collaborative masters programme

AFRICAN ECONOMIC RESEARCH CONSORTIUM

(AERC)

COLLABORATIVE MASTERS DEGREE

PROGRAMME (CMAP) IN ECONOMICS FOR SUB-

SAHARAN AFRICA

JOINT FACILITY FOR ELECTIVES

Teaching Module Materials

ECON 547 Public Sector Economics II

(Revised: August, 2020)

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of 143 Copyright © 2020 African Economic Research Consortium (AERC), All Rights Reserved

CONTENTS

I. COURSE OBJECTIVES ................................................................................................................. 5

II. COURSE OVERVIEW ................................................................................................................... 5

III. COURSE ASSESSMENT ........................................................................................................... 5

IV. PRE-REQUISITES .................................................................................................................... 5

ONLINE RESOURCES AND LINKS ................................................................................................... 6

VII. DETAILED MODULE CONTENT ............................................................................................... 6

LESSON ONE: INTRODUCTION ................................................................................................ 7

1.1 Definitions ............................................................................................................................... 7

1.2 Principles of a good tax system ....................................................................................... 8

1.3 History and Rationale of Taxation ....................................................................................... 8

1.4 Types of Taxation .................................................................................................................. 9

1.5 Vertical and Horizontal Equity ............................................................................................ 9

1.5.1 The Equity Criterion ...................................................................................................... 9

1.5.2 Conflicts between Efficiency and Equity ............................................................. 10

Basic Readings: .......................................................................................................................... 10

LESSON TWO: THEORY OF TAXATION .............................................................................. 10

2.1 Effect of Taxation on Savings ....................................................................................... 11

2.1.1 Introduction ............................................................................................................ 11

2.1.2 Life Cycle Income Model ...................................................................................... 11

2.2 Taxation and Investment..................................................................................................... 13

2.2.1 Introduction and basic model ............................................................................... 13

2.3 Effects on the taxation on investment .......................................................................... 16

2.4 Effects of taxation on Labour Supply ................................................................................ 18

2.4 Effect of Taxation on Risk Taking ..................................................................................... 22

2.5 Tax Incidence Analysis ........................................................................................................ 22

2.5.1 Introduction and Theories of tax shifting ............................................................ 22

2.5.2 Partial Equilibrium Analysis ................................................................................ 24

2.5.3 General Equilibrium Analysis .............................................................................. 28

Trial Questions ........................................................................................................................... 34

Basic Reading: ............................................................................................................................ 35

LESSON THREE: THEORY OF OPTIMAL TAXATION ...................................................... 37

3.1 Introduction and efficiency of taxes ............................................................................. 37

3.2 Determinants of excess burden of taxation .................................................................. 38

3.3 Optimal Commodity Taxation ...................................................................................... 40


3.3.1 The Inverse Elasticities Rule ................................................................................. 40

3.3.2 The Ramsey (1927) Rule ........................................................................................ 41

3.6.3 The Corlett-Hague Rule ........................................................................................ 42

Basic Readings: .......................................................................................................................... 42

LESSON FOUR: TAX EVASION AND AVOIDANCE ............................................................ 44

4.1 Definitions ............................................................................................................................. 44

4.2 Causes of Tax Evasion ......................................................................................................... 44

4.3 Models of Tax Evasion (Myles, 1999) ................................................................................. 46

4.3.1 Tax Evasion as a Decision with Risk. .......................................................................... 46

4.3.2 Optimum Auditing and Punishment ........................................................................... 49

4.4 Tax Evasion and Labour Supply ........................................................................................ 50

4.5 Tax Evasion by Firms .......................................................................................................... 54

4.5.1 Competitive Firms (Myles, 1999) ................................................................................ 54

4.5.2 Imperfect Competition ................................................................................................. 56

4.6 Optimal Taxation with Aversion ........................................................................................ 57

4.6.1 Commodity taxation ...................................................................................................... 57

4.6.2 Income Taxation ........................................................................................................... 58

4.7 Consequences of Tax Evasion ............................................................................................. 59

4.8 Dealing with tax evasion ...................................................................................................... 60

4.9 Evidence of Tax Evasion from Africa ................................................................................ 61

4.9.1 Tax evasion by Individuals ........................................................................................... 62

4.9.2 Tax fraud/Evasion by Business Entities ...................................................................... 63

4.10 The Underground Economy ............................................................................................. 67

4.11 The Role and Trends in the African underground economy/informal sector .............. 69

4.12 Characteristics of Informal Employment in Africa ........................................................ 72

4.14 Tax Amnesty ....................................................................................................................... 79

4.14.1 Definition(s) ................................................................................................................. 79

4.13.2 Principles of Tax Amnesty (Leonard & Zeckhauser, 1987). ...................................... 80

4.13.3 Advantages of Tax Amnesty ...................................................................................... 81

4.13.4 Disadvantages of Tax Amnesty .................................................................................. 81

Trial Questions ....................................................................................................................... 81

Basic Readings ........................................................................................................................... 82

LESSON FIVE: TAX POLICY, STRUCTUREAND ADMINISTRATION ................................................... 89

5.1: Definition and objectives of a tax policy ............................................................................. 89

5.2 The Salient Features in Tax Policies of African Economies .................................................. 89


5.3 Tax Revenue Forecasting ................................................................................................ 91

5.3.1 Tax Buoyancy ........................................................................................................... 91

5.3.2 Tax Elasticity ................................................................................................................... 92

5.4 Tax Structure and revenue mobilization in Developing Countries ................................ 94

5.5 The Role of ICT in Tax administration............................................................................. 96

5.6 The Role of Mobile Money in Tax improvement ........................................................... 98

5.7 The State of Mobile Money Economy in Africa ............................................................. 99

5.8 Mobile Money Taxation .................................................................................................. 99

Readings: ................................................................................................................................... 100

LESSON SIX: FISCAL FEDERALISM .................................................................................................. 102

6.1 The Theory of Fiscal Federalism ................................................................................... 102

6.2 Principles of Federalism ................................................................................................ 104

6.3 Sharing of Revenue ............................................................................................................. 105

Basic Readings: .......................................................................................................................... 109

LESSON SEVEN: INTERNATIONAL ISSUES IN TAXATION .............................................................. 111

7.1 Concepts and principles of international issues in taxation ........................................ 111

7.2 Tax harmonization ........................................................................................................ 111

7.3 Tax Competition ............................................................................................................ 113

7.4 Transfer Pricing, Tax Treaties and Regulations ............................................................ 115

7.5 Tax Havens and illicit financial flows ............................................................................ 117

Basic Readings: .......................................................................................................................... 119

LESSON EIGHT: PUBLIC DEBT ............................................................................................ 120

8.1 Definition and causes of budget deficit ............................................................................ 120

8.2 Definition, classification, and purpose of public debt ............................................... 121

8.2.1 Definition and classification ........................................................................................... 121

8.2.2 Purposes of public debt ................................................................................................... 123

8.3 Burden, measurement and theories of public debt ......................................................... 123

8.3.1 Debt burden and measurement ................................................................................. 123

8.3.2 Theories of the Burden of the Debt ........................................................................... 126

8.4 Effects, management, financing and sustainability of public debt ................................ 133

8.4.1 Effects and consequences of public debt ................................................................... 133

8.4.2 Debt management and sustainability in Africa: Policy Issues ......................... 134

8.4.3 Financing and sustainability of public debt [Redemption] ..................................... 137

8.5 Overview of external debt in Africa ........................................................................... 138

Basic Readings: ........................................................................................................................ 140


I. COURSE OBJECTIVES

The course will expose students to the state-of-the-art in public sector economics theory,

while drawing on empirical evidence from developed and developing countries. The aim is

to develop analytical tools and methods that will enable students to appreciate issues

pertaining to public spending, taxation and financing of government. As much as possible,

evidence will be drawn from African and other developing countries. By the end of the

course the students should be able to:

• Discuss critically key issues in public economics, informed by recent research; and

• Demonstrate familiarity with a range of public policy issues and relevant analytical

and empirical tools.

II. COURSE OVERVIEW

This is a master’s level course in Public Sector Economics. The course covers: the role and

size of the public sector, including the rationale for public sector interventions such as

market and government failure and distributional concerns; public expenditure policy,

including assessment of government social protection programs, public projects, public

investment management, public-private partnerships, privatization and the role of the

private sector in the production and provision of public goods and services. Also addressed

are key factors determining a nation’s fiscal architecture; public resource mobilization via

user charges and taxation, including the economics of taxation, taxation of income, wealth,

and consumption, tax incentives, tax compliance and enforcement, and tax reform. It also

covers fiscal federalism and issues related to public debt, deficit financing and fiscal

federalism.

III. COURSE ASSESSMENT

The course will be assessed by continuous assessment and a final examination. The

weighting will be as follows:

Continuous Assessment: 40%

Final Examination: 60%

Continuous assessment shall be made up of trial questions at the end of each lesson,

assignments, and term paper on a selected topic in public sector Economics.

IV. PRE-REQUISITES

The students are expected to have successfully completed the core courses

(Microeconomics, Macroeconomics, and Quantitative Methods).

V. RECOMMENDED TEXTBOOKS

Atkinson, A. and J. E. Stiglitz (2015). Lectures on Public Economics, Updated Edition New

York: Princeton University Press

Leach, J. (2004), A Course in Public Economics, Cambridge: Cambridge University Press.


Hindriks, J. and G.D. Myles, (2013), Intermediate Public Finance, (2nd edition), Cambridge:

MIT Press.

Myles, G. (2008) Public Economics, Cambridge University Press

Kaplow, L. (2008), The Theory of Taxation and Public Economics, Princeton University

Press

Salani (2011), The Economics of Taxation, MIT Press

Other readings

Stiglitz, J. E. Rosengard, Jay, K. (2015). Economics of the Public Sector. 4th Edition.

W.W.W. Norton & Company

Rosen, H. S. and T. Gayer, (2014), Public Finance, Boston: McGraw Hill, 10th edition.

Gruber, J. (2016), Public Finance and Public Policy, 5th edition, New York: Worth

Publishers.

Howard, M. M., A. La Foucade & E. Scott (2010) Public Sector Economics for Developing

Countries, 2nd Edition, Barbados: University of the West Indies Press

Gaspar, V. Gupta, S. Mula-Granados. Ed. (2017). Fiscal Politics. Washington D.C.: IMF.

Hillman, A. L. (2009), Public Finance and Public Policy – Responsibilities and Limitations

of Government, Cambridge: Cambridge University Press.

Cornes, R. and T. Sandler (1996), The Theory of Externalities, Public Goods, and Club

Goods, Cambridge: Cambridge University Press.

ONLINE RESOURCES AND LINKS 1. https://www.sciencedirect.com/handbook/handbook-of-public-economics/volumes

2. www.jstor.org

3. www.ebsco.org (EBSCO host articles)

4. http://aercafrica.org/index.php/publications/view_category/20-senior-seminar-

policy-reports?layout=table

5. http://www.journals.elsevier.com/journal-of-public-economics/

6. www.globethics.net/library

7. www.digitallibrary.edu.pk/oaebooks.html

8. https://www.wdl.org/

9. www. elibrary.bigchalk.com/

10. www.webcrawler.com

11. https://www.academia.edu/37552359/Economics_of_the_Public_Sector_-_Joseph_E._Stiglitz

VII. DETAILED MODULE CONTENT

https://www.sciencedirect.com/handbook/handbook-of-public-economics/volumes

http://aercafrica.org/index.php/publications/view_category/20-senior-seminar-policy-reports?layout=table

http://aercafrica.org/index.php/publications/view_category/20-senior-seminar-policy-reports?layout=table

http://www.webcrawler.com/

https://www.academia.edu/37552359/Economics_of_the_Public_Sector_-_Joseph_E._Stiglitz


LESSON ONE: INTRODUCTION

By the end of the lesson you should b able to:

1.1 define a tax distiguish it from fees, fines, user charges, royalties; and penalties

1.2 describe the canons of a good tax system,

1.3 explain the history and rationale for taxation.

1.4 explain types of taxes;

1.5 explain vertical and horizonatal equity

1.1 Definitions

Fines and penalties: compulsory payments made without any guid pro quo.

➢ Fines are imposed to curb certain offences i.e. due to contravention of the law.

➢ The purpose is deterring people from doing certain acts.

Fees (user charges): voluntary transactions. Are prices determined through the political

process rather than market interaction. The payer has a choice, for example, a license.

Those who directly consume the service pay for at least part of the cost.

Price: received in payment for the goods and services sold by the government. E.g

electricity and water provision.

Special assessment: levied in proportion to the special benefits derived by individuals as a

result of government performing certain services that increases the value of wealth for

an individual. E.g charged on house owners due the government providing good

transport to the area.

Donations and Gifts: are voluntary contributions made by individuals, private

organisations, and foreign governments. E.g during disaster(s).

Privatisation: transfer of publicly owned assets into the ownership of the private sector.

Borrowing: Individuals and organisations lend funds to note government and in return they

receive a bond or other note of government indebtedness that embodies the promise to

repay the loan with interest in future.

Printing of paper money: creates money and assigns it legal tender qualities.

Taxes: is a compulsory charge or payment levied or imposed by a public authority (central,

or local government) on an individual or corporation. A tax payer does not receive a

definite and direct quid pro quo from the public authority.

Tax Base: the legal description of the object with reference to which the tax applies e.g.

excise duty is based on production; income tax is based on income.

Buoyancy of a tax: where revenue increases with the growth of its base, but without an

extension of the tax coverage or an upward revision of the tax rates. It has an inherent

tendency to yield more tax revenue with the growth of the base e.g. yield from income

tax increases as national income increases with a given rate of income tax.

Elasticity of a tax: the responsiveness to steps taken by the authorities in increasing its yield

through an extension of its coverage or revision of its rates.


1.2 Principles of a good tax system

There are certain principles which help in assessing whether a tax system is good or

otherwise (Stiglitz and Rosengard, 2015).

A Benefit Principle of Taxation

Taxes should be paid by those who directly benefit from the consumption of the

good. For example taxes on fuel, toll taxes.

B. Revenue Adequacy

Total tax revenue depends on the sizes of the tax base and levels of tax rates. Taxes

should be appropriate and sufficient to finance government needs over time.

C. Ability to pay

The amount of the tax is directly related to the wealth of the individual. Here taxes

help government perform its redistributive role. Tax structure is usually classified as

➢ Proportional – ratio of tax burden to income is constant for different income

levels

➢ Progressive - ratio of tax burden to income increases when income levels

increase

➢ Regressive - ratio of tax burden to income decreases when income levels increase

D. Stability

Taxes need to be stable to help in the proper planning within the economy (both for

the government as well as the private sector). Rates (and consequently the revenue)

and rules should be clear and understandable

E. Simplicity

The tax system should be such that it is easy to comply with and administer

F. Low Administration and Compliance costs

The cost of administering the tax should be a small proportion of the tax collected

G. Neutrality

It should not create major distortions in consumption and production. i.e. it should

not bias investment incentives unnecessarily.

1.3 History and Rationale of Taxation

Taxation has been an important source of revenue for governments since time in memorial.

It has been acknowledged, as a way of funding the activities of the governing body for

collective satisfaction of all the citizens wants. In the biblical times, the Pharisees and the

teachers of law disliked taxation. They thought that tax collectors were sinners (Luke, 5:27-

30 and Luke, 19: 1-7). In fact, a Pharisee while praying thanked God that he was not like

the tax collector. On the other hand, the tax collector prayed asking God to have pity on

him since, by virtue of his job; he thought he was a sinner (Luke, 18: 9-14). However, Jesus

exonerated taxation from sin by telling people to pay to the emperor what belonged to him

and to God what belonged to God (Luke, 20: 25). Taxation is therefore justified, and the

question now is how it should be carried out.

Taxation is a method of transferring resources from the private sector to the public sector.

The reasons/purpose for this transfer (See for example, Musgrave, 1959) are always given

as:


1. A way of obtaining money to fund the activities of the governing body for collective

satisfaction of all the citizens wants.

2. Overcoming the inefficiencies of the market system in the allocation of economic

activities and resources.

3. Redistributing income and wealth in a just or equitable manner.

4. Smoothing out cyclical fluctuations in the economy and ensuring a high level of

employment and price stability.

5. Providing social welfare services including maintaining peace and security

6. Protection of domestic commodities from competition

7. Improvement of social welfare by discouraging the consumption of harmful

commodities such as cigarettes.

8. Discouraging certain economic activities by heavy taxation and encouraging others

through tax exemption and

9. Boosting employment level by starting new projects using the revenue collected from

various taxes

Taxation is therefore based on production, receipt of income, ownership and transfer of

wealth, sale and consumption of commodities and services, and profits from business

activities (Gruber, 2016).

1.4 Types of Taxation

Read the relevant chapter in Gruber (2016) and make notes on the following:

➢ Types of taxes: direct and indirect and the reasons for their levying.

➢ Proportional, progressive, regressive and degressive taxes

➢ VAT

➢ Expenditure tax

➢ Capital Gains tax

➢ Taxes on wealth

➢ International trade taxes

1.5 Vertical and Horizontal Equity

1.5.1 The Equity Criterion

Taxes need to be fair such that each payer contributes her fair share to the cost of

government; the richer should pay a larger proportion of their incomes as taxes i.e.

progressive taxes. Approaches: the benefit principle and the ability to pay principle

(Kaplow, 2008).

The benefit principle: argues that taxes be paid in accordance with the benefits received

from government expenditures. Since preferences differ, no general tax formula can be

applied to all people hence the appropriate formula depends on preference patterns which

in turn depends on the income and price elasticity of demand for public goods.

Ability to pay principle: Tax is imposed according to what one can afford. The rich are

required to pay more in taxes than the poor.

Equity: is concerned with how the burden of output reduction in the private sector is

distributed among the various members of society under different taxing schemes. This


burden will include both the deadweight loss and the value of real resources transferred. It

is also referred as social justice and comprises (Stiglitz and Rosengard, 2015):

Horizontal equity: implies that the tax is treats equals equally. Two persons who had equal

welfare before the tax is imposed should enjoy equal welfare after the imposition of the tax.

Vertical equity: those persons who are in a position to pay more taxes should do so. It recognizes the

fact that not only must we be able to judge when two persons are equally well off, but also

we must have some scale according to which their well-being must be measured. The

comprehensive income base: it includes all income of a person regardless of either its source

or its use. It includes on an equal basis for example wages, rent, capital gains, gifts received,

and bequests received.

1.5.2 Conflicts between Efficiency and Equity

Although one could theoretically design a system of efficient lump-sum taxes which

discriminate between persons to obtain vertical equity, such as system would be impossible

to implement. It would require that government elicit information about the well-being of

individuals which they would not naturally reveal. Individuals would have every incentive

to misrepresent their true “utility” in order to reduce their tax obligations. In practice,

government instead rely upon discrimination between individuals according to an imperfect

index of their utility such as income, expenditures, wealth, among others.

Many of the taxes governments levy impinge upon the decisions of individuals and thus

cause inefficiencies or deadweight losses (Atkinson & Stiglitz, 2015).For example, taxes

levied on comprehensive income, while strong on equity grounds, will cause inefficiencies

due to its effect on distorting the supplies of factors of production

Similarly, taxes which are efficient in the sense that they impose only small deadweight

losses often tend to be “inequitable” For example, taxes on commodities with low price

elasticities of demand (cigarettes, alcohol) are relatively efficient. At the same time, since

such items also often tend to have low income elasticities of demand they impinge relatively

more heavily on the poor as a proportion of income (Atkinson & Stiglitz, 2015). .

Basic Readings:

Atkinson, A. and J. E. Stiglitz (2015). Lectures on Public Economics, Updated Edition New

York: Princeton University Press

Stiglitz, J. E. Rosengard, Jay, K. (2015). Economics of the Public Sector. 4th Edition.

W.W.W. Norton & Company

Gruber,2016, chapter 18

Musgrave, R. A. (1959). The Theory of Public Finance. New York: McGraw-Hill.

Other Readings

Mankiw, N.G., Weinzierl, M. and D. Yagan (2009): Optimal Taxation in Theory and

Practice, Journal of Economic Perspectives 23(4): 147-174

Mirrlees, J.R. (1997): Information and Incentives: The Economics of Carrots and

Sticks, Economic Journal 107:,1311-1329. (Nobel Prize Lecture)

LESSON TWO: THEORY OF TAXATION

By the end of the lesson, you should be able to:


2.1 explain the effects of taxation on savings,

2.2 discuss the effect of taxation on investment,

2.3 discuss the effcet of taxation on labour supply;

2.4 explain the effect of taxtion on risk taking; and

2.5 dicsuss tax incidence analysis.

2.1 Effect of Taxation on Savings

2.1.1 Introduction

Taxes affect savings and in turn economic growth. Past savings also represents a source of

inequality within economies.

The question that need to be answered are:

(a) Should income taxes be replaced by consumption expenditure taxes? Thus exempt

interest income from tax. Is it true that taxes on expenditure leads to a higher level

of savings?

(b) Should taxes be imposed on transfers of wealth through gifts or bequests? What are

the savings implications of such a policy?

(c) Should taxes be imposed on wealth (the ownership of capital)?

To analyse the effects of taxation on savings, we explain the determinants of an individual’s

choice of consumption hence saving. The following are alternative theories savings

behaviours in an economy (Atkinson and Stiglitz, 2015):

(a) Life-cycle motive: Whenever the time profiles of income and desired consumption

do not coincide, savings provide the mechanism by which purchasing power

available in one period is transferred to an earlier or later date, e.g., saving for

retirement, for financing education, or home purchase.

(b) Precautionary motive: Individuals may save in order to provide “insurance” against

times in which their incomes are low or their needs (e.g., a medical emergency) are

high.

(c) Bequest motive: Individuals may save in order to provide for their children or other

heirs.

2.1.2 Life Cycle Income Model

The current analysis of saving decisions is based on the life-cycle model, which says that

individuals’ consumption and saving decisions during a given year are the result of a

planning process that considers their lifetime economic circumstances (Modigliani, 1958).

The amount one saves per year depends on one’s income that year, the income that one

expect in the future and the income one received in the past. The life-cycle model is hereby

used to explore the impact of taxes on saving decisions.

Fugure 2.1 Ilustrates the income effect, the human wealth effect, and the substitution effect

of eaxation.


Figure 2.1 Substitution, Income and human wealth effects

Source: Modified from Stiglitz and Rosengard (2015) and Rosen & Gayer (2014)..

The ultimate effect of an increase in the interest rate is given by the move from to

Hicksian decomposition:

1. the move from to is the substitution effect (SE)

2. the move from to

3. is the income effect (IE)

4. the move from to is the human wealth effect (HWE)

If the household were to have non-interest income in the Period two ( ) the human

wealth effect would not be there. If the increase in the interest rate declines the

value of human capital and shifts the budget restriction inward.

It is difficult to predict whether an individual will save more or less after the imposition of

a tax. It depends on the relative strengths of the income and substitution effects. For

example, if interest rate are taxed and interest payments are tax deductible, then tax reduces

saving since the substitution effect predominates the income effect. If on the other hand,

interest receipts are taxed and interest payments are deductible, saving will increase since

income effect will predominates the substitution effect so the tax increases savings (Rosen

and Gayer, 2014).

A proportional tax on wages plus initial assets (for example inheritance) changes the

budget.

Summary of equivalence results – wage vs. consumption tax:

1r 0E1E

0E

1E

E

E

E

E

02 =Lw

)0( 2 Lw


➢ There is no effect of these sorts of taxes on optimal consumption plans (relative price

of future consumption unaffected)

➢ Private savings plans would be affected (time path of tax revenues affected)

➢ But, equivalence result strictly dependent on time-constancy of the consumption tax.

Summary of Equivalence Results – Interest Vs. Wealth (Asset) Tax:

➢ Optimal consumption plans are affected by both sorts of taxes (relative price of

future consumption affected)

➢ The results are equivalent under the assumption of a single-asset situation (we

modify this in next topic – risk-taking)

➢ The imposition of a wealth tax must take into consideration the possibility that

interest rate may be time-variant.

Borrowing constraints

According to Sandmo (1985), the two-period model suffers from at least two potentially

serious abstractions:

➢ Assumes that the lending and borrowing rates are the same, when in the actual sense

they are different. The differences affect the saving behaviour through changes in

the consumption behavour.

➢ there are no quantity constraints on borrowing. This means that borrowing is not

limited hence can affect consupmtion behavour too.

In reality these two assumptions can not hold.. Lending and borrowing rates and usually

different and there is always a borrowing constraint for example in terms of conditions that

must be made.

2.2 Taxation and Investment

2.2.1 Introduction and basic model

Investment determines the long-run growth in an economy since it adds to capital stock that

is used for production of goods and services. The effects of taxation on decision-making of

the firm in terms of investment behaviour is key. The first point we need to note about

investment is that it is always an intertemporal decision (Jha, 1998). A firm sets aside some

resources for future use in order to derive more profits later. We will be looking at the effects

of various taxes on these investment decisions of the firm.

Some of the taxes imposed on firms:

1) Taxes on factors of production

a) payroll tax: tax base is the wage bill


b) wage subsidies, for example on unskilled labour

c) corporate profits tax: can be seen as a tax on the return on capital

d) investment tax credit / investment subsidy

2) Taxes on output

a) value-added tax

b) production / turnover tax

Taxes may be specific or ad valorem. There are various transmission channels of corporate

income taxation on investment process and the specific determinants are the fiscal variables

that include:

a) the level and dynamic of marginal tax rate. This being the proportion of the last

shilling (domestic currency) of income taxed by the government (Rosen & Gayer,

2014), its level (high or low) and if it changes with time, will affect investment.

b) the level and evolution of average tax rate (ratio of tax paid to income). This will

also affect investment depending on the level and how the rate change over time.

c) Investment tax credit or the existence of tax-deductible depreciation allowances.

The marginal and average tax rates have a negative effect on investment decisions. The

fiscal treatment of dividends has also an impact on investment decisions. A higher tax rate

on dividends constitutes an additional disincentive to undertake investments. Another way

in which taxation affects investment decisions is related to capital taxation. A tax on the

stock of capital of a firm is a strong disincentive to invest.

A Basic Model of Firm Behaviour

To show the firm behvoiur with imposition of a tax, we use the model described by Myles

(2001) and Jha (1998) with modifications.

Some simplifying assumptions:

1) Partial equilibrium effects only (ignore GE output effects and focus on factor

substitution effects).

2) The assumption is that the prices paid by the firm are unaffected by the tax.

3) Model is static in nature

4) Labour and capital assumed to be freely adjustable

5) Assume constant returns to scale – perfect competition

6) Assume firm produces a single product

7) Profit maximizing representative firm

We can write the profit function of a representative profit-maximizing and competitive firm

as follows (Myles, 2001):

P is the goods price

K is the capital stock

L is labour

( ) KRWLLKPF K−− ,


W is the wage rate

Rk is the capital rental rate

Firm chooses K and L to Maximize profit:

First-order conditions:

How do taxes affect the objective function and the F.O.Cs?

Some examples follow:

Payroll tax [ad valorem] :

Factor substitution effect: higher K/L ratio

Figure 2.2 Factor substitution effect.

Sourec: Modified from Myles (2001)

Output tax [ad valorem]:

K

K RPF =

WPFL =

Pt

( ) KRLtWLKPF K

P −+− )1(,

P

RF

K

K =

P

tWF P

L

)1( +=

( ) KRWLLKPFt K

Y −−− ,)1(

Yt


Factor substitution effect: no effect on K/L ratio. Acts as common tax on both factors of

production. Specific subsidy on labour :

Factor substitution effect: lower K/L ratio. Labour becomes cheaper.

Tax on pure profits :

1) Factor substitution effect: no effect on K/L ratio.

2) No effect on output in short-run

3) No effect on marginal product (for which )

4) No effect on output in the long run

5) Tax falls on pure profit: “return on entrepreneurship”

Definition of tax base is crucial (thus it excludes )

2.3 Effects on the taxation on investment

There are four main views on taxation of dividends and its effect on the investment

behavoiur:

1. Traditional View: dividend tax is part of corporate taxation therefore it discriminates

against capital investment in the corporate sector (Harberger, 1962). This approach has

)1( Y

K

KtP

RF

−=

)1( Y

LtP

WF

−=

LS

( ) KRLSWLKPF K

L −−− )1(,

P

RF

K

K =

P

SWF L

L

)1( −=

t

( ) KRWLLKPFt K−−− ,)1(

P

RF

K

K =

P

WFL =

0=

KRK


been criticized because it ignores the role of corporate financial policy in investment

(Stiglitz, 1973).

2. Tax Capitalizations View: according to Ulbrich (2011: 48), “capitalization is the

process by which changes in taxes or service levels are translated through fiscal surplus

into appreciation or depreciation in home prices. One consequence of tax capitalization

is that the wealth effect of a change in tax or service levels falls on those who own

property at the time of the change and not on subsequentowners”. Dividend tax does not

affect the cost of capital and therefore does not affect the marginal incentive to invest.

The tax is is essentially a lump-sum tax on initial holders of corporate capital (Auerbach,

1979; Bradford, 1981; King (1977; and Ulbrich, 2011).

3. Tax Irrelevance View: dividend paying firms are not penalized in the market. The

marginal investor does not effectively pay any taxes on dividends or capital gains. This

is aided by, for example, institutional investors or sophisticated tax strategies. Dividend

tax has no effect on firm value or its real decisions Miller and Scholes, 1982). :

4. Behavioral View: dividends are paid because shareholders derive benefits. Lowering

dividend taxes increases firm value and investment and the firm may also pay dividends.

Chetty and Saez (2004) reported that dividends payments surged following a tax cut.

The following are reasons why firms pay dividends:

a) signalling quality of the firm

b) need to restrict management discretion

c) to self-control

Developing countries use tax incentives to stimulate the inflow of foreign investment. The

main tax incentives include income tax holidays, investment tax credits, accelerated

depreciation allowances, and exemptions from import duties (Howard, La Foucade &

Scott, 2010). Howard, La Foucade and Scott (2010) concluded as follows on tax incentives

in developing countries:

a) Tax incentives are generous and governments tend to overconcede to foreign investors,

who are able to recover the cost of their investment before being subjected to taxation.

b) Tax incentives assist in reducing the cost of investment but also other factors play a role

in attracting FDI including natural resources, infrastructure, low wage costs, and

political stability.

c) Tax incentives are not not effective in attracting FDI.

d) Government looses revenue by overconceding to tax incentives and may create

distortions in the economy through encouraging high levels of capital intensity and low

levels of local value added.

Tax incentives lead to distortionary effects since firms may take advantage of the incentives

to avoid tax and may engage in tax tax-evasion or other firms may also ask for same

treatment. For example, a tax policy that allows government officials to generously grant

tax holidays and exemptions to multinational companies is widely abused. Companies that

operate within the tax-break window often close and move todifferent jurisdictions just

before the full tax rate comes into effect, or frequently change names and start enjoying the

tax holiday afresh as a new entity (Wawire, 2020).

Governments have signed tax treaties to deter tax evasion and enable sharing of tax

information. But tax-sharing can have a negative influence on FDI while lower tax evasion

is associated with more FDI. In a nutshell, the effect of the taxation on an investment


depends: on the tax-wedge;on the prevailing tax-system; the existing withholding taxes on

repatriated taxes or dividends; and on specific incentives.

More profits is an indicator of a favourable business climate that boosts business

confidence. Reduction in the tax burden on firms is key to improving the investment and

business climate. Djankov, et al. (2010), showed cross-country evidence that effective

corporate tax rates adversely affect corporate investment and entrepreneurship. They also

studied the effect of corporate taxation on the size of the unofficial economy, since taxes

might deter official entry or even official investment is by keeping firms in the unofficial

sector. They found a that an increase the rate raises the unofficial economy indicating that

taxation is an important reason that makes firms operate in an official economy.

Capital gains are realized from the sale of stocks, bonds and property (Jha, 1998). It is treated

as an income and therefore it is taxed. When the tax rate increases, there is less revenue

realised and , investment capital decreases thereby slowing down the economic growth.

The cost to acquire capital increases also. If the return on investment is lower there is less

investment and the amount of available capital in the economy declines. A reduction in the

capital gains tax rate is increases investment. The firms will be able to to acquire the funds

required to undertake new projects. A lower capital gains tax would increase individual

wealth that could be re-invested.

Firms require funds to continue operation that are in turn repaid to the investor along with

an incentive for taking the risk of lending money. When the tax rate is increased, the

incentive for taking the risk of investing is diminished and new projects cannot be

established. When there is a lack of investors the ability to raise capital for firms is reduced

so new projects are not strtedlimiting the amount of capital in the economy. When the taxes

on investing are reduced there is more money in the economy and the government receives

more ax revenue. An increase in taxes reduces the entrepreneur’s cash flow. To the extent

that there are liquidity constraints, the result would be a reduction in the demand for capital,

hence reduction in investment.

2.4 Effects of taxation on Labour Supply

How labour supply is determined and whether taxes affect it are the issues to be discussed

here (Jha, 1998). Utility-maximizing choice of leisure and income.

Individuals have preferences over consumption Y and “leisure” L (or equivalently, hours

H=T-L)

U=U(Y ,L); UH=UH(Y , H);

U satisfies the normal regularity conditions

Individuals maximize preferences over the range of their budget constraint

Y=f(gross income):

Max U=U(Y ,L) subject to budget constraint Y = f(gross income)

Leads to the Marshallian labour supply function H*


Budget constraints with taxes and personal allowance (PA).

In the absence of tax and PA, we have:

Y =w.H+ Y0 = G + Y0

G is gross earned income; Y0 represents unearned income

For a single pro rata tax rate of t on all earned income:

Y = G + Y0 - t.G

= (1-t).G + Y0

For a single pro rata tax rate of t on earned income above a personal allowance PA:

Y = G + Y0 - t.(G-PA)

= (1-t).G + Y0 + t.PA if G > PA

Y = G + Y0 if G < = PA

In the presence of a general system of tax payments

on earned income:

Y = G + Y0 - T(G)

T(G) represents the amount of tax paid at earnings G

Taxes on income can distort economic behaviour in a number of ways (Stiglitz and

Rosengard, 2015)

(a) Taxes affect employment incentives

(b) Taxes affect consumption patterns

(c) Taxes affect savings decisions

The pattern of distortion depends on the type of tax:

✓ lump-sum versus pro-rata tax

✓ consumption versus income tax

Example: single pro rata tax rate of t on earnings above personal Allownace (PA)


Fig. 2.3: The effect of a simple income tax

Source: Jha (1998)

The effect:

(a) the person chooses to work to a point at which tax is payable

(b) the tax reduce the price of ‘leisure’

(c) Labour supply is reduced

The effect would have been been different:

(a) if the personal chose to earn below PA, then this tax structure would have no effect

on labour suply.


Figure 2.4; No effect on labour supply

Source: Jha (1998)

(b) if the person had different tastes, then she/he might have increased labour supply

following the introduction of the tax.


Figure 2.5: Increases labour supply

Source: Jha (1998)

A pro-rata tax on earned income alters the relative price of income and ‘leisure’. This creates both an income

and a substitution effect. The overall impact of tax on labour depends on which effect dominates.:

✓ income tax increases labour supply if the income effect dominates while income tax

decreases labour supply if the substitution effect dominates.

2.4 Effect of Taxation on Risk Taking

Taxes taxes on capital discourage risk taking? Most investors will take risks when they

perceive a sufficiently high expected return over what they could have obtained in a safe

investment. Stiglitz (2000) noted the wide concern that taxing the return to capital is

effectively taxing the return to risk bearing, and thus discourages risk taking. High rates of

taxation on capital gains could discourage risk taking and entrepreneurship. The fact that

capital gains are taxed only when the asset is sold could give rise to the locked-in effect;

individuals may retain an asset when in the absence of a tax they would have sold it. If the

return on safe assets were zero and the government taxed gains and subsidized losses at the

same rate, then capital taxation would encourage risk taking.

2.5 Tax Incidence Analysis

2.5.1 Introduction and Theories of tax shifting

When a tax is levied, the impact will be felt by the individual who actually pays it. This can

an individual earning income, or a property owner or a buyer or seller of a good or a service.

In some some cases, she/he may it might be possible for the individual to shift the tax burden

to someneone else. Tax incidence therefore refers to who bears the tax burden (Kotlikoff

Summers, 1987). There are two types:

(a) The statutory/formal incidence of a tax indicates who is legally responsible for the tax

i.e. whom the initial impact of the tax falls or where legal liability of the tax falls.

(b) The economic /effective incidence of a tax is the change in the distribution of private real

income induced by a tax. It is the final resting place of a tax after all individuals and

firms have adjusted their behaviour in respect of work, spending, saving and investment.

