax reform in 2004/5.

3.2 Case study 2: Tax reform in Burundi since 2009

In 2009, ASI began working in Burundi to assist the Government of Burundi to establish a semi-autonomous revenue agency (OBR), which would manage tax and customs collection. Funding for our work is provided by Trade Mark East Africa, itself largely funded by DFID. We facilitated the transition of the Tax and Customs Departments to the OBR, the retrenchment of redundant staff and the consequent recruitment of 200 senior and middle level staff members for OBR, supported the development of day-to-day operations, and provided training and mentoring on tax and customs administration.

Since July 2010, the team reported directly to the newly-appointed Commissioner of the OBR, an effective individual who had achieved great success in increasing tax revenue in Rwanda as head of the tax administration there. During the second stage, the project oversaw and advised on the procurement of a new IT tax system, the design and implementation of new revenue collection and management systems, the design of financial management and budget procedures and the provision of customs systems.

Under the leadership of the new Commissioner OBR is now being run professionally and tax administration in Burundi has undergone a real transformation. The result is that since 2009 tax revenue has doubled. Around £160m of extra revenue per annum is now being raised. This is a very significant figure and can be expected to increase year by year as revenue performance continues to improve.

There is zero tolerance of corruption and a constant effort to pursue defaulters, whether or not they have political connections. OBR’s quasi-autonomous status and flexibility in making decisions has helped it considerably in achieving this turnaround, although there are still challenges to overcome in that many systems and procedures still require modernisation and negligence and corruption amongst staff have yet to be completely rooted out.

As in the Afghan case, very high value for money has been achieved by the UK-financed technical assistance, with large amounts of extra revenue now being raised on a sustainable basis.

4 How donors can better support developing countries to improve revenue collection

4.1 Holistic, integrated reforms

Revenue reforms should be holistic if they are to have maximum impact and not be counter-productive. A common cause for concern is that revenue reforms are not joined up. This happens when reforms are focused very narrowly, i.e. dealing with one aspect of revenue policy, say VAT, without attention to other policies that should be reformed as well to ensure maximum impact of the VAT reform, i.e. most obviously excise taxes but also direct taxes. Putting in place a range of new policy measures and rates without specifying exemptions is also likely to cause problems as specific sectors and industries lobby for, and are granted, exemptions which are counter-productive long-term.

Similarly, it is often the case that revenue policy and revenue administration reform are undertaken separately, which is a crucial flaw. Administrative capability is a constraint on policy and should inform which policies are adopted. In the same way, policy might be formulated without any thought to how to reflect that policy in law or without the prerequisite assessment of revenue potential.

We recommend that donors should take a holistic approach to revenue reform, ensuring that their involvement is part of a comprehensive package of integrated reforms along the following lines.

4.1.1 Revenue potential study

Revenue potential studies should identify what levels and types of revenue would be available under an adequate revenue system. In the poorest or most fragile countries this study would usually be top-down, using available macroeconomic data to get a general sense of the revenue gap. In more developed countries a bottom-up study can be used to identify the level of non-compliance from the known tax base in an extant tax system.

Revenue potential studies are extremely important in laying the foundations for appropriate revenue policy, law and administration. Without it there is some danger that subsequent reforms will be poorly targeted and counter-productive. A classic example is increasing the tax burden on already compliant taxpayers through more taxes/higher rates when in fact low revenue is more related to the poor compliance of a different set of taxpayers.

4.1.2 Revenue policy

Revenue policy support should culminate in a package of policies which together ensure effectiveness and efficiency across direct and indirect taxes, customs and fees/charges. The more sophisticated the economy, the more detailed the analysis behind the policy will need to be, including which taxes, customs and fees/charges to apply and at which rates, including thresholds and exemptions. Understanding the incidence of different taxes (who ultimately bears the burden of them) is absolutely critical, otherwise the reforms will be at best ineffective and at worst counterproductive/unfair.

Policy can also include the sub-national level, especially in decentralised systems where states/provinces may have substantial revenue autonomy. In some cases revenue policy includes inter-governmental transfers, e.g. in decentralised systems where some states/provinces cannot raise sufficient revenue locally to support public services. Policy formulation requires widespread consultation and agreement with stakeholders.

4.1.3 Legal reform

Legal reform should present the policy in the form of laws that can be implemented in practice. Once revenue policy is in place it should be reflected in the law, either in amended versions of existing laws or in completely new laws. Developing a reformed legal framework requires skilled drafting, excellent translation/reverse translation and widespread consultation. It also requires support for parliamentary scrutiny and approval of amended laws, which can be a complex and lengthy process.

4.1.4 Revenue administration

Revenue administration reforms should develop effective and efficient revenue administration. This is the final, and longest, stage of revenue development, often taking several years in low capacity environments.

It requires intensive support to develop HRD/HRM/training; infrastructure and equipment; processes and procedures; organisation along revenue payer size/admin function lines; taxpayer communications/education; IT for revenue administration that speeds up processing times and reduces the need for human discretion.

