collaborative masters programme
TRANSCRIPT
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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)
Website
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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
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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
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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
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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.
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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
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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.
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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:
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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
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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:
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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.
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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
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➢ 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
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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−− ,
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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
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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
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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
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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*
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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)
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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.
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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.
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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.
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(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
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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
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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
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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.
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(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)
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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
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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.
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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
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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
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“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
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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
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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
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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
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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)
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LESSON THREE: THEORY OF OPTIMAL TAXATION
By the end of the lesson, you should be able to:
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.
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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:
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• 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
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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 // =
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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.
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(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
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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.
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LESSON FOUR: TAX EVASION AND AVOIDANCE
By the end of the lesson, you should be able to:
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.
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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
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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
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= 𝜕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:
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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.
.
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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.
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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
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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)
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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)
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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.
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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.
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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)}
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𝜕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.
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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)
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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
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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.
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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.
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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.
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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)
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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.
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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.
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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%.
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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%.
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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.
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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
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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
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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.
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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
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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:
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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)
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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
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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.
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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,
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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.
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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,
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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
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➢ 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
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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
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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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United Nations (1996). Informal Sector Development in Africa. UN, New York.
Vishwanath, T. (2001). Informal Economy: Safety Valve or Growth Opportunity. Paper
presented at the Linking Work, Skills, and Knowledge: Learning from Survival and
Growth International Conference, 10-12 September 2001, Interlaken, Switzerland
Walker, M.B. & Sennoga, E.B (2007). Does Tax Evasion influence the composition of tax
instruments? Examining the effect of tax evasion on tax structure
Xaba, J., Horn, P. and Motala, S. 2002. The informal sector in sub-Saharan Africa.
ILO Working Paper on the Informal Economy, No.2002/10.
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Balan, J., Browning, H. L., & Jelin, E. (1973). Men in a developing society. Institute of
Latin American Studies, Austin, TX: University of Texas Press.
Barr, A., & Packard, T. (2000). Revealed and concealed preferences in the Chilean pension
system: an experimental investigation. Oxford Department of Economics Discussion
Paper: 53, Oxford University.
Davila Capalleja, E. (1994). Regulationes laborles y mercado de trabajo en Mexico. In
Marquez Gustavo (Ed.) Regulacion del Mercado de Trbajo en America Latina. San
Francisco: Centro International para el Desalloro Economico.
Maloney, W. F. (2004). Informality Revisited. World Development Vol. 32, No. 7, pp.
1159-1178, 2004.
Morduch, J. (1999). Between the market and state: Can informal insurance patch the safety
net? World Bank Research Observer, 14, 187-207.
Robles, M., Saavedra, J., Torero, M., Valdivia, N., & Chacaltana, J. (2001). Estrategia y
racionalidad de la pequena empresa, Lima, International Labor Organization.
Cunningham, W., & Maloney, W. F. (2001). Heterogeneity in the Mexican micro-enterprise
sector: An application of factor and cluster analysis, Economic Development and
Cultural change, 5, 131-156.
Fields, G. S. (1990). Labor Market Modelling and the Urban Informal Sector: Theory and
Evidence In: OECD, The informal Sector Revisited. Paris, France.
Hart, K. (1972). Employment, income and inequality: a strategy for increasing productive
employment in Kenya. Geneva: International Labor Organization.
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LESSON FIVE: TAX POLICY, STRUCTURE AND ADMINISTRATION
By the end of the lesson, you should be able to:
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
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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
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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
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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)
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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.
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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
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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
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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.
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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
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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.
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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.
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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).
Gupta, S. Plant, M. Strengthening Revenue Performance in Africa Requires Tough Political
Decisions, 2019. https://www.cgdev.org/blog/strengthening-revenue-performanceafrica-
Requires-tough-political-decisions.
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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
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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
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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
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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.
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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?
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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.
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Source adopted in the Economics of Public Sector by Stiglitz and Rosengard, 2005).
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
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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*.
Source adopted in the Economics of Public Sector by Stiglitz and Rosengard, 2005).
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
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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.
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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.
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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
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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
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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.
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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
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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).
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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
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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
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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?
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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.
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LESSON EIGHT: PUBLIC DEBT
By the end of the lesson, you should be able to:
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.
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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).
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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
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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
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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.
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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
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(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
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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.
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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
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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.
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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:
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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
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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.
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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:
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(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-
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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
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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.
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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.
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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
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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.
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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
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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
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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:
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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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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:
http://www.fondad.org/product_books/pdf_download/27/African_Debt_Revisited_BookC
omplete.pdf
Nautet, M., & Van Meensel, L. (2011).Economic impact of the public debt. Economic
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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
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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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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:
4. Dr. William Bekoe, University of Ghana, Ghana. (Email: [email protected];
Thank you.
Website
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