Individuals or firms will attempt to shift the tax backward to suppliers and forward to

consumers.

Theories of tax shifting (https://www.slideshare.net/9129/public-finance-52461996)

There are three theories of tax shifting (which assume that the incidence of a tax can be

shifted only through sale/purchase transactions involving real or financial resources. No

taxpayer can recover the tax paid by him from someone else unless something is bought

from or sold to the latter.

(a) Concentration Theory

This theory asserts that there is an inherent tendency for the taxes to be absorbed by

certain income classes. Only those persons that have surplus bear the taxes. Acording

to Smith (1976/1776) and Ricardo (1817),taxes can rest only on net income or rent.

Wages form a higher proportion of the cost of production. And since labour and

businesses receive little net income, most taxes that are imposed on them have to be

shifted through increased prices and wages.


(b) Diffusion Theory

Given the interdependence of economic units in the economy and assuming that wage

rates can be higher than the subsistence level, it follows that economic “surpluses” can

exist throughout the economy. In the short run, even in a competitive market, there is

an element of “rent” in the earnings of every factor of production. By implication, a tax

levied and collected anywhere in the economy could finally shift to anywhere else in

through numerous phases of this process. It, therefore, becomes extremely difficult to

ascertain the final location of its incidence. It gets fully “diffused” in the economic

system.

However, the assumptions upon which this theory is based are unrealistic. Factually

speaking, modern market economies are victims of a variety of market failures. They

suffer from monopolistic elements and malpractices, imperfect factor mobility and so

on. It is therefore, unrealistic to assume that the tax incidence gets fully diffused in the

economy. In several situations, it may not shift at all. Similarly, the incidence of a

specific tax may tend to concentrate on some sections of the society or some sections of

the business, while leaving others totally unaffected. Moreover, it is the duty of the

authorities to ensure that the tax regime helps in attainment of maximum social welfare.

Therefore, instead of being moot spectators, they are expected to pursue an active

taxation policy counteracting market failures.

(c) Demand and Supply Theory

It starts with the basic fact that incidence of a tax can be shifted only through

sale/purchase transactions and, therefore, only through a variation in prices (Stiglitz and

Rosengard, 2015; Musgrave and Musgrave, 1984). Given the levying of a tax on an

item, the direction and extent of revision in its price is determined by relative values of

its demand and supply elasticities. The general rule is that irrespective of whether the

statutory liability of paying the tax (that is, its impact) rests upon the buyer or the seller,

the share of the tax borne by the seller will be the larger if the elasticity of demand of

the taxed item is larger, and the share of the tax borne by the buyer will be the larger if

the elasticity of supply is larger. The tax burden will be shared between the buyer and

the seller in the ratio of the elasticities of supply (Es) and demand (Ed) of the taxed item

using the following formula:

𝐵𝑢𝑦𝑒𝑟′𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑖𝑛𝑐𝑖𝑑𝑒𝑛𝑐𝑒

𝑆𝑒𝑙𝑙𝑒𝑟′𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑖𝑛𝑐𝑖𝑑𝑒𝑛𝑐𝑒=

𝐸𝑠

𝐸𝑑

In absolute terms, the total incidence of a commodity tax on the buyers will be given by

𝑡𝐸𝑠/(𝐸𝑠+ 𝐸𝑑)where 𝑡 is the tax per unit (it may be ad valorem or specific) and the share

of the sellers will be given by 𝑡𝐸𝑑/(𝐸𝑑 + 𝐸𝑠). In genarl form, the formula becomes:

∑ 𝑡𝑖𝑒𝑖𝑥𝑖

𝑛𝑡=1

∑ 𝐸𝑑𝑖𝑥𝑖+∑ 𝑒𝑖𝑛𝑡=1 𝑥𝑖

𝑛𝑡=1

,

where 𝐸𝑑 is the elasticity of demand.

In some cases, the price of a commodity may increase by more than the amount of the tax

levied on it. This can happen, for example, in the case of a commodity which is subject to

the law of increasing returns.such as those produced by a monopolist An imposition of a


tax in this case reduces the amount supplied and purchased, the average cost of production

increases and that adds to the upward shift in price. The sellers will pass both the tax and

the loss of the interest which they suffer by first paying the tax to the authorities and then

collecting it later from the buyers. In this case, the share of the buyers would be given by

(𝑡+𝑖)𝐸𝑠

𝐸𝑠+ 𝐸𝑑,

where 𝑖 is the interest loss to the seller. If this price rise for the buyer is more than the tax

amount, then it will follow that: (𝑡 + 𝑖)𝐸𝑠

𝐸𝑠 + 𝐸𝑑> 1

𝑡 + 𝑖

𝑡>

𝐸𝑠 + 𝐸𝑑

𝐸𝑠

𝑖

𝑡>

𝐸𝑑

𝐸𝑠

In a nutshell, a smaller elasticity of demand and a bigger elasticity of supply will lead to

increased price more than the tax levied. The same will happene where the competitive

market is converted into a monopolistic one by the sellers through collusion, which will

allow them to to restrict the supply and raise the price.

The greater the elasticity of demand, the smaller will be the share of the incidence borne by

the purchasers. Supply curve, however, may have a positive or a negative slope. In the

former case, with higher elasticity of supply, the tax share of the buyer will be more. In the

latter case, on the other hand, the share of the buyers will increase as the elasticity of supply

becomes smaller (Stiglitz and Rosengard, 2015).

Determinants of tax shifting in an economy

1. The degree of market power of the buyers and sellers. A discriminating monopolist may

identify those groups of customers with relatively inelastic demand and pass most of the

tax burden to them unlike an individual firm in perfect competition.

2. The coverage of the tax base. If indirect taxes are applied selectively to a narrow range

of goods and services, consumers will tend to substitute untaxed goods and services for

those taxed. In contrast, value added tax with its extensive coverage limits the scope for

substitution by consumers of untaxed goods and services. The effective incidence of a

value added tax is mainly on consumers which reflect its wide tax base.

3. The relative elasticities of demand and supply. The higher the supply elasticity, the more

an indirect tax is shifted forward to the purchaser of the taxed commodity. The lower

the demand elasticity, the more an indirect tax is shifted forward to the purchaser.

2.5.2 Partial Equilibrium Analysis

Suppose a proportional tax is imposed on a perfectly competitive market for either goods or

factors of production. If it is a market for a good, the tax would be a selective commodity

tax falling only on this good as, for example, a tax on fuel or tobacco. If it is a factor market,

the tax is a general factor tax on all uses of that factor as, for for example ., a payroll tax on


labor income alone. The partial equilibrium incidence (Jackosn and Brown, 1996) of such a

tax is depicted in Figure 2.6 where X is the output and p the price. The initial equilibrium

output is X1 and price p

1.

Fig. 2.6: The partial equilibrium incidence of such a tax where X is the output and p the

price.

Source: Brown and Jackson (1996); Stiglitz and Rosengard (2015)

Suppose now an ad valorem tax on X at the rate t is imposed where t is calculated on the net

price. The new market equilibrium output is X2 with the net price p

2 and gross price p

2(1+t).

The sellers have had to absorb a price fall from p1to p

2 and therefore are worse off. However,

the net price has not fallen by the full amount of the tax since the gross price to consumers

has risen from p1to p

2(1+t). Thus, if the sellers bear the legal incidence of the tax, they have

shifted part of the burden to the buyers. Note that the same result would have been achieved

had we shifted D downward by the amount of the tax rather than S upward. In Fig. 2.7, we

can also measure the burden borne by each of the parties involved.

The demanders lose an amount of consumer surplus equal to area p2(1+t)AB

p1 and suppliers

lose producer surplus equal to p1BCp

2 for a total loss of p

2(1+t)ABCp

2. This loss exceeds

the gain in government tax revenue p2(1+t)ACp

2 by the triangle ABC which is the

deadweight loss of the tax. The distribution of the burden of taxation (as well as the

magnitude of the deadweight loss relative to tax revenue generated) depends upon the slopes

of the demand and supply curves. For example, if the supply curve were completely

inelastic, the tax will not change the quantity supplied, the gross price will not change [p1=

𝑆

𝑆(1 + 𝑡)

𝐷

𝑃

𝑃2(1 + 𝑡)

𝑃1

𝑃2 𝐶

𝐴

𝐵

𝑋2 𝑋1 𝑋


p2(1+t)] and the entire burden of the tax would be borne by the supplier. Moreover, no

deadweight loss would be generated. The suppliers will also bear the full burden of the tax

if demand is perfectly elastic although in this case there is substantial deadweight loss

included in the burden.

Conversely, with supply perfectly elastic, the consumers bear the burden of the tax including

the deadweight loss. Finally, if demand is perfectly inelastic, the consumers will bear the

entire burden and no deadweight loss will result. In general, the consumers will bear

relatively more of the burden the more elastic is supply and the less elastic is demand. We

can show that the ratio of the deadweight loss borne by consumers to that by suppliers is

ES/ED, the ratio of the supply and demand elasticities.

Shortcomings of a partial equilibrium analysis

As a complete theory of tax incidence, partial equilibrium analysis is insufficient because it

ignores a number of changes in relative prices which are likely to take place in other markets

and which will influence relative utility levels. If the market being taxed is a market for a

factor of production, the decrease in supply of that factor as a result of the imposition of the

tax will cause a relative scarcity of that factor compared to others and will tend to reduce

the relative price of other factors. The strength of this effect on other factor prices will

depend upon how substitutable one factor is for the other in production processes and upon

the share of the taxed factor in the cost of producing output (Brown & Jackson, 1996).

In analysing, say, a tax on labour income, we are interested not only in what happens to the

price of labour but also to the price of capital since we would like to know how the tax bears

on the owners of various factors of production. The same sorts of problems arise if we are

analyzing a tax on a specific commodity output. A partial equilibrium analysis can only tell

us what happens to the price of that commodity. However, the tax is also likely to cause

other commodity prices to change as well as relative factor prices. Another problem with

PE analysis is that it is extremely limited in the types of taxes it can properly handle, i.e.,

those taxes which apply to a specific market.

In particular, it can neither handle partial factor taxes nor general income or commodity

taxes. Partial factor taxes, or taxes on a limited number of uses of a factor of production (for

example, corporate income tax to the extent that it is a tax on the return to corporate sector

capital), bear only on part of the market for that factor even though they will influence the

economy-wide factor price. Demand and supply curves will obviously not suffice.

A general income tax can be viewed as a tax on all factors of production and thus it

simultaneously hits several markets at once so the analysis of a single market is insufficient.

The same problems arise when commodity taxes are levied on several commodities at the

same time as is the case with general commodity taxes. Even if all commodities or factors

are taxed at the same rate, their relative prices may change if they have different elasticities

of demand or supply. A single aggregate demand and supply curve analysis will not pick up

these relative price changes final problem with PE analysis is that it ignores the use to which

government revenue is put. This is a particularly important problem when one wants to do

a differential incidence analysis to compare two taxes. All these problems are explicitly

taken into consideration in the general equilibrium analysis of taxes.


(a) Partial Equilibrium in Non-Competitive Markets

Markets which are subject to a tax might be less than perfectly competitive ( Brown &

Jackson, 1996). Consider the extreme case in which the industry is a monopoly and is

subject to a specific commodity tax on its output. Fig. 2.6 illustrates the case of an ad

valorem tax at rate t imposed commodity X. Before the tax, the monopolist selects an output

X1 where MR

1=MC. The price at output X

1 is p

1 as determined by the AR

1 curve.

Fig. 2.7: The case of an ad valorem tax at rate t imposed commodity X.

Source: Brown and Jackson (1996); Stiglitz and Rosengard (2015)

Now, suppose an ad valorem excise tax is imposed. Whatever output the firm sells, its net

price is now reduced by the tax. The amount by which the net price diverges from the gross

price depends upon the output level chosen since the tax is based upon the price. The higher

the price, the higher will be the tax. The average revenue curve to the firm becomes

AR2where AR

1=AR

2 (1+t).

As a result, the marginal revenue curve facing the firm is MR2. The profit maximizing output

of the firm is now X2 with a net price of p

2 and a gross price to consumers of p

2(1+t).As

expected, output has fallen and the price to consumers has risen, reflecting the partial

shifting of the tax to the consumers. The share of the burden imposed upon consumers [p2

(1+t)ABp1] will be greater the less elastic is the demand curve and the flatter is the MC curve

of the firm. This result is similar to that obtained in the competitive case above. Once again,

however, the PE view may be insufficient if the tax applies to more commodities than one.

One might also analyze the effects of a factor tax imposed on a monopoly industry. However,

here since the tax will, in general, apply to more than one industry’s use of this factor, an

analysis concentrating on a single industry may be seriously deficient.

Consider a factor tax imposed upon the monopolist producing product X in Fig. 2.9.

MC

AC

AR2

MR1

MR2

B A

P

P1

P2

X1 X2

AR1

𝑃2(1 + 𝑡)


The tax may be on labour or capital or any other factor of production.

Fig. 2.7: A factor tax imposed upon the monopolist producing product X

Source: Brown and Jackson (1996)

Before the tax, the output is X1 at a price of p

1. The tax on the factor will increase the long

run average and marginal costs of production to AC2 and MC

2. The effect of the rise in cost

curves is to reduce output to X2 and to raise the price to p

2, thereby shifting some part of the

burden to consumers of the product. More of the burden will be shifted the less elastic is

demand and the flatter is the MC curve of the firm. The amount of the upward shift in AC

and MC will be influenced by the share of the taxed factor in the costs of production and in

the ability to substitute away from the taxed factor in favour of untaxed factors in the

production process. Much of this substitutability may be possible only in the long run.

Hence, the tax revenue obtained cannot be observed directly in the diagram.

2.5.3 General Equilibrium Analysis

The GE analysis of a tax change explicitly takes into consideration the changes in price and

quantity that occur in all markets (for both goods and factors) as a result of the tax (Brown

& Jackson, 1996). In the real world this would be a mammoth task due to the large number

of markets that actually exist. For the purposes of analysis we must therefore abstract from

the real world by assuming that the economy consists of a manageable number of markets

for goods and factors. It turns out that considerable insight can be obtained into the GE

incidence of tax changes if we restrict ourselves to an economy consisting of two goods and

two factors.

(a) Two-Sector Model - Assumptions

X X

2

X

1

MC

2 MC

1 AC2 AC1

A

R M

R

P1

P2

P


The economy has 2 factors: labour (L) and capital (K). The services of these factors may be

purchased at prices w (wage rate) and r (rental rate) as determined on competitive markets.

Factors L and K may be allocated by the price system to the production of two commodities,

X and Y. Each industry hires L and K to produce output with given technologies. We shall

assume that production exhibits constant returns to scale, and that L and K are substitutable

for one another with diminishing marginal rates of technical substitution (MRTS). The

competitive conditions ensure that the ratio of factor prices, or the wage-rental ratio (w/r),

equals the MRTS (Brown & Jackson, 1996; Atkinson & Stiglitz, 1980).

The two industries X and Y may exhibit different K/L ratios at the same w/r ratio. That

industry which has the higher K/L at any given w/r ratio is said to be the capital-intensive

one. The other industry is then the labour-intensive one. Both labour and capital are fully

employed and completely mobile between industries. We shall normally assume that the

supplies of L and K are fixed to the economy. This implies that we may represent the

production possibilities of the economy in an Edgeworth box diagram. From the contract

curve of the Edgeworth box we may derive the PPC.

The technology with which the two industries employ L and K to produce X and Y are

represented by a map of isoquants, assumed to be homogeneous. Each isoquant shows those

combinations of L and K which are required to produce a given level of output. Successive

(higher) isoquants represent higher levels of output for the respective industries. The slope

of the isoquant at any point indicates the increase in K required compensating for a small

reduction in L and still maintaining the same given output. The curvature of the isoquants

determines the amount that the w/r changes in response to a change in K/L or vice versa.

Prices of goods and factors are such that demand equals supply in all markets. All exercises

involve the substitution of one tax for another yielding the same resource transfer to the

public sector. In all instances, it is assumed that the government has acquired a given

quantity of L and K. We are concerned with how the remaining L and K are allocated by the

price mechanism, and how that allocation changes when the type of tax used to finance the

government’s purchases is changed. In other words, the analysis is of differential tax

incidence. In this model, four types of taxes are of interest to us: specific commodity tax,

general consumption or income tax, general factor tax, and partial factor tax. We shall

proceed by analyzing insofar as possible the GE incidence of these taxes using geometrical

techniques (Harberger, 1962; Atkinson & Stiglitz, 1980; Howard, La Foucade & Scott,

2010).

(a) Specific Commodity Tax

Suppose we consider the simple case in which factor supplies are fixed. Then the

substitution of a tax on good X for an equal-yield lump-sum tax may be analyzed using the

PPC PP of Fig. 2.8.The curve pp shows the combinations of X and Y available for use in the

private sector after the public sector has met its given requirements. When lump-sum

taxation is used, the economy reaches a point such as A where MRTxy

=MRSxy

. Assume for

the moment that all individuals have identical tastes and incomes so that the indifference

curves drawn have the same properties as those of individual consumers.


Fig. 2.8: The substitution of a tax on good X for an equal-yield lump-sum tax using the PPC

PP.

Source; Atkinson and Stiglitz (1980); Stiglitz & Rosengard (2015); Howard, La Foucade &

Scott (2010).

When lump-sum taxation bearing equally on all individuals is replaced by a tax on good X

at rate tx, the economy moves to point B at which the relative price of X to consumers has

risen and that to producers has fallen such that

To determine the influence of the reduction in MRTXY

on relative factor prices we use the

Edgeworth box diagram in Fig. 2.9. Recall that each point on the contract curve in Fig. 2.9

corresponds to a point on the PPC PP in Fig. 2.8.The same two points A and B on PP are

shown on the contract curve joining OX and O

Y.

( )( ) XYX

Y

XXXY MRTt

p

tpMRS +=

+= 1

1

OY

A

B

P

Y P

X


Fig. 2.9: After the tax is imposed on X the economy’s production is reallocated from point

A to B.

Source; Atkinson and Stiglitz (1980); Howard, La Foucade & Scott (2010).

At point A the rental-wage ratio is given by the common slope of the isoquants of X and Y.

Notice that at point A the ratio of labour to capital employed in X, LX/K

X, is the slope of the

line OXA. Similarly, the ratio L

Y/K

Y is the slope of the line O

YA. As the diagram is drawn,

LX/K

X >L

Y/K

Y at A and at all other points along the contract curve. Industry X is therefore

labour-intensive and Y capital-intensive. Had the contract curve been diagonal the factor

intensities in X and Y would have been equal (LX/K

X = L

Y/K

Y ). And, had the contact curve

been southeast of the diagonal Y would have been labour-intensive and X capital-intensive.

Effects of the tax

After the tax is imposed on X the economy’s production is reallocated from point A to B.

It is important to notice that the L/K has risen in both industries. As L and K are released

from the X industry, which employs relatively more L per unit of K, the L/K must be

increased in both industries in order to employ all factors. As the L/K rises in both industries,

so does the MRTSKL

or r/w. The relative rise in the price of K compared with L induces firms

to economize on K by raising their ratio of L to K. Hence, in the move from A to B, the ratio

r/w must rise until all L and K are fully employed. Thus, (r/w)B>(r/w)

A.This demonstrates

that a tax imposed on the X industry will cause r/w to rise if the X industry is relatively L-

intensive. A similar analysis would show that r/w would fall if the X industry is relatively

K-intensive (Harberger, 962; Atkinson & Stiglitz, 1980). More generally, this result may be

stated as follows:

A

B

(𝑟 𝑤Τ )𝐵

(𝑟 𝑤Τ )𝐴

K

L

OX


“A tax imposed on the output of an industry will cause a reduction in the relative price of

the factor used relatively intensively in the taxed industry.”

Modifications to include many individuals

The foregoing analysis shows how the relative goods and factor prices might be expected to

change as a result of the tax on X in an economy consisting of identical individuals. We now

assume there are many different individuals in the economy each of whom owns differing

amounts of L and K. The tax will still divert demand from X to Y as compared with, say, a

non-distorting tax levied on all income. The effect of that shift in demand on relative factor

prices will be as already analyzed. However, as compared with a proportional income tax,

the excise tax will hurt those individuals who get proportionately large amounts of income

from the factor used intensively in the taxed industry (since its relative reward will fall).

(Atkinson & Stiglitz, 1980)

Conversely, individuals obtaining a large share of their income from the factor used

intensively in the untaxed industry will be better off after the tax change. On the use side of

the budget, individuals will consume differing proportions of the two goods. Hence, the tax

will be borne relatively more heavily for those individuals for whom X takes up a larger

share of their budget. Finally, let’s briefly examine the implications of having a variable

rather than a fixed factor supply. Suppose that the labour supply varies with the wage rate.

If X is a L-intensive industry, a tax on X tends to cause the wage rate to fall. The fall in the

wage rate would be tempered by the reduction in the supply of labour. The economy-wide

L/K ratio falls and the impact of the tax on r/w is reduced. By the same token, if X is K-

intensive industry, the tax would tend to reduce r/w, thus causing the labour supply to rise.

The supply of labour raises L/K in the economy, thus reducing the fall in r/w. In either case,

the beneficial or detrimental impact of the tax change on the return to labour is reduced

because of the variability of the labour supply (Brown & Jackson, 1996; Atkinson & Stiglitz,

1980)

(b) General Consumption Tax

Consider now a tax imposed on X and Y at the same rate: In an economy with fixed L and K

supplies such a tax is a lump-sum tax since it is equivalent to a tax on fixed-factor incomes.

It is borne in proportion to the income (or consumption) of each member of the economy.

In a single-consumer economy or one with several identical consumers, the substitution of

a general consumption tax would not affect relative prices or resource allocation. If factor

supplies are variable, a general consumption tax will no longer be neutral. The tax would

reduce the return from supplying factors of production and therefore the supplies would

change. For e.g., if the L supply varies positively with wage but K is fixed, a general

consumption tax would reduce the supply of L, reduce the economy’s L/K ratio, and thereby

increase w/r. Labour owners would have succeeded in shifting part of their tax burden to

capital owners. If capital were variable, the opposite would hold (Brown & Jackson, 1996;

Rosen and Gayer, 2008)

(c) Partial Factor Tax (Corporate Income Tax)

This represents a tax on the use of a factor of production in one industry. This type of

taxation is one of the most complex to analyze as it causes production inefficiency in the

economy so that it operates below the PPC. Consider for example, the imposition of a tax

on, say, capital in the X industry at the rate tKX

. This might be thought of as the corporation


income tax where X is the corporate sector and Y is the unincorporated sector of the economy

(Jackosn and Brown, 1996; Atkinson and Stiglitz, 1980).

To facilitate geometric analysis we shall assume that factor supplies are fixed. This enables

us to use the Edgeworth box diagram of Fig. 2.10 to illustrate the possible allocations of the

given stocks of K and L between the two industries. Under lump-sum taxation, the economy

will operate with full efficiency. A point such as A will be reached along the contract curve

representing the outputs of X and Y at which MRTXY

=MRSXY

. At point A, the rental-wage

ration (r/w)A equals MRTS

KL in both industries.

Fig. 2.10: The

Source; Atkinson and Stiglitz (1980); (1980); Howard, La Foucade & Scott (2010).

Edgeworth box diagram illustrating the possible allocations of the given stocks of K and L

between the two industries.Imagine now the substitution of a tax on capital in X for the

lump-sum tax. We can expect that two things would happen. First, since the input of one of

the factors in X is being taxed, the price of X would rise relative to Y. This would cause

demand to shift from X to Y and resources would be reallocated from industry X to Y.

Second, the tax on KX violates the production efficiency conditions since:

Since the MRTSKL

differs in X and Y the allocation of L and K will be off the contract curve.

Suppose B is the new equilibrium production point attained under the partial factor tax. At

B, X is producing less and Y is producing more than at A and production is inefficient.

;w

rMRTS Y

KL =( )

w

trMRTS KXX

KL

+=

1

ሾ𝑟(1 + 𝑡𝐾𝑋)/𝑊ሿ𝐵

(𝑟 𝑤Τ )𝐵

(𝑟 𝑤Τ )𝐴

B

A

L

B OX

OY


In analyzing the incidence of the partial capital tax it is useful to distinguish conceptually

between the reallocation of output from X to Y due to the change in relative prices; and the

movement off the contract curve due to the induced inefficiency. Using the terminology of

Mieszkowski, the former will be called the output effect and the latter the factor substitution

effect. Let us consider how each of these effects bears upon r/w.

Output effects

The output effect is concerned with the effect on r/w of a reallocation of resources from X

to Y but ignoring the production inefficiency. If X is L-intensive (as in Fig. 2.10), the

reallocation of L and K from X to Y tends to cause r/w to rise since the ratio of L to K released

in X exceeds that currently used in Y. Labour becomes less scarce relative to capital and its

relative price falls. If the taxed industry X were K-intensive the opposite would hold; the

output effect would produce a tendency for r/w to fall. Therefore, the output effect of

imposing a tax on KX can work in favour or against capital owners according to whether X

is labour or capital -intensive.

Factor Substitution effects

The FSE is concerned with the movement off the contract curve to B as a result of the

distortion imposed upon the market for K. The impact of the tax initially is to reduce the

return to capital in the X industry. Owners of K will be induce to move K out of X and into

Y. This will continue until the economy-wide r/w falls by enough so that

Unlike the output effect, the FSE has an unambiguous influence on r/w. It causes r/w to fall

thereby tending to harm capital owners relative to labour owners.

Total effects

The overall impact of the tax on r/w depends upon the combined strengths of the output and

factor substitution effects. If the X industry is K-intensive, both effects will cause r/w to fall.

Capital owners would be worse off and labour owners better off. If the X industry is L-

intensive, output and factor substitution effects work in opposite directions. One cannot

predict the effect of the tax on r/w a priori. It depends upon the relative strengths of the two

effects. If they just offset each other, r/w will not change, and the incidence of tKX

will be

the same as that of a general income tax on all capital and labour income. In effect, capital

owners would have succeeded in shifting a share of the tax burden to labour (Brown &

Jackson, 1996).

Trial Questions

Question 1

Assume that you are a tax consultant and you are asked to estimate the incidence and the

excess burden of a proposed new tax on petrol. You are told that: the proposal tax is to 2

per litre, the uncompensated elasticity of demand is 0.6, income elasticity is 1.5, the share

of income spent on petrol is 0.067, and supply of petrol is perfectly elastic at the world price.

In the absence of the tax, the price of petrol is 4 shillings per litre and 2 billion litres are

sold.

;w

rMRTS Y

KL =( )

w

trMRTS KXX

KL

+=

1


Required

(a) Who bears the incidence of the tax consumer or producer? Why?

(b) Given the income elasticity of demand, what is the effect of the tax on the distribution

of the income, and why?

(c) What is the excess burden of the tax?

(d) What is the revenue generated by the tax?

Question 2

Read and review the original article for Harbeger (1962) on tax incidence. Using Harberger

model, evaluate the ways in which changes in the assumptions underlying the general

equilibrium model can modify its implications for tax incidence

Basic Reading:

Stiglitz, J. E., (1973). “Taxation, Corporate Financial Policy, and the Cost of Capital,”

Journal of Public Economics. (February 1973): 1–34.

Djankov, S. Ganser, T. McLiesh, C. Ramalho, R. and Shleifer, A. (2010). "The Effect of

Corporate Taxes on Investment and Entrepreneurship," American Economic Journal:

Macroeconomics, American Economic Association, vol. 2(3), 31-64, July.

Howard, M. M., A. La Foucade & E. Scott (2010) Public Sector Economics for Developing

Countries, 2nd Edition, Barbados: University of the West Indies Press

Brown, C. V. and Jackson, P. M. (1996). Public Sector Economics. 4th Ed. Oxford:

Blackwell Publishers.

Wawire, N.H. W. (2020). Constraints to Enhanced Revenue Mobilization and Spending

Quality in Kenya. CGD Policy Paper 163, Washington DC: Center for Global

Development. www.cgdev.org

Kotlikoff, L. and Summers, H. L. (1987).Tax Incidence. In Handbook of Public Economics,

edited by Feldstein, M. and A, J. Auerbach, , Vol. 2: 485 - 1106. Amsterdam: Elsevier.

Auerbach, Alan J.(1987). “Taxation and Corporate Financial Policy.” In Handbook of

Public Economics. 3, edited by Alan J. Auerbach and Martin Feldstein. Amsterdam:

Elsevier,

Modigliani, F., and Miller, M. H. (1958). “The Cost of Capital, Corporation Finance, and

the Theory of Investment,” American Economic Review 48: 261–97

Harberger, A. (1962). The incidence of the corporation income tax, Journal of Political

Economy.

Bradford, D.F., (1981). The incidence and allocation effects of a tax on corporate

distributions. Journal of Public Economics 15, 1–22 King, M.A., 1977. Public Policy and the Corporation. Chapman and Hall, London

Stiglitz, J. E. (2000). Economics of the Public Sector, New York. W.W.W, Norton

Company.

Miller, M.H., Scholes, M.S., 1978. Dividends and taxes. Journal of Financial Economics 6,

333–364.

Smith, A. (1776(. An inguiry into the nature and cause of the wealth of the Nations, London:

Metheun.

Ricardo, D. (1817). The principles of political economy and taxation. London:M. Dent and

Sons.

Miller, M.H., Scholes, M.S., 1982. Dividends and taxes: some empirical evidence. Journal

of Political Economy 90, 1118–1141

http://ideas.repec.org/a/aea/aejmac/v2y2010i3p31-64.html

http://ideas.repec.org/a/aea/aejmac/v2y2010i3p31-64.html

http://www.cgdev.org/


Chetty, R. and Saez, E. (2004). Dividend taxes and coeprate behavoiur: evidence from 2003

Dividend Tax Cut. Working paper No. 10841. Cmbrdge, MA: National Bureau of Economic

Research.

Auerbach, A. J. (1979). Wealth Maximization and the cost of capital. Quarterly Journal of

Economics. 93, 433 – 446.

Miller, M.H., Scholes, M.S., 1978. Dividends and taxes. Journal of Financial Economics,

6, 333–364. Miller, M.H., Scholes, M.S., 1982. Dividends and taxes: some empirical

evidence. Journal of Political Economy 90, 1118–1141

Atkinson and Stiglitz, Chapters 2 - 4, 6, 7, & 12-14

Howard, M. M., A. La Foucade & Scott, Chapter 14 https://www.academia.edu/37552359/Economics_of_the_Public_Sector_-_Joseph_E._Stiglitz Rosen, H. S. and T. Gayer, (2014), Public Finance, Boston: McGraw Hill, 10th edition.

Zhang, L., Y. Chen, H., Zongyan (2017), “The effect of investment tax incentives: evidence

from China’s value-added tax reform”, International Tax Public Finance, DOI

10.1007/s10797-017-9475

Feldstein, M. (2006), “The Effects of Taxes on Efficiency and Growth,” Tax Notes,

(available at http://www.nber.org/feldstein/taxanalysis.pdf)

https://www.academia.edu/37552359/Economics_of_the_Public_Sector_-_Joseph_E._Stiglitz


LESSON THREE: THEORY OF OPTIMAL TAXATION


3.1 explain efficiency of taxes

3.2 explain optimal commodity taxation; and

3.3 discuss optimal income taxation

3.1 Introduction and efficiency of taxes

Taxes can correct market failure and pervasing behaviour (See for example Crain, Deaton,

Holcombe & Tollison, 1977; Freebairn 2010; and Briggs 2016), as explained in part one of

this modulee. These corrections lead to welfare gains. However, taxes may also divert

resources from private to the public sector, hence impose varying degrees of distortions on

the operation of the of the market economy. These distortions in turn impose welfare losses

or deadweight losses on the economy by causing a departure from Pareto optimality. A good

tax system should aim at minimizing the deadweight loss imposed on society by diverting

resources to the public sector.

Taxes are judged by the deadweight loss per revenue collected. Those taxes which impose

less deadweight loss are said to be more efficient in the economic sense. Income taxes: An

income tax will not impose any distortions on the economy. The income tax in a simple

economy is completely efficient.

Excise taxes: An excise tax levied on purchases of a good will cause a distortions on the

economy. Why? There will be a wedge between the relative price facing the individual

(MRS) and the relative price facing producers (MRT).

The equity criteria is concerned with how the burden of output reduction in the private sector

is distributed among the various members of society under different taxing schemes. This

burden will include both the deadweight loss and the value of real resources transferred. It

is also referred as social justice and comprises (Kaplow, 2008):

Horizontal equity: A tax is horizontally equitable if treats equals equally. Two persons who

had equal welfare before the tax is imposed should enjoy equal welfare after the tax (.

Vertical equity: Not only must we be able to judge when two persons are equally well off,

but also we must have some scale according to which their well-being must be measured.

The comprehensive income base: it includes all income of a person regardless of either its

source or its use. It includes on an equal basis such things as wages, rent, capital gains, gifts

received, and bequests received (Kaplow, 2008; Atkinson and Stiglitz, 1980).

Although one could theoretically design a system of efficient lump-sum taxes which

discriminate between persons to obtain vertical equity, such as system would be impossible

to implement. It would require that government elicit information about the well-being of

individuals which they would not naturally reveal. Individuals would have every incentive

to misrepresent their true “utility” in order to reduce their tax obligations. In practice,

government instead rely upon discrimination between individuals according to an imperfect

index of their utility such as income, expenditures, wealth, among others.


Many of the taxes governments levy impinge upon the decisions of individuals and thus

cause inefficiencies or deadweight losses. For example, taxes levied on comprehensive

income, while strong on equity grounds, will cause inefficiencies due to its effect on

distorting the supplies of factors of production.

Similarly, taxes which are efficient in the sense that they impose only small deadweight

losses often tend to be “inequitable” For example, taxes on commodities with low price

elasticities of demand (cigarettes, alcohol) are relatively efficient. At the same time, since

such items also often tend to have low income elasticities of demand they impinge relatively

more heavily on the poor as a proportion of income (Atkinson and Stiglitz, 1980).

3.2 Determinants of excess burden of taxation

Consider a single pro-rata tax on earned income labour supply is a function of the net wage

LS=f(w);

Assume that: dLS/dw ≥ 0; and taxes are levied on earned income: net wages w

n= w(1-t)

➢ labour supply before tax: Lbefore tax=f[w]

➢ labour supply after tax: Lafter tax=f[w(1-t)]

Taxes can lead to substitution away from the taxed item: [taxing earned income can lead to

substitution away from employment] such that:

dLs/dt < 0; and L after tax < L before

Excess burden is the difference between how much one is willing to pay to avoid the tax

and the value of the tax which is the personal loss from taxation. Excess burden exists when

there is the possibility of substitution away from the taxed item (Musgrave and Musgrave,

1984).

The determinants of excess burden include:

1. the wage;

2. the tax rate and

3. the elasticity of demand (for ‘leisure’)

Elasticity of demand:

eS = (w/L).dLS/dw

Imagine the labour supply schedule is linear:

LS=a + bw; b>0

eS = (w/L).dLS/dw = b.(w/L)

Excess burden is the area of a right-angled triangle:

EB = (1/2) x (height) x (length).

= (1/2).w eS t

2

L

Changes in excess burden:


• dEB/dw >0

• dEB/dt >0

• dEB/deS >0

Tax revenue determinants

TR = w t L

Changes in tax revenue:

dTR/dt = w.L dt + w.t (dL/ dt)

(positive) (negative)

A measure of efficiency loss from income taxation is the excess burden per unit of tax

revenue raised: Efficiency loss = EB/TR

= (1/2).(w eS t2 L) / (w.t. L)

= (1/2).eS t

Tax efficiency loss depends on elasticity (eS) and tax rate (t). Taxes are more efficient when

levied on less elastic modes of economic behaviour. There is no efficiency loss when

economic behaviour is completely inelastic (ie. no possibility of substitution)

Consider two taxes tA and t

B on incomes of individuals A and B. Government has a revenue

target R from taxation:

R = wA tA LA + wB tB LB

Sum of excess burdens:

EB = (1/2). eA wA LA tA2 + (1/2). eB wB LB tB

2

The rule is derived by the government minimising the sum of excess burdens subject to the

revenue target R. The inverse elasticity rule states that to minimize the excess burden, tax

rates should be set inversely proportional to substitution elasticities.

Take two individuals A and B:

tA/tB = eSB / eSA Optimal income tax decision that minimizes excess tax burden.

The rule achieves efficiency through differential taxation. Taxes are heavier on less elastic

economic decisions [individual B].

eSA > eSB Individual B is taxed more.

