DEVELOPMENT ORIENTED TAX POLICY

DEVELOPMENT ORIENTED TAX POLICY JOSEPH STIGLITZ COLUMBIA UNIVERSITY AND THE INITIATIVE FOR POLICY DIALOGUE PRAGUE AUGUST 2003

INTRODUCTION—BASIC ISSUES • DESIRABILITY OF RAMSEY TAXES • DESIRABILITY OF V.A.T. • DESIGN OF CORRUPTION RESISTANT TAX STRUCTURES

DEVELOPMENT ORIENTED TAX POLICY • WHY SHOULD TAX POLICY FOR DEVELOPED COUNTRIES BE DIFFERENT FROM THAT FOR DEVELOPING COUNTRIES? • DIFFERENCES IN STRUCTURE OF THE ECONOMY • DIFFERENCES IN OBJECTIVES

DIFFERENCES IN OBJECTIVES • IN ADDITION TO USUAL CONCERNS ABOUT EQUITY, EFFICIENCY, ADMINISTRATIVE EFFICIENCY, FLEXIBILITY/AUTOMATIC STABILIZERS • PROMOTE DEVELOPMENT • Create markets • Create new institutions • REDUCE CORRUPTION

DIFFERENCES IN STRUCTURES • HIGH LEVELS OF URBAN UNEMPLOYMENT • OTHER MARKET IMPERFECTIONS • Credit rationing • Neoclassical models particularly inappropriate • LARGE INFORMAL SECTOR • Urban rural migration • HIGH LEVELS OF CORRUPTION IN MANY LDC’S • DIFFERENCES IN “OBSERVABILITY”

DIFFERENCES IN STRUCTURE • DISTORTIONS IN TAX POLICY ARISE OUT OF LIMITATIONS ON OBSERVABILITY • WHICH IS WHY LUMP SUM TAXES ARE NOT USED • WHICH IS WHY RELIANCE IS PLACED ON DISTORTIONARY TAXES, LIKE INCOME TAXES

TWO EXAMPLES OF MARKED DIFFERENCES IN POLICIES • DESIRABILITY OF RAMSEY TAXATION • DESIRABILITY OF V.A.T.

I. DESIRABILITY OF RAMSEY TAXATION • NEEDS TO BE VIEWED AS PART OF OVERALL TAX STRUCTURE • IN LIGHT OF WHAT OTHER TAXES CAN BE IMPOSED • AND THAT DEPENDS ON WHAT IS OBSERVABLE

OBSERVABILITY IN DEVELOPED COUNTRIES • IT IS DIFFICULT TO OBSERVE HOURS WORKED • IT IS DIFFICULT TO OBSERVE CONSUMPTION OF ANY INDIVIDUAL OF PARTICULAR COMMODITIES— • LIMITS ABILITY TO USE COMMODITY SPECIFIC NON-LINEAR CONSUMPTION TAXES • ELECTRICITY IS AN EXCEPTION

OBSERVABILITY IN DEVELOPING COUNTRIES • PROBLEMS ARE GREATER • PARTLY BECAUSE DEVELOPED COUNTRIES HAVE BECOME DEPENDENT ON INFORMATION RICH TECHNOLOGIES • BANKS • INTERNAL CONTROL MECHANISMS

MONITORING INCOME IN CASH ECONOMIES IS DIFFICULT • AND CAN IMPOSE SIGNIFICANT INCREMENTAL COSTS • EVEN IN DEVELOPED COUNTRIES, UNTIL RECENTLY IT WAS DIFFICULT TO MONITOR INCOME OF SOLE PROPERTIERSHIPS AND PARTNERSHIPS • BUT THESE PREDOMINATE IN DEVELOPING COUNTRIES • IMPLICATION: FEW DEVELOPING COUNTRIES HAVE A WELL FUNCTIONING INCOME TAX SYSTEM

POTENTIALLY STRONG IMPLICATIONS: • ATKINSON-STIGLITZ THEOREM: WITH OPTIMAL INCOME TAX THERE SHOULD BE NO COMMODITY TAXATION AND NO INTEREST INCOME TAXATION (GIVEN CERTAIN RESTRICTIONS ON PREFERENCES) • RAMSEY TAX STRUCTURE DEPENDS ON THE ABSENCE OF AN INCOME TAX • CLEARLY NOT RELEVANT FOR MOST DEVELOPED COUNTRIES • BUT MAY NOT BE A BAD APPROXIMATION FOR MANY DEVELOPING COUNTRIES