Implementing a modern, self-assessment tax system that shifts responsibility to taxpayers and requires the tax administration to act as a service provider is a huge cultural challenge. Building this capability necessarily requires hands-on work with revenue officers through co-location with management and other revenue officers over a long period of time.

Developing a revenue administration from zero is a substantial effort. It is best to begin reforms in areas of the administration that collect most revenue, e.g. in the case of tax administration establishing and developing a large taxpayer office, followed by a medium taxpayer office. Similarly, it makes sense to begin administration reforms in geographic areas that have most revenue potential (linked to the revenue potential assessment described above), e.g. major economic or industrial centres, or busy border crossings in the case of customs.

4.1.5 Recipient government leadership and ownership

Long-term sustainability of reforms requires that the recipient government is not only engaged and supportive, but actually leads and owns reforms. This means that the government is fully invested, that it will be held accountable for failures and take full credit for successes. Without this leadership and ownership, the chances of effective reform are much reduced and there is risk that reform efforts will be a wasted.

4.2 Bilateral, targeted technical assistance

Some revenue reform technical assistance programmes have been implemented through multilateral mechanisms whereby donor funds have been pooled. This weakens the link between the donor, the recipient government and implementing consultant, leading to a lack of ownership and poor results. The bureaucracy associated with multilateral mechanisms is cumbersome and costly, a fact noted by all stakeholders. It is our view that DFID achieves better revenue reform, and receives greater value for money, when it concentrates on targeted bilateral technical assistance.

4.3 The method and style of technical assistance is as important as its technical content

We have noted that the technical substance of revenue reforms in developing countries is rarely disputed in any great detail. There is a general consensus around what is good and an agreement that revenue systems should be developed in certain ways, e.g.:

· streamlining and minimising exemptions;

· Implementing a broad-based VAT;

· establishing a broad-based corporate income tax, at rates competitive by international standards;

· extending the personal income tax base;

· levying excises on a few key items;

· strengthening real estate taxes, which is most important for local government finance

· administration by self assessment

· administration by function, through large taxpayer and medium taxpayer offices;

· the use of an off the shelf IT package for tax/customs administration; and

· a healthy debate regarding the pros and cons of a unified or autonomous revenue agency.

What often makes the difference between the very best revenue reform programmes and those that fail, or are mediocre, is the method and style of how these reforms are implemented. Through our experience in revenue reforms around the world, we have come to identify the following as a selection of the important methods and styles that, taken together, can contribute very significantly to the success of revenue reform technical assistance.

4.3.1 Physical co-location with government counterparts

Being physically co-located with government counterparts means sitting with them in their offices all day every day and being part of their daily work routine. Supporting them with these day-to-day tasks provides information and understanding about the real issues facing counterparts in their daily work. Working with counterparts in a supportive and problem solving capacity gets actual results in terms of achieving counterpart work objectives and also builds capacity as skills are transferred to counterparts both explicitly and tacitly. As trust grows, advisory support becomes easier and technical assistance becomes more productive.

4.3.2 A genuine commitment to capacity building

Recipient governments are very often under tremendous pressure from the international community and from pressure generated internally within the recipient government itself, to focus all attention on raising revenue in the immediate term. In this environment, long-term capacity building is difficult. It is, however, absolutely critical to make capacity building a priority, ensuring that recipient governments own reforms and maximise lessons learned along the way.

4.3.3 Using national and local expertise

Local advisers and consultants provide invaluable local knowledge, their local experience reduces the start-up costs of international consultants working in a new environment for the first time and using them is more cost effective over the long-term than using international consultants exclusively. Deploying international and local consultants together can lead to a dual skills transfer process with international consultants learning about the local environment and how to work in it more effectively, while local consultants learn from the deep and broad experience of international consultants and their background in the technical and operational detail of international best practice and reform in a wide variety of different contexts.

4.3.4 Long terms versus short term international advisers

In our experience, long-term advisers, working on a full-time residential basis for at least a year at a time, sometimes several years, are usually the best solution for recipient governments. These long-term advisers should be able to build very strong relationships with their counterparts and with each other, adding much more value than could have been achieved through shorter-term inputs which focus on pure technical matters.

It is however very difficult to cover the full range of technical expertise required by a project of such complexity without the use of tactical short-term inputs from time to time. It is therefore important to make use of experts on highly specific areas as required, e.g. preparation for implementation of VAT, intergovernmental fiscal relations, land tax, the effect of different tax amnesties, how to tax income from illegal sources etc.

5 Tax evasion and avoidance in developing countries by private individuals and companies

The best way to help reduce evasion and avoidance is to support the holistic revenue reforms described in this submission. The weaknesses or lack of transparency/fairness may be in the policy, law or administration, indeed the strongest likelihood is that it exists in all three parts of the revenue system. As the tax system is strengthened and made fair and transparent, so avoidance and evasion will fall and compliance will improve.

In our experience, the quality of audit functions and audit officers is critical in scrutinising the tax return of large companies, especially very large multi-national companies. A specialist large taxpayer office or unit should be staffed with very well trained audit staff who have the knowledge and the confidence to deal with the most sophisticated tax planning. This alone can have a significant impact on avoidance and evasion.

February 6, 2012