To minimize efficiency loss through taxation:

1) Levy taxes on goods for which there are no substitution possibilities

2) Levy differential taxes on goods with different substitution effects

Taxes with little/no excess burden

1) Property taxes


2) Taxes on necessary/addictive goods

3) Poll taxes / lump-sum taxes

3.3 Optimal Commodity Taxation

The problem: Given a level of government revenue to be raised, which must be financed

solely by taxes upon commodities, how should these taxes be set so as to minimize the cost

to society of raising the required revenue? [ie. Minimize excess burden]

The solutions to this problem have been given by:

1) The Inverse Elasticities Rule (Baumol and Bradford, 1970)

2) Ramsey (1927)

3) The Corlett-Hague Rule (1953)

3.3.1 The Inverse Elasticities Rule

According to Baumol and Bradford (1970), it is assumed that there are no cross-price effects

between the taxed goods so that the demand for each good is dependent only upon its own

price and the wage rate. This assumption essentially turns the general equilibrium model

into one of a partial equilibrium as it removes all the interactions in demand. As shown by

Atkinson and Stiglitz (1980), the inverse elasticities rule can be derived from minimizing

the excess burden of taxation in a partial equilibrium framework. Using the Harberger

(1964) formula, the excess burden of a selective excise tax on a commodity X would be:

2

2

1XXXX XtPeEB =

Where ex = price elasticity of the compensated demand for good X

Px = Price of good X

X = Quantity of the good X consumed

tx = The rate of tax on good X

Therefore, it follows that the excess burden of tax on commodity Y would be:

2

2

1yyyy YtPeEB =

Assume that the total revenue to be raised is R. Total revenue is equal, by definition, to the

tax raised on good X (i.e. PxXtx) and the tax raised on good Y (i.e PyYty). For any tax revenue

raised, we wish to minimize the sum of 2

2

1xxx XtPe and 2

2

1yyy YtPe and at the same time to

satisfy the constraint that R revenue is raised. More formally, we seek to:

+ 22

2

1

2

1min yyyxxx YtPeXtPe

Subject to

R = PxXtx + PyYty

So that, forming the Lagrangean expression

( )yyxxyyyxxx YtPXtPRYtPeXtPeL −−++= 22

2

1

2

1

0/ =−= XPXtPetL xxxxx

0/ =−= YPYtPetL yyyyy

Rearranging the F.O.C and solving so that to minimize excess burden, yields:

xyyx eett // =


This result is known as the inverse elasticity rule.

The inverse elasticity rule states that to minimize the excess burden, tax rates should be

set inversely proportional to price elasticities of the goods.

3.3.2 The Ramsey (1927) Rule

From the F.O.C and the inverse elasticity rule, txex = tyey. [tx and ty are the percentage

increases in the prices of the two goods] then:

( ) ( )

y

yy

y

x

xxx

t

qdqt

t

qdqt

//=

So it is necessary that dqx/qx = dqy/qy . This is the Ramsey Rule. The rule says that to

minimize total excess burden, tax rates should be set so that the percentage reduction in the

quantity demanded of each commodity is the same. Thus proportional reduction in X should

be equal to the proportional reduction in Y. Ramsey’s rule is saying that it is the distortion

in terms of quantities that should be minimized, since it is the level of consumption that

actually determines welfare and prices that only matter in so far as they determine demand

for the goods.

Implications of the Ramsey Rule

Accepting the approximation interpretation, suggests that since the proportional deduction

in compensated demand must be the same for all goods, it can be expected that goods whose

demand are unresponsive to price changes will bear higher taxes. However this statement

can only be truly justified when all cross-price effects are accounted for.

Goods that are unresponsive to price changes are typically necessities such as food and

housing. Consequently the implementation of a tax system based on Ramsey rule would

lead to taxes that would bear most heavily on necessities, with the lowest tax rates on

luxuries, as demonstrated by Deaton (1981) under the assumption of weak separability of

preferences. This system of taxation would involve low-income households paying

disproportionately larger fractions of their incomes in taxes. The inequitable nature of this

outcome is simply a reflection of single-household assumption: the objective function of tax

maximization does not care about equity and the solution reflects only efficiency criteria.

The equilibrium determined by the set of optimal taxes is second compared to the outcome

that would arise if the tax revenue had been collected via lump-sum tax. This is because the

commodity taxes lead to substitution effects, which distort the household’s optimal choices

and lead to efficiency losses. Although unavoidable, when commodity taxes are employed,

the losses are minimized by the optimal set of taxes that satisfy the Ramsey rule.

The sorts of cases in which Ramsey (1927) theory may be useful are the following:

(i) If a commodity is produced by several different methods or in several different

places between which there is no mobility of resources, it is shown that it will be

advantageous to discriminate between them and tax most the source of supply which

is least elastic. This will be necessary if we are to maintain unchanged the proportion

of production between the two sources.


(ii) If several commodities which are independent of demand and require precisely the

same resources for their production the one with the least elasticity of demand should

be taxed most.

(iii)In taxing commodities which are rivals for demand, like wine, beer and spirits, or

complementary ones like tea and sugar, the rule to be observed is that the taxes

should be such as to leave unaltered the proportions in which the commodities are

consumed.

(iv) In the case of the motor taxes, we must separate off so much of the taxation as is

offset by damage to the roads. This part should be so far as possible equal to the

damage done. The remainder is a genuine tax and should be distributed according to

the theory; that is to say, tax should be placed partly on petrol and partly on motor-

cars, so as to preserve unchanged the proportion between their consumption, and

should be distributed between vehicle models so as to reduce their output in the same

ratio.

(v) Another possible application of the theory is to the question of exempting savings

from income-tax. We may consider two uses of income only, saving and spending,

and suppose that they are independent. We must also suppose that the taxes are

imposed only for a very short time and that they raise no expectation of similar

taxation in the future. On these assumptions, since the amount of saving in the very

short time cannot be sufficient to alter appreciably the marginal utility of capital, the

elasticity of demand for saving will be infinite, and we see that income-tax should

be partially but not wholly remitted on savings. The case for remission would,

however, be strengthened enormously by taking into account the expectation of

taxation in the future.

Problem: The rule is inconsistent with ‘social justice’ because it implies that:

➢ taxes should be higher on necessities than luxuries

➢ taxes should be higher on families with lower incomes

3.6.3 The Corlett-Hague Rule

Corlett and Hague (1953) proved the implication of the Ramsey rule: that when there are

two commodities, efficient taxation requires taxing the commodity that is complementary to

leisure at a relatively high rate.

To understand this result intuitively, recall that if it were possible to tax leisure, a “first-

best” result would be obtainable i.e. revenues could be raised with no excess burden.

Although the tax authorities cannot tax leisure, they can tax goods that tend to be consumed

jointly with leisure, indirectly lowering the demand for leisure. If for example, computer

games are taxed at a very high rate, people buy fewer of them and spend less time on leisure.

In effect, then, high taxes on complements to leisure provide an indirect way to get at leisure,

and hence, move closer to the perfectly efficient outcome that would be possible if leisure

were taxable.

Basic Readings:

Howard, M. M., A. La Foucade & Scott, Chapter 21

Atkinson and Stiglitz, Chapters 12-14

Hindriks & Myles chapters 15 & 16


Baumol, W. J. and Bradford, D. F. , 1970). Optimal Departures from marginal cost pricing.

American Economic Review, 60, 265 – 283.

Ramsey, F. P. (1927). A Contribution to the Theory of Taxation. Economic Journal, 37, 145,

47 – 61.

Corlett, W. J. and Hague, D. C. (1953). Complementarity and the Excess Burden of

Taxation. Review of Economic Studies. 21, 21 – 30.

Crain, M., Deaton, T., Holcombe, R., & Tollison, R. (1977). Rational choice and the taxation

of sin. Journal of Public Economics, 8(2), 239-245

Freebairn, J. (2010). Special taxation of alcoholic beverages to correct market

failures. Economic Papers: A journal of applied economics and policy, 29(2), 200-214.

Briggs, A. (2016). Sugar tax could sweeten a market failure. Nature, 531(7596), 551-551.)

Deaton, A. S. (1981). Optimal taxes and the structure of preferences, Econometrica 49;

1245 – 1260.

Mankiw, N. Gregory, Matthew Weinzierl and Danny Yagan (2009), “Optimal Taxation in

Theory and Practice,” Journal of Economic Perspectives 23(4): 147-74.

Gordon, R. and W. Li (2009), “Tax Structures in Developing Countries: Many puzzles and

a possible explanation”, Journal of Public Economics (93): 855-866.

Simula, L. and A. Trannoy (2010), “Optimal income tax under the threat of migration by

top-income earners”, Journal of Public Economics (94):163-173.

Piketty, T. E. Saez, and S. Stantcheva (2011), "Optimal Taxation of Top Labor

Incomes: A Tale of Three Elasticities" NBER Working Paper 17616.


LESSON FOUR: TAX EVASION AND AVOIDANCE


4.1 define tax evasion and tax avoidnce

4.2 discuss causes of tax evasion

4.3 discuss models of tax evasion

4.4 explain the relationship between tax evasion and Labour Supply

4.5 define tax amnesty,discuss its principles, advantages and disadvantages

4.1 Definitions

Tax evasion is the general term used for efforts by taxpayers to evade the payment of taxes

by illegal means (Asher 2001). It has also been defined as the conscious attempt to under-

declare a taxable activity. It usually entails a premeditated misrepresentation or concealment

of the true state of one’s economic activity in order to reduce one’s tax liability and includes

dishonest tax reporting such as under declaring income, profits or gains, or overstating of

deductions. Tax evasion is thus illegal and a criminal offence punishable by fines or even

imprisonment. Tax evasion may be distinguished from tax avoidance-the reorganization of

economic activity, possibility at some cost, to lower tax payment. Tax avoidance is legal.

Tax avoidance, on the other hand, is within the legal framework of the tax law. It consists

in exploiting loopholes in the tax law in order to reduce one’s tax liability. An example of

tax avoidance is converting labour income into capital income that is taxed at a lower rate

provides one class of examples of tax avoidance. In engaging in tax avoidance, the taxpayer

has no reason to worry about possible detection; on the contrary, he makes a detailed

statement about his transactions in order to ensure that he gets the tax reduction that he

desires.

4.2 Causes of Tax Evasion

The Commonwealth Association of Tax Administrators’(CATA) Practical Guide (2005)

identified many causes of tax evasion but those applicable to the African situation include

the following:

Complexity of Law/System: Since income tax law deals with commercial transactions and

has to cover a very wide variety of transactions, it has to be complex. However, a highly

complex tax system makes taxpayer compliance burdensome, so taxpayers have less (or

even no) incentive to comply with tax laws. This complexity provides ample justification

for the ordinary people to evade tax. This also relates to the transparency and visibility

concept- if taxpayers do not understand how taxes are calculated and when they should be

paid, they will not be comfortable in paying them.

High Rate of Taxes: High rate of taxes also provides another justification for evading it.

Low rates may not promote the payment of taxes but high rates are, definitely, ill-conducive

for tax compliance. It is an indisputable fact that where the effective tax rate is fairly high

evasion thrives because taxpayers may consider the distribution of their incomes unfair and

attempt to make a unilateral adjustment for equity by non-compliance through tax evasion.


Attitudes and perceptions towards the tax system, tax administration and government:

The fairness of the tax system, perception of procedural justice of the tax administration and

community confidence in the tax administration and government are important factors in

determining tax evasion.

The fairness of the tax system encompasses:

➢ Horizontal and vertical equity –similarly situated taxpayers should be taxed

similarly. The preferential treatment of taxpayers, where there are exemptions,

allowances and other preferential treatment given to a selected group of taxpayers

for no real reasons leads other taxpayers to devise means of evading tax to balance

the inequality.

➢ Transparency and visibility-tax payers should know that a tax exists and how and

when it is imposed upon them and others.

Perception of procedural justice stems from tax administrators and how staffs treat

taxpayers. For example, whether tax administrators treat taxpayers with respect or scorn?

Whether taxpayers are provided with adequate assistance and information to help them

comply? Whether tax administrators take into consideration personal circumstances that

might explain a taxpayer’s inability to pay? Whether fines and penalties for non-compliance

are appropriate? Whether tax administrators reciprocate timely behaviour, for instance, in

issuing refunds or responding to queries? Confidence in the administration and government

further depends on the extent of corruption in the tax system and how tax revenues are spent

on public goods and services. When taxpayers are unable to establish any tangible benefits

from the payment of taxes they have no incentive to continue paying taxes.

Limited resources and capacity of administration: Limited resources and capacity for

effective tax administration often mean that tax evasion activities remain unchecked.

Limited resources and capacity take the form of inadequate numbers of staff in terms of

adequate staff with the required skills and knowledge, poor infrastructure or systems; and

lack of support from the government. With the tax administration unable to adequately

carry out their roles of enforcement and education/ assistance effectively and efficiently,

this often translates into perceptions that there is a low risk of getting caught and/or there

are minimal consequences of non-compliant.

Cash Economy: In a predominantly cash-based economy, it is not only easy but safe to

conceal income. In such economies, evasion has a very conducive atmosphere to thrive. The

lack of banking facilities in most rural communities in Africa for instance, means taxpayers

have no option but to transact businesses in cash.

Low literacy and education: In most African countries, the rate of literacy and tax education

is rather low when compared with the rates of developed countries. For the uneducated, it

is often difficult to understand the need for full compliance. Little or no effort is made, either

by the government or by the private sector to educate the citizenry on the economic benefits

from paying taxes. On the other hand, some unscrupulous taxpayers exploit the general low

literacy perceptions by not maintaining any business records or accounts when in reality

many of them are fully capable or literate enough to do so.

Commercial compulsions: Where a producer or importer hides his transactions, he forces

the wholesaler to do the same. The retailers down the line have no choice but to keep those

transactions hidden too. In order to keep his expenses low, the consumer is also interested


in keeping the transaction hidden. In such a culture, it becomes impossible for anyone to

keep his records straight. Even the honest are forced to swim with the flowing currents.

4.3 Models of Tax Evasion (Myles, 1999)

4.3.1 Tax Evasion as a Decision with Risk.

The decision to evade tax can be analyzed within the framework of choice under

uncertainty. In the attempt to evade taxes, the taxpayer faces the risk/probability of being

caught by tax authorities and so being punished. On the other hand, if he is not caught, he

stands to gain by increasing his wealth. Tax evasion is modelled with an initial

approximation that we consider an individual evader whose objective is to choose the

extent of tax to evade subject to the probability of being caught and paying a penalty to

maximize expected utility.

Assumptions:

• The taxpayer receives an exogenous income M which is known to the taxpayer but

not known to the tax collector.

• Taxpayer declares income, X, which is taxed at a constant rate t.

• If the taxpayer is caught evading, which occurs with probability p, a fine F > I is placed

on evaded tax.

Based on these assumptions, evaded income =(𝑀 − 𝑋) and evaded tax =𝑡(𝑀 − 𝑋)

The goal of the taxpayer is to maximize the VNM utility function given as:

𝑀𝑎𝑥{𝑋}

𝐸ሾ𝑈(𝑋)ሿ = ሾ1 − 𝑃ሿ𝑈(𝑀 − 𝑡𝑋) + 𝑃𝑈(𝑀 − 𝑡𝑋 − 𝐹𝑡ሾ𝑀 − 𝑋ሿ) − − − (1)

Where: E = the expectation operator and Ft [M — X] = Total fine paid when caught evading

taxes

Defintions : Let Y = M — tX and Z =M — tX-Ft[M —X],

First-Order Condition:

𝑃ሾ𝐹 − 1ሿ𝑈′(ᵶ) − ሾ1 − 𝑃ሿ𝑈′(𝑌) = 0 − − − (2)

Second-Order Condition:

𝐷 ≡ +{ሾ1 − 𝑃ሿ𝑈′′(𝑌) + (𝐹 − 1)2𝑃𝑈′′(ᵶ)} ≤ 0 − − − (3)

The goal of the consumer is to choose some optimal amount of evasion to maximize X. For

evasion, the solution to (2) should be X < M. Under the assumption that expected marginal

utility declines in X, the amount of reported income X,

⇒𝜕𝐸ሾ𝑈ሿ

𝜕𝑋|

𝑋=𝑀

< 0

That is, (3) holds for all X, when the partial derivative of the expected utility evaluated at

the point of no evasion is negative, implying that the optimum evasion occurs when the full

income is not reported.

Now for (2), we substitute all X with M


= 𝜕𝐸ሾ𝑈ሿ = 𝑃ሾ𝐹 − 1ሿ𝑈′(𝑀(1 − 𝑡)) − ሾ1 − 𝑃ሿ𝑈′(𝑀(1 − 𝑇)) < 0

⇒ 𝑃𝐹 − 𝑃 < 1 − 𝑃

⇒ 𝑃𝐹 < 1

That is, for tax evasion to take place then the expected fine should be less than 1. If greater

than 1, it means the evader pay more than what he should have paid if incomes were

voluntarily paid. If equal to 1, the evader is indifferent. So, then it is profitable to evade if

𝑃𝐹 < 1

Effects of Changes in Model Variables on Tax Evasion.

The variables include:

• The level of income, M

• Tax rate, t

• Probability of detection, P

• Fine, F

We are investigating how changes in these variables affect the decision to evade tax.

1. Probability of detection, P

Totally differentiating (2) and (3) with respect to P and X and rearranging gives:

𝑑𝑋

𝑑𝑃=

−ሾ𝐹 − 1ሿ𝑈′(ᵶ) + 𝑈′(𝑌)

𝐷> 0 − − − (4)

Equation (4) indicates that as the probability of detection increases, the declaration also

increases and evasion rate falls. That is, higher chances of detection, lower the expected

payoff from engaging in tax evasion and so discourages evasion.

2. The Fine rate, F

By totally differentiating (2) and (3) with respect to F and rearranging we have:

𝑑𝑋

𝑑𝑓=

𝑃𝑈′(ᵶ) − 𝑃(𝑓 − 1)𝑈′′(ᵶ) + 𝑡(𝑀 − 𝑋)

𝐷> 0 − − − (5)

Y > ᵶ.

Y = income when not caught

ᵶ = income when caught.

Intuition of (5): An increase in the fine rate reduces the amount of evasion.

3. Tax rate, t

Differentiate (2) with respect to X and t produces the expression:

ሾ𝐷ሿ𝑑𝑥 + {ሾ1 − 𝑃ሿ𝑈′′(𝑌)𝑋 − 𝑃ሾ𝐹 − 1ሿ𝑈′′(ᵶ)𝑋 − 𝑃ሾ𝐹 − 1ሿ𝑈′′(ᵶ)ሾ𝑀 − 𝑋ሿ}𝑑𝑡

= 0 − (6)

From (2):

𝑃ሾ𝐹 − 1ሿ𝑈′(ᵶ) = ሾ1 − 𝑃ሿ𝑈′(𝑌)

Therefore, the second- bracket can be represented as:


ሾ1 − 𝑃ሿ𝑈′(𝑌) [ሾ1 − 𝑃ሿ𝑈′′(𝑌)𝑋

ሾ1 − 𝑃ሿ𝑈′(𝑌)−

𝑃ሾ𝐹 − 1ሿ𝑈′′(ᵶ)𝑋

𝑃ሾ𝐹 − 1ሿ𝑈′(ᵶ)−

𝑃ሾ𝐹 − 1ሿ𝑈′′(ᵶ)ሾ𝑀 − 𝑋ሿ

𝑃ሾ𝐹 − 1ሿ𝑈′′(ᵶ)] − −

− (7)

By using the Arrow-Pratt measure of absolute risk aversion to simplify (7),

We define 𝑅𝐴(𝐼) =−𝑈′′(𝐼)

𝑈′(𝐼)− (7′)

Using (7′) and (7) and substituting results into (6), the effect of the tax rate upon tax evasion

is given by: 𝑑𝑋

𝑑𝑡=

−ሾ1 − 𝑃ሿ𝑈′(𝑌)ሾ𝑋ሾ𝑅𝐴(ᵶ) − 𝑅𝐴(𝑌) + 𝐹(𝑀) − 𝑋ሿ𝑅𝐴(ᵶ)

𝐷> 0 − − − (8)

Since RA is positive, for an increase in the tax rate to increase the level of income declared

it is sufficient that RA(Z)- RA(Y)>0. Thus, absolute risk aversion decreases as income

increases, higher tax rates will lead to greater income declarations and a reduction in

evasion. This result runs counter to the intuitive expectations that an increase in tax rates

should provide a greater incentive to evade.

Differentiating (2) with respect to X and M and repeating the substitution used in (7)

determines the effect of an increase in income on evasion as:

Given than RA is positive, an increase in tax rate will increase the amount of income declared

if 𝑅𝐴(ᵶ) − 𝑅𝐴(𝑌) > 0. Hence, absolute risk aversion declines in wealth (risk aversion is

prominent with the rich than with the poor), thus an increase in the tax rate leads to an

increase in under-declared income leading to a reduction in tax evasion. This outcome is

counter-intuitive as it is expected that the tax rate should encourage evasion. This outcome

is specifically due to the assumption of declining risk aversion. If risk aversion were to be

increasing 𝑅𝐴(ᵶ) would be negative and the whole expression will be negative.

4. Income level, M

Differentiating (2) with respect to X and M and repeating substitution in (7) gives 𝑑𝑋

𝑑𝑀=

𝐹𝑡𝑅𝐴(ᵶ) − ሾ𝑅𝐴(ᵶ) − 𝑅𝐴(𝑌)ሿ

𝐹𝑡𝑅𝐴(ᵶ) − 𝑡ሾ𝑅𝐴(ᵶ) − 𝑅𝐴(𝑌)ሿ> 0 − − − (9)

Given that 𝑅𝐴(ᵶ) − 𝑅𝐴(𝑌) > 0, and since 𝑡 < 1,

Then: 𝑑𝑋

𝑑𝑀< 1

That is declared income decreases at a faster rate than total income, meaning that tax evasion

increases with income.

Caution: When assessing the effects of the tax rate and income on tax evasion we relied on

the assumption that absolute risk aversion decreases with income, but it could be increasing

or decreasing in reality. So, the outcome that higher tax rates and higher income cause tax

evasion to increase must be taken with some level of uncertainty. Hence the z effects could

be ambiguous.

.


Also, these results depend on the definition of fine, which is the punishment for evading

taxes. That is, should the fine be defined as evaded tax or evaded income?

Where:

𝐹𝑡(𝑀 − 𝑋) = Fine on evaded tax.

Or 𝐹(𝑀 − 𝑋), 𝑓 > 1 = Fine on evaded income.

In the literature, if the fine rate is defined as fine evaded income then both tax rate and

income can be signed unambiguously despite decreasing absolute risk aversion.

4.3.2 Optimum Auditing and Punishment

Our earlier analysis was dependent on the assumption that the probability of

detection and the fine rate paid for evasion were constant. These variables can be

used by tax authorities to deal with tax evasion. The results from (4) and (5), however,

indicate that an increase in both the probability of detection and the fine rate can cause

tax evasion to fall. These two instruments can, therefore, be seen as substitutes when

it comes to reducing tax evasion since a reduction in one can be compensated by an

increase in the other. But this can only hold when increases in the instruments can raise

more revenue.

Previously we assumed a representative taxpayer, whose action towards risk was a

representative characteristic of the entire economy. Now we assuming a representative

taxpayer and the average tax revenue from the taxpayer is equal to the expected revenue

from each taxpayer in the economy.

This revenue will be given by:

𝑅 = 𝑡𝑋 − 𝑝𝐹𝑡ሾ𝑀 − 𝑋ሿ − − − (10)

Differentiating (10) with respect to p gives: 𝜕𝑅

𝜕𝑃= 𝐹𝑡ሾ𝑀 − 𝑋ሿ + 𝑡ሾ1 − 𝑃𝐹ሿ

𝜕𝑋

𝜕𝑃> 0 − − − (11)

Intuition: If the probability of auditing increases, declared incomes increase and revenues

also increase. This outcome follows from (4) and the interior solution assumption that

pF<1.

Repeating the differentiation for fine rate, F gives: 𝜕𝑅

𝜕𝐹= 𝑃𝑡ሾ𝑀 − 𝑋ሿ + 𝑡ሾ1 − 𝑃𝐹ሿ

𝜕𝑋

𝜕𝐹> 0 − − − (12)

The implication is that marginal fine rate increases revenue. Thus, increasing the auditing

rate and the marginal fine rate will be optimal in raising revenue. The goal is to set the

optimum. But the probability of auditing is not costless. Auditors will have to be employed

auditors but there is no extra cost involved in imposing a fine. Since auditing has a cost but

fining is not, the optimal tax will be realized if we set P = 0 but increase F without limit.

Therefore, optimal policy seeking a combination of P and F is to set P=0 but increase F

without limit.


4.4 Tax Evasion and Labour Supply

Tax evasion can affect labour supply. The labour market can be official (where taxes are

paid) or unofficial (where taxes are not paid). The decision on the number of labour hours

supplied with tax evasion is underpinned by the following two issues:

1. Labour Supply: The extent to which tax evasion affects the labour

supply decision in terms of the comparative statics on labour supply.

2. Allocation Decisions: How tax evasion affects the level of employment in the

different labour markets and hence the need for households to decide on the

number of labour hours allocated to work when the decision to work is settled.

Evasion and Labour Supply (Myles, 1999)

Denoting hours of labour supply by X1 and

Individual separate utility function:

𝑈 = 𝑅(𝑋1) + 𝑆(𝑤𝑋1) − − − (13)

Where: w = income level attained,

According to Anderson (1999): 𝜕𝑋𝑖

𝜕𝑡|

𝑈𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡< 0;

𝜕(𝑤𝑋𝑖 − 𝑋)

𝜕𝑡|

𝑈𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡> 0 − − − (14)

Where:

𝜕𝑋𝑖

𝜕𝑡= change in labour supply due to a change in tax rate t

Deductions:

1. An increase in the tax rate, constantly reduces labour supplied.

𝑤𝑋𝑖 = 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑡𝑡𝑎𝑖𝑛𝑒𝑑. 𝑋 = 𝐷𝑒𝑐𝑙𝑎𝑟𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒

⇒ 𝑤𝑋𝑖 − 𝑋 = 𝑒𝑣𝑎𝑑𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒. 2. An increase in the tax rate leads to an increase in evaded income. Consistent with

earlier results.

Conclusion: An increase in the tax rate holding utility constant, reduces labour supply X but

increases the level of evaded income.

Also,

𝜕𝑋𝑖

𝜕𝑓|

𝑈 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡

< 0, 𝜕(𝑤𝑋𝑖 − 𝑋)

𝜕𝑓|

𝑈 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡

< 0 − − − (15)

(3) (4)

Conclusion:

(3) ⇒ Increase the fine rate labour supply decreases.

(4) ⇒ Increase the fine rate evaded income decrease.

Evasion and Allocation of Hours

Does tax evasion affect occupational choices? We answer this question in the following

analysis:

Assumptions:

1. We define 2 types wages:

𝑤𝑟 = Wages in registered/official sector 𝑋1𝑟

𝑤𝑛 = Wages in unregistered/unofficial sector 𝑋1𝑢


2. Given that workers in the unregistered sector do not pay taxes on their wages,

𝑤𝑟 > 𝑤𝑛. The implication is that the gain from engaging in tax evasion can be split

between the worker and employer in the unregistered labour. Respectively the labour hours

supplied for the wage rates are the wage rate earned by labour in these two sectors are xu1

and xr1.

Income level when evasion is not detected:

𝑤𝑟𝑋1𝑟(1 − 𝑡) + 𝑤𝑢𝑋1

𝑢 − − − (16)

Income level when not detected:

𝑤𝑟𝑋1𝑟(1 − 𝑡) + 𝑤𝑢𝑋1

𝑢(1 − 𝑓) − − − (17)

Where: f = penalty rate.

The consumer chooses xu1,xr

1 to maximize expected utility subject to the constraints

(16) and (17).

The aim is to determine how the allocation of labour between the two markets is affected

by changes in the tax and punishment parameters.

Individual’s utility function is:

𝑈(𝑀, 1 − 𝑋1𝑟 − 𝑋1

𝑢) − − − (18)

Where M is total income and the time endowment is normalized at 1, the important

restriction is that:

𝜕 [𝑈1𝑈2

]

𝜕𝑀= 0 − − − (19)

where 𝑈1 ≡𝑑𝑈

𝑑𝑀, 𝑈1 ≡

𝑑𝑈

𝑑𝑀, with L, the leisure consumed, defined by 𝐿 = 1 − 𝑋1

𝑟 − 𝑋1𝑢

The importance of this restriction is to help define the total labour supply, x1r + x1

u as

a function of the post-tax wage on the official market and any lump-sum income. To get

interpretable results, a precise functional form that satisfies (19) is employed using the

following separable utility function:

𝑈 = log 𝑀 + log 𝐿 − − − (20)

Consumer’s maximization problem is accordingly presented as: 𝑀𝑎𝑥

{𝑋1𝑟 , 𝑋1

𝑢} ሾ1 − 𝑃ሿ{logሾ𝑤𝑟𝑋1𝑟(1 − 𝑡) + 𝑤𝑢𝑋1

𝑢ሿ + log(𝐿)}

+ 𝑃{log 𝑤𝑟𝑋1𝑟(1 − 𝑡) + 𝑤𝑢𝑋1

𝑢ሾ1 − 𝑓ሿ + log(𝐿)} − − − (21)

For an interior solution we assume:

𝑤𝑢ሾ1 − 𝑃ሿ > 𝑤𝑟ሾ1 − 𝑡ሿ − − − (22)

Where:

(1) 𝑤𝑢ሾ1 − 𝑃ሿ ⇒ The wage in the unofficial economy when not detected.

(2) 𝑤𝑟ሾ1 − 𝑡ሿ ⇒ Wage in the official economy with tax.

That is, for the wage to be efficient to evade 𝑤𝑢ሾ1 − 𝑃ሿ > 𝑤𝑟ሾ1 − 𝑡ሿ

First-Order Conditions:

Differentiate (21) and rearranging gives: 𝑋1

𝑟

𝑋1𝑢 =

𝑤𝑢{ሾ1 − 𝑃ሿሾ1 − 𝑓ሿ𝑤𝑟ሾ1 − 𝑡ሿ + 𝑃𝑤𝑟ሾ1 + 𝑡ሿ − ሾ1 − 𝑓ሿ𝑤𝑢}

𝑤𝑟ሾ1 + 𝑡ሿ{ሾ1 − 𝑃ሿ𝑤𝑢 + 𝑃ሾ1 − 𝑓ሿ𝑤𝑢 − 𝑤𝑟ሾ1 − 𝑡ሿ}− − − (23)


Differentiating (23) and using (22) gives:

𝜕 [𝑋1

𝑟

𝑋1𝑢]

𝜕𝑓> 0,

𝜕 [𝑋1

𝑟

𝑋1𝑢]

𝜕𝑃> 0 − − − (24)

(A) (B)

(24A) increasing the fine rate increases the hours supplied to the informal sector but less

hours supplied to the informal sector.

(24B) increasing the auditing rate increases labour supply in the formal sector and less in

the informal sector.

𝜕 [𝑋1

𝑟

𝑋1𝑢]

𝜕𝑡< 0, − − −(25)

The intuition behind (25) is that increasing the tax rate increase labour supply in the informal

sector and increases evasion.

Note that our income is based on the nature of the utility function we use. We also made use

of the following assumptions:

• Incomes are fully declared

• One has the option to decide on the use of his time

• Evasion only takes place in the informal sector

• There on two sectors- formal and informal

Incentive Implication Of Informal Employment

Recent studies on tax evasion and the growth of the informal sector have centred on the

welfare implications of evading tax (See Fields, 1975; Stiglitz, 1976 and Gunther, and Launov, 2012). We discuss two of these studies:

The study by Gunther and Launov (2012) and titled “Informal employment in developing

countries Opportunity or last resort”, aimed at applying empirical modelling to test the

empirical relevance of the hypothesis that; the informal sector is an attractive employment

opportunity whereas for others who have been rationed out of the formal sector, the informal

sector is a strategy of last resort within the informal sector to the urban labour market in

Côte d'Ivoire.

The model is expressed follows:

The entire labor market Y consists of J segments Yj, such that; Y=∪jj=1 J Yj .It is assumed

that within any given segment Yj log-earnings are described by the wage equation,

lnyij = xi′βj + uij; i∈Yj; (1)

Where yij are the earnings of an individual i in segment j. The error term follows a normal

distribution with zero mean and variance σ2j, uij∼N (0, σj), and errors are uncorrelated

across segments.

Since the observed sample of workers is a non-random sample of all individuals because of

self-selection into the labor market, it is assumed that individuals' employment decision is

a function of a set of personal characteristics zi:

yis = z′i γ + uis; uis ∼ N (0, 1) (2)


Such that the earning yij is observed only if the outcome of the selection Eq. (2) is positive.

Assuming that the errors of the segment specific wage Eq. (1) and the selection Eq. (2)

follow a bivariate normal distribution with correlation coefficient ρj, it is easy to show that

the distribution of observed wages in the j-th segment of the labor market is given by;

F (yij| yis > 0) = φ((lnyij−xi′βj )/ σj

𝜎𝑗𝛷 𝑧′𝑖 𝛾Φ(

𝑧′𝑖 𝛾 +ρj = σjሾlnyij−xi′βሿ

1−𝜌2𝑗) (3)

Where φ and Φ denote the density and the cumulative density functions of the standard

normal distribution, respectively.

Treating segment affiliation as unobserved, an estimate the probability P (i∈Yj) =πj of any

individual i belonging to any segment Yj, and the distribution of observed wages in the

entire labor market is: f (yi) = πjf (yi | yis > 0, θj)

(4)

F (yi | yis > 0, θj) is given in equation 3 and θj≡ {βj, σj, ρj}.

Assuming that workers are earning maximizers who know the wage function, and hence

also their expected earnings given their own characteristics, for each segment of the labor

market, the hypothetical distribution of individuals across sectors in a competitive market

will therefore be given by;

P (i∈Yj) = P (E [ln yi | yis > 0; xi] = Maxl; l∈½1; J_ {E [ln yi | yis > 0; xi]}) ( 5)

The total log-likelihood can then be written as:

ln =∑ ሾln f (θf, ρ|yif, yis > 0, Xi, Ziˆγ) − Nf lnπf +i∈Y𝑓

∑ ሾln(∑ 𝑓(𝜃𝐼𝑗, 𝜌|𝑦𝑖, yis > 0, Xi, Ziˆγ )πij𝑗−1𝑗=1i∈Y𝑓 )ሿ (6)

Where πF is the probability of belonging to the formal sector, πIj is the probability of

belonging to the j-th segment of the informal sector and f (⋅) is the component density

function given in Eq. (3) with the relevant j-specific parameter vector θIj. The asymptotic

covariance matrix of the parameter estimates on the second step is given by;

V (ξ) = D−1 (ξ) M (ξ; γ) D−1 (ξ) (7)

Where ξ={{θj}j=1 J ,ρ,{πIj} j=1 J−1} is the parameter vector, D(ξ) is the expected negative

Hessian from the second step and M(ξ,γ) is the matrix constructed using scores from the

first and second steps (for the exact form of M(ξ,γ).

The findings of the paper are summarized as follows;

1. The informal sector is composed of two segments with a distinct wage equation in

each segment. Also, each segment is considerably large and makes up half of the

informal sector.

2. Again, one segment of the informal sector is found to be superior to the other in

terms of significantly higher average earnings as well as higher returns to education

and experience.

3. The informal sector includes both individuals for whom informality is a strategy of

last resort to escape unemployment and individuals who have a comparative

advantage in the informal sector.


4. Individuals would be found in the sector where, given their specific characteristics,

they have the highest earning opportunity.

Since individuals in the informal sector may be there voluntarily or involuntarily, policies

for tax collection or employee protection should consider labour market dynamics as these.

The other study by Fields, (1975) is based on the premise that the same kinds of forces that

explain the choices of workers between the rural and urban sectors can also explain their

choices between one labor market and another within an urban area and are probably made

simultaneously. Thus, individuals are presumed to consider the various labor market

opportunities available to them and to choose the one which maximizes their expected future

income.

Building on the received theory of rural-urban migration by Harris and Todaro (1970), the

analysis is extended to take into account a number of important factors which have

previously been neglected. Thus, a more generalized approach to the job search process, the

possibility of underemployment in the so-called urban "murky sector," preferential

treatment by employers of the better-educated, and consideration of labor turnover will be

analyzed to demonstrate that the resulting framework gives predictions closer to actual

experiences.

The study focused on the voluntary movement of individuals between labour markets as the

equilibrating force rather than the traditional view of wage adjustment.

