Tax policy for the post-Covid-19 era

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Rabah Arezki and
Grégoire Rota-Graziosi
July 13, 2021

Covid-19 offers an opportunity for developing countries to rethink their tax policy to contribute to the reconstruction effort and promote the recovery. This column explores what the legacy of the pandemic will be for our tax systems and several dimensions for the required rethinking.

In a nutshell

There are three levers to support the rethink of taxation in developing countries needed in the post-Covid-19 era: reinforce tax administration and promote tax simplicity; consider the use of taxation for industrial policy and to encourage formalisation; and look beyond taxation when approaching the issue of resource revenue mobilisation.

To do so, they should reaffirm the social contract and enhance tax administration and transparency – including in the natural resource sector; governments also need to look beyond taxation to mobilise savings into much needed investment for developing countries.

At the end of the First World War, Joseph Schumpeter (1918) coined the term ‘thunder of history’ to describe the historical roots of fiscal systems. Indeed, wars, revolutions or disasters persistently shape domestic tax systems. For example, the two world wars gave way to new taxes, notably the income tax, which are still in existence and reflect the thundering of history. Fast forward to today, fighting Covid-19 is in many ways analogous to fighting a war. One might thus wonder what the legacy of Covid-19 would be for our tax systems ten or twenty years from now.

Covid-19 crisis is an opportunity to renew the ‘social contract’. The disease reinforces the role of the state through its role in protecting against health risk and its social transfer programmes to shield the citizenry against the economic consequences of the health crisis. Covid-19 has thus reasserted the need for an effective state and hence may help improve the willingness of the citizenry to pay tax.

There is a strong rationale for the instauration of a wealth tax post Covid-19 as after all calamities such as wars and other pandemics. What’s more, the older generations who have been the most vulnerable to the disease are richer than the younger generations who have been most hit economically by the containment measures against the disease. That may further justify a wealth tax.

Yet the implementation and effectiveness of a wealth tax has been challenged in United States where the debate has been raging. For developing countries facing much bigger challenges on tax administration and compliance, a more pragmatic approach would be the instauration of real estate tax for property beyond a certain threshold (Ahmad et al, 2018; Norregaard 2013; Franzsen and McCluskey, 2020).

Indeed, too often developing countries, including in Africa, do not tax properties adequately, creating leakages and speculation on unoccupied land parcels including in downtown areas in the main cities with far reaching consequences for the average citizen and the poor.

Beyond a potential property tax, Covid-19 offers an opportunity for developing countries to rethink their tax policy to contribute to that reconstruction effort and promote the recovery. There are three levers to support the needed rethink of taxation in developing countries in the post-Covid-19 era.

First, governments should both reinforce tax administration (Acemoglu, 2005, Besley and Persson, 2013) and promote tax simplicity. Too often economists obsess over tax rates while overlooking issues related to implementation including related to tax administration and compliance. Weaknesses in the area of tax administration combined with complex tax codes can lead to important leakages in turn making governments lose resources to finance much needed economic development.

Beyond domestic tax administration, customs remain important and are often the main tax collectors in developing countries (Dequiedt et al, 2012). The cooperation between custom and tax authorities for countries without tax revenue agency is here essential for an effective enforcement of the tax laws.

For countries with tax agencies, which encompass tax and customs agents in a unique organisation, the main risk is that these agencies exceed their initial function by defining the tax policy they must enforce. This should remain the exclusive competence of the government – more particularly of the ministry of finance, which is better placed to take a more holistic view on what rates could serve the economy best.

Often, developing countries suffer from the fragmentation of taxing power between ministries, which participates to the complexity and the multiplicity of actual tax regimes. Designing taxes that are simple to administer is the way to go.

There is a risk that the post-Covid-19 era will lead to the proliferation of derogatory tax regimes in order to promote the economic recovery. Such a proliferation may complexify actual tax regimes. The assessment and publication of tax expenditures become a high priority to safeguard the tax system and improve fiscal transparency.