II. DESIRABILITY OF V.A.T. • IMF ADVOCATED V.A.T. AROUND THE WORLD • LONG STANDING OBJECTIONS: NOT PROGRESSIVE • BUT COUNTERBALANCING THESE OBJECTIONS: • EFFICIENCY • LOW ADMINISTRATIVE COSTS

EFFICIENCY • BASED ON PRE-RAMSEY REASONING—UNIFORM TAXES ARE LESS DISTORTIONARY THAN DIFFERENTIATED TAXES • REINFORCED BY CONCERNS ABOUT ABILITY TO ADMINISTER DIFFERENTIATED TAX SYSTEM

BUT…. • ABSENCE OF INCOME TAX MAKES IT EVEN MORE DESIRABLE TO HAVE DIFFERENTIATED TAXES THAN IN DEVELOPED COUNTRIES • AND FACT IS V.A.T. IS NOT A UNIFORM TAX

TAX IS LARGELY COLLECTED IN FORMAL SECTOR • WHICH IS PRECISELY SECTOR THAT DEVELOPING COUNTRIES WANT TO PROMOTE • INTRODUCES DISTORTIONS BETWEEN FORMAL AND INFORMAL SECTOR—EVEN IF IT REDUCES DISTORTION BETWEEN IMPORTED AND LOCALLY PRODUCED GOODS • INTRODUCES DISTORTIONS IN THE MIX OF INPUTS

V.A.T. IS NOT AN EFFICIENT TAX • V.A.T. MAY BE PARTICULARLY UNDESIRABLE BECAUSE IT DISCOURAGES THE FORMAL SECTOR, THE SECTOR WHICH MOST DEVELOPING COUNTRIES WANT TO PROMOTE

OTHER OBJECTIONS TO VAT • VAT MAY LEAD TO INCREASED UNEMPLOYMENT • VAT MAY LEAD TO REDUCED GROWTH • WHEN APPLIED GLOBALLY, V.A.T. HAS GLOBAL DISTRIBUTION EFFECTS—HURTING DEVELOPING COUNTRIES

OTHER OBJECTIONS TO VAT • VAT MAY NOT HAVE LARGE ADMINISTRATIVE ADVANTAGES IN DEVELOPING COUNTRIES • VAT IS LESS CORRUPTION RESISTANT THAN OTHER TAX STRUCTURES

SUMMARY • USUAL ARGUMENT: V.A.T. IS NOT PROGRESSIVE, BUT IS EFFICIENT • OTHER INSTRUMENTS FOR DEALING WITH DISTRIBUTION • BUT FOR DEVELOPING COUNTRIES, VAT IS NOT AN EFFICIENT TAX • GIVEN ABSENCE OF OTHER PROGRESSIVE TAXES, LACK OF PROGRESSIVITY OF V.A.T. IS OF PARTICULAR CONCERN

EVEN WITH WTO, MAY BE POSSIBLE TO DIFFERENTIATE TAX RATES BETWEEN FINAL GOODS PRODUCED AT HOME AND IMPORTED FINAL GOODS • Encourage domestic production, development • If imported goods differentially consumed by well off, such differentiation introduces an element of progressivity

V.A.T. May Lead to Higher Unemployment Rate • In standard migration equilibrium model, with efficiency wage, labor productivity is higher in urban than in rural sector • Hence V.A.T. lowers overall output as labor is induced to move to low productivity sector • And if there is diminishing returns in rural sector, V.A.T. leads to lower wages in both the rural and urban sector and higher unemployment • Potentially large adverse distributional consequences

V.A.T. May also lead to lower overall growth • If rate of productivity growth is higher in the formal sector • Simple case—no productivity growth in rural sector • Assume Qu = F(λLu) • Then gQ = gλ (sm) • Where s is share of formal sector • m ≡ F’λL/F • The effect is even stronger if we introduce learning by doing. For then • gλ = ξ (Lu), ξ’ > 0

EVEN STANDARD ARGUMENT THAT V.A.T. IS A GOOD TAX BECAUSE IT IS “SELF ENFORCING” IS NOT VALID IN DEVELOPING COUNTRIES • BECAUSE PURCHASERS OF MANY INPUTS DO NOT PAY V.A.T.