The results of the analysis shows that, that each of the extensions implies a lower

equilibrium unemployment rate than is predicted by Harris and Todaro. Particularly, most

migrants were seen to opt for paid opportunities in the informal (murky) sector rather than

stay unemployed whilst searching for employment in the formal (modern) sector since this

maximized their earnings given the constraint they were faced with.

4.5 Tax Evasion by Firms

4.5.1 Competitive Firms (Myles, 1999)

Assumptions

➢ Firm in the competitive industry produce at constant marginal cost 𝐶

➢ The output is subject to a specific tax rate t

➢ Each firm in the industry can choose to reveal only a fraction of its sale.

➢ There is a cost to under-declaring (such as cost of hiring an attorney when caught,

keeping two books). The total resource cost of under-reporting each unit of sale is

determined by the convex function 𝑎(1 − 𝜙)

➢ Probability of detection is 𝜌.

➢ Fine = 𝑇 − 1

➢ Market price q

A typical firm will maximize expected profit given by:

𝜋𝑒 = {𝑞 − 𝐶 − ሾ1 − 𝜙ሿ𝐺(1 − 𝜙) − ሾ1 − 𝑃ሿ𝜙𝑡 − 𝜌(𝑡 + ሾ𝑇 − 1ሿሾ1 − 𝜙ሿ𝑡)}𝑦 − − − (26)

Where y= output > 0.


The goal of the firm is to choose the optimal amount of sales to declare since y > 0, we do

away with it to get:

𝜋𝑒 = 𝑞 − 𝐶 − ሾ1 − 𝜙ሿ𝐺ሾ1 − 𝜌ሿ𝜙𝑡 − 𝜌ሾ𝑡 + ሾ𝑇 − 1ሿሾ1 − 𝜙ሿ𝑡ሿ − − − (27)

Defining:

𝑔(1 − 𝜙) ≡ ሾ1 − 𝜙ሿ𝐺(1 − 𝜙)

First-Order Conditions: 𝜕𝜋𝑒

𝜕𝜌= 𝑔′(1 − 𝜙) > 0 − − − (28)

When would under-declaration be an optimal decision? This is satisfied when 𝐺(1 − 𝜙) is

convex.

Eqn (28) characterizes the optimal 𝜙(𝑓𝑖)

Defining the expected tax rate 𝑡𝑒: : 𝑡𝑒 = ሾ𝜙 + (1 − 𝜙)𝜌𝑇ሿ𝑡 − − − (29)

For the perfect competition, price equals expected marginal cost

Price in our case is q

⇒ 𝑞 = 𝑐 + 𝑔 + 𝑡𝑒 − − − (30)

⇒ 𝑚𝑘𝑡 𝑝 = 𝐸𝑥𝑝𝑒𝑐𝑡 𝑀𝐶

Where g and 𝑡𝑒 are evaluated at the optimal value of 𝜙

Comparative Statics:

i. Tax rate: Totally differentiate (28) with respect to 𝜙 𝑎𝑛𝑑 𝑡 𝑑∅

𝑑𝑡=

ሾ1 − 𝜌𝑇ሿ

𝑔′′< 0 − − − −31

Intuition: An increase in tax rate raises evasion, or an increase in tax rate r causes sales to

decrease

ii. Effect of a tax rate, t, on expected te (follows from (29)) gives:

𝜕𝑡𝑒

𝜕𝑡= ሾ 𝜙 + ሾ1 − 𝜙ሿ𝜌𝑇ሿ −

ሾ1 − 𝜌𝑇ሿ2𝑡

𝑔′′≶ 0 − − − (32)

Intuition: Following from (29) an increase in tax rate increases expected tax rate 𝑡𝑒 but

causes an indirect decrease as evasion rises. So, the effect depends on the magnitude of the

2 effects.

iii. Effects of t on q using (29) and (30) 𝑑𝑞

𝑑𝑡= ሾ𝜙 + ሾ1 − 𝜙ሿ𝜌𝑡 , 0 <

𝑑𝑞

𝑑𝑡< 1

Intuition: The post-tax price increases by less than the amount the tax. Because some of the

tax increase is absorbed by the increase in evasion.

iv. Effect of 𝜌 𝑜𝑛 𝜙 {follow from (28) and (29) i.e. taking total differentiation} 𝜕𝜙

𝜕𝜌=

𝑡𝑇

𝑔′′> 0 − − − (34)

Intuition: Increasing the probability of audit increases the probability of what is reported.

𝑑𝑡𝑒

𝑑𝜌= [ሾ1 − ∅ሿ𝑡𝜏] +

ሾ1 − 𝜌𝜏ሿ𝑡2𝜏

𝑔′′> 0 − − − − − (35)

Intuition: Increasing the probability of audit increases expected tax.

v. Effect of 𝜌 𝑜𝑛 𝑞 {follows from (30)}


𝜕𝑞

𝜕𝜌= ሾ1 − 𝜙ሿ𝑡𝑇 > 0 − − − −(36)

Intuition: Increasing the probability of detection, increases the after-tax price. It is evident

from the results that increasing the probability of detection has an ambiguous effect on

welfare as it causes the price level to increase to the detriment of consumers.

4.5.2 Imperfect Competition

Two scenarios are involved namely, Monopoly or Oligopolistic firms.

Reference: See Marelli (1984) - Monopoly firm and Marelli & Martina (1988) – Oligopoly

firm

The structure remains as the case for a competitive firm but in this model, the practice

is chosen by a profit-maximizing monopolist

Assumptions:

➢ Monopoly firm

➢ Risk neutrality

➢ Price level is chosen by the monopoly firm.

Denote demand function X (q), price level is chosen to maximize:

𝜋𝑒 = 𝑋(𝑞)ሾ𝑞 − 𝑐 − 𝑔(1 − 𝜙) − ሾ1 − 𝜌ሿ𝜙𝑡 − 𝜌{𝑡 + ሾ𝑇 − 1ሿሾ1 − 𝜙ሿ𝑡}ሿ − − − (37)

First-Order Condition for the choice of 𝜙: {𝜙} = 𝑋(𝑞)ሾ𝑔′(1 − 𝜙′)ሿ − (1 − 𝜌𝑇)𝑡ሿ = 0 − − − (38)

Assuming X (q) > 0 (based on the condition given in (28).

Note, q does not appear in (38) - q does not appear in the condition determining 𝜙, - it

implies that tax evasion does not affect pricing decision - tax evasion is independent of the

pricing decision (it does not depend on the type of market structure).

But is the price change independent of tax evasion? To answer this question the first-order

condition for the choice of q is given as: {𝑞} = 𝑋′(𝑞)ሾ𝑞 − 𝑐 − 𝑔(1 − 𝜙) − ሾ1 − 𝜌ሿ𝜙𝑡 − 𝜌{𝑡 + ሾ𝑇 − 1ሿሾ1 − 𝜙ሿ𝑡}ሿ + 𝑋(𝑞)

= 0 − − − (39)

It is not so in this case because of the presence of 𝜙 in (39). Thus, the price is affected by

tax evasion. This implies that tax evasion affects the cost of production (including taxes)

and is translated into the price level.

Where (39) is evaluated at the optimal ∅.

In conclusion, the results from the comparative statics are similar to those of the competitive

model. There is however the imperfect model is characterized by tax over shifting,

represented as:

𝐸 > 2 − ሾ𝜙 + ሾ(1 − 𝜙)ሿ𝜌𝑇 − − − −(40)

Intuition: Tax evasion reduces the possibility of over shifting whenever p𝑇< l and increases it

if p𝑇>1. Thus, the higher the rate of punishment, the more likely is over shifting of taxation.


4.6 Optimal Taxation with Aversion

4.6.1 Commodity taxation

Assumptions (Myles, 1999)

➢ We have a single-consumer competitive economy with n industries.

➢ We normalize the wage rate to unity

➢ A given industry i operate at a constant marginal cost 𝐶i .

Given a tax tk on good k, the post-tax price will be represented as:

𝑞𝑘 = 𝑐𝑘 + 𝑔𝑘 + 𝑡𝑘𝑒 − − − (41)

where: 𝑡𝑘𝑒 = ሾ∅𝑘 + ሾ1 − ∅𝑘ሿ𝜌𝑘𝜏ሿ𝑡𝑘 is the expected tax payment for every unit of output

of a firm in industry k and the tax evasion cost, gk,, the evasion choice, ∅k, and the detection rate,

𝜌𝑘 , are industry-specific.

Using that each industry is composed of a large number of firms, actual and expected tax

revenue will be the same so that:

𝑅 = ∑ t𝑖𝑒

𝑛

𝑖=1

𝑋𝑖 − − − (42)

To optimize the tax problem the instruments of interest to the government are the set of tax

rates (𝑡1, … , 𝑡𝑛) and the detection probabilities (𝑝, … , 𝑝𝑛).

This problem can be presented as:

𝑚𝑎𝑥{𝑡1…….𝑡𝑛}𝑉(𝑞1 … … . 𝑞𝑛) 𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 ∑ t𝑖𝑒𝑛

𝑖=1𝑋𝑖 − 𝐶(𝜌1 … … . 𝜌𝑛) = 𝑅--------- (43)

where 𝐶(𝜌1 … … . 𝜌𝑛) = cost of implementing the chosen set of detection probabilities

The Lagrangean form is:

𝐿 = 𝑉(𝑞1 … … . 𝑞𝑛) + ƛ [∑ t𝑖𝑒

𝑛

𝑖=1

𝑋𝑖 − 𝐶(𝜌1 … … . 𝜌𝑛) = 𝑅] − − − −(44)

First-Order Condition of differentiating with respect to tk gives:

[𝐴𝑘

𝛼

ƛ] 𝑋𝑘 + ∑ t𝑖

𝑒

𝑛

𝑖

𝜕𝑋𝑖

𝜕𝑞𝑘 0 − − − (45)

Where:

𝐴𝑘 =𝜕𝑡𝑘

𝑒 𝜕𝑡𝑘Τ

𝜕𝑞𝑘 𝜕𝑡𝑘Τ− − − − − −(46)

First-Order Condition for the optimal choice of probability for detection is:

[𝐵𝑘 −𝛼

ƛ] 𝑋𝑘 + ∑ t𝑖

𝑒

𝑛

𝑖=1

𝜕𝑋𝑖

𝜕𝑞𝑘

𝐶𝑘

ሾ1 − ∅𝑘ሿ𝑡𝑘𝑇− − − −(47)

Where the right-hand side of (47) follows from (36) and

𝐵𝑘 =𝜕𝑡𝑘

𝑒 𝜕𝜌𝑘Τ

𝜕𝑞𝑘 𝜕𝜌𝑘Τ− − − − − −(48)


Also by subtracting (47) from (45), replacingሾ1 − ∅𝑘ሿ𝑡𝑘𝑇 with 𝜕𝑞𝑘

𝜕𝑝𝑘 and solving gives:

𝜕𝑞𝑘

𝜕𝑡𝑘

𝜕𝑞𝑘

𝜕𝜌𝑘

=

∂t𝑘𝑒

𝜕𝑡𝑘

𝜕𝑡𝑘𝑒

𝜕𝜌𝑘−

𝐶𝑘

𝑋𝑘

, 𝑘 = 1, … , 𝑛 − − − − − (49)

Intuitions: Taxes and the probabilities for detection should be adjusted until the rate of substitution

between tax and probability, holding the price of good k constant, and hence welfare constant,

[given by the term on the left-hand side] equals the rate of substitution holding tax revenue

constant, [which is the right-hand term Such equality of substitution rate is the reason behind

the balance between the effects of the alternative variables.

To provide a direct contrast between the tax rule in (45) and its counterpart with

evasion not detected given by (16), By using the Slutsky equation, equation (45) can be

transformed into equation (50), where this expression offers a direct contrast between the tax

rule in (45) and (16).

∑ t𝑖𝑒

𝑛

𝑖=1

𝑆𝑘𝑖 = [∑ t𝑖𝑒

𝑛

𝑖=1

𝜕𝑋𝑖

𝜕𝐼+

𝛼

ƛ− 𝐴𝑘] 𝑋𝑘 − − − (50)

𝑤ℎ𝑒𝑟𝑒: 𝑡𝑖𝑒 = ሾ𝜙𝑖 + ሾ1 − 𝜙𝑖ሿ𝜌𝑖𝑇ሿ𝑡𝑖 =

expected tax payment per unit of a firm in industry k

𝐴𝑘 =𝜕𝑡𝑘

𝑒 𝜕𝑡𝑘Τ

𝜕𝑞𝑘 𝜕𝑡𝑘Τ⇒ Measures the rate at which the expected tax rate increases relative to

price as the nominal tax is raised.

The RHS of the (50) can be bigger or smaller/raised or lowered depending on whether

Ak is greater or less than zero (see equations (32) & (33))

Intuition:

With tax evasion, the optimal tax rule calls for the proportionate reduction in compensated

demand to be higher for those goods characterized by a high value of Ak, namely, goods for

which the distortion created by tax evasion is smaller.

Conclusion:

It is preferable to tax (given the definition of Ak) those goods where Ak is relatively high

(50). When Ak is high it implies the price 𝑞𝑘 is increasing at a slower rate relative to the

expectation of tax as we vary the nominal tax increases.

4.6.2 Income Taxation

Tax evasion has the effect of altering the elasticity of labour supply due to the

possibility of working in the shadow economy. Sandmo,(1981) considers the

determination of an optimal income tax in the presence of tax evasion. Taxpayers are divided

into two groups. The first group consists of taxpayers who have a choice of allocating

some, or all, of their labour to an unobserved sector and hence avoiding income tax. The

second group does not have this option and must pay tax upon all their earned income.

An optimal tax is then derived by maximizing a utilitarian social welfare function. The

resulting tax rule provides an implicit characterization of the optimal marginal tax and can


be partitioned into two parts: the first being the standard formula for the optimal marginal tax

and the second being a correction term for the existence of tax evasion.

If a high tax rate leads to substitution towards labour in the unobserved sector then this makes

the correction term positive and implies a tendency for the marginal rate of tax to be increased.

This result is in marked contrast to the view that tax evasion should be offset by lower marginal

rates of tax.

4.7 Consequences of Tax Evasion

Tax evasion leads to a loss in government revenue: In general, the level of tax evasion in

an economy depends on several structural and institutional factors such as the degree of risk

aversion, the wealth of taxpayers, the overall tax burden of the economy, and the efficiency

of the tax enforcing authority. The enforcement strength, in turn, depends on the extent of

corruption entrenched in the tax administration, which in turn depends on the wages of

public officials or the degree of monitoring or both. Martinez-Vasquez, Arze, and Boex

(2004) argue that there could be an inverse relationship between corruption and the tax

revenue per GDP collected by authorities. If tax collectors or tax administration officials

engage in corrupt practices such as either directly stealing from the treasury, or by allowing

taxpayers to evade taxes in return for a bribe, then corruption on the revenue side will result

in direct decreases in overall revenue collections. The resulting tax revenue loss may cause

serious damage to the proper functioning of the public sector, threatening its capacity to

finance its basic expenses, Franzoni, (2009). Provision of public services offers a rationale

for taxation. The presence of tax evasion, in turn, influence public expenditure and capital

accumulation, which affect output and economic growth Chen, (2003).

Tax evasion imposes different tax burdens on taxpayers: If the government compensates

for the loss by raising rates, tax evasion becomes even more serious. Higher tax rates in

effect penalize honest taxpayers, who comply either because they want to or because they

have no opportunities for evasion. If the government, however, takes effective steps to

prevent or combat non-compliance, it can raise revenue without increasing taxes or reducing

spending.

Evasion promotes inefficient allocation of resources: In economies where evasion is

widespread, government revenue declines. The government will, in turn, impose further

taxes which usually comes with their attendant effects such as a reduction in work efforts,

the decline in savings and diversion of investment resources from the formal sector to

informal sector activities to avoid monitoring. Sectors that are less subject to the

administrator’s scrutiny are less efficiency and the inefficiency could lead to lower revenue

for the government, reduced functional capacity, and inefficiency and effective government

machinery. Capacity suffers because of reduced resources. Efficiency declines since

important functions may have to be given less priority than others. And effectiveness

declines as compliant taxpayers realize that the government is unable or unwilling to take

corrective action and, therefore, feel increasingly comfortable in joining the rest in the act

of tax evasion.


Evasion creates unfair competition : Efficient markets lead to competition between

businesses, but when one company is evading taxes and another is not, it creates an artificial

advantage for the company evading taxes. This could lead to companies with fewer business

practices outlasting those with more efficient practices, which could undermine the

performance of an economy.

Imposes extra cost to tax authorities : In order to monitor tax evaders, the government

must use extra resources. These resources could be used for other developmental activities

water, schools, hospitals etc. Also, corruption in tax administration affects the level of tax

revenue that can be collected. Some economists argue that corruption in tax administration

is important than tax rate policy. For instance, Casanegra (1990) argues that in developing

countries “tax administration is tax policy”.

Tax evasion has serious fiscal effects: First, horizontal and vertical equity suffer because

the effective tax rates faced by individuals may differ because of different opportunities for

tax evasion, Alm et al., (1991). Again, Shome (2005) stresses that an important adverse

effect of tax evasion is perhaps its effect on equity. There is horizontal and vertical inequity,

wherein both forms of inequity, the higher-taxed person pays for the lower-taxed person

since, had there been no tax evasion; the tax rates would have been lower under the premise

of revenue neutrality. Secondly, there is a growing concern about the expanding

underground economic activities, and how these activities affect economic policies, Tanzi

and Shome, (ibid). Acts of corruption by tax collectors often play a role in promoting or

sustaining underground economic activities and in facilitating tax evasion, Tanzi, (1994):

Tanzi, (1995). Tax evasion and fiscal corruption thus contribute to undermining the

efficiency of government.

Tax evasion reduces the taxable capacity of a country: The taxable capacity of a country

has been defined severally. For instance, it’s been defined as the ability of individuals and

businesses in a given country to pay taxes. It is not the ability of taxing authorities to raise

tax revenue. More generally, therefore the taxable capacity of a country means the

proportion of a country’s national income that is above the 'subsistence' level, which is the

minimum required to sustain its population and to maintain the productive capacity of an

economy. It, therefore, implies the capacity of the people as a whole and different sections

of the community to pay taxes, beyond which productive efforts began to suffer. When a

country’s GDP is high, there is an associated larger demand for public goods and services,

and higher-income increases the overall ability of citizens to pay tax (Bahl 1971; Fox, et al.

2005). With widespread evasion, however, the GDP of the country declines as the

subsistence level becomes larger and depresses the taxable capacity of the country in

question.

4.8 Dealing with tax evasion

Tax evasion can be controlled in several ways. The key measures to be taken include but

not limited to the following:

➢ Reduction of tax rates by the government: This might bring a positive response as

it creates a sense of feeling in the public that the government is striving hard to

reduce their tax burden.

➢ Simplified Tax Laws and procedures: Tax Systems in most developing countries

are usually characterised by many complex and cumbersome procedures and

sometimes tax laws tend to be difficult to be understood by the ordinary taxpayer.


The tax system and tax laws must be revised. Tax laws should be explained using

simple terms to be easily understood by taxpayers. The mode of payment must be

made more convenient and easier through the use of mobile phones for instance.

➢ Well organised and a more Autonomous Tax Administration Structure: Not

only the tax system but also its administration is sometimes complex as the tax

authorities may be widespread across a given country. Tax administration should be

autonomous and should be coordinated under a unified body.

➢ Increased awareness among the taxpayers: Proper measures must be taken to

ensure that taxpayers are educated at various levels about the importance of tax-

taxes being the major source of revenue to the government- through various

seminars, conferences and the media.

➢ Corruption free officials and taxpayers: People do resort to bribery to evade tax,

where they either bribe the tax officials to reduce or evade the tax completely. This

practice must be curbed by making the punishment for corruption among tax officers

more deterring.

➢ Stronger penalties for noncompliance: The penalties for noncompliance of the tax

procedures must be made stronger in addition to which it must also be ensured that

these penalties are properly implemented.

➢ Sense of responsibility among the taxpayers: The taxpayers must also realize that

compliance with the tax procedures are crucial for the overall development of the

economy and must develop a sense of responsibility that the noncompliance of these

procedures is detrimental to their individual growth as well. Social conscience needs

to be aroused among people against tax evasion, for attaching social stigma for tax

evaders and to work as sentinels for identifying black marketers and tax evaders.

4.9 Evidence of Tax Evasion from Africa

Tax evasion in Africa is rife and may exist partly because of difficulty in information

gathering (Burgess and Stern, 1993). Information on incomes, production, transactions,

property records, and inheritances is difficult to obtain. According to Radian (1980),

information problems do not originate solely from the deficiency of collecting agencies but

also from the fabric of economic, social, and cultural relations which exist in a given society.

There may be no conventions of issuing receipts, recording transactions, reporting the

existence of enterprises to the government, complying with accounting and bookkeeping

standards, defining farm boundaries, and so on. Differences in the tradition of compliance

probably explain as much of the worldwide pattern of taxation as do under-resourced or

poorly organized tax administrations. The success or failure of taxation systems such as

VAT depends on the level of voluntary compliance as well as on enforcement. Very few

like paying taxes but the hostility to taxation and the propensity to evade depend on cultures

as well as economic incentives. Problems of information and measurement imply that

individual income tax is particularly vulnerable to noncompliance (Gordon 1990). For some,

evasion may be relatively passive in that there is little attempt by the government to impose

the tax. Taxes are therefore evaded by individuals as well as corporate entities and take

place in the administration of both direct and indirect taxes.


4.9.1 Tax evasion by Individuals

In order to enjoy the benefit of evading taxes, individuals engage in a myriad of tax evasion

and avoidance activities and behaviours. The most prevalent ones are discussed as follows1:

Non-reporting/declaration of income: In most African countries (given their predominantly

case-based economies), a very large number of people earn income which is liable to income

tax, but do not file their returns in an attempt to escape the tax net. Once a person fails to

file the return for the first year, he often does not file for the next and subsequent years for

the fear that tax administrators would demand payments for earlier years. He then never

files. If they are caught, instead of becoming a taxpayer, they try to buy themselves out of

the situation and in most cases end up paying more than they would have paid had they

embraced being part of the tax net. The fundamental reason for such behaviour arises from

the apprehension that once they are in the net, whether their income increases or not, their

tax obligation must be met.

Underreporting of incomes: In countries like Ghana, Nigeria, Kenya and Cote d’Ivoire this

group form the largest majority of tax evaders. Individuals who fall into this category do

file their returns but they do not report their incomes fully. This is usually achieved by either

omitting one or more sources of their income, that is, if they have income from more than

one source. Sometimes they report all the various sources but understate receipts.

Sometimes they report their receipts correctly but claim expenses they may not have

incurred or they may inflate their expenses.

Misreporting of income: This is the situation where sometimes the receipt of money is

declared but declared in the form of exempt income, an inheritance or gift and so on. At

certain times receipts are correctly declared but personal expenses are claimed as business

expenses.

Diversion of income: Sometimes income is of a nature that cannot be hidden. An attempt is

therefore made to divert it to another person so that the income is divided and the incidence

of tax is reduced. Fake partnerships, dummy agencies and outlets are examples of such

diversions.

Failure to register business: Such practices are common in Ghana, Nigeria and South

Africa. In South Africa, the issue of individuals not registering their business is made even

more difficult because there is no linkage between business registration and the tax

authority.

Moonlighting: Moonlighting refers to the process where a worker engages in multiple jobs.

This involves keeping one’s primary job in addition to a secondary job(s). Moonlighting

may not be illegal but usually, incomes from the second job(s) are received in cash rather

than cheque. Working an extra job is perfectly legal. However, the income received on

such jobs is often paid in cash rather than by cheque. As a result, no formal records are kept and the

income is not reported to declared to tax authorities.

1 This section draws on “Tax Audit Techniques in Cash Based Economies” (2005) and “Strategies and

Initiatives used by CATA member countries (2006) by The Commonwealth Association of Tax

Administrators (CATA)


4.9.2 Tax fraud/Evasion by Business Entities

Just as in the case of individuals, non-filing of tax returns; non-declaring income/

underreporting of income; and the over-claiming of expenses by businesses and corporation

are the primary sources by which businesses and corporations evade tax in Africa. However,

in addition to these behaviours, abuse of transfer pricing; promotion/participation in

aggressive tax planning schemes; engaging in VAT fraud; and the abuse of thin

capitalization and debt financing have also been regarded as contributing sources of tax

evasion in Africa. Taken as a whole, the effects of evasion are impressive. Acharya (1985)

estimated that, for developing countries, of the total income assessable for tax, the actual

percentage declared was 53.3 per cent in 1975 and 41.9 per cent in 1980.

Evidence from Botswana indicates that both the self-employed and multinational

corporations engage in tax evasion activities. The form of evasion by former are mainly in

the form of non-filling of returns and failure to keep records. Small to medium companies

do register for tax purposes and file returns, but their most attractive method of evasion is

underreporting of income and overstatement of deductions. This is done through accounting

misleads and failure to keep adequate records2. Multinational corporations, on the other

hand, tend to use more complicated methods to conceal and shift their tax base through

intra-company transactions.

Similar to Botswana, tax evasion takes several forms in Ghana, including:

➢ Keeping two sets of accounts simultaneously with one account showing very low

profits before tax;

➢ Failure to report fully and adequately on income and expenditure by either omitting

items of income or claiming inflated deductions or expenses;

➢ Refusal to take delivery of notices of assessment sent through the post. Such notices

are sometimes returned with messages such as “Taxpayer not known”, or “Taxpayer

ejected”;

➢ The use of false names or false documents;

➢ The inclusion of an overseas entity in a domestic transaction;

➢ The use of transactions that have no apparent commercial reality or relevance;

➢ Keeping of goods away from their registered places of business (sometimes in their

homes) and distributing them to selected customers; and

➢ Attempts to reduce tax liabilities by splitting incomes amongst wives, children and

other close relatives or associates.

Tax evasion is not limited to income taxes alone. Sales taxes and excises are evaded in many

ways. A popular method is under-invoicing. The problem seems to be particularly severe in

the service sector, where clients are often presented with an option: a higher fee if tax is to

be declared or a lower one if the transaction is to go unreported (Burgess and Stern 1993).

The introduction of VAT systems, with their built-in incentives to seek correct invoicing of

2 Rather than depend on declaration of income by small taxpayers and businesses, Musgrave (1990) and others suggest

that presumptive-income and estimated- income approaches, where incomes and returns on capital are calculated

independently, might be used instead.


one's purchases, seems to contribute to a reduction of noncompliance in domestic indirect

taxation (Tait 1988 and Goode 1990). The revenue security advantages of VAT over simple

sales and business taxes are twofold; namely, only buyers at the final stage have an incentive

to undervalue purchases and nonpayment of tax at one stage can be reversed by payment at

a later stage.

Evasion of import or export duties (also called smuggling) remains a serious problem in

many African countries. The procedures used vary and do not always require avoidance of

customs officials. Duties may be evaded even though goods that are physically brought

through customs: goods can be under-declared; goods that are correctly described may have

their values understated; fake delivery papers may be used to remove the goods from the

customs area before duties are paid, and so on.3 Taxation is thus constrained in the sense

that if customs duties or excises are raised smuggling may increase. The response may be

sufficient to result in a net decrease in government revenue from this source.

Table 4.1: Summary of Some Empirical Findings on Tax Evasion Studies on Africa

AUTHOR STUDY

AREA

METHODOLOGY CONCLUSION

Aumeerun, B.,

Jugurnath, B. and

Soondrum, H. (2016)

Sub-Saharan

Africa

Generalized Least Squared

Approach

Found a positive impact of tax

evasion on the GDP per capita.

However, the p-value states that

the tax evasion is insignificant

and is not an important

component for the determination

of the GDP per capita.

Moreover, in the presence of tax

evasion, GDP per capita has a

negative relationship with the

Foreign Direct Investment

(FDI), positive relationship the

Gross Domestic Fixed Capital

Formation (GDFCF), a

favourable connection with the

export, a negative relationship

with the import, a positive

impact on the inflation and a

negative relationship with

government expenditure.

3 Underinvoicing of imports can be used to evade high import duties. For Tanzania, Maliyamkono and Bagachwa (1990),

by comparing Tanzania and U.K. records, found that in 1985 imports from Britain were under invoiced by 18.7 percent.


Abdulsalam Mas’ud,

Almustapha Alhaji

Aliyu and El-Maude

Jibreel Gambo (2014)

Africa Multi-Stage Approach. The findings showed that there is

a significant negative correlation

between tax rate and tax

compliance and the tax rate has

a negative effect on tax

compliance

Jörgen Levin and

Lars M.Widell (2014)

Kenya and

Tanzania

compared

with the

United

Kingdom

Measurement Errors

Approach in reported trade

flows between the two

countries and correlate

those errors with tax rates

Tax evasion was found to be

more severe in trade flows

between Kenya and Tanzania

compared to trade flows

between the United Kingdom

and Kenya/Tanzania. Tax

evasion coefficient is lower in

Kenya–United Kingdom case

compared to the Tanzanian–

United Kingdom case which

suggests that tax evasion is more

severe in the Tanzanian customs

authority.

Antoine Bouët and

Devesh Roy (2012)

Kenya,

Nigeria and

Mauritius

Evasion Elasticity

Approach

Found significant effect from

tariff rates on evasion. The point

elasticity for Kenya was similar

to a study on Mozambique at

approximately 1.4. The study

also found that the ranking of the

estimated evasion elasticity

matched the ranking of the three

countries in terms of

institutional quality

approximated by the

Transparency International

Corruption Perception Index.

Even though the Kenya bribery

index was found to have

improved over time, the estimate

for the evasion elasticity was

found to have increased.

Dunem, J. and Arndt,

C. (2009)

Using the

Fisman–Wei

approach

Mozambique The study found a strong and

positive effect of tax rates on tax

evasion in Mozambique. For

every percentage point increase

in customs tax rates, evasion

increases by 1.4%.


Antoine Bouet and

Devesh Roy (2009)

Kenya,

Mauritius and

Nigeria

Evasion elasticity

Approach

Found robust evidence for

positive elasticity of evasion

with respect to tariffs in Kenya

and Nigeria with relatively

weaker evidence for Mauritius.

The results match the rankings

of countries in institutional

quality (in terms of the

Corruption Perception Index).

Greater responsiveness of

evasion to the level of tariffs is

established in Nigeria

(comparatively weak

institutional quality) vis-à-vis

Kenya, and in Kenya vis-à-vis

Mauritius (comparatively good

institutional quality). This

pattern is preserved even when

focusing on the same set of

trading partners and the same set

of imported products for the

three countries.

Embaye A.B (2007).

South Africa Tax share Measurements Found a positive relationship

between the tax evasion and the

GDP per capita. The study

measured the income,

population rate, wage rate, total

tax share, total income and

wealth tax share, individual

income and wealth tax share,

corporate income tax share,

VAT tax share and production

and import tax share for a period

starting from 1990 to 2002. The

result of the test showed that a

percentage increase in the total

tax payment decreases the GDP

per capita by 0.606%, this

implies that when there is no tax

evasion the

GDP per capita would decline.

However, if the total tax

payment decreases by one

percentage, the GDP per capita

would increase by 0.606%.


Walker M.B and

Sennoga E.B (2007

33 East

African

Countries

Panel Data Estimates If GDP per capita increases by

1% the tax evasion would

decrease by 1.1751% for the 33

East African countries

Merima Ali,

Odd‐Helge Fjeldstad

and

Ingrid Hoem Sjursen

(2013

Kenya,

Tanzania,

Uganda and

South Africa

Binary Logit Regression An increase in the perception of

individuals about the difficulty

of evading taxes is found to

increase the likelihood of tax

compliant attitude in Kenya and

South Africa. Individuals who

are more satisfied with public

service Provision are more likely

to have a tax compliant attitude

in all the four countries.

However, frequent payment to

non‐state actors, e.g. to criminal

gangs in exchange for

protection, reduces an

individual’s tax compliant

attitude.

Furthermore, individuals who

perceive that their ethnic group

is treated unfairly are less likely

to have a tax compliant attitude

in Tanzania and South Africa.

Tax knowledge is also

significantly correlated with tax

compliant attitude in Tanzania

and South Africa.

Osoro, N. (1995) Tanzania Used OLS to estimate the

size of the underground

economy and tax evasion

for the period 1969-1990

The size of the underground

economy is significant and grew

from 10 % of GDP in 1967 t0 31

% in 1990. Tax evasion in 1990

was equal to more than one-third

of total tax receipts that year.

4.10 The Underground Economy4

The operations of the underground economy form a considerable part of the problems that

tax authorities face in dealing with tax evasion. By its very nature, any attempt to estimate

the size of the underground economy must first deal with the problem of defining it.

4 It’s also known as the Informal Sector, Parallel Economy, Cash Economy, Unrecorded Economy etc.


The definition of the underground economy often differs with the objective and approach

of the study, but in general, it encompasses a myriad of activities that are deemed to be both

legal and illegal. Fiege (1979) defines the underground economy to include all unreported

activities that go unmeasured by “society’s current techniques for monitoring economic

activity”. Smith (1994) defines it as “market-based production of goods and services,

whether legal or illegal that escapes the official estimates of GDP”. These definitions,

therefore, adopt a broad view of the underground economy to include both legal (unreported

income that would normally be reported in GDP) and illegal activities such as prostitution,

money laundering and drug trafficking. Tanzi (1980;1982; Tucker, 1982) and Schneider

(1986), however, in their definition of the underground economy provided a different

emphasis by restricting themselves to measuring the extent to which official statistics are

distorted, namely the extent to which fiscal income is evaded or goes underreported. Their

definition identifies as potential distortions to the measurement of aggregate economic

activity, all unreported income which has contributed to value-added according to the

System of National Accounts, but which is not included in the official statistics. These

include unreported profits, interest income, rental income and receipt of tips, welfare

benefits, moonlighting, domestic employment, under-invoicing and exchange of

professional services (barter).

Tokman and Klien (1996) rather define it as the part of the economy where economic

activities largely take place outside the established regulatory authorities, so that it is

common to find businesses operating without licenses and regulations. Aryeetey and Codjoe

(2005) broadly defined informal economic activities as those enterprises that for various

reasons have their output unrecorded in the national accounts, though their size is relatively

large. It is thus an unofficial sector of underground economic activities beyond government

regulation and taxation. The kind of economic activities that would be considered informal

includes small-scale enterprises and their employees, self-employed persons engaged in the

production of goods and services, commerce, transport, food processing and so on. Baah-

Nuakoh (2003), also observed that most of the activities in the underground economy are

not specific to that sector; they spill over to the formal sector as well.

Despite the difficulty in providing an appropriate definition, several persons have viewed

the underground economy in different ways. Some have viewed it as an employment

provider, whereas others view it as a breeding ground for indigenous entrepreneurship, or a

refuge for those who have migrated from rural to the urban environment for formal

employment but have been unable to secure one. Ninson (1991) however, described the

undergroundeconomy as the dumping ground for unemployed labour, especially during

periods of severe economic crisis. The underground economy is regarded as operating

outside the regulatory framework partly because of inadequate legislation and inefficient

bureaucracies.

Boateng (1998) attributed the beginning of the creation of the underground economy in

Africa to developments in the labour market after the implementation of Structural

Adjustment Policies (SAPs) across several African countries during the 1980s and early

1990s. Boateng (ibid) for instance observed that before SAPs, formal sector employment

in Ghana grew from 337,000 in 1980 to 464, 0000 workers in 1985, implying an average

annual growth rate of 7.5 percent. After the implementation of SAPs employment levels in


the formal sector dropped from 414, 000 in 1991 to 186,000 in 1996. The underground

economy is thus considered as the sponge that absorbs entrants to the labour force including

the redeployed and the retrenched, because of the low absorptive capacity of the formal and

public sectors arising from the public sector redeployment and retrenchments programmes.

4.11 The Role and Trends in the African underground economy/informal sector

Since many African countries either do not collect data on the underground economy or

they use different definitions, it becomes difficult to make strict comparisons within and

between countries. Nonetheless, available data indicates that the underground economy

represents both a significant component of gross domestic product and employment in most

African countries. The World Bank as part of its work on benchmarking business regulations

has developed a measure of the size of the informal economy. The methodology for

estimating this indicator is based on the study by Schneider (2002). Using this data, Figure

1 graphs thesize of the informal economy as a percentage of gross national income (GNI),

which ranges from under 30 percent in South Africa, to almost 60 percent in Nigeria,

Tanzania and Zimbabwe. The average in Sub-Saharan Africa (SSA) is 42.3 percent.

Figure 4.2: Size of the Underground Economy in Selected African Countries (ratio of GNI in

2003)

Source: World Bank Doing Business Database.