What’s more, economies that depend on oil and other natural resources often have tax exemptions to support investment in the sector combined with royalty schemes. The peril with such exemptions is that they are often abused and could lead to a crowding out of tax revenues in other sectors. To address the challenge, ‘ring fencing’ exemptions to ensure there are no loopholes is paramount including a strict definition of sub-contracting firms, which are eligible to exemptions.

While hiking taxes on moribund economies would not be advisable, corporate income tax holidays are a giveaway. Indeed, tax holidays especially disproportionately benefit larger and more profitable firms whose investment plans would have occurred irrespective of tax holidays (Arezki et al, 2020).

Taxation provides important information about economic agents and tax holidays would unnecessarily deprive tax authorities from having access to crucial information. Tax credits should be systematically preferred to tax holidays.

The second lever to rethinking taxation for developing countries is to consider its use for industrial policy and to encourage formalisation. For example, the use of tax incentives in China has made it possible to direct raw producing firms away from exporting the raw product and toward selling to manufacturing firms. Hence, these tax incentives have increased the added value for the Chinese economy.

Specifically, offering tax credits on (capital) inputs to promote transformation of raw products while taxing exports of the latter can be a powerful transformative tool for economic development.

Developing countries including Africa need to build new comparative advantages away from exporting raw products. To do so, the private sector needs to be incentivised to innovate and venture into higher technology sectors. Lobbies of importers can make it difficult and influence the design of policies including taxes and tariffs away from the promotion of domestic productive systems.

The informal sector is a contestable sector in that it is open to entry but suffers from chronically low productivity and low profitability. The informal sector should not be punished for being informal but rather incentivised to move up the ‘sophistication’ ladder. Taxation can play a role in smoothing formalisation.

For example, the design of the value added tax (VAT) can help to encourage formalisation (Keen, 2008). Indeed, adjusting the VAT threshold liability – the level at which a firm is subjected to VAT – can encourage small agriculture farmers to get rebate on their investments and hence move up the value-add chain.

The third lever of rethinking taxation in developing countries is to look beyond taxation when approaching the issue of resource revenue mobilisation. Indeed, we need to make financial systems work for development. Too often in developing countries financial systems, namely banks, do not fulfil their basic functions – which include information production, price discovery, monitoring and payment systems, as well as resource mobilisation.

When financial systems function properly, savings both domestic and foreign are allocated toward productive investments through the core banking functions. Optimal allocation occurs through a combination of better macro policies and more competition in the financial system – which includes ‘fintech’ operators, which are making headway on payment systems including in many developing countries.

But in developing countries including Africa banks largely fail to channel domestic and foreign saving properly to investment. Financial systems must develop to include all normal bank functions to contribute to sustainable development. Developing countries especially Africa crucially needs resources to build the social and economic infrastructure.

Part of the issue lies in the heavy focus of financial regulation in developing countries on risk, emphasising compliance with prudential regulations to ensure financial stability. Yet while bank regulation is geared to curb excessive risk-taking, the reality in many developing countries has been too little risk-taking, which penalises development.

We must encourage financial systems to mobilise billions if not trillions of saving for investment. To do so, we must account for the fact that incentives of banks are shaped by both competition in the financial system (including non-bank operators) and a country’s macroeconomic stance – for example, whether the exchange rate is overvalued.

Actively promoting currency swaps and the regionalisation of financial systems, including stock market and domestic currency bond markets, would be a way to increase the weight of developing countries including Africa in global investors’ portfolios.

All in all, the key to a successful recovery from Covid-19 lies in governments eliminating all forms of leakages in public resources both on the spending and revenue sides to improve domestic resource mobilisation. To do so, they should reaffirm the social contract and enhance tax administration and transparency – including in the natural resource sector. Governments also need to look beyond taxation to mobilise savings into much needed investment for developing countries.

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