Equity and Eciency in Tax Reform in Developing Countries

M. Shahe Emran1 Department of Economics and ESIA George Washington University Joseph E. Stiglitz Columbia University This Version: July 2007

ABSTRACT This paper provides a critical analysis of the current consensus on tax reform in developing countries in terms of both eciency and equity objectives. Drawing on the recent theoretical advances it shows that the emphasis on value-added tax (VAT) as the main instrument for indirect taxation is likely to result in ineciency in resource allocation due to production and consumption substitutions in favor of the informal/shadow economy. Such a reform can also have adverse eects on the long-run growth as a small formal sector reduces the scope for technological progress in the economy. Imposition of VAT may also retard the development of markets, especially in the rural areas. The tax reform policies implemented in a large number of developing countries that reduce the tari and shifts the burden of raising revenue to VAT are also likely to be undesirable in terms of equity. The available evidence shows that the current emphasis on uniform VAT is especially regressive. The prevalence of corruption in tax administration is likely to make the incidence of tax reform more inequitable as compliance with VAT is information-intensive, and thus it places the poor in a disadvantage in the bargaining against a corrupt tax collector given their lack of education and record-keeping.

1 We would like to thank Stephen Smith for helpful discussions, and Zhaoyang Hou, Tony Castleman, and Anastasia Gushchina for excellent research assistance. The standard disclaimers apply. Email: shahe.emran@gmail.com (M. Shahe Emran), Ph: 202-994-6922.

Electronic copy available at: http://ssrn.com/abstract=1001269

Introduction
Over the last few decades, signicant tax reform has been undertaken in a large number of developing countries, most often under the policy conditionalities of the structural adjustment programs of the World Bank and IMF (for recent discussions of tax policy in developing countries, see Bird and Zolt (2005), Gemmell and Morrissey (2003), Emran and Stiglitz (2005, 2004), Munk (2005)). The core of the tax reform program constitutes of the following components: (i) a drastic reduction in import tari and export taxes, (ii) the introduction of VAT to recover the lost trade tax revenue. Although the trade-o between the eciency and equity has been at the heart of the theory of tax policy, the recent literature on tax policy reform in developing countries has focused primarily on the eciency aspects. An important implicit assumption underlying this reform package has been that the expenditure side of the budget is the appropriate instrument for redistribution, and tax reform will be able to provide the government with the revenue required to make the over-all incidence of the scal system progressive through targeted expenditure programs. The recent evidence, however, shows that the loss of revenue from a reduction of import tari was not compensated for by other taxes including the introduction of VAT in the low income countries. Table 1 reports the tax eort of a sample of Asian countries over a period of three decades. There are a number of countries (Pakistan, Indonesia, Sri Lanka, Iran, Malaysia, and Singapore) where the tax revenue as a percentage of GDP has actually declined in 2004 compared to the benchmark of 1980. The picture for the other countries in the sample is also not very encouraging as the tax revenue as a percentage of GDP remained mostly stagnant. This paper takes a fresh look at the equity and eciency implications of the prevailing consensus on tax reform in developing countries. The paper raises some important questions about the consequences of this reform package in terms of both equity and eciency. The main ndings of the paper are summarized as follows. In terms of eciency implications of the recent tax reform in developing countries, the conclusions are: (i) the almost exclusive emphasis on VAT as an instrument for indirect taxation is likely to be welfare reducing due to intersectoral substitutions in favor of the informal sector, (ii) it might have adverse eects on economic growth as the informal sector rms are technologically backward, and the technological progress depends on the size of the formal sector, (iii) VAT might retard the development of the markets by reducing market participation by households, especially in the rural areas. With regards to the distributional eects of the 1

Electronic copy available at: http://ssrn.com/abstract=1001269

tax reform, the main conclusions are: (i) the recent reform of indirect taxes is likely to make the scal incidence more regressive in developing countries, especially when the distributional eects of corruption is taken into account, (ii) the uniform VAT coupled with VAT base broadening is, in general, signicantly regressive, (iii) the exemption of (as opposed to zero rating) agriculture from VAT as an indirect way of taxing the sector might be an undesirable policy because of missing risk and insurance markets, (iv) the current practice of assuming a full forward shifting for all commodities and all households is likely to provide us with an optimistic picture of the progressivity of indirect taxes, and nally (v) the employment eects of the standard indirect tax reform are likely to be unfavorable. A major reorientation of the current tax reform policies is needed to make the scal reform in developing countries more ecient, equitable, and growth promoting.

Section 1: Tax Reform, Eciency and Growth

(1.1) Indirect Tax reform and Economic Eciency
It is obvious yet little appreciated in the current scal reform literature that the developing countries dier systematically from the developed countries, and such dierences have profound implications for designing appropriate tax policies. The share of agriculture is signicantly larger in the developing countries, especially in the low income ones. It is, in general, extremely dicult to tax agricultural sector due to the prevalence of small farm households. An important aspect of an underdeveloped economy for the design and implementation of scal policy is that the extent of markets and monetization is limited in such an economy. According to the estimates of the level of monetization in Table 2, the extent of monetization has increased signicantly in the Asian countries over the last three decades. However, the level of monetization in relatively low income countries like Bangladesh (38 percent of GDP) and Nepal (35 percent of GDP) remains signicantly lower when compared to high income countries like Singapore (117 percent of GDP) and Japan (134 percent of GDP) in 2003. The set of markets available in low income developing countries like Bangladesh and Nepal is rather limited, especially the markets for risks and intertemporal transactions like credit and insurance markets are either missing or function poorly. Even when a market exists, the participation by the households in the market may be low, as is

the case for most of the agricultural markets in the developing countries. Only a relatively small proportion of the production of agricultural commodities like rice (which is important for most of the Asian developing countries) is actually transacted through the markets. In other words, marketed surplus is very low for most of the agricultural crops, except for the crops that may be produced exclusively for exports in plantation agriculture. Even when rural households transact in the market, it may be barter transaction and the level of monetization may be low. The straightforward implication of this observation is that one has to be careful about the ecacy of the standard indirect taxes like general sales tax or value added tax in such an economy, a point explored in further detail below. The low level of monetization also has important implications for seigniorage as a possible revenue instrument in a developing economy. The policy implication of missing risk markets is that any policy choice has to pay close attention to the possible role of a tax instrument for mitigating the risk faced by the households, especially the poorer section of the society. For example, a classic argument in public economics favors land tax over output taxation as land tax is a tax on rent and thus non-distortionary2 . However, as shown by Ho (1991), an output tax (ad valorem) might in fact dominate a land tax in terms of welfare as the land tax does not vary with the prices but the tax burden from an ad valorem output tax does vary with the price volatility in a desirable way; when the price falls, the tax burden on the farmers also goes down. The ad valorem output tax thus works as a partial insurance mechanism for the poor farmers lacking any kind of insurance markets against price or weather risk.3

Informal Economy and Tax Reform

Given that the economic structure is markedly dierent in developing countries, the relevant question, for both theory and policy, is what are the implications of the dierences for appropriate tax policies. As we discuss in the following, a better appreciation of the economic structure in developing countries raises serious doubts regarding the appropriateness of the current consensus on tax reform in developing countries. As Table 3 shows there has been a signicant shift in
This is a static argument. In a dynamic context, taxes on land might aect the investments made to improve the productivity of land (tax overhang). 3 Note that even if the land tax is indexed to the land price, the negative risk bearing implications of a land tax remains there. This is because of a couple of reasons: (i) the land price used for indexation can not presumably be adjusted to reect negative weather shocks immediately, (ii) the land price as a present value of net returns will be much less responsive to a production shock. Also, with weak tax administration and lack of reliable land price information, a land tax indexed to the price of land is likely to open doors to signicant corruption and abuse.
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the indirect tax structure in a sample of Asian countries over the decades of 1980s to 1990s. The traditional and historical reliance of the developing countries on trade taxes (mostly import tari) has been signicantly reduced, and value added tax (VAT) has become the preferred instrument for indirect tax revenue. For example, in case of India the share of trade taxes in total tax revenue declined to 13 percent in 2004 from 28 percent in 1990 (the year immediately preceding the trade liberalization in 1991). The intellectual underpinning for the shift away from trade taxes to VAT has been provided by the Diamond-Mirrlees production eciency Lemma. The Diamond-Mirrlees Lemma says that, under certain conditions, it is optimal to preserve the production eciency in the economy, i.e., the producer prices should not deviate from the world prices (for tradable goods). This implies, in particular, that trade taxes should be eliminated as they aect the producer prices, and taxes on domestic consumption is the optimal instrument for raising revenue to nance government expenditure. This theoretical result constitutes the fundamental justication for the indirect tax reform implemented in developing countries over the last few decades (see, for example, the recent IMF publication titled The Modern VAT). The proponents of this tax reform, however, neglect the implications of the economic structure of developing countries: the most critical being the presence of a large informal economy. Table 4 provides some estimates of the shadow economy and the size of the informal economy in a sample of Asian countries. Note that the informal economy is dened as the segment of the economy that escapes the tax net; it thus includes both the shadow economy and agriculture. The size of the informal economy is very large in a typical developing economy, often exceeding 50 percent of GDP. This implies that the eective base for a consumption tax like VAT is narrow in a developing country. A recent estimate for Nepal shows that less than 25 percent of gross national expenditure constitutes the base for VAT (Jenkins and Kuo, 1996). As emphasized recently by Emran and Stiglitz (2005, 2004), the presence of a large informal sector invalidates one of the critical assumption underlying Diamond-Mirrlees Lemma: the assumption of complete coverage for the consumption tax. When the size of the informal and shadow economy exceeds 50 percent of GDP, the argument that the conditions for Production Eciency Lemma to be valid are satised approximately seems completely untenable. As shown by Emran and Stiglitz (2005), a revenue neutral reduction in the tari on one commodity with an increase in VAT on another might lead to a worsening of consumer welfare when the incomplete coverage of VAT is factored 4

in. The intuition for the above conclusion is straightforward; the VAT which can only be levied on the formal rms generates perverse incentives for the rms to move to the shadow of informal economy. The tari on the other hand aects the formal and informal rms symmetrically and thus does not induce the production substitutions in favor of the informal economy. To see this dierence in the eects of VAT and tari on the prices of formal and informal sectors, denote the VAT by vi and tari by i on commodity i. Normalizing the world prices to 1, we have the following price relations:
f s qi = ps = 1 + i = qi = pf i i

