How to Increase Tax Revenue in Poor Countries - YouTube

In many of the world’s poorest countries, tax revenues are extremely low.

Rich countries collect 40% of GDP in taxes, but the equivalent number here is only 10%.

This constrains economic development as a lack of government revenue can lead to lower-quality

public services and inhibit growth.

Is raising tax rates one potential solution?

The answer is not clear-cut: while higher rates mechanically increase revenue by increasing

what taxpayers owe, they can also induce behavioral responses (such as increased delinquency)

that reduce revenue.

This concern is especially relevant in countries where state capacity is low and tax enforcement

is far from perfect.

To assess the relationship between tax rates and tax revenue, the authors conducted a randomized

controlled trial in the Democratic Republic of the Congo.

The DRC is one of the largest and most populous countries in Africa, but also one of the poorest.

The country has low state capacity, especially in terms of tax enforcement, and from 2000

to 2017 was ranked 188th out of 200 countries in terms of its tax to GDP ratio.

To test the impact of changing the tax rate, an experiment was embedded in the 2018 property

tax campaign in Kananga, the country’s fourth largest city.

Each of the city’s 38,000 properties was randomly assigned to receive either the status

quo tax liability or a reduction of 17, 33, or 50%.

Those in the Treatment group were informed of their liability, but not that they had

received a reduction.

And the results show that lower rates substantially increased tax compliance.

Only 5.6% of the Control group paid their property tax, while compliance was 6.7, 10,

and 13% for those who received reductions.

Notably, the compliance response was largest for property owners facing liquidity constraints.

This suggests the results partly reflect that low-income or otherwise cash-constrained individuals

only enter the tax net when rates are sufficiently low.

And, because taxes in this setting are levied as a flat fee and partial payments are not

allowed, higher compliance translated to higher revenue.

A 1% increase in the tax rate reduces revenue by 0.243%.

These findings imply that cutting tax rates would increase revenue.

In fact, the authors estimate that the revenue-maximizing tax rate, or RMTR, is 66% of the status quo

rate.

In other words: under existing conditions, the government would maximize revenue by cutting

tax rates by 34%.

However, this is the RMTR under existing conditions.

Is it possible to change it?

In particular, a natural question in countries with low state capacity is whether investments

in tax enforcement would affect the RMTR.

To investigate, the authors utilize two sources of variation in enforcement.

First, property owners in this setting were informed of their tax liability via a printed

government tax notice.

In addition to information about the property tax and rate, these letters contained randomly

assigned messages.

While one set informed recipients that refusal to pay their property tax would entail the

possibility of audit and investigation, the other simply stated that paying the tax is

important.

Not only did enforcement messages increase compliance and revenues, the estimated RMTR

is 41% higher among owners in this group.

This suggests that investing in tax enforcement can actually raise the RMTR.

To further explore this, the authors also exploit the random assignment of tax collectors

to neighborhoods.

Property taxes in Kananga are collected door-to-door, and individual collectors vary in their enforcement

capacity: some are systematically more skilled at collecting taxes than others.

And the authors find that collectors with higher enforcement capacity also have higher

RMTRs.

If the government were to replace the tax collectors in the bottom quartile of enforcement

capacity with average collectors, the RMTR would increase by 42%.

This indicates that investing in enforcement capacity could allow developing countries

to increase their revenue-maximizing tax rates.

In fact, a key takeaway of this paper is that tax rates and tax enforcement are complementary

policy levers.

A government attempting to maximize its revenue should jointly optimize both dimensions rather

than optimizing each independently.

To illustrate that point, this figure plots estimated tax revenue as a function of the

tax rate in this setting.

The pink dot indicates the status quo tax rate, while the maximum of the curve is the

RMTR.

As seen before, if the government were to cut the status quo rate to reach the RMTR,

revenue would increase by 32%.

Suppose, however, that after implementing the RMTR, the government also decides to increase

enforcement by replacing low-capacity tax collectors with average collectors.

This shifts the estimated revenue curve up and to the right, and at the same tax rate,

revenue would now be 61% higher.

But the key is that higher enforcement has actually shifted the RMTR.

If the government jointly optimized by increasing enforcement and prospectively choosing its

tax rate to correspond to this new RMTR, revenue would be even higher.

In conclusion, this paper sheds light on the joint role of tax rates and tax enforcement

in generating tax revenue in settings with low state capacity and limited compliance

with formal taxes.

Countries in this category represent some of the most urgent development challenges

today, and increasing tax revenues are a key step in facilitating their growth and development.

To read more on this topic you can check out the paper’s references to other related

work.

These include other papers on taxation in developing countries, those studying tax enforcement

more broadly, and finally research on optimal tax rates.