Based on data from the International Labour Organization, (ILO, 2002a) the underground

economy in sub-Saharan Africa (SSA) is estimated to represent almost three-quarters of

non-agricultural employment. According to the ILO (2002c), the sector accounts for 72

percent of employment in SSA, 78 percent if South Africa is excluded. Statistics reported

in Chen (2001) suggest that 93 percent of new jobs created in Africa during the 1990s were

in the informal sector, reflecting the impact of globalization, economic reforms and

competitive pressures on the labour market in recent years. Employment opportunities in

0

10

20

30

40

50

60

70

SSA Ave

rage

Botsw

ana

Camer

oun

Cote d'I

voire

Gha

na

Kenya

Mala

wiM

ali

Moz

ambiq

ue

Nigeria

Seneg

al

South

Africa

Tanza

nia

Uganda

Zambia

Zimba

bwe

Countries

Per

cen

tag

e o

f G

NI


this sector range from small-scale mining, street vending, petty trading, food vending and

artisan and craft workers to small-scale businesses. However, the sector is dominated by

trade-related activities, with services and manufacturing accounting for only a small

percentage of this sector (UN 1996). In Angola, Nigeria, South Africa and Uganda, the

majority of underground economy workers are active in retail trade (ILO 2002a). Street

vending is also one particular informal activity that is prevalent on the continent. According

to Charmes (1998a), street vendors represented 80.7 percent of all economic units surveyed

in urban areas in Benin, with women making up over 75 percent of vendors. Although the

sector helps in alleviating poverty, jobs in this sector are usually characterized by low

income, with little or no employment protection and job insecurity. The underground

economy in Africa has therefore been described as “a poor man’s sector: a sector of the

poor, by the poor and for the poor” (ILO 2002a).

ILO (2002b) reports on the share of employment in the underground economy for many

African countries based on the harmonized and national definitions. Generally, about 70

percent of workers are employed in this sector; with the remainder in wage employment

(ILO 2002c). Informal employment in Kenya and Uganda exceeds employment in the

formal sector. In Zambia 43 percent of urban employment is in the informal economy, while

in Mozambique evidence suggests that 38 percent of urban households were dependent on

the informal economy in the 1990s. As also reported by Xaba et al. (2002), 89 percent of

the labour force in Ghana was employed in the underground economy in 1999. Figure 2

presents the share of total employment in the underground economy using the national

definition for a number of African countries. Though the figures are for different years, it is

clear that the share of informal employment varies considerably within Africa, ranging from

8.8 percent in Zimbabwe to 94.1 percent in Mali.


Figure 4.3: Share of Total Employment in the Informal sector

Source: ILO (2002b)

Regarding domestic production, the underground economy produces a wide range of goods

and services usually for the local market because of its low quality. The products of this

sector are generally meant for the lower income group but due to declining incomes, goods

produced by the underground economy is patronised by middle-income groups. The ILO

(2000a) indicated that the sector’s output was approximately 22% of GDP in 1988; with a

possibility of a larger share for the rural areas compared with the urban centres. In the non-

agricultural sector, underground economy activities in trade and commerce are the largest

contributor to GDP (52 percent), followed by industry with a share of 28 percent and the

transport sub-sector contributing 8 percent (Baah-Boateng et al., 2005).

The underground economy also serves as a breeding ground for future entrepreneurs, where

people enter to learn a trade or some form of skill and work their way up from apprenticeship

to become master craftsmen, and eventually to become entrepreneurs (Aryeetey and Adjasi

2005). An associated benefit from this process of training is that the underground economy

provides skills acquisition to trainees in the form of apprenticeship and self-tuition. The

sector thus plays a significant role in the training of skilled labour force and the transfer of

skills through cheap traditional apprenticeship system (Baah-Nuakoh, 2003).

0

10

20

30

40

50

60

70

80

90

100

Botswana(1996) Mali(1996) South Africa (2001) Zambia (1990)

Percentage


4.12 Characteristics of Informal Employment in Africa

Informal employment in Africa is characterized by a number of traits (see, Vishwanath,

2001 and Avirgan et al., 2005). Besides the high proportion of women and self-employment,

there are also a number of other defining characteristics of informal workers in terms of

education levels, wages, hours worked and overall employment conditions. In particular,

informal employment is characterized by the lack of decent work or deficits in comparison

with employment in the formal segment of the economy.

Workers generally have lower levels of education compared with the formal sector,

reflecting that poor human capital increases the probability of participation in the informal

sector. As reported in Braude (2005), there is a stark difference in the education levels of

workers in the South African informal and formal sectors – 37 percent of workers in the

informal economy in South Africa have not completed primary school education compared

to only 16 percent for the formal sector.

Related to low education is the phenomenon of skill mismatch, which occurs when job

seekers lack the skills demanded by employers. This problem is evident in the urban labour

markets of many African countries where school leavers seek jobs in the public sector, but

as a consequence of downsizing and retrenchments, there are few opportunities. At the same

time, these youths do not have appropriate skills for other forms of formal sector

employment in industry or service activities. They, therefore, end up unemployed or

working in the informal sector, with many of them still “queuing” or waiting for a job in the

public sector.

Also, given that wages are usually much lower in the informal sector, rates of poverty are

subsequently higher amongst workers and families who rely on informal employment.

According to the ILO, wages are on average 44 percent lower in the underground economy

(ILO 2002a). A study by Braude (2005) found that informal workers in Egypt earn

approximately 84 percent lower on average of what workers receive in the formal sector.

Similar results were also found for South Africa. However, the study for South Africa did

not control for occupation, which has been found in the gender wage gap literature to have

a large impact on the disparity between female and male wages.

Finally, workers within the underground economy typically work longer hours in a week;

results for Egypt suggest that the average number of hours worked in the informal economy

was 51.6 in 1998, while it was 44.6 in the formal segment of the economy. Other decent

work deficits that are more prominent in the informal economy compared with the formal

sector include poor health and safety, high job insecurity, no worker representation and few

opportunities for skill enhancement (ILO 2002a). Finally, child labour is a persistent

problem in the African informal sector, an issue addressed in Xaba et al. (2002).

4.13 Incentive Implication of Informal Employment

Recent studies on tax evasion and the growth of the informal sector have centred on the

welfare implications of evading tax (See Fields, 1975; Stiglitz, 1976 and Gunther, and Launov, 2012). We discuss two of these studies:


The study by Gunther and Launov (2012) and titled “Informal employment in developing

countries Opportunity or last resort”, aimed at applying empirical modelling to test the

empirical relevance of the hypothesis that; the informal sector is an attractive employment

opportunity whereas for others who have been rationed out of the formal sector, the informal

sector is a strategy of last resort within the informal sector to the urban labour market in

Côte d'Ivoire.

The model is expressed follows:

The entire labor market Y consists of J segments Yj, such that; Y=∪jj=1 J Yj .It is assumed

that within any given segment Yj log-earnings are described by the wage equation,

lnyij = xi′βj + uij; i∈Yj; (1)

Where yij are the earnings of an individual i in segment j. The error term follows a normal

distribution with zero mean and variance σ2j, uij∼N (0, σj), and errors are uncorrelated

across segments.

Since the observed sample of workers is a non-random sample of all individuals because of

self-selection into the labor market, it is assumed that individuals' employment decision is

a function of a set of personal characteristics zi:

yis = z′i γ + uis; uis ∼ N (0, 1) (2)

Such that the earning yij is observed only if the outcome of the selection Eq. (2) is positive.

Assuming that the errors of the segment specific wage Eq. (1) and the selection Eq. (2)

follow a bivariate normal distribution with correlation coefficient ρj, it is easy to show that

the distribution of observed wages in the j-th segment of the labor market is given by;

F (yij| yis > 0) = φ((lnyij−xi′βj )/ σj

𝜎𝑗𝛷 𝑧′𝑖 𝛾Φ(

𝑧′𝑖 𝛾 +ρj = σjሾlnyij−xi′βሿ

1−𝜌2𝑗) (3)

Where φ and Φ denote the density and the cumulative density functions of the standard

normal distribution, respectively.

Treating segment affiliation as unobserved, an estimate the probability P (i∈Yj) =πj of any

individual i belonging to any segment Yj, and the distribution of observed wages in the

entire labor market is: f (yi) = πjf (yi | yis > 0, θj)

(4)

F (yi | yis > 0, θj) is given in equation 3 and θj≡ {βj, σj, ρj}.

Assuming that workers are earning maximizers who know the wage function, and hence

also their expected earnings given their own characteristics, for each segment of the labor

market, the hypothetical distribution of individuals across sectors in a competitive market

will therefore be given by;

P (i∈Yj) = P (E [ln yi | yis > 0; xi] = Maxl; l∈½1; J_ {E [ln yi | yis > 0; xi]}) ( 5)

The total log-likelihood can then be written as:

ln =∑ ሾln f (θf, ρ|yif, yis > 0, Xi, Ziˆγ) − Nf lnπf +i∈Y𝑓

∑ ሾln(∑ 𝑓(𝜃𝐼𝑗, 𝜌|𝑦𝑖, yis > 0, Xi, Ziˆγ )πij𝑗−1𝑗=1i∈Y𝑓 )ሿ (6)


Where πF is the probability of belonging to the formal sector, πIj is the probability of

belonging to the j-th segment of the informal sector and f (⋅) is the component density

function given in Eq. (3) with the relevant j-specific parameter vector θIj. The asymptotic

covariance matrix of the parameter estimates on the second step is given by;

V (ξ) = D−1 (ξ) M (ξ; γ) D−1 (ξ) (7)

Where ξ={{θj}j=1 J ,ρ,{πIj} j=1 J−1} is the parameter vector, D(ξ) is the expected negative

Hessian from the second step and M(ξ,γ) is the matrix constructed using scores from the

first and second steps (for the exact form of M(ξ,γ).

The findings of the paper are summarized as follows;

1. The informal sector is composed of two segments with a distinct wage equation in

each segment. Also, each segment is considerably large and makes up half of the

informal sector.

2. Again, one segment of the informal sector is found to be superior to the other in

terms of significantly higher average earnings as well as higher returns to education

and experience.

3. The informal sector includes both individuals for whom informality is a strategy of

last resort to escape unemployment and individuals who have a comparative

advantage in the informal sector.

4. Individuals would be found in the sector where, given their specific characteristics,

they have the highest earning opportunity.

Since individuals in the informal sector may be there voluntarily or involuntarily, policies

for tax collection or employee protection should consider labour market dynamics as these.

The other study by Fields, (1975) is based on the premise that the same kinds of forces that

explain the choices of workers between the rural and urban sectors can also explain their

choices between one labor market and another within an urban area and are probably made

simultaneously. Thus, individuals are presumed to consider the various labor market

opportunities available to them and to choose the one which maximizes their expected future

income.

Building on the received theory of rural-urban migration by Harris and Todaro (1970), the

analysis is extended to take into account a number of important factors which have

previously been neglected. Thus, a more generalized approach to the job search process, the

possibility of underemployment in the so-called urban "murky sector," preferential

treatment by employers of the better-educated, and consideration of labor turnover will be

analyzed to demonstrate that the resulting framework gives predictions closer to actual

experiences.

The study focused on the voluntary movement of individuals between labour markets as the

equilibrating force rather than the traditional view of wage adjustment.

The results of the analysis shows that, that each of the extensions implies a lower

equilibrium unemployment rate than is predicted by Harris and Todaro. Particularly, most

migrants were seen to opt for paid opportunities in the informal (murky) sector rather than


stay unemployed whilst searching for employment in the formal (modern) sector since this

maximized their earnings given the constraint they were faced with.

Critics of the dual labour market hypothesis argue that labour market segmentation may not

exists if there is free labour movement (Dicokens and Lang, 1985; Heckman and Hotz, 1986;

Rosenzweig, 1988; Pratapand Quintin, 2006 Basu, 1997). We provide a summary of this

hypothesis based on these studies as follows:

Contrary to the view that welfare incentives motivate individuals’ involvement in the

informal labour market, other theories suggest it is due to the barriers to entering the formal

labour market.

A test of the dual labour market theory as conducted by (Dickens and Lang, 1985) showed

that there are non-economic barriers that prevented labour in the secondary sector (informal)

from entering the primary (formal) sector. Such barriers include discrimination against

whites for which there is no economic incentive to stop. This was again explained to be due

to whites overcrowding the informal sector.

Heckman and Hotz (1986) also found that the labour market for Panamanian males appeared

to be geographically segmented and also, that sheer differences exist in the functional forms

of earnings functions fit for samples of high-earnings and low-earnings workers. This

geographical segmentation is ascribed to the differences in the demand for labor which may

arise because regions differ with respect to the availability of complementary factors of

production. Also,

Alternatively, geographical differences may exist in the quality of education giving rise to

differences in the efficiency units of labor (or the stock human capital associated with

various levels of education) which lead differences in the rates of return to education. This

segmentation was explained to result in earning differentials and caused by the impact of

one’s social background, mother’s level of education and inter-generational educational

attainment.

Building on the assumption that labour markets in low-income countries have some market

distortions, (Rosenzweig, 1988) assessed the role of the determination of returns to labour

in economic development models. The study found private and social costs of reallocating

labor to be presumed to be different. This discrepancy implies the immobility of agricultural

labor vis-a-vis the industrial sector and representing a source of inefficiency. Again, the

discrepancy between the social and private costs of moving was found to be due to (i) the

absence of a labor market and (ii) the family sharing rule, for if the migrant family members

still incur a loss for moving out.

In light of literature suggesting wage differentials in workers of different firms, Rosenzweig

(1988) suggested that the presumed immobility of labour may be due to;

i. Technological differences in production across industries, sectors and products

which may entail different organizations, inclusive of operational scale, and

possibly different contractual wage payments.

ii. Second, if workers are heterogeneous in unmeasured skills and such skills have

greater payoffs in large enterprises, then seemingly identical employees of firms

of different size may have different lifetime earnings.


iii. A third reason that such studies may find inter-sectoral wage differences is that

the earnings of family workers in family-based enterprises reflect the

contribution of other production factors, since such workers are residual

claimants.

Contrary to the notion of barriers to entry causing a large informal sector by earlier studies,

recent studies suggest that large informal sectors arise as the optimal response to

burdensome institutional environments. Thus, affirming that barriers into the formal sector

still exist.

Based on the critics of the dual labour market hypothesis as discussed in the [preceding

section, leading to the non- existence of labour market segmentation, informal employment

would no more be choice made out of necessity, rather an outcome of individual strategic

decisions to avoid taxation (Maloney, 2004, Magnac 1991, Gindling, 1991). The ensuing

section is devoted to discussion this arguments

Informality Employment as an individual strategic decision

Basing on the studies by (Maloney, 2004, Magnac 1991, Gindling, 1991) we summarize the

individual employment as an individual strategic decision as follows:

The concept of an “informal sector” has lacked precise definition, in spite of several

attempts by numerous authors. This is due to the unclear dichotomy between what is best

fit to be described as “formal” or “informal”. The formal sector is mostly regarded as one

with low productivity, low start-up capital, small scaled, etc. (Maloney 2004). This

perception comes with lots of criticisms as they can be seen in most “formal” sectors.

According to Maloney (2004), the informal sector should rather be seen as an “unregulated

voluntary” entrepreneurial cluster of small firms: as against a cluster of “discouraged

workers” who are out of well-paid jobs. It should be viewed as a sector that is characterized

by low enforcement of labor and tax codes, hence, making it a beneficial strategy (evasion

of compulsory payments and requirements) for individuals to voluntarily opt for such a

sector.

The perception of a “good” or “bad” job varies and is mostly subjective. For any individual,

being in the informal sector is just like any normal optimal decision-making based on

individual preference and constraints. Individual preferences may include job type, wages,

job security, safety, risk nature, hours of work, etc. Individuals are also constrained with

time, level of human capital, number of children, taxes paid, etc. Faced with such

preferences and constraints, individuals may either join the informal formal as last option

or as a voluntary decision. A popular view held about the informal sector is that, it comes

with lots of privileges such as independence, higher pay, etc. Balan, Browning and Jelin

(1973). Maloney (2004) confirms that, about 60% of people who work in the Mexican

informal sector and are self-employed entered the sector voluntarily. Additionally, Oswald

(1998) confirms this view with facts that, 63% of workers in the US, 49% in Germany would

prefer to be self-employed. With these cross-country evidence, one might zoom into

accessing why individuals may want to offer their services voluntarily in the informal sector.

On the account that most of these self-employed nationals want to be their “own boss”, these

individuals take into account both costs and benefits involved in their decisions. The formal

sector is burdened with lots of payments but seen as a “high-earning” sector. Payments made

within this sector are enforced by law and have high compliance costs. Such payments

include pensions, insurance (health and property), income tax (normally huge), legal system,


health inspection, and many others. These can be seen as deductions to income levels should

an individual or an enterprise engage in the formal sector. Since these payments are not been

enforced in the informal sector, individuals find it optimal to engage in the informal sector,

as a strategy of evading such payments, which they necessarily do not get any value for.

Most of these payments made by firms and employees are used in financing budget deficits:

an unproductive venture for welfare sustenance and redistributive purposes. Barr and

Packard (2000). It is worth noting that, when a self-employed worker earns an income which

is more than the income less payments of a formal worker, being self-employed is

considered to be an optima decision, taking other factors into account. In this case, a worker

is only interested in the utility of the work “package” as compared to the amount stated on

pay slip.

One may argue that, since the formal sector provides social protection, it is safer to work in

the formal sector. This can be criticized due to the fact that, these social protection programs

and policies are not free: they always come with costs (reduction in a part of income) which

the individual may not be aware of. Formal service in less developed countries are

characterized by poor administration and huge overhead costs, making workers view

mandatory contributions to benefits programs negatively affecting salaries of workers

within the formal sector. Robles (1989). Morduch (1999) also argues that, informal support

and welfare programs can replace social protection services as perfect substitutes with much

lower provided there are minimal transaction and cheating costs.

Rigidities in the labor market also affect an individual’s decision for choosing between the

formal and informal sector. Most of these rigidities are centered on the payment of minimum

wages. These rigidities bridges the gap of expected wages between members in opposite

grounds. In the absence of such rigidities, the formal sector becomes the ideal sector for

employees to seek employment and settle down. Davila Cappalleja (1994), in his analysis

on the formal sector the Mexican labor market found that, minimum wages are not binding

the formal sector. This affects an individual’s decision of staying in the formal sector.

Within such a labor markets, inter-sectoral movements will be the order of the day.

Individuals may also engage in the informal sector due to the fact that, payments for their

services are “unobservable” and untaxable. These “unobservable” payments are mostly in

kind- coming in the form of food, accommodation, payment of ward’s fees and family dept.

These payment cannot be taxed and hence, individuals find it very strategic to offer

themselves voluntarily for such employment avenues. In some cases, such a form of

employment can be seen as a breeding grounds for “shifting” responsibilities to abled

employees.

Strategy of last resort (lower-tier) and voluntary decision (upper-tier) in the informal

Other strnd of studies on the informality literature attenpts to reconcile these competing

hypotheses by arguing for the possibility of informal labour markets which are

characterized by internal duality ( see Fields 1990, Tokman 1987, Marcouiller et al. 1997,

Cunningham and Maloney2001). Given such charateristics, the informal sector is argued to

operate a a two-tier system-lower-tier and upper-tier. systems Whereas the fomer results

due to the strategy of last resort, the latter emanates from voluntary and strategic decisions.


The strategy of last resort (lower-tier) and voluntary decision (upper-tier) in the informal

sector based on the above studies may be summasied as follows:

The literature in development and labor economics have unique ways of characterizing a

job as “formal” or “modern”. These descriptions use the term “formal” to refer to activities

in factories and offices, with “higher” earnings Fields (1990). A theoretical informal sector

is one seen to be composed of homogenous, unprotected by labor legislation, no fixed

workplace, and small-scaled, highly unskilled workers with lower earnings. Most studies

have assessed the compatibility of the theoretical view of this sector with empirical studies:

Hart (1973), Standing (1977), Sinclair (1978). A major finding in these works point to the

act that, the informal sector is not homogenous but heterogeneous, and that being employed

in this sector can be seen as a choice. This choice can be seen as one resulting from last

resort or a voluntary decision to take advantage of gains within this sector. The former is

mostly termed as the “lower tier” of the sector whereas the latter is known as an “upper

tier”. Fields (1990) and Hart (1972).

Working in the informal sector is a decision an individual makes based on preferences and

constraints. Individual preferences may include job type, sector, wages, job security, safety,

risk nature, hours of work, etc. Individuals are also constrained with time, level of human

capital, number of children, taxes paid, etc. Faced with such preferences and constraints,

individuals may either join the informal formal as last option or as a voluntary decision. For

an individual to join the informal sector as a last resort, then this individual may lack the

basic required human capital and have to join the informal sector for survival. Additionally,

the lower-tier segment of the sector consists of individuals who joined the sector not because

of its “hidden” advantages and gains but out of frustration from their numerous attempts to

get hired in the formal sector. In these individuals’ preferences, working in the informal

sector was their last option provided all attempts fail. Such a move may include engaging

in family ownership enterprise as a means of waiting and hoping to be employed in the

formal sector.

A very crucial feature of the formal sector is that, it is characterized by a long period of

search and a very low probability of success in searches. For most urban residents, when a

search in the formal sector is unsuccessful, the worker automatically takes up informal

sector employment. Lopez (1970). In his analysis on employment in the rural formal sector,

Lopez postulate that, the probability of getting a job in the informal sector now is almost

equal to unity. This probability approaches zero with time and the same work projects that,

employment in the informal sector will be as competitive as that of the formal sector.

Individuals may want to get employed in the informal sector with the fear of not been able

to secure a job in the coming years. Others will hold on to working in this sector with the

hope of finding a “better” job in the formal sector after some years. Grouping this group

under either lower-tier or upper-tier will be problematic since there is no clear distinguishing

reason whether they are fed up with trying or they see a “hidden” advantage in the informal

sector.

The upper-tier of this sector consists of individuals who see some “hidden” advantages and

gains in the sector, irrespective of whether they have the required human capital or not. To

these individuals, the sector is coupled with laxity in labor and tax codes and hence, very

profitable to engage in. These laxities come in the form of free entry, no required payments

including insurance (property and health) and social protection, low level of taxes, low

government involvement, and many others. Individuals use these factors to their advantage,


and even end up earning more than those in the formal sector since such factors can be

considered as reductions in costs of running an enterprise. These workers in the second tier

of the sector can be considered as those who made such choices not because of any form of

disappointment, but due to the fact that, diverting resources into this segment is very

optimal.

Entering the informal sector comes with almost no cost at all and hence, mostly termed as

an “easy-entry” sector. Individuals find this advantageous since the required capital to

startup businesses is normally very low. For an “easy-entry” sector, it is seen to be more of

an individual strategic decision than a choice of last resort, hence belonging to the “upper-

tier” segment of the sector. Again, individuals make decisions based on comparison between

short-run and long-run gains and returns to human capital. A young entrepreneur may not

consider working in a formal sector because, returns to human capital is mostly constant

throughout the individual’s life. Earnings for most formal sector works do not take into

individual productivity and reward them accordingly. Individuals may prefer to set up their

own enterprises to ensure a growing level of returns to human capital and efforts. For a self-

employed enterprise, individuals can always relate their level of productivity to their

earnings. This is another form of ensuring that productivity is either kept constant or

improved upon. Since individuals are aware that non-performance leads to low earnings,

the upper tier of this sector serves as a better way of assessing individual productivity and

rewarding them accordingly.

4.14 Tax Amnesty

4.14.1 Definition(s)

A tax amnesty can be defined as a limited-time offer by the government to a specified group

of taxpayers to pay a defined amount, in exchange for forgiveness of tax liability (including

interest and penalties), relating to a previous tax period (s), as well as freedom from legal

prosecution (Baer, & Le Borgne, 2008).

Amnesties generally fall in two categories: financial and legal. For the former, a tax amnesty

implies a reduction (in real terms) of taxpayers’ declared or undeclared tax liabilities as

established by law. This reduction can be achieved through a variety of measures: for

example, through a reduction or cancellation of interest and penalties owed on the

underreported or undeclared taxes or tax liabilities (or some combination of these). The

latter includes a waiving of prosecution (Baer & Le Borgne, 2008).

Examples of Tax Amnesty

➢ The Tax Amnesty Act, 2017, Act 955, Ghana

➢ The Voluntary Assets and Income Declaration Scheme (Vaids) in June 2017 and the

Voluntary Offshore Assets Regularization Scheme (Voars) in October 2018 in

Nigeria

➢ In 2003 South Africa enacted the Exchange Control Amnesty and Amendment of

Taxation Laws Act, a tax amnesty.

➢ “The 100 percent amnesty on interest and penalties from 1st July 2018 up to 31st

December 2018,” in Tanzania


➢ The Kenyan tax amnesty program (“the Program”) on foreign income

Why the Need for Tax Amnesty?

i. To collect outstanding tax revenues inexpensively, including revenue which might

be otherwise uncollectible due to the limited availability of enforcement resources.

In 1983, for example, Philadelphia collected over 160,000 volumes during its highly

publicized one-week library amnesty books that would otherwise have been lost to

its system (Leonard & Zeckhauser, 1987).

ii. To place additional taxpayers on the tax rolls promote improved future citizen

compliance with the tax code. After a parking amnesty, people may take more care

to park legally. This benefit is particularly large when, in the absence of amnesty,

there is a strong incentive for delinquents to remain so (Leonard & Zeckhauser, 1987).

iii. Giving an amnesty often makes society better able to control the future. The

conquering army that offers amnesty to its vanquished opponents if they surrender

their arms and threatens powerful action against those who do not cooperate by a

given date not only begins to heal society's wounds but dramatically reduces the

potential for future armed conflict (Leonard & Zeckhauser., 1987).

iv. Amnesties can make the transition to a new enforcement regime seem fairer. When

society systematically fails to enforce law over a long period, it implicitly creates a

presumption that the offense is not serious, encouraging otherwise honourable

members of society to choose noncompliance (Leonard & Zeckhauser, 1987).

v. To bring into the state's revenue system individuals who have somehow managed to

remain outside the tax rolls and who are thus not easily detectable by other means.

vi. Speed up collections and produce a short-term revenue windfall;

vii. Create data concerning patterns of taxpayer noncompliance and identify specific

areas where enforcement reforms are necessary; and

viii. Act as a ‘lightening rod’ to attract public attention around programs to increase

enforcement" (Leonard & Zeckhauser 1987).

4.13.2 Principles of Tax Amnesty (Leonard & Zeckhauser, 1987).

Neutrality: A tax amnesty system should seek to be neutral and equitable between forms

of business activities

Efficiency: Compliance costs to business and administration costs for governments should

be minimized as far as possible

Certainty and simplicity: Tax amnesty rules should be clear and simple to understand so

that taxpayers know where they stand


Effectiveness and fairness: Tax amnesty policy should not lack the ability to produce the

right amount of tax at the right time and should ensure fairness between forms of business

activities

Flexibility: Tax amnesty systems should be flexible and dynamic enough to ensure they

keep pace with technological and commercial developments

4.13.3 Advantages of Tax Amnesty

➢ Collects back taxes

➢ Increases future compliance by lowering its cost (no longer necessary to evade to

hide past bad behaviour)

➢ Improves records, e.g., adding non-filers, which enhances future control of evasion

➢ Reduces deadweight costs from the burden of guilt; fosters repentance

➢ Permits politically feasible transition to the harsher enforcement regime

➢ Lowers short-term penalties, raises long-term; such twisting can raise or lower on

net

➢ Avoids "inequity" from sudden change

➢ Permits imposition of severe penalties on those who refuse amnesty offer

➢ Permits productive and vigorous enforcement against future evasion

4.13.4 Disadvantages of Tax Amnesty

➢ Angers honest taxpayers

➢ Undermines guilt from tax evasion

➢ Reduces fear of future sanctions that may be amnestied

Trial Questions

Question 1

There is good evidence that much economic activity is unrecorded in official statistics.

This “hidden economy” includes legal activities that are not reported to the authorities

in order for tax to be evaded and illegal activities. Should official statistics ignore the

hidden economy (which is the current practice) or make an effort to incorporate an

estimated value in national accounts? Explain


Question 2

Consider the pay-off matrix given below and determine the Nash equilibrium.Where:Y=

tax payer’s income, T=tax rate, F=fine rate, C=cost of auditing.

Tax Authorities

3. Tax evasion is sometimes described as “contagious,” meaning that an increase in evasion

encourages yet further evasion. In such circumstances, is the only equilibrium to have

everyone evading? Explain

Basic Readings

Atkinson and Stiglitz

Hindriks & Myles, Chapter 17

Howard, M. M., A. La Foucade & Scott, Chapter, 20

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LESSON FIVE: TAX POLICY, STRUCTURE AND ADMINISTRATION


5.1 definine and explain the objectives of tax policy;

5.2 describe the salient features of tax policy in developing countries;

5.3 explain tax revenue forecasting

5.4 describle the taxstructureand constraints of revemnue mobillazation in Africa

5.5 Explain the role of ICT in tax administration

5.6 Explain the role of mobile money in tax improvement

5.7 describe the state of mobile money in Africa.

5.8describe the mobile money taxation

5.1: Definition and objectives of a tax policy Tax policy entails a range of choices by Government in relation to tax administration,

efficiency and effectiveness of the entire tax system. The need for optimal tax policy to

mobilize the desired level of resources and promote tax policy frameworks that can respond

to development needs. Adjustments in tax policy are required to ensure high incomes and

wealth are taxed effectively to redistribute revenues for the social uplift of the population.

The issue of what constitutes ideal tax policies gained prominence after the Second World

War. Approaches to tax and development have changed several times over the past decades.

Some have attempted to find a simple framework and a universal solution to manage a

complicated reality, yet what is most needed is a variety of fiscal tools and measures suited

to the context of each country. The question of whether developing countries would learn

to tax more was asked by Kaldor over 50 years ago (Kaldor, 1963). The observation

reflected the fact that the ratio of tax to GDP was much lower in developing countries than

in developed countries and this remains as relevant today as it was back in 1963 (Genschel

and Seelkopf, 2016).

5.2 The Salient Features in Tax Policies of African Economies The persistently low tax-to-GDP in developing countries implies that tax revenue

enhancement requires a much more nuanced approach than simply taxing more. A single-

minded effort to raise tax-to-GDP ratios without considering the underlying local context

for tax policies and the underlying mechanism that determines long-term revenue trends is

unlikely to deliver the desired results. Indeed, the search for optimal tax policies for

developing countries has lasted for more than five decades and has undergone significant

transformation. During the 1960s, the dominant view of good tax policy for developing

countries called for a progressive personal income tax with a broad base. At the same time,

indirect consumption taxes were considered undesirable, and both the international and

subnational dimensions of taxation were largely ignored (Auerbach, 2010). Tax policy

ideology held that taxes should be more progressive and that more taxes were an important

pre-condition for development.

The Washington consensus began to dominate the policy framework from the 1980s

onwards and the recommended tax model for development changed to reflect the new

ideology. The main feature of tax policy was the broad-based and single rate value-added

tax (VAT) (Ebrill et al., 2001). Countries were under pressure to substantially reduce their

tariffs on imports. Personal and corporate income taxes remained important sources of

revenue but with broader bases and lower rates, together with a call for few or no tax

incentives. Experience in member countries of the Organization for Economic Co-operation


and Development and more recently in Latin America demonstrates progressive direct taxes

can help mitigate economic inequality and ensure intergenerational equality of opportunity.

Due to the legacy of indirect taxes for quick revenue mobilization and the capacity constraint

for effective design, most developing countries have yet to deploy progressive direct taxes

such as personal income tax, property tax and wealth tax as policy tools for dealing with

pervasive inequalities. Developing countries may streamline and rationalize tax incentives

to expand and protect the tax base, since substantial revenue is lost through ill-conceived

tax policy practices adopted to promote investments. Tax breaks and incentives, which are

prevalent in the region, have been found to result in wasteful tax expenditures that result in

tax evasion and profit shifting, while being ineffective in promoting investment.

Excessive tax incentives should be reduced, but there is also a case for scrutiny and redesign

of tax incentive regimes to better align incentives that do indeed promote businesses and

tightening and administration to prevent tax evasion and misuse of incentives. transparency.

Where there are large informal sectors, tax incentives could be employed as a tax base

protection tool to encourage businesses to stay in the formal sector and pay tax.

Encouraging public listings and ensuring profits reported to shareholders match those

declared to tax authorities could reduce underreporting of taxable income. The size of the

shadow economy was larger than that of tax revenue among many sample economies, thus

the potential benefit of reducing the level of tax evasion is huge among countries with a

large informal sector.

There are range of weaknesses of taxation systems in Africa which calls for propositions on

how to restructure fiscal and tax policy to promote sustainable development. There are

perspectives on strengthening fiscal governance and search for options and an inventory of

solution effective revenue systems. African Government are expected to investigates how

tax policy can be redesigned to address wealth and income inequalities, and how to use tax

policy to curb environmental excesses while being eco- and business-friendly without

compromising revenue goals.

It is well understood that tax policies are path-dependent and have to be context specific, so

policymakers need to take into account the local economic, political, social and institutional

environments as transformational tax policies are implemented. Besides exploring ways for

unleashing their tax potential at both the national and sub national levels, African economies

need to redesign tax policies to serve the multiple goals of their tax revenue collection and

Development Goals

The International Monetary Fund and international tax experts promoted a broad-based low

rate approach to VAT and income taxes as a better alternative to sales taxes and as a tool to

compensate for lower taxes on trade. The main idea of the tax policy recommendations to

developing countries remained the same: it is better to tax more (Bird, 2013). In practice,

however, taxing more does not always mean taxing better.

Despite attempts at taxing more, developing countries still have low levels of tax share in

GDP, which may reflect economic and institutional factors that constrain the amount of

taxes they can actually raise (Langford and Ohlenburg, 2016). The new insights on tax

policies in more recent years have recommended a deviation from the old “one-size-fit-all”

approach. It is now recognized that tax policies are path dependent and context specific

(Bird, 2012), or in other words, they are highly localized. Many early tax policy


recommendations for developing countries largely replicated what seemed successful in

developed countries at that time. Yet the failure to adapt tax policy recommendations to

local economic foundations, political and institutional environments, capacity constraints,

technological limitations and social-cultural differences often resulted in tax policies that

were ill-suited to the local context and fell far short of their promises.

5.3 Tax Revenue Forecasting

Tax revenue need to be predicted and where possible an accurate forecats is called for.

There are three possibilities or aproaches to the budget forecasting.

The first method is by using Computer Model. This is attained using macroeconomic models

within a section of fiscal sector or simulation model that draws on a representative set of

taxpaying. The second method is known as effective tax rate approach which entails forecast

revenues by applying an effective tax rate –the ratio of anticipated revenues to the tax base

to a forecast tax base.

The last method is called tax elasticity or buyyancy approach which forecast the percentage

change in different elements of revenue as a function of percentage change in

macroeconomic indicators

5.3.1 Tax Buoyancy

Tax buoyancy is defined as an expression which measure the revenue mobilization

efficiency and responsiveness pf mobilization in reponse to growth in Gross Domestic

Product In principal a yax is said to be buoyant if revenues increase more than

proportionately in a response to a change in national income or output. A tax is buoyant

when revenues increase by more than, say, 1 per cent for a 1 per cent increase in GDP. Tax

elasticity is taken as a better indicator to measure tax responsiveness.

How Tax Buoyancy is measured

Measurement of tax buoyancy is facilitated by regression the log of tax revenue on the log

of National income or GDP. In order to get the precise mrasure controll variables are added

into the estimated mpdel. It is important to note that tax buoyancy differs from tax elasticity

as the later

corrects revenue data for changes in tax policy parameters. In the absence of such

information in a systematic way for all countries, we focus only on tax buoyancy.

Modelling tax bouyance can be best arrived ta using any time series model where you have

data on

i) Total tax revenue in a contry

ii) GDP statistics over a reosonalble time span

iii) And any other variable as a control.

iv) Tax data can be any form of tax


Theoretical Expectations

In estimating tax bouyance. the coefficient for long-run buoyancy is expected to be 1( one).

In cross countries study long-run buoyancy can take different sizes across countries and

between tax categories. There are some properties such as luxury goods that have income

elasticity greater than 1 hence likelt to be subjected to Value Added Tax rates, while for

neccesary googs with income elasticity of demand less than 1 may fase reduces VAT rates

then the long run buoyancy of VAT can exceed 1.

