Subnational Tax Policy Design World Bank Decentralization & Intergovernmental Reform Course

1. Subnational Tax Policy Design World Bank Decentralization & Intergovernmental Reform Course May 8-9, 2006 Robert D. Ebel Rebel@worldbank.org

2. Organization of Remarks Part 1 • Why Local Tax Policy Matters • The Five Fundamental Questions of Facing Any Decentralizing System • Policy Framework • Sequencing SNG Revenue Mobilization • Assignment of Revenues • Normative Criteria and Policy Tradeoffs • Tax Architecture • Initial Conditions: Starting Points • What is a “Local Tax”? (Measuring Autonomy) Considerations • Revenue Administration Part 2 • Tax-by-Tax: Normative Evaluation of Choosing Among Tax Bases

3. Part 1

4. Key Messages • Tax Autonomy as the essence of fiscal decentralization • Be clear on what constitutes an “own” local tax • Fiscal Architecture and Starting Points : • On capacity building: do not let lack of “capacity” become an excuse for delay. The challenge is as (more?) likely to be lack of organizational and institutional capacity as distinct from human capital. • Tax administration as tax policy

5. Five Fundamental Questions Facing Any Decentralizing System • Expenditure Responsibility • Revenue Authority • Role for Intergovernmental Grants and Transfers • Timing of Revenues: Borrowing and Debt • Capacity Development: Organizational, Institutional and Human

6. Why Local Tax Policy Matters • Globalization and Localization • The Millennium Development Goals • Fundamental Elements of Design • Efficiency & The Decentralization Theorem • The Essence of Fiscal Decentralization

7. First Policy Considerations • Fiscal equivalence: Each government should finance its own expenditures out of its own revenues to the extent possible. • Subsidiarity in taxation: Assign to the lowest “tier” of government that can administer the tax and for which it is not inappropriate. • Need for mix of local taxes. • No one assignment fits all. • Accountability (own source) • As external factors change, so may policy

8. Preface to Sequencing Revenue Mobilization • LICUS and Post Conflict: What to do when everything is a priority? • Finance Follows Function 1 (4 reasons) • Finance Follows Function 2 - Simultaneity • External Constraints • Be flexible and opportunistic

9. Sequencing SNG Revenues revenue assignment and normative framework  tax principles tax architecture  country starting point  definition of “own” source revenues  implementation

10. Assignment and the Normative Framework (Refer to Accompanying Handout) • Accountability • Revenue Productivity • Benefits Received • Non-Distortion of the Market (Neutrality) • Tax Fairness • Simplicity

11. Tax Architecture (Refer to Accompanying Handout) The Interplay Between Subnational Revenue • Demographic Trends • Economic Structure • Institutional Arrangements and Traditions

12. Politics and Institutions: Country Starting Points(Refer to Accompanying Handout) • Initial Conditions • Illustrations: World Bank Client Countries • Framework and Risks • Subnational Tax Implications

13. What is a “Local Tax” • Who determines whether the tax is to be imposed? • Who determines the nature of the tax base? • Who determines the tax base to which the rate is applied? • Who determines the tax rate applied to that base? • Who collects the revenue and enforces the tax? • Who receives the revenue? • Measurement matters

14. Classification of Local Taxes by Degree of Local Autonomy

15. What To Do When Options Have Been Narrowed? • Matching Principle --Specific Benefits --Generalized Benefits • Fiscal Expediency (?)

16. Revenue Administration • Central Administration with Tax Sharing (Vietnam) • Central Administration with Local Autonomy (Cambodia) • Multilevel Administration (China, Indonesia, Thailand) • Self (Own) Local Administration (Philippines)

17. Further Non-Revenue PolicyConsiderations • Lack of Good Governance & Accountability • Overlapping Assignments • Tax Competition • Intergovernmental Grants Interplay

18. Part 2

19. Normative Framework and Choosing Among SNG Tax Bases • Value Added Tax • Foreign Trade Taxes • Business Income Tax • Individual Income Tax • Excises • Retail Sales Tax • Motor Vehicles • Property Tax • User Charges • Borrowing • Commercial Ventures

20. Criteria for Evaluation Taxation • Accountability and Transparency • Benefit/Tax-Price Link • Neutrality (Non-distortion) • Taxpayer Equity • Revenue Productivity Reliability, Stability, Buoyancy/Elasticity • Administration and Compliance

21. Accountability Local politicians should be responsive to the expressed preferences of the citizens. Voice and participation becomes important. Do Elections Matter? And, need they be local? Implications of the Principle: • Local officials should have the power to determine their “own” tax rates at the margin • What about tax base determination? • And, who should administer the tax base? • The burden of taxes should be borne by local citizens. • The question of “tax exporting” • Information as key to accountability.