Import tari

f s ps = qi = 1 + vi = qi > pf = 1 VAT i i

where q and p stand for consumer and producer price respectively, and superscripts s and f denote informal and formal economy respectively. The more recent theoretical results on consumer or producer price neutral tax reform (so called win-win reform) that are readily invoked to justify the current trend toward heavy reliance on VAT (for example, Hatzipanayotou et. al. (1994), Keen and Ligthart (2002), Emran (2005)) also share the same limitations, as the conclusions critically depend on the assumption that there is no informal economy (for details see Emran and Stiglitz (2004)). The extensive use of these theoretical results in the literature on tax policy reform in developing countries are thus misleading and inappropriate.4 In a recent paper, Keen (2006) shows that when the intermediate inputs used in the informal economy is taxed optimally by setting the VAT rate appropriately as part of an optimal tax design, there is a version of Diamond-Mirrlees result that holds and it is optimal to eliminate the tari. It is argued that the standard tax reform implemented in developing countries is thus desirable even in the presence of an informal economy. This argument is, however, misleading for a number of reasons. First, the theoretical analysis mentioned above does not take into account the implications of missing risk markets in developing countries. It is
An argument often made in defense of a tax like VAT is that it should be looked upon as an agent of over-all modernization of government and thus should be interpreted as a visionary policy (see, for example, Keen (2006)). This argument is curious, as it is a selective application of the much maligned infant industry argument to the case of tax administration. It is interesting that such arguments were common in 1960s when a comprehensive income tax was being pushed through by the international tax experts as the solution of the scal woe of the developing countries. For a discussion on the experience with the comprehensive income tax reform in developing countries, see Bird and Zolt (2005).
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especially important for agriculture as the insurance market for crops is non-existent in most of the countries. Indirect taxation of inputs like fertilizer through VAT exemption of agriculture may be welfare reducing as the farmers bear all the production and price risks; even if there is drought or ood and the farmer loses all her crops, it is not possible for her to claim input rebates under a VAT exemption. The tax burden is not sensitive to the weather and price (of output) shocks faced by the farmers, it stays same even when their revenue and thus the value added is reduced signicantly because of a drought or a ood (a common and signicant problem in a country like Bangladesh). In contrast, a tax on output, like an (ad valorem) export tax has the desirable Note that

feature that the tax burden goes down with a negative production or price shock.

the traditional village level consumption smoothing mechanisms emphasized in the development literature (see, for example, Morduch, 1995 ), are ineective in this case, as every farmer faces the same input taxes and the shocks are usually common to all villagers. Another issue relevant for taxation of agricultural inputs like fertilizer is that it is likely to adversely aect the incentives for farmers to adopt HYV technology.
5

Again, a tax on output does not discriminate against

the modern technology (HYV rice, for example) and thus does not constrain the technological change in agriculture. Second, from a practitioners point of view, the optimal tax design result due to Keen (2006) might be of little relevance as the policy makers almost never start with a clean slate. For all realistic policy scenarios, the relevant results are the ones that look at the role of intermediate inputs in tax reform starting from an arbitrary tax structure determined by history. The tax reform (as opposed to optimal tax design) results due to Emran and Stiglitz

(2004) remain more relevant for any realistic policy reform exercise in a developing country.

VAT and the Extent of the Market

A common argument in favor of a consumption tax compared to tari is that while tari is doubly distortionary (i.e., it distorts both consumption and production decisions), consumption tax only aects the consumer price leaving the production decisions undisturbed. This argument however fails to recognize that the VAT also creates an additional distortion; it creates a wedge between the consumer and producer prices, but tari does not. To see this, consider the following
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Although, arguably, it is more important in Africa where the spread of green revolution still remains a challenge.

price relations under VAT and import tari: qi = pi = 1 + i qi = 1 + vi > pi = 1 Import Tari VAT

This has important implications in a developing economy where the standard separability of consumption and production decisions is not valid, and home production (or self-supply) is predominant, especially in the rural areas. The market participation by the rural households is limited, a point discussed earlier. The wedge between the consumer and producer price created by VAT works eectively as a transaction costs band and the households for which the shadow value of commodity i falls inside the band withdraw from the market. Denote the shadow price of commodity i by i (Zh ) which is a function of a vector of household characteristic Z for household h. In the absence of a VAT almost all the households participate in the market (except for the household h such that i (Zh ) = qi = pi = 1 + i ). With the imposition of VAT, the households in the interval [h, h] do not participate in the market, where h h i (Zh ) = pi = 1 i (Zh ) = qi = 1 + vi In

The imposition of VAT thus can result in a contraction of the extent of the market. contrast, tari leaves the extent of the market unchanged.

Administrative Costs and Indirect Tax Reform

An important factor in the choice of appropriate tax bases is the dierential administration costs involved in dierent taxes. The theoretical analysis of tax policy design or tax policy

reform, however, usually neglect the administrative costs. There is substantial evidence that the administrative costs of VAT are much higher than that of trade taxes (see, for example, World Development Report, 1988). In a recent paper, Munk (2005) shows that when this dierence in the adminstration cost is taken into account, the case against a VAT-centric indirect tax structure in developing countries is substantially strengthened. It is sometimes argued that VAT is self-enforcing under an invoice- credit system of rebates 7

and thus administratively attractive. However, the recent evidence shows that because of the extensive informal economy, the VAT is far from self-enforcing.6 . In fact, as shown recently, both theoretically and empirically, by de Paula and Scheinkman (2006), in the presence of informal sector the VAT invoice-credit system generates a chain eect of informalization between the upstream and downstream rms. Their empirical evidence using rm-level data from Brazil shows that such chain eects are quantitatively important.

(1.2) Indirect Tax Reform and Economic Growth

The standard indirect tax reform that relies heavily on VAT as an instrument for government revenue also has important implications for long run growth in a developing economy. The central concern here is that as rms move to the informal sector it is likely to retard technological progress in an economy. The recent evidence from in-depth studies on a number of developing countries by McKinsey Global Institute (see Farrell et. al. (2004)) shows convincing evidence that the informal sector rms suer from technological backwardness. According to their estimates, the labor productivity of an informal rm (relative to a formal rm) is only 39 percent in Turkey and 46 percent in Brazil. A move to the informal sector thus adversely aects the average More importantly, a shrinking (or lower growth in) formal

level of technology in an economy.

sector is likely to have dynamic eects, especially because of the fact that learning by doing and technological progress is a positive function of the size of the formal sector. adversely the long-run economic growth in a developing country. This will aect

Moreover, as pointed out

recently by Greenwald and Stiglitz (2006), there are important cross-sectoral externalities from the formal industrial sector to the agricultural/traditional sector, and thus a shrinking formal industrial sector may constrain the growth of the agricultural sector also.

Section 2: Distributional Implications of Tax Reform

As noted before, the current discussion on tax reform in developing countries focuses on the eciency aspects. It is argued that the expenditure side is the appropriate instrument for redistribution.
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Such assignment of policy instruments (i.e., tax policy for revenue raising and

The recent IMF publications like The Modern VAT de-emphasizes this presumed advantage of the VAT rebate system, although earlier World Bank and IMF publications actively promoted the argument

expenditure for distribution), however, lacks any theoretical basis. More importantly, as mentioned before, the recent tax reform has failed to recover the last trade tax revenue, especially for the low income developing countries (Bunsgaard and Keen, 2005), and as a result expenditure cut has been a common feature of the structural adjustment programs. The tension between equity and eciency has always been at the center of economic analysis of tax policy and there is a large literature that discusses the roles of direct and indirect taxes in achieving equity objectives. The seminal result in this regard is the Atkinson-Stiglitz (1976) theorem that tells us that, under certain conditions of separability, indirect taxes have little, if any, role to play in an optimal tax structure when the government can employ a non-linear income tax. The importance of this theorem is that it provides a rationale for the fact that while the developed countries rely heavily on income tax and social security contributions, the developing countries rely predominantly on indirect taxes. The predominance of indirect taxes in developing countries is precisely because of the fact that it is dicult to administer an income tax for a large part of the economy given the paucity of information about economic activities. This has profound implications for the equity aspects of tax reform and also for the role of indirect taxes in any redistribution program. In developed countries, the primary instruments for income redistribution are income tax and transfers and unemployment benets. Both of these instruments are of only limited use in the context of a developing country; the problems in transferring income (negative income tax) and administering unemployment benet assume critical proportions due to a lack of information in the presence of a large informal economy. It can be argued that the income tax can and should play a more prominent role than has been the case in recent past, especially in the high growth Asian countries like India and China. However, the role of unemployment benet in a typical developing country with high level of unemployment is at best restricted. This implies that one cannot use the extant model of the welfare state in European countries as the relevant one for designing a progressive scal system in developing countries (for a similar argument see Lindbeck, 2002). In fact, the current form of the welfare state in the Western Europe is of relatively recent origin; a comprehensive system of income maintenance was introduced in these countries mostly after the second world war. So it is not appropriate to look at the current system in Western Europe as a model for a progressive scal system in todays developing countries. 9