Furthetmore, thirdly, with falling labor income which is typical in real wages especially this

is likely to reduce buoyancy of some taxes It is also true tha when a country experience

export led growth which might be dominated by certain sectors this will impact buoyancy

of certain taxes. tThe fourth fact is that in many countries excise rates on gasoline tobacco

and alcohol are not indexed to GDP. Thus tax buoyancy smalle r than 1 if annual

discretionarry adjusmnet in rates are smaller than GDP growth. The other important aspect

to note is that countries with rigid wages and tight employment protection, revenue from

income are relatively stable and, therefore, the short-run buoyancy coefficient might be

below one. For the sales tax it is argued that people might smooth consumption in response

to flactuations in business cycle hence short run buoyancy can be smaller one.

5.3.2 Tax Elasticity

Tax elasticity is another form of measure that has economic importance in relation to tax

collection. In terms of definition tax elasticity is defined as responsiveness to change in tax

revenue as a resonse to increase in income by a unit. A high tax elasticity rate is the targeted

anticipation in an economy hence a dsirable attribute of an economy. This indicate the ablity

to finance development by raising taxes without political resistency Then, growth in tax

revenue may come about through a high buoyancy -including growth through discretionary

changes- as opposed to the natural growth through elasticity.

Tax Elasticity Formally Defined

An aggregated model that takes taxation as one of the key variables in the model is used to

estimate the change in tax revenue due to change in income. This is shown below as follows;

(This model is adopted from Charles Y. Mansfield (2019) in International Monetary Fund,

Palgrave Macmillan Journals)


The ideas of Tax Elasticities may be summarized symbolically as follows, where:

Given these definitions it follows that in a system of n taxes

stated in identity (2), the elasticity of any separate tax may be decomposed into the product of

the elasticity of the tax to its base and the elasticity of the base to income.


Interpretation of Results as indicated Charles Y. Mansfield 2019) in International

Monetary Fund, Palgrave Macmillan Journals)

➢ Analysis of the income elasticity of a tax system permits identification of the sources

of fast revenue growth or conversely, the causes of lagging revenue growth.

➢ It also permits identification of that part of revenue growth within the control On the

one hand, the tax-to-base constituent of elasticity by an improvement in

administration. (This effect if the tax structure is progressive.)

➢ In this sense the tax to base constituent of elasticity is partly within the control of

the other hand, the growth of the tax base lies outside authorities (apart from the

influence of tax policy determined by the way in which the structure of the with

economic growth.

➢ In designing taxes that would prove income elastic, both the predicted response of

the tax base to income and the potential for an effective and/or improving level

should be taken into account.

5.4 Tax Structure and revenue mobilization in Developing Countries

Tax efficiency and especially the tax structure explained role in achieving economic growth

and fiscal consolidation (Stoilov & Patonov, 2012). There has been a strong

recommendation of usage of diret and indirect taxes by conter balancing both. But for

developing countries direct taxes have a limited application hence large chunk of taxes are

indirect in nature. When it comes to application tax policies in practice vary dramatically

among the poorest and richest countries (Gordon, Li). In order to increase revenue, low-

Finally, as stated in identity (3), the elasticity of total revenue to income in a system of n taxes

depends on the product of the elasticity of tax to base and base to income for each separate tax,

weighted by the importance of that tax in the total system


income countries have historically supported more international trade taxes, while richer

countries use more taxes on consumption and revenues (McNabb, LeMay -Boucher, 2014,

Gordon, Li). Between 2000 and 2002, small states collected around 36 percent of tax

revenues in international trade compared to 1.1 percent collected from the same source in

the OECD (Borg, 2006). In this process, however, the poorest countries collect much less

revenue as a share of GDP than they gather in the richest countries (Gordon, Li). Currently,

personal income taxes are relatively small in developing countries, while taxes such as the

VAT have become central to mobilizing domestic revenue (Newbery and Stern, 1987).

Literature has warned tha challenges include the narrowness of the tax base, which limits

the opportunity for collecting additional revenue. The other salient feature of taxes in

developing countries is that while property taes play a little role the same property taxes

represent about 6.7% of total OECD revenue, compared to 2.4% in developing and transition

countries (Bird, 1999). While personal income taxes from a significant percentage of tax

revenues in high-income countries (around 9-11% of GDP), developing countries increase

only about 1-3% of GDP. The other feature is that unlike developed countries where

personal income tax and social security contributions increase by two-thirds of total taxes,

a tight tax base and high implementation costs make direct impractical taxation for

developing countries.

There are other problems related to tax administrations and structure in developing countries

and Africa in particular. The nature of Afeica economies is more informal. This has resulted

into narrow tax base mixed with shadow economy. The related issue is loss of massve

revenue from off shore by welathy individuals who make use of tax havens.

The World Bank and IMF reveal tha data on revenues lost to developing countries from

evasion, avoidance and the use of tax havens is unreliable, and estimates vary greatly. Most

estimates, however, exceed the level of aid received by developing countries–around $100

billion annually. Profit shiftng is another form of loss which is indicated to have great impact

on tax revenue.

Tax Avoidance and Evasion and Havens in Africa

Tax avoidance, tax evasion, tax heavens, illicit financial flows and global tax governance

are real buzzwords that have come to dominate current international political and financial

domains.

What Is a Tax Haven?

A simple definition is generally defined as a situation where one country termed as off shore

which provide foreign individuals and companies little or no tax liability within the political

and economic environment. One of the major concern with tax havens is the tendency to

deny access to information and in most cases refusal to share information with other national

authirities. Hence this is typically undesirable in tax systems at it is a conduit for massive

revenue losses. You can thin of a company that is oparating in Nairobi Kenya but

headquatered in Port Luis. There are several tax loopholes within a given country that will


deny Nairobi tax There is a question on how we breakdown tax haven. This is a challenge

because off shore Governments tend to benefit revenues from this act. There are huge sum

of funds and financial resources flowing into a beneficiary country that give incentives to

collude with tax avoiders in another country.

Individuals and corporations can potentially benefit from low or no taxes charged on income

in foreign countries where loopholes, credits, or other special tax considerations may be

allowed. IMF regularly provide a list of most popular tax haven countries includes: Andorra,

the Bahamas, Belize, Bermuda, the British Virgin Islands, the Cayman Islands, the Channel

Islands, the Cook Islands, Hong Kong, The Isle of Man, Mauritius, Lichtenstein, Monaco,

Panama, St. Kitts, and Nevis.

5.5 The Role of ICT in Tax administration

Poor Tax administration account for significant portion of lowly collected revenue in most

of the African Economies. Manual and manipulatable recording, tracking and reporting

systems which are hard to countercheck or monitor frustrates efforts to expand tax base,

accurate registration of tax payers and realistic tax assessment. Rapid development and

access to ICT make the the possibility of making use of digital technology to enhancement

tax administration. In particular accesses to reliable, quality information and communication

processes to conceptualize, design, develop, evaluate and apply innovative ways in tax

domain, with a primary focus on increased tax base.

The 3rd, 4th and fifth generation of technological revolution has made t possible to create

economic platform supported by ICT devices, networks, mobiles, services and applications;

ranging from Internet-era technologies to sensors and other pre-existing aids to speed up

development. Therefore tax authorities world wide have made a great deal in improvement

of tax administration through application of ICT in tax management and administration,

recording and registration.

ICT and tax base expansion

In the past few decades the role of information communication technology (ICT) has

substantially increased (Ndung’u, 2017; Wawire, 2020). Initially it played role in the form

of electronic commerce (e-commerce) particularly on selling goods to consumers. This so-

called business-to-consumer (B2C) e-commerce grew spectacularly in advanced economies

of Europe and Northern America. The trade volume was substantially high with estimated

value of $7.7 billion in 1998 and two years later tripled to $28 billion. Such innovation

motivated a shift to the trade that companies do with each other. By building on-line

electronic marketplaces, it became possible to bring together businesses such as car

manufacturers and their component suppliers, or fruit wholesalers with primary producers.

This business-to-business (B2B) e-commerce has shown even biggest impact than any other

innovative economic facilitation.


In particular the B2B e-commerce was $226 billion worldwide in 2000 and within five years

it jumped to $2.7 trillion. The role of technology is significant whether we consider the B2C

and B2B sectors, and this has taken various forms such as a Web that discover products and

services, where quality and quantity is displayed against a price tag and a mode of payment.

Both options of either payment online or offline are displayed

Though ICT has enabled integration of the global economy and ability to make a quick

follow up and assessment from the economic value of online economies, Africa economy is

still dominated by the Micro economy rural based which is hard to track and even tax. The

problem is complicated by the reality that economies of developing countries are known to

have a large proportion of informal rural agriculture and urban service sectors which account

to over 90 percent of total employment. In many regions of Tanzania rural agriculture

accounts for, over 80 percent of total employment. Poor linkage and coordination partly

explain under development of such economies. Deployment of ICT on rural and poor

communities can play major developmental role such as through improved access to finance

for bank customers in rural and poor communities who cannot conveniently access banks

located in the formal sector due to poor transportation networks and long queuing hours in

banking halls, and will reduce bank customers’ presence in bank branches and reduce cost

because bank would cost efficiently maintain fewer branches, and the lower costs would

have positive effects for bank profitability and financial inclusion in rural and poor

communities. This is a critical point for tax authorities to get light on what exist and where

to tax in the informal rural and urban economies.

Table; Trends in e-commerce and e-trading in the United States


Some of the important ICT systems that have enhanced revenue management include

Automatic Identification Systems (AIS), Vessel Traffic Management System (VTMS) and

Port Operating Systems (POS).

GROWTH OF MOBILE MONEY IN AFRICA

One of the digital transformation with greatest potential to strengthen tax administration and

improve collection is made possible through growth on mobile money transactions. While

over 75 percent of the entire population in Africa is excluded from traditional financial

systems, the opposite is true when it comes to usage of mobile money. In fact Africa is the

World leader commanding 47 percent of the global mobile money transactions. Existence

of this kind of a platform provide a ready made innovative source of accessing the largerst

informal economy which is usually outside the tax machinery.

5.6 The Role of Mobile Money in Tax improvement

Africa stands one of the best time ever to make use of spreading mobile telephones and ICT

technology and substanrtially change the existing mode of tax administration. Taking the

mobile money system which is based on mobile payment systen uses accounts held by

mobile operators and accessible from subscribers of mibile phones. The conversion

of cash into electronic value (and vice versa) happens at retail stores (or agents). All

transactions are authorized and recorded in real-time using SMS. The opprtunity for tax

administration is based on the reality that Africa alone accounts for 45.6 percent of mobile

money activity worldwide and Tanzania is among the top three players. The transaction

value is significantly high and in 2008 alone stood at US dollar 26 billion.


5.7 The State of Mobile Money Economy in Africa

There are some large mobile telephone companies in Africa that can play a major role in

expanding tax base. In East Africa companies like Vodacome in Tanzania, the Safari Com

in Kenya are predominant. Other companies are Tigo, Zantel, Halotel and Airtel.

The Central Bank of Kenya (2018) statistics indicate that over 40 million people moved

$38.3 billion on Kenya’s mobile financial rails, a significant chunk of which is M-Pesa.

Mobile Money: Lessons for Africa Tax Authorities

The recent study by Raddy Fibre Solution and Nokia of 2019 outlined a numbre of issues

related to taxation in connection to mobile money. They are;

➢ The narrowness of tax base in Africa is largely attributed to inadequate information

on what the informal micro economy hides. There is a dire need to increase efforts

to integrate the macro economy with the huge micro economy.

➢ Mobile money sector is the perfect solution to facilitate such an integration. It is

evident that while financial inclusion via traditional banking system has failed,

innovative mobile money has expanded to the largest ever inclusion.

➢ Efforts to expand tax base need to concentrate in encouraging all payment through

mobile money such as payment of utilities, school fees, purchase of goods etc.

5.8 Mobile Money Taxation

In connection to tax issues of mobile money taxation the Rddy Fibre Solution revealed

that;

➢ The trend of sector-specific mobile money taxation continued in Sub-Saharan Africa

in 2019. Over the course of the year, Côte d’Ivoire, Republic of the Congo, Malawi

and Gabon all proposed new mobile money taxes.

➢ Seventy-seven per cent of mobile money providers reported paying such taxes,

according to Global Adoption Survey, whether have taxes and fees on , transaction

values or total revenue.

➢ Twenty-three per cent of those affected said taxation was having a negative impact

on the uptake of mobile money services and their business.

➢ since poorer households are more likely to use mobile money services, sector-

specific taxation applied to mobile money could be considered regressive and

deepen inequality.

➢ Equally, by incentivising a move back to cash, tax authorities risk reversing financial

inclusion gains and undermining the payments infrastructure that will underpin the

digital economy at the heart of many national development plans.

➢ The broader tax base that digital economies inevitably create will therefore be

sacrificed for a short-term increase in the tax take.


Beyond financial inclusion, mobile money taxation also puts other development goals at

risk, including poverty reduction, economic growth and human capital development.

➢ Mobile money has enabled developing countries to achieve unprecedented levels of

financial inclusion, and will continue to contribute to broader development goals.

➢ When contemplating sector-specific taxation for mobile money, authorities should

consider the longer term negative impacts of such policies.

➢ Ideally, finance authorities and policymakers should engage in dialogue with the

mobile money industry when formulating policies so that, together, they can ensure

mobile money continues to have the greatest possible impact on national

development agendas.

Readings:

Ndung’u, N. (2017).“Digitization in Kenya: Revolutionizing Tax Design and Revenue

Administration.” Digital Revolution in Public Finance. Gupta, S, M. Keen, A. Shah, G.

Verdier, eds. Washington, DC: International Monetary Fund.

Wawire, N.H. W. (2020). Constraints to Enhanced Revenue Mobilization and Spending

Quality in Kenya. CGD Policy Paper 163, Washington DC: Center for Global

Development. www.cgdev.org

Egwaikhide, F. O. (2019). Nigeria’s Low Tax Collection and Poor Quality of Government

Expenditure: Political and Administrative Impediments to Improvement. CGD Policy Paper

162, Washington DC: Center for Global Development. www.cgdev.org

Mabugu, R. E. and Rakabe, E. (2019). How Erratic Tax Policies Are

Impeding Revenue Mobilization in Zambia.CGD Policy Paper 161, Washington DC:

Center for Global Development. www.cgdev.org

Wawire, N.H.W. (2016) Analysis of Income Tax System Productivity in Kenya. Amity

Journal of Economics 1, no. 2, 1-18.

Wawire, N.H.W. (2017). Determinants of Value Added Tax Revenue in Kenya. Journal of

Economics Library 4, no. 3 (2017): 322-344. Available at www.kspjournals.org.

Ndung’u, N. (2017). Digitization in Kenya: Revolutionizing Tax Design and Revenue

Administration. Digital Revolution in Public Finance. Gupta, S, M. Keen, A. Shah, G.

Verdier, eds. Washington, DC: International Monetary Fund.

Oguso, A., and N. Sila. (2019) “Fiscal Exchange, Tax Expenditure and Tax Morale:

Evidence from Kenya. African Tax and Customs Review 1, no. 2. Available at:

https://atcr.kra.go.ke/ojs/index.php/atcr/article/view/32).

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Decisions, 2019. https://www.cgdev.org/blog/strengthening-revenue-performanceafrica-

Requires-tough-political-decisions.





Jingxian Zou, J, G.,Shen, .& Gong, Y (2018), “The Effect of Value-added Tax on Leverage:

Evidence from China’s Value-added Tax Reform”, Chieco,

doi:10.1016/j.chieco.2018.10.013

Andoh, F. K. (2017), “Taxable capacity and effort of Ghana's value-added tax”, African

Review of Economics and Finance, ISSN 2042-1478,Volume 9, Issue 2

Pantamee, A. A., & M. B., Mansor (2017), “A Modernize Tax Administration Model for

Revenue Generation”, International Journal of Economics and Financial Issues, 2016,

6(S7) 192-196

Asafu-Adjaye, J & T. Feger, (2014),”Tax effort performance in sub-Sahara Africa and the

role of colonialism”, Economic Modelling 38, 163–174

Ghura, D. (2002).“Tax Revenue in Sub-Saharan Africa: Effects of Economic Policies

andCorruption.” Chapter 14. Abed, G.T., and S. Gupta, eds. Governance, Corruption and

EconomicPerformance. Washington, DC: IMF, 2002.

Gordon, R. and W. Li (2009): Tax Structures in Developing Countries: Many puzzles and a

possible explanation, Journal of Public Economics 93: 855-866.

Omondi, V. Wawire, N. H. W. Manyasa, O. &Thuku, G. (2014).Effects of Tax Reforms on

Buoyancy and Elasticity of the Tax System in Kenya: 1963–2010. International Journal of

Economics and Finance 6(10): 97 – 111.

Wawire N. H. W. (2000)“Revenue productivity Implications of Kenya’s Tax System” in

KwesiKwaaPrah and A. G. Ahmed (Eds.) Africa in Transformation: Political and Economic

Issues. Vol.1 Chapter 6. Addis Ababa: OSSREA pp. 99 - 106

Wawire N.H.W. (2003) “Trends in Kenya's Tax Ratios and Tax Effort Indices, and Their

Implications for Future Tax Reforms". Egerton Journal. Vol. IV, Numbers 2&3. Njoro:

Egerton University Press. pp. 256 - 279.

Tabi A. J, Atabongawung J. N. and A. T. Afeanyi.(2006), “The Distribution of Expenditure

Tax Burden Before and After Tax Reform: The Case of Cameroon,AERC Research

Paper No. 161 November

Kinyanjui , M. M.and Moyi, E.D. (2003), “Tax Reforms and Revenue Mobilization in

Kenya, AERC Research Paper No.131, May

Gruber chapter 25

Howard, M. M., A. La Foucade& Scott, Chapter 13, 17 and part of 20

Rosen and Baye Chapter 21


LESSON SIX: FISCAL FEDERALISM

By the end of the lesson, you shulod be able to:

6.1 describe the theory of Fiscal Federalism (Tiebout Model);

6.2 explain the princples of intergovernmental relations

6.3 explain the assignment of functions

6.4 explain tax competition

6.5 descibe revenue sharing mechanisms, intergovernmental grants and transfers.

6.6 discuss fiscal federalismand the African experience

6.7 explain County/local government revenue collection systems [the African

experience]

6.1 The Theory of Fiscal Federalism

The Theory of Federalism is one of the branches of public sector economics theories. As a

subfield of public economics, fiscal federalism is concerned with "understanding which

functions and instruments are best centralized and which are best placed in the sphere

of decentralized levels of government" (Oates, 1999). Thus based on the theory the area is

concerned with expenditure side and revenue side efficiency in allocating fiscal resources

across Government levels of Development from local to the central government. There are

key areas of the subject such as grants and transfer payments. It is expected that any federal

Government will take some time in regulating and subsiding the states and localities.

In the past, it also provided general revenue sharing. In matching grants, the amount

received by states and localities depends on the amount they spend. Indirect aid is provided

by the exemption from taxation of interest on state and local bonds and the tax deductibility

of state and local income and property taxes

Matching grants are more effective in encouraging expenditures in the direction desired,

but there is a deadweight loss associated with their use. The deadweight loss comes from

the fact that there is likely to be tax subsidies or tax exemptions that will influence the

outcome of fiscal aspects within a given economy. There are bonds in local and states which

lead to increased expenditures on publicly provided goods. Capital investment by state and

local government is another vehicle of maximizing deadweight loss.

Tax exemption of interest on state and local bonds is another possibility of funding local

government. However, this and other forms of tax subsidies are an inefficient way of

subsidizing state and local communities. The argument against this mode of development

financing in local government is the fact that some of the benefits tend to accrue to specific

individuals than the entire society. The other fact is the tax exemptions are discriminatory

in nature especially by favoring high income and those with string preference on socially

supplied goods. In a nutshell there is political power embedded in revenue mobilization.

At times federal Government make use of this tasks to enforce rules and regulations. Tax

for instance is by a law a legal issue.

A conditional transfer from a federal body to a province, or other territory, involves a certain

set of conditions. But an unconditional grant is usually a cash or tax point transfer, with no

spending instructions. An example of this would be a federal equalization transfer. All these


are forms of financing local Government activities one hand and federal government on the

other. There is usually an agreement before a lower level of Government can be given a

transfer. Such agreement are on whether and how the transfer money will be used.

The other aspect is that horizontal and equity fiscal prelateships are part and parcel of

federalism. These notions are also related to the imbalances and horizontal competition.

While the concept of horizontal fiscal imbalance is relatively non-controversial (as

explained above), the concept of vertical fiscal imbalance is quite controversial (see Bird

2003) Following Sharma (2011), any existing revenue-expenditure asymmetry between the

two levels of a government should simply be called a Vertical Fiscal Asymmetry (VFA).

Fiscal asymmetry with fiscal imbalance: VERTICAL FISCAL IMBALANCE (VFI). This

means inappropriate allocation of revenue powers and spending responsibilities. This state

can be remedied by reassignment of revenue raising powers.

Local, national and international public goods

The Federalism theory is also keen to explore the supply of local and international public

goods by the local and Government. This is important because there are different activities

within the local and federal government that lead to provision of goods and services.

Therefore it is important to follow the dimensions and dynamics of types of goods at all

levels of development. The divide among the goods is that these goods that have local

supply nature will be local public goods such as traffic light or fire protection. National

Parks is an international public good. The supply chain for local and international public

goods follows the levels at which they exist. To be efficient international public goods must

be supplied by the federal government. If the provision of national public goods is left to

local communities, there would be a free rider problem and there can occur an undersupply

of those goods. Similarly, there is likely to be an undersupply of international public goods,

if they are provided by the national governments.

On the other hand, it is beneficial, when local public goods are provided by local

governments and not national. Charles Tiebout of the University of Washington argued that

competition among communities ensures efficiency in the supply of local public goods, like

it does a competition among private subjects in the supply of private goods. Competition

between communities arises naturally, because if the citizens of the community do not like,

how the public goods are provided to them, they can move to the other community, where

they think the provision of public goods is better. Moving from one town to another is

naturally much easier than moving to a different country. This argument is called Tiebout

hypothesis.

Division of Responsibilities

Given the likelihood of differences in provision of goods and services there is usually need

to have a clear division of labor between the federal governments. Decision making for

instance is one area that require a consensus. It must be clear between the two points who

makes what decisions at what time and circumstances. This is followed by who imitates

programs and implement them. In some cases, the federal government pays for a program,

and gives broad discretion to the states as to how to carry out the mandate. In other cases,

the federal government essentially dictates all the terms, and the states simply administer


the program. There is another scenario when federal Government do finance local

government initiated programs. Under such a circumstance

federal government gives matching grants— the state determines the level of expenditure

(within limits) and the federal government pays a portion of the costs, which may depend

on the per capita income of the state. In other cases, the federal government provides a

block grant—a fixed amount of money subject to general expenditure guidelines.

6.2 Principles of Federalism

There are guiding principles of federalism that support the operations of local and

federal performance. With the development of the modern theory of public finance,

however, we can ask: What principles should guide the assignment of responsibilities?

The guiding principles for the Federalism is to have a well-defined institutional set up

that make a clear distinction of the legal definition of the local Government along with

the clear responsibility and rights. In addition the guideline should give the scope and

limitations of the federal Government in relation to revenue collection, spending,

program initiation and type of goods and services allowable for production and supply.

There must be clear definition of all sources of revenue at the two levels.

Tiebout hypothesis

This hypothesis tend to examine the extent and need for competition among states to

ensure efficiency in the supply of public goods and services. This hypothesis believes

the need to provide incentives for innovativeness by rewarding extra ordinary

performance. It has been observed in some countries including Tanzania where local

Governments are given special certificates and reward as winners in revenue collection

Limitations:

There are a range of limitations of the Tiebout hypothesis. In particular market failure

is one of the limitations.

The market failures according to Stiglitz (2010) can emanate from the following

dimensions;

➢ When externalities: decisions of community have effects on others

➢ With limited number of communities there is likely to be imperfect competition.

➢ When tax competition just lead to lower taxes on business. The other aspect is on

redistribution—with free migration and local competition, there will be no (or, at

most, limited) redistribution at local level

In terms of the hypothesis Tiebout was originally concerned with the problem of preference

revelation. Individuals reveal their preferences for private goods simply by buying goods,

but how are they to reveal their preferences for public goods? When individuals vote,

they choose candidates who reflect their overall values, but they cannot express in detail

their views about particular categories of expenditures. Only limited use of referenda is

made in most states. Even if individuals were asked to vote directly on expenditures for

particular programs, the resulting equilibrium would not, in general, be Pareto efficient.


Tiebout argued that individuals could “vote with their feet”—their choice of communities

revealed their preferences toward locally provided public goods in the same way as their

choices of products revealed their preferences for private goods.

In recent years these developers, recognizing that many individuals would like more security

and more communal facilities (swimming pools, tennis courts) than are provided by the

typical city, have formed large developments providing these services. Because these

communities meet the needs of the individuals better than the available alternatives,

individuals are willing to pay higher rents (or spend more to purchase homes in these

communities). This gives developers a return for their efforts to ascertain what individuals

want and to meet these desires.

6.3 Sharing of Revenue

Initially the federal government was sharing its revenues with the states, based on the

presumption that the federal government could raise revenues more efficiently but states

could make certain types of expenditure decisions more effectively. Today, it no longer does

this, but there are efforts to convert matching grants for specific purposes such as welfare

into block grants

Production versus Finance

Many of the arguments typically made for local provision of public goods— that local

communities are more responsive to the needs and preferences of those who actually receive

the goods, that local communities have greater incentives for efficiency, and that devolving

responsibility to local communities provides greater opportunities for experimentation—are

mainly arguments for local control (local decision making) rather than local finance.

However, there are good reasons for concern about separating finance from control.

If voters of the country as a whole believe that their tax dollars should be used to finance

welfare expenditures for the poor, they want to be sure that their money actually goes for

this purpose, and not to finance suburban swimming pools (Stiglitz and Rosengard, 2005).

Effectiveness of Federal Categorical Aid to Local Communities

The intention of federal categorical aid to local communities is to encourage local spending

on particular public services. Aid to bilingual education, to vocational education, and to

school libraries is intended to result in an increase in expenditures in each of these

categories. How effective is this aid? Do federal funds just substitute for local funds, or do

they actually result in more expenditures for the intended purpose?


Source adopted in the Economics of Public Sector by Stiglitz and Rosengard, 2005).

The Figure shows the budget constraint of the community. (We simplify by assuming all

individuals within the community are identical, so that we can ignore questions concerning

differences in tastes. The community would choose point E, the tangency between the

budget constraint and the indifference curve of the representative individual.

Now assume that the federal government provides a block grant to the community. This

shifts out the budget constraint, to line B’B’. There is now a new equilibrium, E*. It entails

a higher level of expenditure on local publicly provided goods and a higher level of per

capita consumption of private goods. That is, the federal aid has, in fact, resulted in lowering

the tax rate imposed on individuals. The federal money has partially substituted for local

community money; the community, because it is better off, spends more on publicly

provided goods as well as privately provided goods.

Now assume, however, that there are two different publicly provided goods, garbage

collection and education, on which the community can spend funds. We represent the

allocation decision of the community between the two goods by the same kind of

diagrammatic devices we have used to represent the allocation between private and publicly

provided goods. The community has a budget constraint; it needs to divide its total budget

between the two goods, as represented by Figure below. The community also has

indifference curves between the two goods.



These results for block grant categorical aid need to be contrasted with a government

program of matching local expenditures, for instance, on libraries. Suppose the federal

government matches local expenditures on a dollar-for-dollar basis. If the local community

wishes to buy a book that costs $10, it costs the community only $5, as the federal

government provides the other $5 with a matching grant. This arrangement obviously

creates a considerable inducement to spend more on these services, as illustrated in the

above. The new budget constraint, with the subsidy for local government expenditures, is

rotated around point B. If the community were to decide to spend nothing, it would not

receive federal aid. For every dollar of privately provided goods that the community gives

up, it can obtain twice as many publicly provided goods as previously. Thus, the budget

constraint is much flatter. This outward shift in the budget constraint has an income effect

as before, but now there is, in addition, a substitution effect.

Because publicly provided goods are less expensive, the community will wish to spend

more. The equilibrium will change from E to E*. These results for block grant categorical

aid need to be contrasted with a government program of matching local expenditures, for

instance, on libraries. Suppose the federal government matches local expenditures on a

dollar-for-dollar basis. If the local community wishes to buy a book that costs $10, it costs

the community only $5, as the federal government provides the other $5 with a matching

grant. This arrangement obviously creates a considerable inducement to spend more on

these services, as illustrated in Figure 26.6. The new budget constraint, with the subsidy for

local government expenditures, is rotated around point B. If the community were to decide


to spend nothing, it would not receive federal aid. For every dollar of privately provided

goods that the community gives up, it can obtain twice as many publicly provided goods as

previously. Thus, the budget constraint is much flatter. This outward shift in the budget

constraint has an income effect as before, but now there is, in addition, a substitution effect.

Because publicly provided goods are less expensive, the community will wish to spend

more. The equilibrium will change from E to E*.


Inefficiency of Tax in Local Governments

Based on the discussion from Stiglitz and Rosengard (2005), there are four reasons why

providing aid to local communities through the federal income tax system may be

inefficient:

1. Aid provides a large incentive for the public provision of goods, regardless of

the efficiency with which the local communities are able to deliver these

goods and services.

2. A significant fraction of the benefits of interest exemption accrue not to the

communities, but to wealthy taxpayers.

3. Because of competition among communities, some of the benefits may accrue to

industries within the communities rather than to the communities themselves.

Local communities can issue tax-exempt bonds to help finance some of the

capital costs required to provide the infrastructure to attract firms.

4. Inequities they create for individuals with different tastes and incomes. We have

already noted that these provisions represent a considerable subsidy to the public

provision of goods. Individuals who have a relatively strong preference for

goods that tend to be publicly provided at the local level benefit by such


measures, at the expense of those who have a weak preference for those

commodities. Because the magnitude of the reduction in effective costs of

publicly provided goods depends on individuals’ marginal tax rates, those who

face a higher tax rate (usually wealthier individuals) receive a larger subsidy,

and a larger reduction in their effective price of publicly provided goods

Basic Readings:

Gruber chapter 10

Rosen and Gayer, Chapter 22

Hindriks & Myles chapter 19, 20

Other Readings

Oates, W. E. (1999), “An Essay on Fiscal Federalism”, Journal of Economic

Literature37:1120- 1149.

Alfaro, Laura, and Fabio Kanczuk. (2016)"Fiscal Rules and Sovereign Default." Harvard

Business School Working Paper, No. 16-134, June 2016. (Also NBER Working Paper

w23370. Revised January 2019.)

Dada A. E. (2015), “Fiscal Decentralization and Social Services in Nigeria” AERC Research

Paper 291, African Economic Research Consortium, Nairobi.

IMF. (2012) ‘Fiscal regimes for extractive industries: design and implementation’ IMF

Policy Paper. Washington, DC: IMF.

Morrissey, Oliver; Islei, Olaf; M'Amanja, Daniel (2006), “Aid loans versusaid grants: Are

the effects different?” CREDIT Research Paper, No. 06/07. The University of Nottingham,

Centre for Research in Economic Development and International Trade.

Rubinfeld, D. (1987), “The Economics of the Local Public Sector” in Atkinson and

Feldstein (eds), Handbook of Public Economics, Vol 2.

Cremer, J. and T. Palfey (2000), “Federal Mandates by Popular Demand”, Journal of

Political Economy 108: 905-927.

Fisher, Ronald and Leslie E. Papke (2000), “Local Government Responses to Education

Grants”,National Tax Journal 53(1): 153-168.

Gramlich, Edward M. (1993), “A Policymaker’s Guide to Fiscal Decentralization”,National

Tax Journal46(2): 229-235.

Lockwood, B. (2006),“The political economy of decentralization”, in Handbook of

FiscalFederalism, ed. By E. Ahmad and G. Brosio, Edwar Elgar, 33-60.

http://www.hbs.edu/faculty/Pages/download.aspx?name=16-134.pdf


Janeba, E. and G. Schjelderup (2009),“The Welfare Effects of Tax

CompetitionReconsidered: Politicians and Political Institutions”, Economic Journal 119:

1143-1161

Kempf, H. and G. Rota-Graziosi (2010),“Endogenizing leadership in taxcompetition,

Journal of Public Economics 94 (9-10): 768-776

Oates W. E. (1972), Fiscal Federalism. New York: Harcourt Bruce,

Ekpo, A.H and J.E. Ndebbio, (1994),“Local Government Fiscal Operations in An Oil-

Export Economy:Nigeria, 1980-1992" African Journal of Economic Policy 1(2): 1-18.

Ekpo, A.H (1994), “Fiscal Federalism: Nigeria’s Post Independence Experience, 1960-

1990" World Development 22(8): 1129-1146.


LESSON SEVEN: INTERNATIONAL ISSUES IN TAXATION

By the end of the lesson, you sholud be able to:

1.1 explain concepts and principles of international taxation;

1.2 discuss tax harmonization;

1.3 describe tax competition,

1.4 explain how fiscal externalities and coordination failure arises;

1.5 assess the implications of trade costs for taxes and investment flows.

1.6 demonstrate transfer Pricing, Tax treaties, and regulations

1.7 Discuss tax havens and illicit financial flows.

7.1 Concepts and principles of international issues in taxation

International taxation is the study or determination of tax on a person or business As the

name suggests international taxation encompasses aspects of understanding the dynamics

of taxation beyond the border of a given country. There are taxes in international business

in accordance to international laws, or laws of various countries as long as they affect the

observable country specific tax revenues and compliance generally. Hence this focuses in

this area. This area is important for a number of reasons and most significantly Governments

have limitations in terms of tax laws and regulations enforcements. There are regional and

bilateral agreements that tend to influence performance of taxation. The manner of

limitation generally takes the form of a territorial, residence-based, or exclusionary system..

It has been observed that there are countries which adopt hybrid of tax laws and policies as

a measure to mitigate international spillover of tax policies that tend to adversely affect

domestic tax system. In this respect, many governments tax individuals and/or enterprises

on income. Such systems of taxation vary widely, and there are no broad general rules. One

of the major short fall has been the possibility of double taxation which is a situation that

the same income is taxed in more than one country and in extreme cases the no taxation

tragedy where no tax is imposed in income in all countries. . Income tax systems may

impose tax on local income only or on worldwide income. Generally, where worldwide

income is taxed, reductions of tax or foreign credits are provided for taxes paid to

other jurisdictions.. There are limits which are imposed in attempt to mimic international

adverse effect of taxation. In some cases limits are universally imposed on credits

Multinational corporations usually employ international tax specialists, a specialty among

both lawyers and accountants, to decrease their worldwide tax liabilities. When this happens

it is hard for them to pay tax as they are given all the loopholes that enable them to avoid

tax without legally being detected.

7.2 Tax harmonization

In inyternational taxation the issue of tax harmonization has taken a great deal of dicsussion.

This problem isobserved in areas where countries are close to each other with common types

of business. For instance Tanzania and Kenya at Namanga Border the business conducted

there is the same in bth countries. They also share the same market therefore any tax

imposed on one side of the border will have spill over effect on the other side. Hence tax

harmonization is generally understood as a process of adjusting tax systems of different

jurisdictions in the pursuit of a common policy objective. Under this area need to harmonize

tax has involves total removal of taxation in certain areas where the closely related business


tend to suffer by a tax imposed on a certain line of business. The other dimension of tax

harmonization involve reduction of increase of taxes until there are on the same level.

Harmonization of taxes in international tax system has aimed to attaining other several

macro objectives such as equity or stabilization. It also can be subsumed, along with public

expenditure harmonization, under the broader concept of fiscal harmonization.

In tax harmonization in international setting convergence has been arrived at by ensuring

alignment of elements that enter the determination of effective tax rates, the statutory rates

and tax base along with the enforcements. Perhaps the most widely accepted argument for

harmonization involves convergence in the definition of product value or income for tax

purpose. The political anticipation of tax harmonization is enhanced transparency and

accelerated economic growth in both countries where harmonization is directed. In

particular, a common income tax base for multinational companies operating in different

jurisdictions would be instrumental not only in enhancing efficiency, but also in preventing

overlaps or gaps in tax claims by different countries. There has been a cry for fiscal

integration in a number of regional groupings. In many respects tax harmonization has taken

the lead in a number of reforms suggested to attain the fiscal integration. It is worthwhile

noting that tax harmonization doesn’t automatically lead to the formation of a fiscal union,

the second part involving much larger scale project that includes fiscal transfers, a fully

harmonized legislation and maybe some supervising institutions, beside a long-run

agreement.