GLOBAL GENERAL EQUILIBRIUM EFFECTS • WHEN V.A.T. IS IMPOSED IN ALL DEVELOPING COUNTRIES, IT INCREASES OUTPUT OF GOODS PRODUCED IN INFORMAL SECTOR, WITH GLOBAL GENERAL EQUILIBRIUM EFFECTS—PRICE OF COMMODITIES, INPUTS INTO DEVELOPED COUNTRIES, FALLS • WHILE V.A.T. DISCOURAGES PRODUCTION OF FORMAL SECTOR—GOODS THAT ARE SUBSTITUTES FOR GOODS PRODUCED IN DEVELOPED COUNTRIES

AT A GLOBAL SCALE • VAT SHIFTS DISTRIBUTION OF INCOME/WELFARE TO BENEFIT DEVELOPED COUNTRIES AT THE EXPENSE OF DEVELOPING COUNTRIES

TWO KEY ISSUES THAT TAX POLICY SHOULD HAVE FOCUSED ON • PROMOTING DEVELOPMENT • SHIFTING RESOURCES INTO SECTORS WITH FASTER ECONOMIC GROWTH, MORE SPILL-OVERS • CAN BE IMPORTANT INGREDIENT IN INDUSTRIAL POLICIES

CASE AGAINST V.A.T. • FOR DEVELOPED COUNTRIES, V.A.T. IS EFFICIENT, BUT REGRESSIVE (OR AT LEAST NOT PROGRESSIVE) • But lack of progressivity made up for by progressive income tax • IN DEVELOPING COUNTRIES, • Typically there is no effective income tax to make up for lack of progressivity • V.A.T. IS ALSO NOT EFFICIENT • And may impede development • And when imposed in all developing countries, may have adverse terms of trade effects

III. CORRUPTION RESISTANT TAX STRUCTURES • RECOGNIZE THE EXISTENCE OF CORRUPTION • CORRUPTION CAN BE VIEWED AS A PROBLEM IN OBSERVABILITY • SOME TAX STRUCTURES PROVIDE LESS OPPORTUNITY FOR CORRUPTION

STANDARD APPROACHES OFTEN A FAILURE • ARGUE THAT GOVERNMENT SHOULD STRENGTHEN ENFORCEMENT • SUCH POLICIES ENABLE CORRUPT TAX POLICE TO EXTRACT MORE MONEY FROM PRIVATE SECTOR • INHIBITING DEVELOPMENT, WITHOUT GENERATING MUCH REVENUE FOR GOVERNMENT

MODELLING CORRUPTION RESISTANT TAX STRUCTURES • TWO TYPES OF CORRUPTION • Underreporting incomes of rich • Insisting on bribes not to overreport incomes of “honest” tax payers • ADDRESSING CORRUPTION • Penalties for those caught cheating • But limits imposed by errors in judgment • And by capital constraints

Corruption Resistant Tax Structures • SOME BASES OF TAXATION ARE EASIER TO OBSERVE AND VERIFY • Window tax • Car imports • Square meter tax in housing • IT MAY BE EASIER TO DESIGN INSTITUTIONAL ARRANGEMENTS FOR THE COLLECTION OF SUCH TAXES WITHOUT CORRUPTION

CONCLUDING REMARKS • NOTE OF CAUTION • TAX STRUCTURES, SUCH AS THE V.A.T. THAT MAY WORK WELL IN DEVELOPED COUNTRIES MAY NOT WORK WELL IS DEVELOPING COUNTRIES • OBJECTIVES AND ECONOMIC STRUCTURES DIFFER MARKEDLY • KEY OBJECTIVES SHOULD BE PROMOTING DEVELOPMENT • Including helping create good institutions • Individuals respond to incentives, badly designed tax structures enhance opportunities for corruption, and undermine institutional development

DEVELOPMENT ORIENTED TAX POLICY