(2.1) Distributional Eects of Major Taxes in Developing Countries

The standard approach used in the literature to gauge the distributional eects of a given tax or a tax system is to estimate the incidence of taxes in a partial equilibrium framework or in a computable general equilibrium (CGE) model. However, the results from existing incidence studies in the context of developing countries needs to be interpreted with due caution. To understand the true incidence of a tax, it is important to take into account the following factors, especially in the context of a developing country. First, the relation between the statutory rate and the actual rate paid by a tax payer may be determined by the institutional environment, in particular, the extent of corruption. When corruption is endemic in the tax administration, the actual tax rate paid by a rm or individual depends on its relative position in the bilateral bargaining with the tax collector. The bargaining strength of dierent sections of income dis-

tribution may be aected by a tax reform dierently, as dierent tax bases might have dierent implications for such bargaining between the tax payer and tax collector. Second, once the actual tax rate is determined, the nal sharing of the burden of a tax depends on the pattern of shifting, especially for indirect taxes. As we discuss in more detail later, the standard assumption in the existing incidence studies has been that indirect taxes are shifted fully forward to the consumer prices, although there is no convincing empirical evidence on the pattern of shifting, especially in developing countries. One important aspect of this general equilibrium shifting in the context of developing countries is that one has to take into account the implications of a large informal sector with a focus on inter-sectoral consumption and production substitutions. Another important issue is the geographic incidence of taxes, especially the indirect taxes. There is now substantial evidence on the spatial dierences in the prices faced by households depending on their geographic location and the existing incidence analysis does not take into account the spatial dierences in the shifting of a tax. Third, by construction, most of the CGE models

are full employment models, and thus the eects of taxes on unemployment are in general not addressed. This can be a major handicap when analyzing an economy like India and Bangladesh where unemployment remains a major problem. Fourth, the implications of the tax structure for risk bearing of the poorest section of the population in a developing country is not addressed in

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the standard CGE incidence analysis, although there is a substantial literature that identies the lack of proper insurance mechanisms as a fundamental source of vulnerability of poor people in developing countries (Morduch, 1995, 2004). The following discussion on the distributional consequences of recent tax reform in developing countries tries to spell out some of the implications of these neglected factors in standard incidence analysis.

(i) Value Added Tax

Most of the available incidence studies nd VAT to be regressive, as poor households spend most of their income on current consumption and thus as a proportion of income they pay higher taxes (see Ebrill et. al., 2001). However, it is often argued that the incidence of VAT from a lifecycle perspective is likely to be less regressive. By saving more today, the rich can only defer the VAT liability to the future but can not escape it altogether. This means, the argument goes, that the regressiveness of VAT incidence might largely be due to the use of an incorrect time horizon. However, this argument fails to take into account two aspects of economic reality especially important in the developing countries: (i) capital ight, and (ii) intergenerational transmission of wealth inequality. Since only the richest segment of the society has access to capital ight as part of their portfolio choice, the rich may escape the VAT (also income tax) by moving the money out and buying assets or investing in human capital of their children abroad. While one can debate the welfare implications of such investments in the education of children (because of the brain drain versus brain gain), it is clear that the argument that the rich ends up bearing a tax burden proportional to their life time wealth is misleading at best. The second observation is that wealth accumulated through deferring current consumption may have high returns in a developing country, as it bestows better access to an array of economic opportunities for the children, from better access to credit market, to better education, to better access to political power. This widens the gap between the poor and rich through intergenerational transmission and magnication of wealth inequality. The standard models of tax incidence analysis employed in the literature fails to appreciate the implications of large informal/shadow economy. In an interesting analysis of the inappropriateness of conventional assumptions underlying most of the available incidence analysis in the context of developing countries, Shah and Whalley (1990) noted that the existence of a signicant black 11

market means that any indirect tax on the formal markets will have general equilibrium eects on the black markets with signicant implications for equity and income distribution. This insight is important not only for black markets (which were the results of government price controls in 1960s and 1970s in most of the developing countries) but remains valid more generally for a large informal sector part of which (like agriculture) may not be black or illegal. As emphasized earlier, VAT can only be collected from the formal part of an economy. But imposition of VAT will have general equilibrium eects on the prices of products produced in the informal sector and in the shadow/black markets. In the canonical model of tax policy analysis for a small open economy, a VAT on a tradable commodity is shifted fully forward to the consumer prices. While this assumption of a complete forward shifting of VAT is heroic, especially in the context of developing countries, as a rst pass at the issue, it seems appropriate to try to understand the implications of the informal economy in this case. If the informal sector producers produce a close substitute of the formal VAT-liable commodity, then consumer expenditure will be reallocated to the informal sector products, thus increasing the demand for it and its equilibrium price. In the polar case when the informal sector produces exactly the same commodity as the formal sector, the full forward shifting assumption implies that the informal producers get a higher price for their product that exceeds the formal sector producer price by exactly the amount of VAT. If the informal sector producers are among the poorest section of the population, then imposition of VAT (or any other general sales tax) on the formal sector might in fact be a simple and clever redistribution scheme that involves no administration costs. This is the argument recently put forth by Piggott and Whalley (2001) in the context of Canadian GST. But the critical assumption for this redistribution scheme to work is that the poorest households are net sellers of the commodities that are close substitutes of the formal sector commodities (and services) under the VAT coverage. The more realistic scenario in the context of developing countries is, however, the one where the poor in rural areas do not sell any products that compete against the manufactured goods under VAT. More likely, they are the net buyers of these commodities (like mass consumption clothing produced in the formal textile mills). If any group is likely to benet from the price rise due to VAT on the formal products it is the rural non-farm and urban informal sectors. This is likely to accentuate the income inequality in rural areas, as the recent evidence shows convincingly that the growth in the rural non-farm sector is a major factor behind 12

worsening rural income inequality (for example, see the recent literature on rural inequality in China (Rozelle, 1994, Khan and Riskin, 1998 )). The imposition of VAT might thus result in income transfers from the lower and upper tails of income distribution to the lower middle and middle income groups. The important point here is that the reform is likely to aect the poorest and most vulnerable segment of the population adversely. Thus far the maintained assumption is that the VAT is fully shifted forward to the consumer prices. Although this is a standard assumption both in the theory and empirical work on the incidence of taxes in developed and developing countries alike, there is no theoretical and/or empirical reason, apart from simplicity, that underlies this particular assumption about shifting. The underlying conditions for full forward shifting are stringent: (i) the market structure is competitive, and/or (ii) the supply curve is innitely elastic. The assumption of a competitive market structure, especially in developing countries, can be of dubious validity. There is evidence that market structure even in developed countries may be non-competitive because of monopolistic elements in the retail distribution sector (see, for example, Hall, 1988). It is likely that the market structure will have more pronounced non-competitive forces in developing countries. The distribution sector is likely to be more monopolistic in developing countries as the access to the credit market is very restricted for potential traders. There is, however, little rigorous empirical evidence on the market structure in developing countries. The available descriptive empirical analysis

shows that the market structure for agricultural commodities like rice might not be competitive, especially, at the wholesale level where entry can be restricted, as the scale of operation is large requiring signicant amount of working capital, and also a critical element in success is building reputation capital with small traders (see Crow and Murshid (1994) on Bangladesh rice market). The theoretical literature on shifting of indirect taxes in non-competitive models shows that a variety of shifting pattern including over-shifting is possible in the non-competitive markets (i.e., consumer price may increase by more than hundred percent of the tax in the long run) (Delipalla and Keen, 1992). It is sometimes argued that the full forward shifting is a good approximation

for the internationally tradable commodities, as the supply curve is innitely elastic at the ruling world market price. While this argument might be valid for a single commodity under certain conditions (most importantly, the assumption that the imported commodity is a perfect substitute of the domestic production), it is misleading when tari and export tax reform aects 13

a large number of commodities in a country, which had been the case in most of the developing countries over the last few decades. The reason is that the import capacity of a country is limited by the availability of foreign exchange. A horizontal supply curve for all the imported goods

would require an innitely elastic supply of foreign exchange which in turn requires an innitely elastic supply of exportable goods, an impossibility. With a exible exchange rate, part of the adjustment works through changes in the equilibrium exchange rate. A full analysis of taxes

and prices thus requires an analysis of the determination of the equilibrium exchange rate. The upshot of the above discussion is that there is little theoretical basis for the widely used assumption of full forward shifting of indirect taxes, especially in a developing country. The choice of an appropriate shifting assumption is ultimately an empirical issue. There is unfortunately no reliable evidence on the relationship between indirect taxes and equilibrium prices in the context of developing countries. The available evidence in the context of developed countries shows that a wide variety of shifting is possible including over-shifting, a possibility noted earlier in the context of non-competitive markets. In an interesting study, Besley and Rosen (1998) nd that, while the standard assumption of full forward shifting might be appropriate for some commodities in USA, for others (like Bananas, Bread, underwear) there is convincing evidence of over-shifting. The fact that the degree of shifting may vary signicantly across dierent commodities undermines the validity of almost all of the available empirical evidence on the incidence of indirect taxes which is based on the assumption of identical shifting (100 percent forward shifting) across dierent commodities. The available analysis might be very misleading if the basic necessities like food and clothing exhibit over-shifting in developing countries, and thus VAT (uniform) might be much more regressive than is usually thought of. An important aspect of tax policy reform introduced in developing countries is its emphasis on broadening the VAT base which is based on the general presumption that a broader base will be more ecient. However, as emphasized by Chan, Gosh, and Whalley (1999) in the context of Vietnam, the VAT base broadening is likely to be very regressive as previously untaxed goods are brought into the tax net which are consumed more by the poorest segment of the population. Their estimates for Vietnam show that such a base broadening with a uniform VAT hurts the bottom two quintiles of households (income loss 1 percent), while the top three quintiles gain half a percent of their income. 14