Experience in African Economies

The issue of tax harmonization in African economies. In the EAC member countries

imposes taxes within their economies. Unfortunately there are differences of taxes rates

which makes economic relationship difficult. There are times when these differences are

harmful to trade between Tanzania and other members of the East African Community. In

an attempt to harmonize taxes within the East African Economies, the partner states last

year 2018 agree a gradual domestic tax harmonization starting with excise duty followed

by value added tax (VAT) and finally income tax.. According to the EAC’s tax policy and

tax administration subcommittee of the committee on fiscal affairs, harmonization will

focus on those aspects of tax regimes that eliminate tax-induced distortions, facilitate trade

and investment and prevent harmful tax competition — rather than a perfect alignment of

tax systems. Harmonization of taxation in In the West African region regional economic

entities have been involved in regional tax coordination and harmonization both on tax rates

and tax policy. The West African Economic and Monetary Union (WAEMU) has had a long

history of tax coordination and harmonization efforts since 1994. Its member countries share

a single currency - the CFA Franc (Franc de la Communauté Financière Africaine) -, form

a customs union, and have had extensive tax coordination and harmonization experience in

domestic taxation.5 Over 80% of member countries’ tax (including tariff) revenues are

derived from taxes that are subject to regional directives or regulations. The formation of

the customs union with a common external tariff (CET) was completed by 2000; directives

on value-added tax (VAT) and excises were introduced in 1998; and, by 2009, the region

completed a set of directives in relation to capital income taxation

The other regional grouping where tax harmonization in Africa has been one of the

paramount aspect is SADC region The aim of these SADC guidelines is to ensure that policy

coordination is easier to achieve, thus avoiding the potential risk of distortions that could


put domestic production at a disadvantage, when it is in competition with imports of similar

goods. The SADC VAT and Excise guidelines were published in November 2016 by the

SADC VAT and Excise Committee, after being approved by SADC Finance Ministers.

These guidelines cover the design, administration and exchange of information, as well as

mutual assistance in the field of VAT and Excise

But what are advantages of international tax harmonization?

There are many advantages of tax harmonization. One of the main advantage is to reduce

tax competition within the regional economies. The main assumption is that once there is

harmonized tax system there is no incentive for any given country in time to battle for

increased or reduced tax rate that can affect other countries.

In so doing tax harmonization tend to reduce economic deadweight loss from increased tax

competition. This is partly because the battle for tax reduction or increase. has its own

price, the reduction of tax rates bringing with it a reduction in tax revenues. The other aspect

is that the harmonization of legislation will bring with it less costs for multinational

companies. Finally harmonization tend to allows the use of fiscal transfers between regions,

reducing borrowing costs on capital markets or from private or international lenders.

Disadvantages

In the above paragraph we have seen the advantages of ensuring tax harmonization. Despite

a number of advantages outlines above there are equally a number of limitations or

disadvantages of tax harmonization. The first and foremost is the likely loss of revenue.

There are radically different advantages in imposing tax which differ from one country to

another. There are obvious possibilities that tax harmonization can have negative impact

on revenue collection. The other disadvantage is that Need to have a coordination and

surveillance institution is necessary, thus presenting additional costs. There is also needs to

solve the problem of the democratic deficit. The other effect of tax.

7.3 Tax Competition

So far we have discussed aspects of tax harmonization and to some extent introduced aspects

of competition. In this section we introduce tax competition. By firsr defining it and then

discuss its dynamics. The definition point out that tax competiton is a situation where a set

of countries from at least two have different tax regimes and keep manipulating their tax

rates to gain from trade or economic relationship after observing the existing tax system of

the counterparts. The preconditions for tax competition is that there should be no tax

harmnization mechanism within the regime or if it exist it should be hard to enforce.

In African context we have seen how countries have strived to use fiscal incentives in

attempt to compete for economic partners. In mining sector for example there have been

lowest rates between countries to ensure they atract investors. Increase of Foreign Direct

investment in many instances has been fueled by lowering tax rates to the level lower than

the neighbor to win the volumes.

In with tax competition in the era of globalization politicians have to keep tax rates

“reasonable” to dissuade workers and investors from moving to a lower tax environment.

Most countries started to reform their tax policies to improve their competitiveness.


The typical form of tax competition include:

➢ reduction of both personal and corporate income tax rates tax breaks/holidays (i.e.

time limited tax exemptions)

➢ favorable tax policies for non-residents

➢ raising the barriers to free movement of capital

➢ not allowing companies domiciled in tax havens to bid for public contracts

➢ political pressure on lower tax countries to “harmonize” (i.e. raise) their taxes

The outcome of the tax competition takes the form of mixed results. Lower tax rates might

result into higher collection and vice versa. It might also result to imbalance of trade and

development between and among countries.

Contemporary Global Tax Issues

In recent years there have been emerging issues of global taxes. The important ones are Base

Erosion and Profit Sharing.

Base erosion is a result of inappropriate tax system in a host country that allows repatriation

or capital flight in a way that international regulations might create loopholes for tax havens

and avoidance. When this happen there is a danger that tax base of a host country will be

shrinked. We have seen examples where multi nationals enjoy regional and international

tax amnesty or national investment incentives that over subscribe to the potential investors.

The other global aspect of international taxation is profit sharing. It is not very different

from the base erosion. Under this setting again we have multinationals which might have a

branch and a head office in two different countries that have differences in tax systems.

Depending on who gets what there shall be differences in outcome of tax payment such that

the revenue will split between the two countries. A strategic design of a national tax policy

will determine who gets what.

Addressing BEPS has become one of the highest priorities of the international community.

developed economies have come up with a comprehensive action plan on BEPS. Areas of

proposed action include: addressing mismatches in entity or instrument characterization;

improvements to or clarifications of transfer pricing rules, including the treatment of

intangibles; updated approaches to issues related to jurisdiction to tax, particularly in

relation to digital goods and services; more effective anti-avoidance measures, including

general anti-avoidance rules; rules on the treatment of intra-group financial transactions;

and more effective actions to counter harmful tax regimes.

Information Exchange is another global aspect.

Transparency and Exchange of Information for Tax Purposes (GF) (now with 120 members)

promotes effective exchange of information (EOI), with automatic EOI becoming the new

standard. Peer reviews examine whether a country complies with the internationally agreed

standards of EOI, which prohibit a country from declining to provide information on

grounds of bank secrecy. The G-8 and G-20 have called on all countries to adopt measures

to facilitate automatic exchange of tax information, and mandated the OECD to develop the

standard for this―which would be a substantial step forward, albeit one that faces


considerable practical difficulty in implementation. Also important in this context is the

opening of the Multilateral Convention on Mutual Administrative Assistance in Tax

Matters—which covers all forms of EOI and assistance in tax collection—to all countries

from 2013; it now covers more than 70 jurisdictions.

7.4 Transfer Pricing, Tax Treaties and Regulations

In international tax system there are other important aspect such as transfer pricing, tax

treaties and regulations.

Transfer pricing is one of the most important issues in international tax. Transfer pricing

happens whenever two companies that are part of the same multinational group trade with

each other: when a US-based subsidiary of Coca-Cola, for example, buys something from a

French-based subsidiary of Coca-Cola. Why transfer pricing? This comes from the fact that

parties may establish a price for the transaction which is what is termed transfer pricing.

One of the complexity is that transfer pricing is not illegal and not even abusive. The

problem comes when there is transfer mispricing or transfer pricing manipulation

This is a form of a more general phenomenon known as trade mispricing, which includes

trade between unrelated or apparently unrelated parties – an example is reinvoicing.) It is

estimated that about a third of international trade happens within, rather than between,

multinationals: that is, across national boundaries but within the same corporate group.

Estimates vary as to how much tax revenue is lost by governments due to transfer

mispricing. Global Financial Integrity in Washington estimates the amount at several

hundred billion dollars annually. A March 2009 Christian Aid report estimated $1.1 trillion

in bilateral trade mispricing into the EU and the US alone from non-EU countries from 2005

to 2007. According to the Christian Aid report of 2009, if two unrelated companies trade

with each other, a market price for the transaction will generally result. This is known as

“arms-length” trading, because it is the product of genuine negotiation in a market. This

arm’s length price is usually considered to be acceptable for tax purposes. The report further

explain how does World Inc. shift its profits into a tax haven?. But when

two related companies trade with each other, they may wish to artificially distort the price

at which the trade is recorded, to minimize the overall tax bill. This might, for example,

help it record as much of its profit as possible in a tax haven with low or zero taxes. For

example, World Inc. grows a crop in Africa, then harvests and processes it and transports

and sells the finished product in the United States. It has three subsidiaries: Africa Inc. (in

Africa), Haven Inc. (in a zero-tax haven) and USA Inc. (in the U.S.). Africa Inc. sells the

produce to Haven Inc. at an artificially low price. So Africa Inc. has artificially low profits

– and therefore an artificially low tax bill in Africa

Sources of Transfer Pricing

The Christian Aid report of 2009 highlighted a number of ways but most important is

globalization and trade liberalization, coupled with advances in information technology,

have contributed to an increase in the number of enterprises expanding beyond their

domestic markets. As a result, foreign direct investment (FDI) stocks and the number and

size of multinational enterprise (MNE) groups have continued to increase. In 2000, the

United Nations Conference on Trade and Development (UNCTAD) estimated that there

were 63,000 parent firms with 690,000 foreign affiliates (UNCTAD, 2000). By the end of

2007, UNCTAD estimated that there were 79,000 parent firms with 790,000 foreign

affiliates (UNCTAD 2008).


Imports and exports of merchandise and services have also continued to rise in both

developed and developing economies. Upon entering a new market, an enterprise generally

faces various options regarding the form the new business activity will take. These options

include direct exportation, establishment of a local representative office or branch, and

establishment or acquisition of a subsidiary that is wholly or substantially owned and

controlled.

As a result of the common ownership, management, and control relationships that exist

among members of an MNE group, their transactions are not fully subject to many of the

market forces that would have been at play had the transactions taken place among wholly

independent parties. The prices charged—known as transfer prices—may be intentionally

manipulated or set in a way that has the unintentional consequence of being unacceptable

to external stakeholders.

How and Why Are Transfer Prices Determined?

How transfer prices are determined is essential for defining the corporate tax base (direct

taxation), but it can also be important for a range of other regulatory and non-regulatory

purposes, including the following:

➢ Taxes and duties (for example, value-added tax [VAT], customs duties, mining

➢ royalties, and petroleum resource taxes)

➢ Corporate laws (for example, directors’ duties and protection of minority

➢ shareholders)

➢ Contractual requirements (for example, investment contracts)

➢ Statutory accounting requirements

➢ Foreign exchange controls

➢ Management accounting

➢ Internal performance management and evaluation

➢ Employee profit sharing requirements

➢ Competition law

➢ Official trade statistics


Source: Adopted from Transfer Pricing Handbook for Policy Makers (2016)

7.5 Tax Havens and illicit financial flows

A tax haven is defined as a country or place with very low "effective" rates of taxation for

foreign investors ("headline" rates may be higher. In some traditional definitions, a tax

haven also offers financial secrecy. However, while countries with high levels of secrecy

but also high rates of taxation (e.g. the United States and Germany in the Financial Secrecy

Index ("FSI") rankings), can feature in some tax haven lists, they are not universally

considered as tax havens.

In contrast, countries with lower levels of secrecy but also low "effective" rates of taxation

(e.g. Ireland in the FSI rankings), appear in most Tax haven lists. The consensus

around effective tax rates has led academics to note that the term "tax haven" and "offshore

financial centre" are almost synonymous. Traditional tax havens, like Jersey, are open about

zero rates of taxation, but as a consequence have limited bilateral tax treaties.

Modern corporate tax havens have non-zero "headline" rates of taxation and high levels

of OECD–compliance, and thus have large networks of bilateral tax treaties.

However, their base erosion and profit shifting("BEPS") tools enable corporates to achieve

"effective" tax rates closer to zero, not just in the haven but in all countries with which the

haven has tax treaties; putting them on tax haven lists. According to modern studies,

the § Top 10 tax havens include corporate-focused havens like the Netherlands, Singapore,

Ireland and the U.K., while Luxembourg, Hong Kong, the Caribbean (the Caymans,

Bermuda, and the British Virgin Islands) and Switzerland feature as both major traditional


tax havens and major corporate tax havens. Corporate tax havens often serve as "conduits“

to traditional tax havens. Use of tax havens results in a loss of tax revenues to countries

which are not tax havens. Estimates of the Financial scale of taxes avoided vary, but the

most credible have a range of US$100–250 billion per annum. In addition, capital held in

tax havens can permanently leave the tax base (base erosion). Estimates of capital held in

tax havens also vary: the most credible estimates are between US$7–10 trillion (up to 10%

of global assets). The harm of traditional and corporate tax havens has been particularly

noted in developing nations, where the tax revenues are needed to build infrastructure. Over

15% of countries are sometimes labelled tax havens. Havens are mostly successful and well-

governed economies, and being a haven has brought prosperity. The top 10–15 GDP-per-

capita countries, excluding oil and gas exporters, are tax havens. Because of Inflated GDP-

per-capita (due to accounting BEPS flows), havens are prone to over-leverage (international

capital misprice the artificial debt-to-GDP).

Higher-tax jurisdictions, such as the United States and many member states of the European

Union, departed from the OECD BEPS Project in 2017–18, to introduce anti-BEPS tax

regimes, targeted raising net taxes paid by corporations in corporate tax havens (e.g. the

U.S. Tax Cuts and Jobs Act of 2017 ("TCJA") GILTI–BEAT–FDII tax regimes and move

to a hybrid "territorial" tax system, and proposed EU Digital Services Tax regime, and

EU Common Consolidated Corporate Tax Base

Illicit financial flows (IFFs) are illegal movements of money or capital from one country to

another. Some examples of illicit financial flows might include:

➢ A drug cartel using trade-based money laundering techniques to mix legal money

from the sale of used cars with illegal money from drug sales;

➢ An importer using trade misinvoicing to evade customs duties, VAT, or income

taxes;

➢ A corrupt public official using an anonymous shell company to transfer dirty money

to a bank account in the United States;

➢ A human trafficker carrying a briefcase of cash across the border and depositing it

in a foreign bank; or

➢ A member of a terrorist organization wiring money from the Middle East to an

operative in Europe

All these transactions cannot pass through tax machinery and to a large extent will

misallocate financial resources. The outcome of the flows are mixed but the ethical approach

is to discourage them as there might be associated adverse impact in the economy. .

Economic Effects of Illicit Financing

According to the Transfer Pricing handbook, estimated economic value of IFFs into and out

of developing countries amounted to on average, over 20 percent of developing country

trade with advanced economies. Additionally, trade misinvoicing is the primary means

for illicitly shifting funds between developing and advanced countries, finding that trade

misinvoicing may account for upwards of 87 percent of measurable IFFs.

What Can We Do About Illicit Financial Flows?


There are efforts to fight illicit financial flows that has major effect of eroding tax base.

International community believes that that the most effective way to limit illicit financial

flows is to increase financial transparency. The methods proposed are:

1. Detect and deter cross-border tax evasion;

2. Eliminate anonymous shell companies;

3. Strengthen anti-money laundering laws and practices;

4. Work to curtail trade misinvoicing; and

5. Improve transparency of multinational corporations.

Basic Readings:

Howard, M. M., A. La Foucade& Scott, Chapter 19

Hindriks and Myles, Chapter 21

Other Readings

Joel Cooper, Randall Fox, Jan Loeprick, and Komal Mohindra (2016) Transfer

Pricing and Developing Economies A Handbook for Policy Makers and

Practitioners

Desai, M and J Hines (2003), “Economic foundations of international tax rules”,

prepared for the American Tax Policy Institute, December 2003. Sections 2.2, 2.3,

3,4.1 and 4.2.

[http://www.americantaxpolicyinstitute.org/pdf/econimic_foundation_internal.pdf]

Perroni, C and K Scharf, (2001) “Tiebout with Politics: Capital Tax Competition

and Constitutional Choices”, The Review of Economic Studies 68:1, 133-154.

A. Auerbach. “A Modern Corporate Tax.” Center for American Progress, 2010.

Devereux, M. R. Griffith, and A. Klemm (2002). “Corporate Income Tax Reforms

and International Tax Competition.” Economic Policy 17: 449-495.

Dharmapala, D. C. Foley, and K. Forbes (2011), "Watch What I Do, Not What I

Say: The Unintended Consequences of the Homeland Investment Act," Journal of

Finance, American Finance Association 66(3): 753-787, 06.


LESSON EIGHT: PUBLIC DEBT


8.1 discuss the causes of budget deficits.

8.2 define public debt and explain its classification, and purpose.

8.3 discuss the measurement and theories of public debt.

8.4 discuss the effects, management, financing and sustainability of public debt.

8.5 assess the overview of external debt Africa and debt relief initiatives.

8.1 Definition and causes of budget deficit

The budget deficit during a time period is the excess of spending over revenues; if revenues

exceed expenditures, there is a surplus. Borrowing involves an issue by the government of

some sort of security such as treasury bills, bonds etc. Total amount of securities issued is

known as a national debt which is defined as a total sum of government indebtness

accumulated over a period of time.

Causes of budget deficit

Government budget deficits in developing countries arise from two sets of causes:

(i) The structural factors determined by the type of economy and its relationship with

the external world.

(ii) The set of causes stems from the implementation of government expansionary

policies which may lead to sharp increases in expenditures. In some cases,

governments may lack the necessary fiscal discipline to control public expenditures.

In other situations government may have to increase spending to maintain levels of

income and employment when the private sector goes into recession.

We examine the reasons for fiscal deficits by looking briefly at the specific views of

Morrison (1982) relating to the structural determinants of budget deficits in developing

countries. This is followed by a closer examination of Tanzi's (1982) concept of fiscal

disequilibrium. Morrison argues that there are five major structural factors which explain

why some developing countries have larger budget deficits than others. These are as follows:

1. Governments at relatively low levels of development may be unable to control their

budgets because of "spending pressures" to improve education and infrastructure.

Further, the existence of low private savings and low tax revenues leads to a situation

where government feels justified in increasing public spending to satisfy public

expectations. A hypothesis of Morrison's study is that "the political pressures to spend

will outweigh the perceived inflationary costs of deficit financing" (Morrison 1982:

468). We believe that Morrisons "spending pressures" may apply to governments at any

level of development in developing countries. His emphasis on the low level of

development may not be required to support this argument.

2. The slow growth of revenues is an important structural cause of budget deficits. Slow

revenue growth means that the budget requires deficit financing.

3. Instability of revenues associated with export earnings means that an export shortfall

will cause a decline in revenue from export taxes. This argument is highly applicable to

petroleum export economies where corporation and export taxes are significant

components of revenue.

4. Government may find it difficult to control expenditures because of inefficient budgetary

systems.


5. Government’s heavy intervention in the economy increases the pressure on its budgetary

system to provide subsidies and transfers to public enterprises. The administrative costs

of government controls on prices and interest rates are also quite high.

Following Tanzi, a fiscal disequilibrium scenario can be described as a fiscal situation

where a particular pattern of fiscal behaviour or causation predominates. In the analysis of

developing countries, Tanzi identifies five dominant scenarios:

1. Export boom: Petroleum export-led economies can experience export slump fiscal

disequilibrium. Oil price movements have an impact on the governments domestic

budget deficit, that is, on the difference between domestic expenditure and domestic

revenue

2. Public enterprise: poor performance by public enterprises (see Howard, 1992). Many

are inefficient and are heavily subsidized

3. Inelastic tax system: the buoyancies of these systems was maintained only by heavy and

sustained discretionary tax changes. The income tax systems of many developing

countries are considered inelastic.

4. Terms of trade: The deterioration in terms of trade can be caused either by a sharp fall

in export prices or by increases in import prices which help to generate domestic

inflation.

5. Growth of public expenditure: the recurrent costs of welfare services, foreign debt

payments, and salaries of civil servants create a built-in tendency for permanent

expenditures to rise

Sources of public borrowing

The sources of public borrowing are as follows:

1. Individuals: who purchase government bonds and other securities

2. Commercial banks: which create an additional purchasing power through making

additional loans up to amount determined by the credit multiplier that is determined

by their excess cash reserve and the required reserve ratio.

3. Central bank: supports government loans in the money and capital markets. By

purchasing government bond the central bank credits the account of government.

4. External sources: individuals, institutions (IMF, World Bank etc.) and countries.

5. Non-Banking financial institutions such as insurance companies, investment trusts,

mutual savings banks etc.

Difficulties of public borrowings in developing countries include:

1. There are no or very small organised capital and money markets. The resources are

too inadequate to fulfil the capital needs of the economy.

2. Resources are hoarded in non-productive sections of the economy, for e.g., real

estate, jewellery.

3. The savings in rural areas cannot be mobilised effectively because rural incomes do

not move through monetary channels

4. The response to government securities is also poor because of rising prices.

8.2 Definition, classification, and purpose of public debt

8.2.1 Definition and classification

The debt at a given time is the sum of all past budget deficits thus is the cumulative excess

of past spending over past receipts. The debt is therefore a stock variable (measured at a

point in time), while budget deficits and surpluses are flow variables (measured during a

period of time).


Classification

Public debt can be classified as followed (Musgrave and Musgrave, 1984; Radhakrishnan,

2008):

(a) Internal and External: When a state finds that it is not possible to obtain further money

by taxation, it resorts to borrowing from citizens and financial institutions within the

country. This is ‘internal borrowing’. The state may accumulate funds by raising short-

term loans or long-term loans or by both. If the state is passing through a very critical

period, then it can borrow all the money which the nation saves. In that case trade and

industry will suffer a lot because no money is left to finance them. In the normal period,

however, the state can borrow only surplus funds which are left with the businessmen

after meeting all the needs of the business.

External loan is that which is raised from international money markets, foreign

governments, and from international agencies like International Monetary Fund. The

foreign governments do not advance loans without a limit. They study the budgetary

position of the borrowing country, the tax-bearing capacity of the nation, the per-capita

income of the people and the purpose for which the loan is desired. If the position of

the budget is sound and the taxable capacity of the nation is high, then a foreign

government may advance sizable loan to the borrowing country.

(b) Productive/reproductive and Unproductive: Productive debt; the debt that is expected

to create assets which will yield income sufficient to pay the principal amount and the

interest on it. In other words, they are expected pay their way; they are self-liquidating.

For instance, if a state borrows money for spending it on the construction of canals,

railways, factories, etc., it is then able to repay the loan from these self-liquidating

projects.

Unproductive debt is the debt that is raised for financing unproductive assets or heavy

unproductive expenditures. Such a debt is a deadweight debt. Debt invested on wars or

prevention of war is a deadweight debt.

(c) Short-term and Long-term: The loans that are repayable within a period of one year,

they are termed as ‘short-term loans’ and if they are taken for more than one year, they

are referred to as ‘long-term loans’. Following are the reasons for raising short-term

loans:

(i) If, at any time, the expenditure of the government exceeds the revenue, then she

takes recourse to short-term borrowing.

(ii) If, at any time, the rate of interest in the market is very high and the government is

in need of large fund to finance her various projects, then it raises loan for a short-

period of time only and waits till the prevailing high rate of interest comes down.

(iii)The commercial banks find a very safe and profitable opportunity to invest their

surplus funds in the government short-term loans.

If the government is in need of large funds and the short-term loans are not enough, then

she takes recourse to long-term borrowing. Long-term loans entail following advantages:

(i) Provides an opportunity to the state in undertaking large projects like construction

of canals, hydroelectric projects, buildings, highways, etc. As these loans are not to


be repaid at a short notice, so the government safely spends them on productive

projects.

(ii) Are unavoidable for strengthening country’s defence.

(iii)Provide good opportunity for commercial banks and insurance companies to invest

their surplus funds. As the rate of interest on long-term loans is higher than on the

short-term loans.

(iv) Can be repaid by the government by the time which is favourable or convenient to

her. She can also convert these loans at a lower rate of interest later on.

(v) If at any time, the rate of interest is low, the government can contract a long-term

loan and with the amount thus raised some public work programmes at lower cost.

(d) Deadweight Debt: Deadweight debt is one which is not covered by any real assets. In

the words of Hicks: “Deadweight is that which is incurred in consequences of

expenditures which in no way increase the productive power of the community, yielding

neither money revenue nor a future flow or utilities.” The loan raised during war period

is a deadweight debt because for such debts no real assets exist to balance them.

(e) Passive Debt: Sometimes government raises loans for spending on such projects which

neither yield money income nor help in raising the productivity of the country. They

simply provide enjoyments to the citizens such as public parks, museums, public

buildings, etc.

(f) Active Debt: Active debt is one which is spent on those projects that directly help in

yielding money income and increasing the productive power of the community.

(g) Funded Debt: Funded debts are long-term debts. The government continues paying the

annual interest on such loans but makes no promise to pay the principal sum to the lender

on any specified date. The examples of funded debts are long-term government stocks,

war loans and console.

(h) Floating or Unfunded Debt: Floating or unfunded debt comprises of short-term loans.

It is payable to the lender with interest on or before a fixed date.

8.2.2 Purposes of public debt

1. Bringing gap between revenue and expenditure through temporary loans from

central bank. The Government issues what are called ‘Treasury Bills’ which are

repayable within one year.

2. To reduce depression in the economy and financing public works programme.

3. Financing the public sector for expanding and strengthening the public enterprises.

4. Wage war and sustain it, arms and ammunition financing.

5. During calamities such as earthquakes, floods, famine etc.

6. Controlling inflation: by raising public debt, the government can withdraw a large

amount of money from the economy [withdrawing the purchasing power from the

public] and prevent prices from rising.

7. Borrow to accelerate economic growth and development

8. To undertake public welfare schemes

8.3 Burden, measurement and theories of public debt

8.3.1 Debt burden and measurement

If the debt is taken for productive purposes, for example, for irrigation, transportation,

railway, roads, information technology, and human skill development, it will not mean any


burden. In fact, they will confer a benefit. But if the debt is unproductive it will impose

both money burden and real burden on the economy.

(a) Burden of internal debt: Internal debt involves a series of transfers of wealth within the

country, i.e., from lender to government and then later on at the time of redemption from

government to lender. Money is thus transferred from one section of the community to

other sections. In this case the money burden on the economy is zero. But there may be real

burden on the community. In order to repay the interest and the principal amount of the

debt, the government has to levy taxes. What the taxpayers pay the lenders receive. The

lenders are generally rich people and tax burden is fall on poor especially in the case of

indirect taxes. The net result may be that the wealth is transferred from poor to rich. This is

the loss of economic welfare.

(b) Burden of external debt: External debt also involves a series of transfer of wealth from

the foreign lender to the borrowing country, and when it is repaid the transfer is in the

opposite direction. As the borrowing country paid interest to the foreign lenders, a direct

money burden is fall on the whole community. The community is also suffered from real

burden of external debts. Government has to cover the amount of interest to be paid to the

foreign lender by heavily taxing the income of the community. As a result the production,

consumption and distribution of income is badly affected. Moreover, the foreign lender has

direct involvement in the economic activities of the country.

The debt burden and the sustainability of the external debt of a country are measured using

the ratios of debt and debt service to various indicators of economic performance. If the

ratios are so high as to make a country unable to meet its contractual debt-service payments

without debt rescheduling, then the external debt is deemed unsustainable.

(a) Debt indicators; including maturity profiles, reimbursement schedules, sensitivity to

interest rates, and debt’s composition in foreign currency. Ratios of external debt or

exports to GDP are useful indicators to define debt’s evolution and reimbursement

capability. Within the context of considerable public sector indebtedness, the

relationship between debt and tax income is also relevant to ponder the country’s

reimbursement capabilities.

(b) Indicators on reserves sufficiency are very important in order to assess a country’s

capability to avoid liquidity crises. The relationship between reserves and short-term

debt is a key parameter to assess the vulnerability of countries with a considerable —

yet limited-access to capital markets.

(c) Financial soundness indicators are used to evaluate strengths and weaknesses of a

country’s financial sector. They encompass the capitalization of financial institutions,

assets quality and out-of-balance positions, profitability and liquidity, as well as credit

growth’s rhythm and quality. They are used to assess the financial system’s sensitivity

regarding market risks, for instance, interest rates fluctuation and exchange rates.

Given the effects of global crisis 2008-2009, national governments have had to come to the

rescue of various sectors of the economy, including the financial, whether the State has a

legal obligation to provide funding to meet these contingencies, or simply because

circumstances force them to do so. Contingent liabilities can lead to large increases in public

debt. In order to fulfill these needs, the international institutions, governments and the

academic sector, have developed different proposals to address the issue of vulnerabilities.


Debt burden indicators that are considered by International Financial Institution include:

(i) Debt-To-GDP Ratio: This is the most generally used indicator is the evolution of debt-

to-GDP ratio. This indicator measures the indebtedness level related to the country’s

economic activity. It implicitly assumes that all GDP resources are available to finance

the debt burden, which is not necessarily true. However, this indicator is recognized as

the most important one to measure the indebtedness degree, stressing the government’s

solvency capability. Also, several other indicators have been established using the

debt-to-GDP criterion:

(ii) Debt balance/domestic budgetary revenues: This indicator measures the indebtedness

level regarding the government’s payment capacity. It shows the number of required

years to pay the total debt balance. A constant debt-to-GDP ratio may produce different

outcomes, given that this ratio reflects the country’s size by showing the Government’s

possibilities to collect revenues compared to the debt burden.

(iii)Debt service/domestic budgetary revenue: This indicator measures the government’s

ability to pay the debt’s service with domestic sources. Debt service is the addition of

interest and capital. [Blanchard, Oliver, (1990), “Suggestions for a new set of fiscal

indicators”, OECD Working Paper No.79].

(iv) Current value/domestic budgetary revenue: This indicator measures the current cost

of debt’s service, compared with government’s payment capacity.

(v) Interests/GDP: This indicator shows how burdensome for the country interests are. It

can also be interpreted as the country’s possibilities to face unproductive expenditures.

(vi) Interests/domestic budgetary revenue: This indicator measures the financial costs as

a proportion of the tax revenue. This ratio is generally used as a measure of the public

income tolerance to an increase in unproductive expenditure.

(vii) Foreign debt/exports: This ratio measures the foreign debt level as a proportion of

exports of goods and services. It shows the debt burden level over exports or the

capability of acquiring currencies. This ratio must be used together with debt’s service

as a percentage of exports; a ratio comparing unproductive expenditures with the foreign

currency reserves.

(viii) Net International reserves/foreign debt: This ratio shows the number of times the

external liabilities exceed the reserves. This ratio is usually accompanied with foreign

debt as a percentage of reserve accumulation’s rhythm. If that is the case, it is interpreted

as the years required for the current foreign debt to be paid, keeping a constant

accumulation rhythm.

(ix) Amortization/external debt payments: This ratio measures the debt amortization level as

a proportion of the external debt payment. This indicator, understood as a revolving

ratio, shows when a country is refinancing its debt with new issue. If this ratio exceeds

100, debt is not refinanced with new debt.

(x) The ratio of the stock of debt to output (or exports of goods and services)

(xi) The ratio of actual debt service to exports (debt service/exports) which captures the

impact of debt-service obligations on foreign exchange cash flow

(xii) The ratio of scheduled interest payments to exports, which measures the ongoing

cost of the accumulated stock of debt

(xiii) The ratio of scheduled interest payments to government revenue. This measures the

country’s capacity to repay as scheduled


(xiv) The ratio of scheduled interest payments to government expenditure, which

measures the constraint imposed by debt servicing on the country’s ability to expand

other (current and capital) expenditures

There is no consensus among international organizations with respect to setting minimal

acceptable levels for these indicators. The following portrays the minimal suggested levels

for emerging countries, provided by two different international institutions:

Suggested Levels

Vulnerability

Indicator

International

Debt Relief *

[%]

International

Monetary

Fund** [%]

Debt/GDP 20 - 25 25 - 30

Debt service/income 28 - 63 25 - 35

Debt PV/Income 88 - 117 200 - 300

Interest /Income 4.6 – 6.8 7 - 10

Debt/Income 92 - 167 90 - 150

Sources: * Debt Relief International: “Key Aspects of Debt Sustainability Analysis”,

2007]. ** International Monetary Fund, Foreign Affairs Department: Technical Note

“Vulnerability Indicators”, April 30, 2003 and INTOSAI, November, 2010].

htt://intosai.org.

8.3.2 Theories of the Burden of the Debt

Why should we care about the national debt, and whether it is increasing or decreasing?

The future generations either have to retire the debt, or refinance it. Refinancing: refers to

borrowing new money to pay existing creditors/debt. In either case, there is a transfer from

future taxpayers to bondholders because even if the debt is refinanced, interest payments

must be made to new bondholders. It would appear, then, that future generation must bear

the burden of the debt. But this might not be the case. Merely because the legal burden is

on future generations does not mean that they bear a real burden. Just as in the case of tax

incidence, the chain of events set in motion when borrowing occurs can make the economic

incidence quite different from the statutory incidence. Just as with other incidence problems,

the answer depends on the assumptions made about economic behaviour.

The following are the Schools of thought about the burden of the debt:

Lerner’s View

Internal debt: Assume the government borrows from its own citizens such that the

obligation is an internal debt. According to Lerner (1948), an internal debt creates no burden

for the future generation. Members of the future generation simply owe it to each other.

When the debt is paid off, there is a transfer of income from one group of citizens (those

who do not hold bonds) to another (bondholders). However, the future generation as a

whole is no worse off in the sense that its consumption level is the same as it would have

been.

External debt: Suppose that the money borrowed from overseas is used to finance current

consumption. The future generation certainly bears a burden, because its consumption level

is reduced by an amount equal to the loan plus the accrued interest that must be sent to


foreign lenders. If, on the other hand, the loan is used to finance capital accumulation, the

outcome depends on the project’s productivity. If the marginal return on the investment is

greater than the marginal cost of funds obtained abroad, the combination of the debt and

capital expenditure actually makes the future generation better off. To the extent that the

project’s return is less than the marginal cost, the future generation is worse off. In the

Lerner’s model, a “generation” consists of everyone who is alive at a given time.

An Overlapping Generations Model

A more sensible way to define a generation is everyone who was born at about the same

time. Hence at any given time several generations coexist simultaneously, a phenomenon

that is taken into account in an overlapping generation’s model. Analysis of this model

shows how the burden of a debt can be transferred across generations (Rosen, 2008).

Assume that the population consists of equal numbers of young, middle-aged, and old

people. Each generation is 20 years long and each person has a fixed income of $11,000

over the 20-year period. There is no private saving (everyone consumes their entire income)

and the situation is expected to continue forever. Income levels for three representative

people for the period 2001 to 2021 are depicted in row 1 of table that follows.

Table 8.1: Overlapping Generations Model

The Period 2001 - 2021

____________________________________________

Young Middle-aged Old

(1) Income $11,000 $11,000 $11,000

(2) Government borrowing -6,000 -6,000

(3) Government-provided

Consumption 4,000 4,000 4,000

The year 2021

__________________________________________

Young Middle-aged Old

(4) Government raises taxes

to pay back the debt $-4,000 $-4,000 $-4,000

(5) Government pays back

the debt +6,000 +6,000

Source: Rosen, 2008

Now assume that the government decides to borrow $11,000 to finance public consumption.

The loan is to be repaid in the year 2021. Only the young and the middle-aged are willing

to lend to the government. The old are unwilling because they will not be around 20 years

to obtain repayment. Assume that half the lending is done by the young and half by the

middle-aged, so that consumption of each person is reduced by $6,000 during the period

2001 to 2021. This fact is recorded in row 2 of the table. However, with the money obtained

from the loan, the government provides an equal amount of consumption for all and each

person receives $4,000. This is noted in row 3.


With the passage of time and the arrival of the year 2021, the generation that was old in

2001 has departed from the scene. The formerly middle-aged are now old, the young are

now middle-aged, and a new young generation has been born. The government has to raise

$11,000 to pay off the debt. It does so by levying a tax of $4,000 on each group of persons.

This is recorded in row 4. With the tax receipts in hand, the government can pay back its

debt holders, the now middle-aged and old (row 5). Introducing a positive rate of interest

would not change the substantive result and means there is no need to discount future

consumption to find its present value. Hence the following results emerge:

➢ As a consequence of the debt and accompanying tax policies, the generation that

was old in 2001 to 2021 has a lifetime consumption level $4,000 higher than it

otherwise would have had.

➢ Those who were young and middle-aged in 2001 to 2021 are better off from the

point of view of lifetime consumption.

➢ The young generation in 2021 has a lifetime consumption stream that is $4,000 lower

than it would have been in the absence of the debt and accompanying fiscal policies.