23. AccountabilityBenefits Received Benefit/Tax-Price Link To the extent possible taxes should function as a “price” for the benefits of public services that accrue to the tax payer/citizen — benefit areas (recall expenditure assignment) should be matched with financing areas. Implications • Taxes play a role similar to the quid-pro-quo of a market transaction • Adjust for local and regional variations in preferences for public goods(social welfare functions) • Spillovers (back to expenditure assignment, again) may call for (i) sub-municipal government (e.g., s.d.); (ii) local cooperation (Tripoli, Bangkok, Budapest); (iii) middle-tier governments; (iv) regional authorities. • Efficiency meets equity (rather than conflict)

25. AccountabilityBenefits – ReceivedNeutrality (Non-distortion) Non-DistortionTaxes should not unintentionally interfere with the private decisions of consumers, factor suppliers, and producers. That is they should be “neutral” Implications • The heart of “efficiency in taxation” • Variability in rates should be allowed — a priori, non-uniform rates • The key issue of price elasticity • Immobile tax bases rank high; “footloose” tax bases are a problem Interjurisdictional Tax Competition: Good or Bad? • Case for uniform tax bases: and watch out for quality of administration

26. AccountabilityBenefits – ReceivedNeutrality

27. AccountabilityBenefits – ReceivedNeutralityTaxpayer Equity Taxpayer Equity This requires that the burden be measured vis-à-vis some agreed upon common denominator of economic ability to pay and/or benefits received. The equity index should be based on economic criteria A Quick Agreement on Terminology Vertical Equity For Persons (Differential treatment of unequals) • Regressivity, progressivity, proportional • A presumptoin for proporitonal taxes • Should subnational units tax “wealth” • Benefits taxes regardless of “gressivity (?) Horizontal Equity (Equal Treatment of Equals) • Individuals And Businesses

28. AccountabilityBenefits – ReceivedNeutrality (Non-Distortion)Taxpayer Equity … and Measurement • Individuals: Income and additions to wealth (broad vs. narrow income) • Businesses • Gross Product (if one can estimate it) • The Key issue of multi-jurisdictional apportionment

29. AccountabilityBenefits – ReceivedNeutrality (Non-Distortion)Taxpayer Equity Implications cont’d • Regulation and intergovernmental revenue sharing comes into play; intergovernmental structure and nation building • What about multinational natural resources? (common property problem)

30. AccountabilityBenefits – ReceivedNeutrality (Non-Distortion)Taxpayer EquityRevenue Mobilization Stability & Buoyancy Reliability, Stability, Buoyancy/Elasticity Question: what should be the elasticity: “Automatic” changes in Revenues = % Change in Yield Change in some economic base Implications • The tradeoff is evident; stability vs. buoyancy • Not to be confused with “adequacy” • Stability is conducive to competitiveness (private investment) • This topic also goes to the intergovernmental grant pool

31. AccountabilityBenefits – ReceivedNeutrality (Non-Distortion)Taxpayer EquityRegional EquityStability, Buoyancy

32. AccountabilityBenefits – ReceivedNeutrality (Non-Distortion)Taxpayer EquityStability, Buoyancy Administration & Compliance Administration and Compliance Taxes and tax systems should be transparently administered at low cost and without placing an undue burden on the taxpayer (business and individual) Implications • Keep it simple: especially locally • What may be optimal to the economist may simply not “work” • Citizens should have a tax system they can understand and control • “Achilles heel” of subnational Credit-Invoice VAT • Standardized Tax Bases

33. AccountabilityBenefits – ReceivedNeutrality (Non-Distortion)Taxpayer EquityRegional EquityStabilityAdministration & Compliance Implications cont’d • Easily identifiable (“simple”) tax bases (e.g., turnover, head) may be in conflict with other criteria); but there are some consistencies as well • Complexity may foster corruption

34. Key Messages (repeated) • Tax Autonomy as the essence of fiscal decentralization • Be clear on what constitutes an “own” local tax • Fiscal Architecture and Starting Points : • On capacity building: do not let lack of “capacity” become an excuse for delay. The challenge is as (more?) likely to be lack of organizational and institutional capacity as distinct from human capital. • Tax administration as tax policy