VAT Exemptions and Risk Bearing by the Farmers

Given that the administration costs of VAT is very high, a common policy is to exempt certain sectors including nancial services and agriculture. The exemption (as opposed to zero rating) of the agricultural sector implies that while the farmers do not pay any VAT, they are also unable to claim the rebates for the taxes they pay on inputs like fertilizer, and pesticides, a point mentioned earlier. Invoking the theoretical results due to Dasgupta and Stiglitz (1971, 1974) and Newbery (1986), it is often argued that it is desirable to tax the inputs to agriculture (fertilizer, pesticide, water), and it is done in a simple way by exemption from VAT (see, for example, Ebrill et. al. 2001, ITD, 2005). However, as emphasized earlier, when the relevant risk and insurance markets are missing, such input taxation is likely to aect the farmers adversely. More importantly, this may have equity implications, as the poorest of the farmers usually have very limited risk bearing capacity.

Compliance Costs of VAT: Its Distributional Implications

It is well known that the compliance costs of VAT are very high which has obvious implications for eciency aspects of a tax reform. However, possible heterogeneity in the compliance costs and its distributional implications are not well appreciated in the current literature. Compliance costs of VAT for the poorer section of the population (small rms) are likely to be much higher as they tend to be relatively less educated or illiterate. This means that VAT is regressive compared to a tari for which it is usually the trading intermediaries who bear the compliance costs. The fact that it is dicult for a small rm to keep appropriate records also implies that they are at a disadvantage in the bargaining with the tax inspector, a point explored further in a later section. Unfortunately, we are not aware of estimates of compliance costs of VAT across dierent rm size for developing countries. The available evidence on developed countries suggests that the regressive bias of compliance costs may be signicant. A recent European Commission Sta working paper shows that the compliance costs of VAT is 2.6 percent of sales for small and medium rms, while it is only 0.02 percent of sales for large rms.

Rate Dierentiation of VAT and Equity

Although the venerable literature on optimal taxation has established that a uniform tax structure is not likely to be optimal under any reasonable set of conditions, the recent consensus 15

in the policy reform literature in the context of developing countries is that rate dierentiation is to be kept at a minimum. The main argument for uniformity of VAT is that it saves on

administrative costs and, more importantly, reduces the scope for corruption and lobbying7 . A second argument is that rate dierentiation can only achieve modest amount of redistribution, an argument originally spelled out by Sah (1983). However, there are signicant dierences in the expenditure pattern of poor and rich households on the one hand, and between rural and urban households on the other. Table 5 shows the expenditure pattern of dierent income groups based on household surveys for Philippines and China. As to be expected from Engels law, the share of expenditure on food and clothing is very high for the poorest households. Also, there is clear dierence between the expenditure pattern of the rural and urban households. The estimates from the household survey data show that in rural China the low income households spend 55 percent of the income on food while the high income households spend only 38 percent. For Philippines, the lowest 1 percentile of income group spends 64.8 percent on food, while the corresponding number for the richest 1 percentile is only 19.8 percent. A distributionally sensitive tax reform has to take into account the dierences in the expenditure pattern and in the price response of dierent commodities across dierent income groups. Not surprisingly, the existing evidence shows that a uniform VAT can be especially regressive. For example, a recent analysis in the context of Bangladesh by Hossain (2003) shows that an uniform VAT that disregards the dierences in expenditure pattern is signicantly regressive, the four poorest groups both in urban and rural areas lose the most from such a tax reform (measured in terms of equivalent variation in income). The estimates reported show that the households

below poverty line (two of the poorest groups in both rural and urban areas who constitute approximately half of the population) suer 2-3.5 percent loss in their income from a uniform VAT. The richer groups on the other hand benet from such a reform, the estimates ranging from 4.5 to 8.1 percent of their monthly expenditure. As noted by Hossain (2003), these estimates are likely to underestimate the regressivity of a tax reform when VAT is introduced to recover the loss of revenue from tari which is the case in most of the developing countries. This is because of the

7 This is a more general argument for uniformity of a tax structure, and not specic to VAT. For an analysis in the context of uniformity of tari structure, see Rodrik and Panagariya (1993).

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fact that usually the rich households consumption pattern is much more import intensive than the poor households, especially the poor in the rural areas. So when import tari is reduced, the consumption of rich is favored which reinforces the regressive eect of the uniform VAT discussed above. The estimates of Hossain show that the incidence of a VAT can be made less regressive with zero-rating of commodities that are consumed more by the poor households (food grain, vegetables, traditional energy, clothing) and by imposing excise on luxury goods (car, consumer durable). Similar conclusions were reached by Ahmed and Stern (1987, 1991) in their extensive analysis of tax reform in India and Pakistan. For example, their analysis of the Indian case shows that a revenue-neutral replacement of excise taxes with uniform VAT is regressive even when the cereal (a good primarily consumer by the poor households) is exempted to reduce the regressivity of uniform VAT. The major conclusion that VAT, especially with the current emphasis on uniformity, is regressive and appropriate care needs to be taken through exemptions, zero rating and rate dierentiation to soften its adverse eect on income distribution seems fairly robust. It is clear from the above discussion that rate dierentiation, zero rating and exemptions can make a dierence to the incidence of VAT. However, it is sometimes argued that the extent of redistribution that can be achieved through indirect taxation is very limited. The basic argument,

due to Sah (1983), is that even though the rich spend relatively smaller share of their budget on commodities like food, the benets of a subsidy on food is still reaped mostly by a rich household, because their total expenditure on food is higher than that of a poor household. However, this argument can be misleading, as there are a number of consumption goods (especially consumer durables) which are not consumed by the poor, especially in the rural areas. Even within the broad category of food, it is possible to tax the high quality (the imported brand of wine and designer clothes, for example) to nance a subsidy on a low quality food item, like coarse rice. The corruption/lobbying argument against rate dierentiation has obvious merit in the context of tax reform in developing countries most of which are beset with problems of endemic corruption and lack of rule of law. This argument can be seen as an attempt to make the tax structure more corruption resistant as has been argued recently by Emran and Stiglitz (2006).8 The argument

8 One might argue that this is a defeatist approach to the issue of corruption and its implications for scal reform. A more forward looking approach would put emphasis on tackling the corruption and on designing a tax structure with a competent and reasonably honest tax bureaucracy in mind. While this might be the rst best reform strategy, it is not likely to be feasible in the short to medium term. Ignoring the implications of prevalence of corruption in the short to medium run can be a stumbling block for the objectives of both ensuring higher tax

17

in favor of designing a tax structure that is less susceptible to corruption, however, is not conned to the choice of rate structure alone, but should be applied symmetrically to the choice of tax bases also. As argued by Emran and Stiglitz (2006), the informational requirement for estimating value-added is high, and can be very demanding in terms of time and resource costs, especially when literacy is low in a country. This is because of the fact that estimation of value-added requires detailed price information and input-output accounts. This makes value-added as a tax base much more manipulable, both by the tax payer and the tax ocial. It can give rise to

corruption that involves both under- and over-assessment of taxes. From this perspective, a shift from other tax bases like import tari to VAT might make the tax structure more susceptible to manipulation by corrupt tax agents. To be sure, the tax base for import tari is also manipulable through over- and under-invoicing. However, the relevant question is which base is likely to be less manipulable and most amenable to better enforcement through a reform of tax administration. Although an answer to this question is ultimately an empirical issue, from a priori arguments, it seems that the advantage lies with the tari, as it is less demanding in terms of information and it is less costly to build a relatively small but ecient customs department than the costs involved in building an ecient VAT administration system. In other words, according to the

available empirical evidence, the administration costs of VAT is much higher than that of import tari. More important, this shift towards a VAT can have regressive eect through corruption as discussed in more detail in a following section.

(ii) Import tari

As noted before, a major aspect of the tax policy reform in developing countries has been the drastic reduction in import tari for a broad range of commodities. The distributional eects

of a reduction in the import tari are more complex than that of a consumption tax, as tari directly aects both the consumer and producer prices. Since both the consumer and producer price of a commodity goes down when a tari is reduced, the consumers as a group benet from the lower price, but the producers suer. However, the standard model of household behavior where separability between consumption and production decisions hold is not suitable for most
revenue for government and reducing corruption, especially scal corruption. In a general framework, one should treat the choice of tax rates and bases as additional instruments for tackling the scal corruption, as the more standard (partial) solutions like eciency wages are likely to be too costly (Mclaren and Besley, 1993).