In effect, $4,000 has been transferred from the young of 2021 to the old of 2001. The debt

repayment in 2021 involves a transfer between people who are alive at the time, but the

young are at the short end of the transfer because they have to contribute to repaying a debt

from which they never benefited. The internal-external distinction that was vital in Lerner’s

model is irrelevant here; even though the debt is all internal, it creates a burden for the

future generation.

The model suggests a natural framework for comparing across generations the burden (and

benefits) of government fiscal policies. This framework, known as generational accounting

by Auerbach, Gokhale, and Kotlikoff (1991), involves the following steps:

1. Take a representative person in each generation and compute the present value of all

taxes she pays to the government.

2. Compute the present value of all transfers received from the government, including

Social Security etc.

3. Compute the difference between the present value of the taxes and the transfers

which is the “net tax” paid by a member of that generation.

By comparing the net taxes paid by different generations, one can get a sense of how

government policy redistributes income across generations. Most calculations using this

framework suggest that current generations benefits at the expense of future generations.

Such calculations rest heavily on assumptions about future tax rates, interest rates, and so

on. Further, they do not allow for the possibility that individuals in a given generation may

care about their descendants as well as themselves. Thus, the main contribution of the

generation accounting framework is to focus attention on the lifetime (rather than annual)

consequences of government fiscal policies.

The intergenerational models discussed so far do not allow for the fact that economic

decisions can be affected by government debt policy, and changes in these decisions have

consequences for who bears the burden of the debt. Instead, it has been assumed that the

taxes levied to pay off the debt affect neither work nor savings behaviour. If taxes distort


these decisions, real costs are imposed on the economy. More importantly, we have ignored

the potentially important effect of debt finance on capital formation.

Neoclassical Model

This model of the debt stresses that when the government initiates a project, whether

financed by taxes or borrowing, resources are removed from the private sector. It is usually

assumed that when tax finance is used, most of the resources removed come at the expense

of consumption. On the other hand, when the government borrows, it competes for funds

with individuals and firms who want the money for their own investment projects. Hence,

it is generally assumed that debt has most of its effect on private investment.

If this is taken as true, debt finance leaves the future generation with a smaller capital stock,

holding other factors constant (including public sector capital stock). Its members therefore

are less productive and have smaller real incomes than otherwise would have been the case.

Thus, the debt imposes a burden on future generations through its impact on capital

formation. But if the public sector undertakes productive investment with the resources it

extracts from the private sector, the total capital stock increases.

The crowding out hypothesis (when the public sector draws on the pool of resources

available for investment, private investment is reduced) plays an important role. Crowding

out is induced by changes in the interest rate. When the government increases its demand

for credit, the interest rate, which is the price of credit, will increases. But if the interest rate

increases, private investment becomes more expensive and less of it is undertaken.

If you examine the historical relationship between the interest rate and government deficits

(as a proportion of gross domestic product) and find the correlation between the two

variables being positive, then the crowding out hypothesis is supported, and vice versa.

However, other variables can also affect interest rates. During a recession, for example,

investment decreases and hence the interest rate falls. At the same time, slack business

conditions lead to smaller tax collections, which increase the deficit ceteris paribus. Hence

the data may show an inverse relationship between interest rates and deficits, although this

says nothing about crowding out. The problem is therefore to sort out the independent effect

of deficits on interest rates. Elmendorf and Mankiw (1999) reviewed the econometric

studies of this issue, they found conflicting results.

Ricardian Model

Our discussion so far has ignored the potential importance of individuals’ intentional

transfers across generations. Barro (1974) has argued that when the government borrows,

members of the old generation realize that their heirs will be made worse off. Suppose

further that the old care about the welfare of other descendants and therefore do not want

their descendants’ consumption levels reduced. What can the old do about this?

One possibility is to increase their bequests by an amount sufficient to pay the extra taxes

that will be due in the future. The result is that nothing really changes. Each generation

consumes exactly the same amount as before the government borrowed. In effect, private

individuals undo the intergenerational effects of government debt policy so that tax and debt

finance are essentially equivalent. This view, that the form of government finance is

irrelevant, is often referred to as the Ricardian model.


Information on the implications of current deficits for future tax burdens is not easy to obtain

and it isn’t even clear how big the debt is. Another criticism is that people are not as

farsighted as they are supposed to be in the model.

If the Ricardian model was correct, one would have expected private saving to increase

commensurately, at the same time the deficit increase, however, private saving (relative to

net gross domestic product) may actually fall. While this finding is suggestive, it is not

conclusive because factors other than the deficit affect the saving rate. A number of

econometric studies have analyzed the relationship between budget deficits and saving

(Smetters, 1999). The evidence is rather mixed.

Is borrowing better than taxing?

Benefits-Received principle: This principle states that the beneficiaries of a particular

government spending programme should have to pay for it. Thus, to the extent that the

programme creates benefits for future generations, it is appropriate to shift the burden to

future generations via loan finance.

Intergenerational equity: Suppose that due to technological progress or oil discoveries, our

grandchildren will be richer than the current generation. It makes sense to transfer income

from the rich generation to the poor generation via loan finance. Of course, if future

generations are expected to be poorer than the present generation due, say, to the exhaustion

of irreplaceable resources, then this logic leads to just the opposite conclusion.

Efficiency considerations: From an efficiency standpoint, the question is whether debt or

tax finance generates a higher excess burden. The key to analyzing this question is to realize

that every increase in government spending must ultimately be financed by an increase in

taxes. The choice between tax and debt finance is a choice between the timing of the taxes.

With tax finance, one large payment is made at the time the expenditure is undertaken. With

debt finance, many small payments are made over time to finance the interest due on the

debt. The present values of the tax collections must be the same in both cases. If the present

values of tax collections for the two methods are the same, is there any reason to prefer one

or the other on efficiency grounds? Assume for simplicity that all revenues to finance the

debt are raised by taxes on labour income. Such a tax distorts the labour supply decision,

resulting in an excess burden of

½ wLt2

where is the compensated elasticity of hours of work with respect to the wage, w is the

before-tax wage, L is hours worked, and t is the ad valorem tax rate. Excess burden increases

with the square of the tax rate. Thus when the tax rate doubles, the excess burden quadruples.

Thus, from the excess burden point of view, two small taxes are not equivalent to one big

tax. Two small taxes are preferred. This point is made graphically in the following figure:


Excess

Burden

X2

X1

t1 t2 Tax rate (t)

Figure 8.1: The relationship between tax rate and excess burden

Source: Rosen (2008)

The figure depicts the quadratic relationship between excess burden and the tax rate. The

excess burden associated with the low tax rate, t1, is X1, and the excess burden associated

with the higher rate, t2, is X2. From an efficiency point of view, it is better to be taxed twice

at rate t1, than once at rate t2. The implication is that debt finance, which results in a series

of relatively small tax rates, is superior to tax finance on efficiency grounds (Elmendorf and

Mankiw, 1999).

This argument however, ignores the fact that to the extent the increase in debt reduces the

capital stock; it creates an additional excess burden. Thus, while debt finance may be more

efficient from the point of view of labour supply choices, it will be less efficient from the

point of view of capital allocation decisions. A priori it is unclear which effect is more

important, so we cannot know whether debt or tax finance is more efficient.

Thus, the “crowding out” issue, which was important in the intergenerational burden of the

debt discussion, is also central to the efficiency issue. According to the Ricardian model,

there is no crowding out. Thus, taxes distort only labour supply choices, and debt finance is

superior on efficiency grounds. However, to the extent that crowding out occurs, tax finance

becomes more attractive. Clearly, as long as the empirical evidence on crowding out is

inconclusive, we cannot know for sure the relative efficiency merits of debt versus tax

finance.

Macroeconomic considerations: Up to now, the assumption made is that all resources are

fully employed. This is appropriate for characterizing long-run tendencies in the economy.

But how does one choose between tax and deficit finance in the short run when

unemployment is possible? In the standard Keynesian macroeconomic model, the choice

depends on the level of unemployment. When unemployment is very low, extra government

spending might lead to inflation, so it is necessary to siphon off some spending power from

the private sector by increasing taxes. Conversely, when unemployment is high, running a


deficit is a sensible way to stimulate demand. This approach is sometimes referred to as

functional finance: use taxes and deficits to keep aggregate demand at the right level, and

don’t worry about balancing the budget per se.

Note that:

(a) If Barro’s intergenerational model is correct, people can undo the effects of

government debt policy. Government cannot stabilize the economy because

anticipated changes in policy have no impact. Unanticipated changes may have an

effect, because by definition, people cannot change their behaviour to counteract

them.

(b) Even in the context of the Keynesian model, there is a lot of uncertainty regarding

just how long it takes for changes in fiscal policy to become translated into changes

in employment. But successful unemployment policy requires that the timing be

right. Otherwise, one might end up stimulating the economy when it is no longer

required, thereby contributing to inflation.

Moral and political considerations: The decision between tax and debt finance could be a

moral issue. Too much reliance on deficits may reflect moral failing, a defect in the

formation of the public’s character and conservatisms (Will, 1985). Morality requires self-

restraint and deficits are indicative of a lack of restraint, hence deficits are immoral. This

view may help explain political attractiveness of using the surplus, if any, to pay down the

debt.

Ethical issues are critical in the formulation of public policy, so arguments that deficits are

immoral deserve serious consideration. Note that the argument rests on the hypothesis that

the burden of the debt is shifted to future generations. On the other hand, the benefits-

received principle implies that sometimes borrowing is the morally right thing to do.

A noneconomic argument against deficit spending is a politics. The political process tends

to underestimate the costs of government spending and to overestimate the benefits. The

discipline of a balanced budget may produce a more careful weighing of benefits and costs,

thus preventing the public from growing beyond its optimal size.

Note that:

1. Whether or not the burden of debt is borne by future generations is controversial.

One view is that an internal debt creates no net burden for the future generation

because it is simply an intergenerational transfer. However, in an overlapping

generation’s model, debt finance can produce a real burden on future generations.

2. The burden of the debt also depends on whether debt finance crowds out private

investment. If it does, future generations have a smaller capital stock, and hence,

lower real incomes, ceteris paribus. In a Ricardian model, voluntary transfers across

generations undo the effects of debt policy, so that crowding out does not occur.

3. Several factors influence whether a given government expenditure should be

financed by taxes or debt. The benefits-received principle suggests that if the project

will benefit future generations, then having them pay for it via loan finance is

appropriate. Also, if future generations are expected to be richer than the present

one, some principles of equity suggest that it is fair to burden them.

4. From an efficiency standpoint, one must compare the excess burden of tax and debt

finance. If there is no crowing out, debt finance has less of an excess burden, because

a series of small tax increases generates a smaller excess burden than one large tax

increase. And the reverse is true if crowding out occurs.


8.4 Effects, management, financing and sustainability of public debt

8.4.1 Effects and consequences of public debt

The effects of public debt on production, consumption, distribution and level of income and

employment are as follows:

1. Effects on Production: Public debts are raised to finance productive enterprises of

various kinds, e.g., steel works, cement, multipurpose projects, construction of ships,

railway lines and highways, heavy electrical and engineering works, mining, oil

refining, etc.

2. Effects on Consumption: When people subscribe to government loans, they

generally have to curtail consumption. Since investment of funds raised by

borrowing raises the level of employment and as a result raises the level of

consumption.

3. Effects on Distribution: Public loans transfer money from rich to government. The

fiscal operations of the government are to benefit the poor primarily. The incomes

of the poor increase directly through increased employment or it benefit them

indirectly through the enlargement of social services. Change the distribution of

income is also attained as interest payments on the debt are financed from taxation.

4. Effects on the Level of Income and Employment: In modern times, public borrowing

is resorted to in order to raise funds for financing agriculture, industry, mining,

transportation, communication, etc. It increases employment opportunities, the level

of income and standard of living.

5. Reduce availability of funds for private sector which will result in a welfare loss if

the return on the funds used in the private sector is greater than in the public sector.

6. If loan is external, there is a potential loss of social welfare because then its

repayments and interest charge mean that society has to consume less than it has

produced. If external borrowing is used to create assets which expand the economy’s

productive capacity, then in the long run, there may be a gain rather than a loss in

welfare.

7. Government borrowing may be more inflationary than tax finance. This is because

raising taxes reduces disposable incomes and so curbs consumption spending which

offsets, to some extent, the rise in government spending.

Consequences of public debt

1. Impact on fiscal adjustment: huge public debt undermines the effectiveness and

sustainability of an otherwise credible reform programme. For instance, due to the

need to raise more revenues for debt repayment and servicing, a sizable public debt

may hinder a requisite reduction in tax rates on some tax bases to increase the

efficiency of the tax system.

2. Current and future resources to enhance economic potential and growth are limited

due to increased debt servicing requirements

3. Effect on private and public investment: investors may interpret these as threats to

the ability to sustain reforms and also as a basis for future tax increases to meet debt

servicing requirements

4. Servicing rapidly growing stock of debt crowds out other expenditures:


(i) Servicing rising debt ratios absorbs a significant share of public revenues and

expenditure and limits resources available for investment in social and

human development such as education, health, water, and infrastructure.

(ii) This implies reduced availability of resources for supporting renewal growth

Non-restoration of growth worsens solvency problems leading to vicious

cycle.

5. Composition of investment: debt overhang tend to skew investment toward;

(i) Short-term investments in trading activities with quick returns rather than in

high-risk investment in production

(ii) Flight capital tends to be held in liquid assets such as treasury bills and

foreign currency denominated assets in domestic banks rather than in capital

assets

6. Places unfair burden to the future generation who have to pay. For this to happen, it

is assumed that the current generation does not reduce its savings and that the

government does not add to the capital stock and productive capacity of the country.

8.4.2 Debt management and sustainability in Africa: Policy Issues

According to Blommestein and Horman (2007):

(a) Debt levels are still a problem: Over recent years, a number of countries have

benefited from external debt relief under multilateral debt relief initiatives. That said,

in many countries, debt levels are still a problem, especially in view of structural

vulnerabilities. Similarly, after debt relief, risk-based debt sustainability needs to

remain a focus of debt strategy, supported by sound macroeconomic policies.

(b) Foreign-currency debt predominates, and local-currency debt is mainly short-

term: Foreign-currency debt predominates in African countries. This situation is

typically a consequence of a reliance on concessional multilateral and bilateral

funding and rudimentary domestic markets, but some African countries now have

good access to the international capital markets or have begun to develop their

domestic markets. Local-currency debt is predominantly short-term (Figure 3), but

some countries successfully issue across the yield curve and out to long tenors. The

issuance of local-currency debt in some countries is erratic and in small volumes,

leading to problems in developing fungible and liquid instruments and benchmarks.

These considerations raise the question of what are the priorities and appropriate

policies for developing market-based funding.

(c) Domestic market needs to be developed: Local commercial banks tend to be the

main holders of domestic securities. This reflects weaknesses in the commercial

lending operations and, in some cases, excessive requirements to hold government

securities. Some countries, however, have relatively vibrant pension funds and other

institutional investors, which encourages more diverse ownership. Non-resident

holdings are typically low. Domestic market infrastructure, including settlement and

custody systems, is often weak. These considerations raise the question of what

priority should be given to developing the domestic market and investor base and

the correct sequencing of steps for doing so.

(d) Local-currency debt is relatively costly but minimizes exchange rate risk: Interest

payments on local-currency debt often consume a larger share of revenues than those

on foreign currency debt, even though foreign-currency debt predominates in

nominal terms. This is because local-currency debt is more costly than foreign-


currency debt, reflecting the availability of externally sourced funding on

concessional terms and high real interest rates in the domestic market. The policy

question arises concerning the appropriate balance between minimizing cost and

minimizing risk, in particular taking account of the major risks (interest rate,

exchange rate, and refinancing) and possibility of other budgetary shocks, such as

from a sudden drop-off in aid inflows.

(e) Quasi-government debt is a common feature: Quasi-government debt is a feature

in many African countries. For instance, some central banks issue their own bills to

manage liquidity or implement monetary policy. This may be a consequence of an

absence of a sufficient supply of government securities, but the question arises

whether the existence of central bank bills impedes the development of the

government securities market. Similarly, there may be pricing anomalies or

fragmented liquidity when government securities and central bank bills co-exist.

Some debt of state-owned enterprises, other government agencies, or even the

private sector is guaranteed as well. With some exceptions, guarantees are not well

managed or accounted for in African countries, albeit that situation is not unique to

Africa.

(f) Institutional frameworks are often weak: Turning to institutional problems and

issues, African countries generally have explicit legal requirements governing debt

contracting and servicing, but the framework is not always clearly defined and

adequately implemented. The legal requirements for transparency and accountability

are often limited. The resources available to debt management are constrained in

many countries, again a situation not unique to Africa. This includes the quantity of

staff, their skill levels, and technological resources for managing the debt stock and

new debt issuance on a professional basis.

(g) Debt management has links with fiscal and monetary policy: Given the

interdependencies between their different policy instruments, it is important that

debt managers, fiscal policy advisers, and central bankers share an understanding of

the objectives of debt management, fiscal, and monetary policies. The role of central

banks is of special relevance for Africa, where many debt management activities

continue to be performed by central banks.

(h) Good governance is important: The specific institutional structure for debt

management is less important than ensuring that there is good governance and that

there are forward-looking policies focused on risk-based debt sustainability. It is

worth noting, however, that institutional responsibilities are often fragmented across

front and back office functions, across local-currency and foreign-currency debt, and

across agencies in Africa countries. In several countries, the focus of debt

management as a distinct activity is still heavily on debt recording and servicing.

The middle office functions of debt strategy formulation and risk management are

often absent. All these factors impede taking an integrated approach to debt

management. Co-ordination between debt management and macroeconomic policies

is often weak.

(i) Formal debt strategies should be developed: Some African countries have

developed formal debt strategies. A formal strategy explicitly balances cost and risk,

takes account of demand constraints but often incorporates initiatives to develop the

market and new funding sources, and supports macroeconomic stability and debt

sustainability. For most African countries, though, debt strategy remains ad hoc.

Admittedly, the range of funding sources is often narrow, and discretion in terms of

the risk characteristics of new debt may be limited. The critical issue here is that


opportunities may be missed, at the margin, to improve the structure of the debt or

widen the range of funding sources. For countries that have benefited from debt

relief, the lack of a formal debt strategy increases the risk of a return to an

unsustainable debt position in future.

Conclusions on Debt management in Africa (Blommestein and Horman, 2007):

(a) Sound debt management reduces the cost and risk of debt: Sound debt

management practices and robust securities markets can help reduce the cost of

managing public debt and maintaining it at sustainable levels. Prudent debt

management, fiscal, and monetary policies can reinforce one another in helping to

reduce the risk premium in the structure of long-term interest rates. Borrowing limits

and sound risk management practices can help to protect the government’s balance

sheet from debt servicing shocks.

(b) International standards have become of greater importance: International

standards in public debt management and related market operations have become of

greater importance to African debt managers. They have introduced the leading debt

management practices of OECD countries; have made impressive progress in

Government Debt Management and Bond Markets in Africa developing their local

government securities markets, and are taking advantage of debt reduction

initiatives. An important challenge for many African countries is to avoid falling

back into positions of unsustainable debt.

(c) An integrated view on debt management is desirable: The division of work for debt

management functions across agencies, including the central bank, is less important

than ensuring that all the functions (strategy formulation, auctions and other methods

of issuance, risk management, debt recording and servicing, and so on) get done as

professionally as possible. An integrated view on debt management is desirable.

Concentrating debt management activity in one agency may facilitate that, and

separation of debt management from the central bank would be consistent with that.

African countries, however, are likely to need to rely on central banks to perform

some functions over the near and medium term. To that end, clear agency

agreements and delineations of responsibilities and decision rights are essential.

(d) Strengthening debt management should be an ongoing process: Strengthening

debt management should be undertaken as an ongoing process, not a one-off

exercise. It also needs to be seen as part of a country’s wider monetary and fiscal

development. High-level policy makers have to be brought on board. The delivery

of technical assistance to-date has not been uniformly effective and has often lacked

good coordination across providers.

Factors necessary for breaking the debt vicious cycle:

1. Improve governance and resolve conflict: poor governance and civil unrest is one of

the major causes of the spiralling public debt in SSA. This is via the effects of

conflict on economic performance and acquisition of military related debt to assist

in “stamping” out rebel insurgents.

2. Invest in people: investment in education and health is critical to human

development and productivity both of which lead to growth and reduced dependence

on donor aid.

3. Increase competitiveness and diversify economies: to ensure increased export

earnings for debt servicing and repayment.


4. Macroeconomic stability to ensure that these efforts take root and lead to

sustainable growth: including inflation control, exchange rate stability which

increases investor confidence leading to increased domestic investment and foreign

direct investment.

5. Measures which address fiscal solvency concerns: including fiscal consolidation and

restrained/prioritized government expenditures

6. Enhance public debt management: Articulation and formulation of policy for

external borrowing, control and surveillance of external borrowing, and keeping

comprehensive and accurate data on external borrowing

8.4.3 Financing and sustainability of public debt [Redemption]

The ability-to-pay approach refers to a situation in which a country is unable to meet its

current debt servicing requirements, directly or through further borrowing. LDCs face an

ability-to-pay problem i.e. required debt service exceeds their debt-servicing capacity. The

willingness-to-pay approach, which focuses on the case where the borrower has the

resources for repayment but finds it optimal not to repay

Debt redemption refers to ending a debt obligation. After the debt crisis of 1982, it became

clear to debtor countries, creditors, and multinational organizations, such as IMF and the

World Bank that full repayment of the developing country debt was no longer realistic and

policy makers started to think about debt reduction schemes as a possible solution to the

debt crisis. Types of debt reduction schemes:

1. Unilateral debt forgiveness, but has free rider problems where some creditors forgive

debt and others don’t forgive debt but benefit from debt forgiveness of others in terms

of increased capacity of debtor country to service unforgiven debts

2. Third-party debt buy-backs: A third-party debt buy-back consists in purchases of

developing country debt at secondary market prices by a third party, such as the World

Bank, the IDB, or the IMF, with the purpose of reducing the debt burden of such

countries

3. Debt swaps: A debt swap consists in the issuance of new debt with seniority over the

old debt. The new debt is then used to retire old debt. It is important that the new debt

is made senior to the existing debt. This means that at the time of servicing and paying

the debt, the new debt is serviced first.

4. Utilization of surplus revenue: This is an old method and badly out of tune with the

modern conditions. Budget surplus is not a common phenomenon. Even when there is

a surplus, it cannot be used for making any substantial reduction in the public debt.

5. Purchase of government bonds: The government may buy her own stocks in the market,

thus wiping off its obligation to that extent. This may be done by the application of

surplus revenues or by borrowing at low rates, if the conditions are favourable.

6. Terminable annuities: When it is intended completely to wipe off a permanent debt, it

may be arranged to pay the creditors a certain fixed amount for a number of years. These

annual payments are called ‘annuities’. It will appear that, during the time these

annuities are being paid, there will be much greater strain on the government finances

than when only interest has to be paid.


7. Conversion of high-interest-rated loans to low-interest-rated loans: A government may

have borrowed when the rate of interest was high. Now, if the rate of interest falls, it

can convert a high-rated loan into a low-rated one.

8. Sinking fund: This is the most important method. A fund is created for the repayment

of every loan by setting aside a certain amount every year out of the current revenue.

The sum to be set aside is so calculated that over a certain period, the total sum

accumulated, together with the interest thereon, is enough to pay off the loan.

9. Repudiate the debt i.e. refuse to pay. But could also be that inflation has reduced its

value in real terms since the par value of outstanding debt is fixed. The problem is that

the government will find it difficult to borrow in the future at a reasonable rate, and it is

financial blow to those creditors who had invested their savings in government debt and

those who receive interest as their income.

10. Refund: convert the existing debt into a new one of longer maturity i.e. holders purchase

a new loan.

11. Debt relief: Lowers credit rating of the country.

12. Debt cancellation: Lowers credit rating of the country.

13. Debt rescheduling; Lowers credit rating of the country.

14. Compulsory reduction in the interest rate. Happens when a government is confronted

with a financial crisis.

15. Capital levy: imposes an all at once tax on all capital value possessions of the people.

A minimum limit of value is first determined beyond which a tax is imposed.

16. Monetization: all the matters concerning public debt are dealt with by the banks in such

manner that it results in an increase in total money supply in the economy.

8.5 Overview of external debt in Africa

Africa's over-indebtedness is not attributable merely to poor governance, rapacious and

corrupt leaderships, protracted civil wars in too many countries on the continent; but also

no democratic checks and balances on government borrowing and spending, excessive

population growth, and the stubborn pursuit of economic policies which contributed to the

relentless impoverishment of a rich continent for over two decades. All of these factors have

indubitably played a major part. But Africa's debt crisis has been severely exacerbated by

several other reasons as well (Mistry, 1992), including:

1. Thoughtless and irresponsible over-lending by private and official creditors, during the

commodity boom of the 1970s, without which irresponsible over-borrowing by African

governments on this scale could not possibly have occurred.

2. The persistence of negative real interest rates during most of the 1970s in global

financial markets caused by lax monetary and fiscal policies in industrial countries

which made it economically rational for developing countries to borrow externally

(rather than save or attract equity investment) for development and consumption.

3. The targeting of developing countries in general and oil-exporting countries in

particular, as major export markets to be provided with too-easy credit to facilitate the

adjustment of industrial countries to the two oil-shocks (of 1973 and 1979).

4. The global monetary shock of1979-81, which aimed at ridding the world of inflation but

had the collateral impact of inducing a deep and long recession, particularly in debt-

ridden developing countries where the recession lasted for 70 months instead of 16 in

the OECD world, and which caused commodity markets and prices to collapse.

5. Over-reliance on external savings between 1979-83 by African governments'

unwillingness to increase domestic savings and cut domestic consumption in the


erroneous belief [encouraged in some instances (e.g. Zambia) by the international

financial institutions - IFls] that the commodity price collapse would be short-lived.

6. A prolonged and devastating drought between 1981-84 which severely impaired the

continent's agricultural and cash crop production and resulted in extensive damage to

output and to the financial structure of Africa’s fragile economies.

7. The emergence of high, positive real interest rates throughout the 1980swhich

compounded Africa's debt servicing and debt accumulation burdens. The unexpected

rise in the world interest rates in the early 1980s worsened the debt situation of LDCs.

This is because; much of the debt carried a floating rate. Thus, debt service increased

rapidly and unexpectedly in the early 1980s.

8. Volatile exchange rate movements throughout the 1980s with US dollar depreciation

between 1985-90 resulting in increasing the dollar value of Africa’s outstanding debts,

over a half of which were denominated in currencies or composites which appreciated

against the US dollar. A policy of fixed exchange rate coupled with overvalued currency

exacerbated current account deficits. Households expanded purchases of imported

goods, especially durables such as cars and electro-domestics.

9. Repeated official and private rescheduling, often on punitive terms in the early years of

the debt crisis, which resulted in further increasing the outstanding level of debt while

providing temporary, but totally insufficient, cash-flow relief.

10. Poor and impractical advice by International Financial Institutions [IFls] and official

creditors on the extent of debt relief African governments needed to negotiate and how

they might adjust, coupled with poor management by the same governments of external

debt records, policies and priorities resulting in several missed opportunities to improve·

their situations.

11. The building up of egregious arrears which creditors have tolerated to a point of doing

more damage to restoring disciplined debtor-creditor relationships than if more sensible

action to reduce debt and debt service burdens had been taken by them in the first place.

12. Protectionism in the world's markets for agricultural products and low technology

manufactures, which makes it particularly difficult for African countries to diversify and

increase exports to hard currency markets, thus making it doubly difficult for them to

earn their way out of the debt trap.

Internal factors causing debt crisis:

13. Lack of restraint on the part of governments and borrow to cover budget deficits.

14. Unwise investments i.e. unproductive investments (White elephants)

15. High levels of consumption in relation to the country’s resources

16. Excessively valued currencies and insular commercial policies distorted domestic price

system resulting in economic imbalances with growing budget and current account

deficits.

17. Unpopularity of the taxation: since people do not like paying taxes the government goes

for an easier method which is borrowing.

18. Inefficiencies of public organizations and corruption

The reasons for the slow rate of progress for rapid and large-scale debt reduction

programmes for Africa and low-income Africa (Mistry, 1992) include:

1. Perennial (and unjustified) concern on the part of creditors, especially commercial

banks, that debt reduction for Africa on the scale necessary - no matter how justified it

might be - would serve as a precedent for similar action to be taken elsewhere and thus

weaken the bargaining position of banks in exerting pressure to maintain debt service

flows from the developing world at unrealistically high levels.


2. The unfortunate reality that National Treasuries continually ride roughshod over the

more intelligent, knowledgeable and sensitive views of their counterparts in aid

ministries.

3. Concern on the part of creditor governments and of some people in the IFls, that debt

reduction would further exacerbate “moral hazard" by rewarding bad policies and

behaviour on the part of debtors.

4. The popular belief that debt reduction would release the pressure on forcing a more

disciplined approach to overall resource management in African countries.

5. Rather than helping disabled economies to recover debt reduction would only serve to

line, to an even greater extent than now, the pockets of corrupt African leaders and civil

servants in countries where graft has now become endemic.

6. African governments have been insufficiently enthusiastic about embracing donor-

advocated structural adjustment and policy reform prescriptions to justify large scale

debt reduction.

8.6 Principles and Imppact Princlpe of analyses of the HIPC initiative

1. According to Arslanalp and Henry (2006), the G-8 countries in 2005, requested called

on the International Monetary Fund (IMF), the World Bank and the African

Development Bank to cancel 100 percent of their debt claims on the world's poorest

countries. The aim was to stimulate economic growth in highly indebted countries. In

the 1980s, debt relief under the "Brady Plan" helped to restore investment and growth

in a number of middle-income developing countries Arslanalp & Henry (2006). But

Arslanalp and Henry (2006), argues that the debt relief plan for the HIPC by the World

Bank and the IMF in 1996 had little impact on either investment or growth in the

recipient countries.

2. Reinhart and Trebesch (2016), report that the economic landscape of debtor countries

improves significantly after debt relief operations, but only if these involve debt write‐

offs. Softer forms of debt relief, such as maturity extensions and interest rate reductions,

are not generally followed by higher economic growth or improved credit ratings

(Reinhart and Trebesch, 2016).

3. Djimeu (2018), argues that between 1996 and 2014, thirty Sub-Saharan African (SSA)

countries benefited from debt relief under the Heavily Indebted Poor Countries (HIPC)

initiative and the Multilateral Debt Relief Initiative (MDRI). The aim was to spur growth

and investment. The study found impact of MDRI and HIPC initiatives to be higher in

countries with low access to international capital markets. There was no effect of the

original HIPC initiative or MDRI on growth, private investment, public investment or

foreign direct investment. There was also no impact of the enhanced HIPC initiative on

growth and foreign direct investment by level of indebtedness, access to international

capital markets, or institutional quality (Djimeu, 2018). The study recommended that

strong improvement in institutional quality if debt relief is to improve investment and

growth in African economies. If this not possible in the short run, the goal of debt relief

should be to support public investment (Djimeu, 2018). (See also, De Talancé, Ferry, &

Niño-Zarazùa, 2019).

Basic Readings:

Rosen and Gayer, Chapter 20


Howard, M. M., A. La Foucade & Scott, Chapter 10

Hindriks and Myles, Chapter 4

Other Readings

Auerbach, G. Gokhale, J. and Kotlikoff, L. J. (1991). General Accounts: A meaningful

alternative to deficit accounting. In Bradford (1991), Tax Policy and the Economy, Volume

5. The MIT Press. http://www.nber.org/chapters/c11269

Elmendorrf, D. W. and Mankiw, G. N. (1999). Government Debt. NBER Working paper

No. 6470.

Alfaro, L. & F. Kanczuk (2017) “Debt Redemption and Reserve Accumulation” Working

Paper 13-074

Alfaro, L. & F. Kanczuk (2019) “Undisclosed Debt Sustainability” NBER Working Paper

20-043

Arslanalp, S., & Henry, P. B. (2006). Policy watch: debt relief. Journal of Economic

Perspectives, 20(1), 207-220. https://ideas.repec.org/a/aea/jecper/v20y2006i1p207-

220.html

Arslanalp, S., & Henry, P. B. (2006). Policy watch: debt relief. Journal of Economic

Perspectives, 20(1), 207-220.

Augustin Kwasi Fosu A. K., (2010), “The External Debt-Servicing Constraint and Public-

Expenditure Composition in Sub-Saharan AfricaAfrican” Development Review 22(3): 378–

393.

Barro, R. J. (1974). Are Government Bonds Net Wealth? Journal of Political Economy. 82:

1095 – 1117.

Blommestein, H. J. and Horman, G. (2007). Government Debt Management and Bond

Markets in Africa. https://www.researchgate.net/publication/227356943

Cassimon D., Campenhout B. V., Ferry M. and M. Raffinot (2015),“Africa: Out of debt,

into fiscal space? Dynamicfiscal impact of the debt relief initiatives onAfrican Heavily

Indebted Poor Countries (HIPCs)” International Economics 144: 29–52.

De Talancé, M., Ferry, M., & Niño-Zarazùa, M. (2019). Did Debt Relief Initiatives help to

reach the MDGs? A Focus on Primary Education . Forthcoming in Journal of Comparative

Economics.

De Talancé, M., Ferry, M., & Niño-Zarazùa, M. (2019). Did Debt Relief Initiatives help to

reach the MDGs? A Focus on Primary Education . Forthcoming in Journal of Comparative

Economics.

Djimeu, E. W. (2018). The impact of the Heavily Indebted Poor Countries initiative on

growth and investment in Africa. World Development, 104, 108-127.

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https://www.researchgate.net/publication/227356943


Du, W., C. E. Pflueger & J. Schreger (2019) “Sovereign Debt Portfolios, Bond Risks, and

The Credibility Of Monetary Policy, NBER Working Paper No. 22592

Gupta, S. Jalles, J. T. C. Mulas-Granados, M. Schena. (2017). “Governments and Promised

Fiscal Consolidations: Do They Mean What They Say?” Chapter 2. Gasper, V., S. Gupta,

and C. Mulas-Granados, eds. Fiscal Politics. Washington, DC: IMF.

Hébert, B. (2016) “The Cost of sovereign Default: Evidence from Argentina NBER

Working Papers 22270

Karlan, D., S. Mullainathan and B.N. Roth (2017), “Debt Traps? Market Vendors and

Moneylender Debt in India and the Philippines” NBER Working Paper Series, No. 24272

Lawanson A. O. (2014) Impact of External Debt Accumulation and Capital Flighton

Economic Growth of West African Countries” AERC Research Paper 279, African

Economic Research Consortium, Nairobi.

Lerner, A. P. (1948). The burden of the National Debt. In Income, Employment, and Public

Policy: Essays in Honour of Alvin H. Hansen. L. A. Metzler et al. (eds). New York: W.W.

Norton.

Mistry, P. S. (1992). African Debt Revisited: Procrastination or Progress? The Hague:

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omplete.pdf

Nautet, M., & Van Meensel, L. (2011).Economic impact of the public debt. Economic

Review 2: 7-19.

Ncube M. and Z.Brixiov (2015), “Public Debt Sustainability in Africa: BuildingResilience

and Challenges Ahead” Development Policy Review 33(5): 555-580.

Oguso, A., F.M. Mwega, N.H.W. Wawire, and P. Samanta. (20118). “Analysis of Budget

Imbalance Dynamics in Kenya.” Journal of Economics and Public Finance 4, no. 4 (2018):

352-377. www.scholink.org/ojs/index.php/jepf.

Panizza, U., & Presbitero, A. F. (2014). Public debt and economic growth: is there a causal

effect? Journal of Macroeconomics 41: 21-41.

Reinhart, C. M., & Trebesch, C. (2016). Sovereign debt relief and its aftermath. Journal of

the European Economic Association, 14(1), 215-251.

Rosen, H. S. and Gayer, T. (2008). Public Finance. Eight Edition. New York: McGraw-

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http://www.scholink.org/ojs/index.php/jepf


ACKNOWLEDGEMENTS

The African Economic Research Consortium (AERC) wishes to acknowledge and express

its immense gratitude to the following resource persons, for their tireless efforts and valuable

contribution in the development and compilation of this teaching module and other

associated learning materials.

1. Dr. Miguel Niño-Zarazúa, UNU-WIDER, Helsinki, Finland. (Email:

[email protected]; [email protected]);

2. Prof. Nelson W. Wawire, Kenyatta University, Kenya. (Email:

[email protected]; [email protected]);

3. Prof. Godius Kahyarara, University of Dar es Salaam, Tanzania. (Email:

[email protected]);

4. Dr. William Bekoe, University of Ghana, Ghana. (Email: [email protected];

[email protected]).

Thank you.

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