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of the households in developing countries facing a multitude of missing markets, and special care needs to be taken to assess the eects of a tari change. Another important point is that the distributional eects of a reduction of import tari through the consumer prices depend on the consumption pattern of dierent income groups. As noted before in the context of the incidence of VAT in Bangladesh, in a lot of developing countries, the consumption of relatively rich people is much more imported goods intensive. This means that an across the board cut (especially

uniform) in tari benets the richer segment of the society more than the poor. Turning to the production side eects, when the tari reduction is across the board then the producers might not lose out in net terms, as the reductions in the price of imported inputs, especially the imported capital goods, might more than compensate for the negative eect of output price reduction (in other words, it is possible that the eective protection actually goes up). Some observers argue that the positive response of private investment after the liberalization in India in 1991 is primarily due to a reduction in the price of imported capital goods (Athukorala and Sen, 2002). It seems plausible that price of capital goods played a signicant role especially given recent evidence that the price response of aggregate private investment has gone up by at least 500 percent after 1991 (see Emran et. al. (forthcoming)). However, this is more likely only in those economic activities where imported capital and raw materials constitute the bulk of cost, i.e., in the manufacturing sector. Another important issue is the labor market implications of

the lower price of imported capital goods. A lower price of imported capital goods is likely to induce substitution of capital for labor and thus result in a higher share of capital in GDP. Import tari liberalization, especially for industrial goods, can thus be regressive. There is evidence that this has in fact been the case in Pakistan (Kemal, Siddiqui, Siddiqui and Kemal, 2003). It

has also been argued that trade liberalization might increase the own price elasticity of labor demand because of a higher elasticity of nal demand due to an intensied competition in the face of available imported goods (Rodrik, 1997). This implies that the bargaining position of

labor weakens which might lead to lower wages. The recent evidence on India show that trade liberalization has, in fact, increased the elasticity of labor demand (see, Hasan et. al., 2003). The distributional eects of a tari reduction program that covers a wide range of outputs and inputs, however, are likely to be signicantly dierent across dierent countries. For example, it has been argued that tari reduction in case of Thailand has been progressive as the initial 19

tari structure provided more protection to the urban manufacturing activities which increased the returns to capital and thus favored the high and middle income groups (the owners of capital). The estimates of Chan, Ghosh and Whalley (1999), on the other hand, show that a tax reform focusing on reduction of import tari and using a broad based VAT (only agriculture is exempted) is strongly regressive in Vietnam; the bottom two quintiles of households in the income distribution lose 5 percent of their income, while the top two quintiles gain signicantly.

(iii) Export Tax and Subsidy

As part of the tax reform package, most of the developing countries, including the Asian countries, have drastically reduced or completely eliminated export tax. At the same time, export subsidies of dierent forms, implicit or explicit, have become prominent as part of an export oriented development strategy. For example, it is standard in developing countries like Bangladesh to provide bonded warehouse facilities or cash incentives (for those who are unable to take advantage of bonded warehouse facilities) for ready-made garments exporters. Agricultural exports from India are given a transportation subsidy on top of the input subsidies provided for fertilizer and irrigation. Other forms of export subsidy widely used in many developing countries include subsidized credit and duty-draw back on imported inputs. The duty drawback on inputs is part of the zero rating of VAT for exports. However, surprisingly, to the best of our knowledge, there is no analysis of the distributional consequences of such changes in the export tax regime; from export tax on certain commodities (mainly agricultural exports like rice in Thailand, Jute in Bangladesh) to export subsidy on a dierent set of commodities (predominantly manufactured exports).9 There are, however, plausible a priori reasons to believe that some of the export

promotion measures like cash incentives are likely to be regressive, as the exporters (marketing intermediaries and owners of capital) get most of the benets from such a policy. Given the

monopolistic elements in the marketing, the benets may not trickle down to the farmers or poor workers in export oriented industries like ready made garments workers in Bangladesh. The reduction and/or elimination of export tax on agricultural exports is expected to have positive distributional eects in a developing country. As the farmers are net sellers of agri-

9 In case of India, the agricultural sector is still highly subsidized. Gulati et. al. () present recent estimates of fertilizer and water subsidy in Indian agriculture. According to their estimates, the budgetary subsidy on fertilizer increased from Rp. 45.42 billion in 1990 to Rp. 132 billion in 2000.

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cultural exportables, a higher producer price increases their income, while the relatively well-o households, predominantly in the urban area, suer as they are net buyers of an agricultural exportable. This standard picture of rural-urban divide regarding the incidence of an export

tax reduction is valid for staples like rice in most of the Asian countries, but may be misleading for a cash crop like Jute in Bangladesh or Rubber in Malaysia where the urban consumption of such commodities might be limited at best. More important, the price rise due to a reduction in the export tax , for example on rice in Thailand, might only benet the relatively well-o households in the rural area, and leave certain households largely unaected, and may even hurt an important group among the poorest, the landless wage earners (Deaton, 1989). The relatively well-o households benet most as they are the net sellers of rice, while the poorer households are self-sucient in rice and do not sell any signicant amount of rice to the market. The richest of the household in Thailand do not produce any rice. According to the nonparametric estimates of Deaton (op cit) for Thailand, the net benet ratio curve for a reduction of export tax on rice has an inverted U shape, it is the middle income class that benets most from a reduction of export tax in Thailand. The landless wage labor is likely to lose out from a higher price of rice resulting from a reduction of the export tax as they are net buyers of a commodity like rice and spend a large share of their household budget on it. It is possible that such groups might benet from general equilibrium eects of a reduction in export tax through the labor market. As the rice production increases, it is expected to stimulate the demand for unskilled labor and thus increase the equilibrium wage. Deatons analysis, however, does not address the response of wage to a higher price of rice. The recent analysis by Warr (2001) using a CGE model shows that a reduction in the export tax on rice in Thailand is likely to benet even the landless labor, as the positive eect of a higher wage might more than oset the negative eect due to a higher consumer price of rice. But as emphasized by Warr (2001), this type of strong wage response may not be likely in case of exports which are not major employer of unskilled labor and technology is not highly labor intensive. The analysis of Sah and Stiglitz (1987, 1992) and Ravallion (1990) imply that the welfare eects on a household of wage response to a higher rice price will depend on two things: (i) whether a household is a net supplier of labor to the market, and (ii) the magnitude of the elasticity of wage with respect to rice price. As shown by Sah and Stiglitz (1987, 1992), a higher food price improves the welfare of all rural households if the elasticity of wage to the price 21

of food (rice) is suciently close to unity (seems to be the case for rice exports from Thailand, according to Warrs analysis). Ravallion (1990) extended the analysis and demonstrated that,

for a rural household who is a net supplier of labor, the necessary and sucient condition for a welfare improvement following a rise in price of food is that the elasticity of wage rate with respect to food price is higher than the ratio of net food expenditure (net of own production) to labor earnings.10

(iv) Income Tax

Table 6 shows the share of income tax in total tax revenue in a sample of Asian countries. Although there is substantial heterogeneity across the countries, the share of income tax in the relatively low income countries like Nepal, Bangladesh and Sri Lanka is around 15 percent in 2002, while the corresponding share in high income countries like Singapore, Malaysia are much higher (more than 50 percent). As argued before, the role of income tax in the overall tax structure in a low income developing country is at best limited (for a similar argument, see Bird and zolt, 2005). This is true in terms of both revenue raising and redistributive roles. The basic argument here is that given the weak information base, the income tax in a poor developing country amounts to a tax on formal sector wage, especially in the public sector (through withholding). The tax base is small and in most cases it is not possible to tax the income of the richest segment of the society appropriately. Taxing the income of rich (particularly corporate income) is especially dicult as there is little credible accounting information even for the largest of the private sector rms in a typical developing country and, with globalization, the ease of capital ight makes the tax base very sensitive to the tax rates. From this perspective, the tax structure and overall scal policy in a typical developing country has to rely predominantly on indirect taxes, a point discussed earlier. It is true that in developed countries, income tax plays a prominent role in redistribution through progressive income tax. However, the importance of income tax in todays developed countries
The estimated elasticity of rural wage rate with respect to food price reported for Bangladesh by Ravallion are 0.22 (short run) and 0.47 (long run). Given that the estimates for both short and long run are well below unity, it is possible for some income groups in the rural Bangladesh to loose out from a rise in food price. Ravallions analysis shows that, the rural poor in Bangladesh is likely to suer adversely in the short run, while in the long run, the welfare may not be responsive to a change in food price. Rice, however, is not yet an exportable commodity in Bangladesh.
10

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is relatively recent.

Table 7 shows the role of income tax revenue in two developed countries

(USA and France) over the long run and also includes the performance of income tax in six Asian developing countries over a decade of tax reform (1990-2000). It is interesting that in USA the income tax contributed only 1.2 percent of total tax revenue in 1914 (per capita GDP was $6700 in PPP 2001 terms) , the corresponding gure for France being 0.8 percent (per capita income was $4500). It is thus not surprising that only 0.5 percent of total tax revenue in China came from income tax in 1990 (per capita GDP 1800). The trend of income tax revenue for countries like China has, however, experienced a major acceleration in last two decades with income tax revenue contributing 6.8 percent of total tax revenue in 2001. According to one projection, the contribution of income tax to total tax revenue in China will increase to 23.1 percent (Piketty and Qian, 2004). It seems only logical that more emphasis should be given to income tax in such high growth countries like China and India. The recent emphasis on VAT seems especially misplaced for these countries, where income tax can play a major role both as an instrument of revenue raising and of redistribution. The available evidence clearly shows that income tax incidence is signicantly progressive in developing countries. The available evidence, however, does not take into account the eects of corruption. We discuss some evidence on the incidence of corruption in personal and corporate income tax in the following section on the implications of corruption for distributional eects of taxes.

(2.2) Corruption and Distributional Eects of Taxes

Corruption and Compliance Costs
A shift from tari to VAT is likely to increase the compliance costs as it is much more dicult to calculate value-added by a small rm with little or no formal accounting practice and written documentation. As emphasized before this also leaves the small rms especially vulnerable to the threat of over-assessment by the tax ocial. In developing countries, a signicant part of

the compliance costs is the bribes paid. By its very nature credible information on corruption, especially at the individual and rm level, is dicult to come by. Unfortunately, we are not

aware of any reliable empirical evidence on the magnitude of the bribe costs involved in VAT in developing countries. In some recent interesting work, Das-Gupta (2004a, 2004b) reports estimates for compliance 23

costs for income tax in India (for both personal and corporate income tax). An interesting aspect of the analysis is that an attempt has been made to capture the compliance costs due to corruption (bribes paid to and harassment by the tax ocials) along with the legal and time costs of compliance. Table 8 reports the estimates of compliance costs for a sample of salaried and non-salaried (personal) income tax payers in India for 2000-2001. The overall picture that emerges from the numbers is that the incidence of compliance costs is biased against the middle income groups. The compliance costs as a percentage of income has an inverted U shape. This implies that while income tax compliance is progressive for the lower tail of the income distribution (increases progressivity for the income range below Rs. 200K for non-salaried group), it is also regressive as the compliance cost of the richest segment of the population is very low. According to the estimates of Das-Gupta (2004a), the average bribe cost amount to almost 20 percent of personal income tax. An interesting nding to note is that the average for nonsalaried group of income tax payers (48 percent of personal income tax) is more than double of the average of the salaried group (10 percent of personal income tax) (see table 18, P. 48 in Das-Gupta (2004a)). A plausible explanation (not discussed by Das-Gupta) is that the bargaining power of a salaried employee is higher due to (i) better documentation of income and thus veriable tax liability, (ii) their familiarity with and access to the bureaucracy. The non-salaried group are the ones who are self-employed households with signicant uncertainty about their income and a lack of credible information which make them vulnerable to the threat by corrupt income tax agents. The evidence on the incidence of corporate income tax compliance costs in India also shows that it is regressive. The bottom Panels in Table 8 reports recent estimates of compliance costs for corporate income tax across dierent rm size. Irrespective of the indicator of rm size used, the compliance cost is consistently regressive. For example, for a small rm with less than 20 employees, the per employee compliance cost is Rs. 20138, while the corresponding estimate for a large rm (with number of employee between 501-1000) is only 3729. In other words, the compliance cost for the small rm is approximately 5 times that of a large rm. The available evidence thus shows that the compliance costs are, in general, regressive. The policy implication of this nding is that the tax policy design has to integrate the compliance costs with the standard tax burdens to come to a better understanding of the distributional eects of a tax regime. 24

Corruption and VAT Refunds: Does It Make VAT More Regressive?

A critical feature of VAT compared to all other existing forms of indirect taxation is that of refund. The VAT refund is very special in the sense that this is the only case in developing

countries when there is a reverse ow of funds from the tax administration to the rms. This opens up extensive opportunities for corruption, both of collusive and coercive types. On the one hand, the rms, colluding with the tax ocials, use fake invoices to get VAT refunds. This has become a major problem in most of the developing countries. For example, VAT rebate fraud has become an important tax policy issue in Pakistan, Bangladesh, Nepal, Thailand, and Vietnam in last few years. On the other hand, the tax ocial may also holdup the rm by delaying the VAT refund and thus extract bribes11 . This type of holdup is common when the enforcement policy is tightened up to address the fraud in refunds (the collusive corruption). Both the delay in refunds and collusive corruption in VAT refunds might make the incidence of VAT more regressive. As we have argued before, whenever there is scope for corruption, the actual tax payment by a rm depends on its bargaining strength relative to the tax collector. It is plausible that the large rms benet most from corruption in VAT refunds, while the smaller rms face harassment and delay and has to pay high amounts of bribe to get the VAT refunds. Unfortunately, to our knowledge, there is no evidence available on this critical issue at this point.

(2.3) Distributional eects of seigniorage

It has been recognized in the literature that seigniorage can be part of an optimal tax structure in developing countries for two reasons: (i) no administrative costs, and (ii) as a way to tax the black economy which relies heavily on cash transactions. However, to the best of our knowledge, there is no formal empirical analysis of distributional implications of seigniorage for a developing country. One can argue that the poor farmers participation in the market is limited and thus the required cash holding is also low. Thus the incidence of seigniorage might be progressive. However, there are a couple of caveats. First, the poorest segment of the population tend to

be landless wage labor who might be aected adversely, except for the case when they are paid
Delay and red tape as a technique used by government bureaucrats to extract bribes has been discussed in the corruption literature. For an interesting theoretical analysis, see Banerjee (1997).
11

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in kind. Second, with the spread of green revolution, the farmers in many developing countries rely on the markets for inputs like fertilizer, seed, and pesticide, and thus hold cash for meeting the cash in advance constraint. The poor households also tend not to participate in the formal nancial sector. This implies that if the interest rate in the banking sector responds to ination (after the elimination of interest rate controls), then the households with access to banks are less aected, but the poor households with less or no access to banks bear the incidence of the ination tax. Also, if privatization of the banks result in a shrinking banking network in the rural area, this will imply that the poorer section of the society will be aected disproportionately by an ination tax.

(2.4) Geography of Tax Incidence

As noted in an earlier section, the existing literature on the tax incidence assumes that the pattern of shifting of indirect taxes does not depend on the geographic location of a household. This assumption while convenient is likely to be seriously misleading, especially in developing countries. There is now substantial evidence that the incidence of poverty has a geographic element and that the extent and the eects of price changes due to a tax policy reform are likely to vary across the geographic space. The growing rural-urban inequality in China after economic liberalization has been the subject of a sizable recent literature. There is evidence that households located in remote areas suer income loss due to a lack of access to urban centers and export markets (Emran and Hou, 2005a). The income loss can be due to unfavorable prices faced in the output, factor (most importantly labor) and intermediate inputs markets in a remote geographic location. The estimates of Emran and Hou (2005a) for rural China show that the pre capita income of a household is 11 percent lower when it is located 100 km further away from the nearest business center and 5 percent lower when 100 km away from the nearest sea port (representing access to international market). The available evidence also clearly shows that the spatial variations in the consumer and producer prices can be signicant in a developing country. For example, using household survey data for Pakistan, Deaton (1997) nds that the inter-provincial dierences in prices are signicantly larger compared to the inter-seasonal variations. There is also evidence of an adverse eect of geographic remoteness on the producer prices ( Minten and Kyle, 1999). The pass-through of a change in 26

the import tari or export tax to the producer (consumer) prices is likely to be lower (higher) for a household located further away from the port of entry (like major sea ports). This has clear implications for the distributional eects of a reform of both import tari and export taxes. Take for example, the case of the recent elimination of export quota on rice in Vietnam. The extent to which this quota elimination will increase the producer price faced by a household depends, among other things, on its geographic location. Since, in general, the poorer households tend to be concentrated in remote areas, it is likely that the eects of such a reform will be regressive in the sense that the benets reaped by relatively better-o households in the form of higher producer price will be higher than the benets that accrue to the poorest of the poor households located in the most remote corners of the country. Another important part of the geography of incidence is that the net buyers and net sellers of a commodity are usually geographically concentrated. For example, in a recent study, Minot and Goletti (2000) show that the welfare eects of an increase in the rice export quota in Vietnam dier depending on the regions considered. The rice surplus regions like Mekong River Delta and Red River Delta (45 percent of the population) would gain from a higher rice price, while the other regions who are net buyers of rice lose out. The upshot o above discussion is that a distributionally sensitive scal reform needs to take into account the implications of dierences in geographic locations across otherwise similar households. The importance of geography for

the distributional eects of a tax reform will vary across dierent countries depending on the nature of terrain and the availability and quality of infrastructure. In this sense, the incidence of an expenditure program focusing on infrastructure can not be analyzed independently of the incidence of the indirect taxes.

(2.5) Unemployment and Tax Reform

As argued before, almost all of the available literature on tax incidence on developing countries ignore the issue of unemployment as the CGE models used for tax (and expenditure) analysis are full employment models. Although some of the available analysis addresses the eects of scal reform on the labor market, the analysis is usually focussed on the wage response of the policy change, as there is no unemployment incorporated in the model. However, unemployment is an important cause of poverty and deprivation in the developing countries, and a complete analysis 27

of the distributional consequences of any scal regime needs to take into account the eects of policy reform on unemployment. According to ILO estimates for South-East Asia region, the

unemployment rate was 3.9 percent in 1993, which increased to 7.1 percent before declining to 6.3 percent in 2003. In contrast, the unemployment rate in South Asia remained unchanged from 1993 to 2003 at 4.8 percent. There is also wide variations across countries in the unemployment rate within each region. Table 9 shows the unemployment rate for a sample of Asian countries. While unemployment rate (open) is around 10 percent in India and Philippines over the decade of 1990s, in other countries in Table 9 like China, Malaysia, and Singapore, the unemployment rate is low, in the range of 2-5 percent. This wide variation in the unemployment rate suggests that the employment eect of a tax reform needs to be analyzed carefully. In a recent paper, Emran and Stiglitz (2007) analyze the employment eects of the standard indirect tax reform implemented in developing countries over the last two and a half decades. Their analysis is built on a simple Harris-Todaro type general equilibrium framework of the labor market which integrates a shirking eciency wage model of unemployment. Their analysis shows that a reduction of import tari , especially on the urban manufacturing activities, coupled with a revenue neutral increase in VAT can actually increase unemployment under plausible conditions. To the best of our knowledge, there is no empirical analysis of the eects of such a revenue neutral tax reform on unemployment in the context of developing countries.

Conclusions
This paper provides a critical analysis of the current consensus regarding tax policy reform in developing countries that draws on the recent theoretical advances and also utilizes available empirical evidence on the distributional eects of dierent taxes. The empirical evidence is drawn from a number of Asian countries. The conclusions reached are, however, more general and likely to be applicable to most of the developing countries. The tax policy analysis that forms the basis of current policy making does not take into account some of the critical features of a developing economy including (i) limited set of markets, especially missing risk and insurance markets, (ii) a large informal economy, (iii) signicant open unemployment and under-employment, (iv) pervasive corruption, and (v) geographic distribution of the poor. The tax reform policies need to take

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proper account of these features. The major conclusion of the paper is that the dramatic shift in favor of VAT as the main instrument for revenue raising in developing countries is misguided both on eciency and equity grounds. The recent theoretical advances clearly show that such a shift is likely to be inecient by driving rms from the formal sector into the shadow of informal economy. Such production substitutions have adverse eects on both allocational eciency and long-run growth in an economy. Such a reform also makes the tax structure more regressive, as VAT, especially with the current emphasis on uniformity, is, likely to be very regressive. Moreover, a tax reform that increases the role of an information and accounting intensive tax like VAT is likely to be especially regressive when one takes into account the corruption in tax administration.

References:
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29

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from Rural China, Working Paper, GWU. (25) Gemmell, N and O. Morrissey (2003): Tax Structure and the Incidence on the Poor in developing Countries, Working paper, University of Nottingham. (26) Greenwald, B and J. Stiglitz (2006): Helping Infant Economies Grow: Foundations of Trade Policies for Developing Countries, American Economic Review, may, 2006. (27) Hall, R (1988): The Relationship Between price and Marginal Cost in US Industry, Journal of Political Economy, 96, 921-947. (28) Hatzipanayotou, P, M. Michael, and S. Miller (1994): Win-win indirect tax reform: a modest proposal, Economics Letters, 44, 147-151. (29) Ho, K (1991): Land Taxes, Output Taxes and Sharecropping: Was Henry George Right?, World Bank Economic Review, vol. 5. pp. 93-111. (30) Hossain, S (2003): Poverty and Social Impact Analysis: A suggested Framework, IMF Working Paper No. 03/195. (31) Iqbal, Z and R. Siddiqui (1999): Impact of Fiscal Adjustment on Income Distribution in Pakistan, The Pakistan Development Review, Spring 1999, pp. 1-24. (32) Jenkins, G and G. Kuo (1996): Revenue Implications of Rates and Base Specications for the Proposed VAT System in Nepal, HIID, Harvard University. (33) Keen, M (2006): Taris, Withholding Border Taxes and Informality in Developing Countries, Working paper. (34) Keen, M and J. Ligthart (2002): Coordinating Tari Reduction and Domestic Tax Reform, Journal of International Economics. (35) Kemal, A. R, R. Siddiqui, R. Siddiqui, and M. Kemal (2003): An Assessment of the Impact of Trade Liberalization on Welfare in pakistan: A General Equilibrium Analysis, MIMAP Working paper, PIDE, Pakistan. (36) Khan, A. R, and C. Riskin (1998): Income and Inequality in China: Composition, Distribution and Growth of Household Income, 1988 to1995, China Quarterly, June, 1998. (37) Minot, N and F. Goletti (2000): Rice market Liberalization and Poverty in Vietnam, IFPRI Research report 114. (38) Morduch, J (1995): Income Smoothing and Consumption Smoothing, Journal of Economic Perspectives, 1995. 31

(39) Morduch, J (2004): Microinsurance: The Next Revolution?, Working Paper, NYU. (40) Munk, K (2005): Tax-tari reform with Costs of Tax Administration, Working paper. (41) Newbery, D (1986): On the Desirability of Input Taxes, Economics Letters, 20, 267-270. (42) Panagariya, A and D. Rodrik (1993): Political Economy Arguments for a Uniform Tari, International Economic Review, (43) Picketti and Qian (2004): Income Inequality and Progressive Taxation in China and India: 1986-2010, Working paper. (44) Piggot, J and J. Whalley (2001): VAT Base Broadening, Self Supply and the Informal Sector, American Economic Review 91, 1084-1094. (45) Ravallion, M (1990) : Rural Welfare Eects of Food Price Changes With Induced Wage responses: Theory and Evidence from Bangladesh, Oxford Economic papers, June, 1990. (46) Rozelle, S (1994): Rural Industrialization and Increasing Inequality: Emerging Patterns in Chinaa Reforming Economy, Journal of Comparative Economics, 19, 362-391. (47) Sah, Raaj (1983): How Much Redistribution is Possible through Commodity Taxes?, Journal of Public Economics, 26, Februaray, 1983. (48) Sah, R and J. Stiglitz (1992): Peasants versus City-Dwellers: taxation and the Burden of Economic development, Oxford University Press. (49) Warr, P (2001): Welfare Eects of an Export Tax: Thailands Rice Premium, American Journal of Agricultural Economics, 83(4), PP. 903-920.

32

Table 1: Tax Effort in Asia (Total Tax Revenue as % of GDP) Country Na Nepal Bangladesh India Pakistan Bhutan Indonesia Sri Lanka Philippines China Iran, Islami Thailand Malaysia Korea, Rep Singapore 1970 1980 6.6 7.8 9.8 13.4 20.4 18.8 12.5 5.7 13.3 23.4 15.5 16.8 1990 7.0 10.1 13.3 4.6 17.8 19.0 14.1 4.0 5.8 17.3 18.9 14.4 15.3 2000 8.7 9.0 10.2 9.0 14.5 13.7 6.8 6.4 13.7 14.3 16.1 15.6 2001 9.5 7.6 8.2 10.2 7.6 11.3 14.6 13.3 7.4 6.3 13.8 18.8 15.4 15.4 2002 9.3 7.7 8.8 10.4 8.3 11.6 14.0 12.5 8.5 5.5 18.8 13.3 2003 9.4 8.1 9.2 10.9 9.8 12.2 12.8 8.5 5.7 15.4 17.6 13.2 2004 9.8 8.1 10.2 10.5 8.0 12.3 12.6 6.0 15.9

19.0

10.4

13.5

12.5

1. Countries in order by GDP per capita in 2000; 2. Source: WDI, GFS.

Table 2: Level of Monelization Money and quasi money (M2) as % of GDP Contries 1980 1990 1995 Bangladesh 13.14 22.28 27.37 China 33.19 70.29 92.05 India 32.84 39.94 42.00 Indonesia 13.21 33.94 43.34 Japan 83.14 108.22 108.94 Korea, Rep. 28.90 34.11 36.00 Malaysia 45.29 61.28 77.43 Nepal 21.92 29.69 35.76 Pakistan 38.68 37.10 40.93 Philippines 21.97 31.11 46.85 Singapore 57.72 84.77 82.36 Sri Lanka 28.45 25.92 33.73 Thailand 34.51 62.66 73.34 Sources: World Development Indicators

2000 31.90 143.63 52.28 54.98 122.44 64.14 96.91 47.46 36.82 59.25 109.50 36.25 103.69

2001 34.84 150.22 54.91 54.30 125.82 70.78 105.46 41.57 37.56 57.22 115.68 36.68 102.30

2002 36.83 163.12 58.67 53.66 131.35 72.08 100.26 35.28 40.64 55.94 114.26 37.01 98.26

2003 37.90 174.93 60.24 51.44 134.59 74.34 97.72 35.57 43.50 55.15 117.87 38.07 93.86

Table 3: Structure of Indirect Tax Revenue Country Nepal India Pakistan Bhutan Indonesia Sri Lanka Philippines China Iran, Islamic Rep. Thailand .. Malaysia Korea, Rep. Singapore Tax on trade ( % of revenue) Taxes on goods and services (% of revenue) 1990 2000 2003 1990 2000 2003 25.63 23.50 21.90 29.53 29.96 28.92 28.60 18.92 14.85 35.84 28.92 30.73 29.63 10.83 9.17 28.30 30.30 32.19 0.22 0.91 1.65 10.74 10.82 17.38 6.39 .. 3.18 23.71 .. 31.69 26.02 11.08 .. 42.23 56.75 .. 24.73 18.69 16.99 30.34 27.46 25.85 9.79 9.83 -8.44 12.49 65.10 79.46 13.47 5.98 7.40 4.18 6.59 3.55 .. 9.72 .. .. 40.02 17.88 7.36 5.59 20.28 23.43 21.43 11.76 4.31 .. 34.72 28.24 .. 2.00 1.43 0.05 16.00 18.04 24.75

Note: 1. Countries in order by GDP per capita in 2000; 2. Source: WDI.

Table 4: The Size of the Informal Economy Size of shadow Economies (as Agriculture, value added Informal Economy (% of GDP) % of GDP) (% of GDP) Average 1990-95 Average 1990-95 Average 1990-93 Nepal 38.40 46.70 85.1 Bangladesh 36.50 28.32 64.82 India 22.4* 29.75 52.15 Pakistan 36.8 26.06 62.86 Indonesia 19.4 18.27 37.68 Sri Lanka 38-50** 24.66 62.66-74.66 Philippines 38-50** 21.77 59.76-71.76 China NA 23.78 NA Thailand 70** 11.00 81.00267 Malaysia 38-50** 14.08 52.08-64.08 Korea, Rep. 20.3*** 5.72 26.02396 Singapore 13** 0.20 13.2 Japan 8.5** 2.18 10.68351 Note: 1. The size of shadow economies are average over 90-93, except India (89-90) and Nepal, Bangladesh, Pakistan, Indonesia (1999-00). 2. *Physical Input Method **Currency Demand Approach ***MIMIC Approach 3. Countries in order by GDP per capita in 2000; 4. Sources: Friedrich Schneider and Dominik H. Enste 2000: "Shadow Economies: Size, Causes, and Consequences." Contries

Table 5: Consumption Pattern in Philippines and China

Philippines: Household Expenditure Shares by Expenditure Percentile (in percent, unless otherwise noted) Expenditure percentiles 25-50 50-75 58.3 51.0 1.1 0.8 1.9 1.5 6.8 7.0 3.5 4.8 2.7 2.2 2.8 3.2

Food Alcohol Tobacco Fuel, light, water Transportation and communication Clothes Education

0-1 64.8 1.2 1.5 7.9 1.8 1.5 0.2

1-10 64.4 1.2 1.7 7.1 2.3 2.0 0.8

10-25 62.6 1.2 1.9 6.7 2.6 2.4 1.2

75-90 43.4 0.7 1.0 6.6 6.9 2.9 4.4

90-99 33.7 0.4 0.5 5.5 9.4 2.9 6.7

99+ 19.8 0.2 0.2 4.5 11.9 1.9 5.0

Source: Fletcher, IMF (2005): staff estimates using the 2000 FIES. Income and Consumption in Rural China (2002) Lower Middle Income Households 2288.34 1310.33 Upper Middle Income Households 4075.6 2086.61 High Income Household s 7567.22 3500.08

Low Income Households Per Cpaita Annual Income (yuan) Per Capita Annual Living Expenditure (yuan) Consumption Pattern (per capita, %) Food Clothing educational and recreational articles and services Medicines and medical services 55.88 5.64 1551.79 1006.35

Middle Income Households 3025.17 1645.04

52.41 5.66

49.18 5.71

45.51 5.89

38.69 5.68

9.67 5.72

11.10 5.71 13.34

11.75 5.52 14.84

11.83 5.58 16.11

11.91 5.76 20.14

Housing 12.68 Income and consumption in Urban China (2002) Lowest Income Housheh olds (first decile) Per Capita Annual Income (yuan) Per Capita Annual Living Expenditure (yuan) Consumption Pattern (per capita, %) food clothing educational and recreational articles and services medicines and medical services housing Note: China Statistical Yearbook 47.21 8.09 13.3 6.89 11.84

Middle Income Households (third quintile)

Upper Middle Income Households (fourth quintile) 9437.99 6939.95

High Income Households (ninth decile)

Highest Income Househol ds (tenth decile)

2527.68 2387.91

7061.37 5452.94

12555.07 8919.94

20208.43 13040.69

39.25 10.47 14.63 7.02 10.33

37.42 10.62 15.08 7.35 9.27

35.55 9.71 15.4 7.37 10.16

31.45 8.46 16.48 7.16 11.39

2003

Table 6: Role of Income Tax Income tax (percent of total tax revenue)

1990 Nepal Bangladesh India Pakistan Bhutan Indonesia Sri Lanka Philippines China Iran, Islamic Rep. Thailand Malaysia Korea, Rep. Singapore 13.03 18.60 12.76 30.73 65.36 11.99 32.54 49.80 31.00 42.94 39.55 44.64

2000 21.02 36.00 28.06 53.45 15.05 44.05 9.12 49.64 55.11 38.08 50.18

2001 21.91 15.96 36.78 28.96 62.17 49.56 16.83 45.61 12.55 50.07 63.74 37.20 52.71

2002 20.51 16.72 38.27 30.83 54.05 47.28 16.96 45.63 24.32 45.35 62.06 51.71

2003 16.15 15.69 40.50 27.46 46.90 46.12 45.65 22.29 45.24 36.36 63.90 46.21

2004 16.87 15.85 43.86 27.74 58.02 42.01 46.52 44.80 39.49

44.60

Note: 1. Countries in order by GDP per capita in 2000; 2. Source: WDI

Table 7: Income Tax Revenue in Historical Perspective

GDP/capita (PPP 2001 $) Total Tax Revenue (% GDP) Income Tax Revenue (% GDP) Income Tax Revenue (% Total Tax Revenue)

United States 1914 United States 1950 United States 2000 France 1914 France 1950 France 2000 China 1990 China 1995 China 2001 China 2010 India 1990 India 2000 India 2010 Bangladesh 1990 Bangladesh 2000 Indonesia 1990 Indonesia 2000 Pakistan 1990 Pakistan 2000 Philippines 1990 Philippines 2000

6,700 13,300 36,100 4,500 7,400 27,200 1,800 3,000 4,200 7,300 1,600 2,200 3,000 1,003 1,602 1,960 3,043 1,363 1,928 3,368 3,971

8.2% 20.7% 31.8% 12.6% 25.5% 46.2% 15.2% 10.3% 15.1% 18.3% 10.1% 9.1% --7.0% 17.9% 16.5% 13.4% 12.1% 14.1% 13.9%

0.1% 5.8% 10.3% 0.1% 1.9% 7.3% 0.1% 0.2% 1.0% 4.2% 0.5% 0.5% --1.0% 11.7% 10.6% 1.7% 3.4% 4.5% 6.2%

1.2% 28.0% 32.4% 0.8% 7.5% 15.8% 0.5% 2.2% 6.8% 23.1% 5.0% 5.5% --14.5% 65.3% 64.5% 12.9% 28.1% 32.2% 44.3%

Sources: National accounts and tax statistics, cited in Piketty and Qian (2004). U.S.: see Piketty and Saez (2003). France: see Piketty (2003). China: see Piketty and Qian (2004). India: see Banerjee and Piktty (2003) (total tax revenues come from WDI database). Bangladesh, Indonesia, Pakistan, and Philippines: 1990 GDP and 1990 & 2000 tax data come from World Bank World Development Indicators; 2000 GDP data come from UNDP Human Development Report 2001.

Table 8: Income Tax Complaiance Costs in India

Percentage of Gross income Personal Income Tax (Non-Slaried)

50 K or Less 50-100 K Time Spent 1.64 2.36 Money Spent 1.23 3.99 Legal Costs (time+money) 2.87 6.35 Bribes Paid N.A. 0.37

100-200 K 9.19 4.81 14.01 0

200-300 K 1.14 13.79 14.93 17.34

400 K or more 1.57 4.19 5.76 7.18

Personal Income tax (Salaried) Time Spent Money Spent Legal Costs (time+money) Bribes paid 0.48 0.31 0.79 N.A 1.56 0.86 2.42 0.02 1.08 0.59 1.67 0.27 1.45 0.16 1.61 0.14 0.55 0.36 0.91 0

Corporate Income Tax Legal Complianae Costs Across Frimsize Turnover Legal Compliance Costs (percentage of turnover) No. of Employees Legal Compliance Costs Per Employee (Rs) Below 20 m 1.28 20-500m 0.4 500-1000 m 0.16 1-5 b 0.13

Below 20 20138

21-100 11818

101-500 2335

501-1000 3729

Table 9: Unemployment Rate in Asia (Percent)

1990 China India Indonesia South Kore Malaysia Philippines Singapore Thailand 2.42 9.60 3.17 2.44 n.a. n.a. n.a. n.a.

1998 3.00 9.29 5.46 6.96 3.23 10.08 3.28 4.33

2000 3.00 9.20 6.08 4.16 3.10 11.18 3.03 3.63

2001 3.25 9.18 8.10 3.78 3.65 11.15 3.30 3.35

2002 3.85 8.93 9.06 3.11 3.45 11.43 4.38 2.45

2003 4.20 n.a. 9.50 3.40 3.58 11.40 4.80 2.15

Source: GDS (Global Data Source)

1990 China Indonesia South Kore Malaysia Philippines Singapore Thailand 2.50 2.51 2.46 5.06 8.43 1.78 3.85

1998 3.10 5.46 6.84 3.20 10.25 3.23 4.38

2000 3.10 6.08 4.07 3.00 11.65 3.08 3.60

2001 3.60 8.10 3.78 3.53 10.88 3.33 3.23

2002 4.00 9.10 3.11 3.47 11.48 4.35 2.34

2003 4.30 9.50 3.40 3.61 11.50 4.73 2.19

Source: APDCORE Database, IMF