5 Indirect Taxation[1]

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Master of Public Administration & Public

ManagementSubject: M.P.A 6104 Public Sector

Economics and Finance

Lecture : 5Indirect Taxation in Developing Countries

Dr. K. Amirthalingam

Senior LecturerDepartment of Economics

University of Colombo

2013

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Indirect tax revenue (% of Total Taxes)

Country1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2011

Sri Lanka 88 86 85 84 86 85 83 85 81 79 81 81

Canada 28 29 29 27 26 24 28 26 23 .. 23 23

USA 02 02

Thailand .. .. .. .. .. .. .. 61 56 52 58 54

Malaysia 57 53 56 54 40 35 38 .. .. .. 33 30

Korea, Rep 60 60 61 63 59 62 63 59 56 .. 58 55

India 81 77 71 70 68 64 62 57 53 48 44 44

Pakistan 87 82 79 80 71 72 69 72 72 73 64 63

Uganda .. .. .. .. 85 84 79 75 73 73 69 55

Kenya .. 71 67 60 62 67 67 64 61 58 56 55

Source: World Development Indicators


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Indirect taxation is defined as taxation

imposed upon others than the person who is

intended to bear the final burden (Atkinson,1977).

The most important single fact about indirect

taxes in developing economies is thedominant role that they play in the revenue

system of almost every country.

Particularly, indirect taxes are an importantelement in stabilization tax packages that aim

at raising revenue in the short run (Bovenberg,

1986).


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Insignificant role of direct taxation in

developing countries

The role of direct taxation in developing

countries is limited.

Because narrow tax base and high

enforcement costs render direct taxation

impractical for developing countries (Yonah

and Margalioth, 2006).

As a result, developing countries depend

mainly on indirect taxes.

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Indirect taxes represent an important part of

tax revenue in developing countries but they

play only an insignificant role in developed

countries.

Tax structure and its administration are often

part of a specific cultural, social, political and

economic situation and they change with new

demands and requirements of society and

economy.

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In developing countries, the insignificant role oftaxes on individual incomes is disappointing.

because these taxes have traditionally beenconsidered the major instrument to achieve theobjective of income redistribution (Tanzi, 1987).

The requirements for an effective system of

personal income taxation are many. When the agricultural sector is large, accounting

standards are poor, the level of literacy is low andmost economic activity takes place in smallestablishments, effective taxation of personalincome is difficult in developing countries(Goode (1962) as qouted in Tanzi, 1987).

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Conditions including advice of internationalinstitutions have also prompted developingcountries to concentrate more and more onindirect taxation.

The general advice given to developingcountries over the past few decades by the

international institutions such as the IMF,World Bank and WTO has been to replace highand relatively inefficient direct taxes withmore efficient means of indirect taxes,

particularly value added tax (Yonah andMargalioth, 2006; Hatzipanayotou et al. 1994).

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In recent years, the issues relating to a shift froman income (direct) to a consumption (indirect) tax

system has been increasingly discussed amongacademics and economic policy makers (Changand Tsai, 2006).

The issues are: firstly a consumption tax isfavoured especially on the grounds of efficiencygains because it eliminates the bias againstinvestment and savings inherent in the income tax

system, thus encouraging capital accumulationand improving future living standards (Kaldor,1955; Summers, 1981);

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Secondly, consumption tax would be less

distorting than an income tax that taxes

capital income (Summers,1981);

Thirdly, annual income can be highly variable,

and people often borrow and save to reduce

the effects of that variation, so thatconsumption may be a better measure of a

household's ability to pay taxes. (Gale, 1995).

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The general problem of taxation of individuals

is complex.

There are a large number of people in anyeconomy who differ with respect to a number

of characteristics, in particular their

endowments and tastes.

On the basis of certain ethical premises, it is

decided that individuals with different

characteristics should pay varying amounts of

tax (Atkinson and Stiglitz, 1976)..

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Stern, (1987) raises the following questionsregarding taxation.

What should be the balance between thetaxation of commodities and the taxation ofincome?

What types of goods should be taxed? How progressive should the income tax be?

These questions are obviously central to

Public Finance. It is important to look at the literature on

direct and indirect taxation to answer thesequestions

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Musgrave (1969) divided the period of

economic development into two:

the early period when an economy is relativelyunderdeveloped and the later period when

the economy is developed.

During the early period, there is limited scopefor the use of direct taxes because the

majority of the populace resides in rural areas

and is engaged in subsistence agriculture andtherefore their incomes are difficult to

estimate.

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Therefore, indirect taxes play an important roleduring the early stage of economic

development. The different contributions to revenue by direct

and indirect taxes in developed and developingcountries conform to Musgraves (1969) theory.

He further notes the ratio of indirect taxes tototal taxes is related inversely to per capitaincome

because the economic structure of low incomeeconomies is not suited to the imposition ofdirect taxes, while indirect taxes can be imposedmore readily.

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Gupta (2002) emphasizes that developingcountries have a basic problem in rapidlyincreasing capital formation.

Hence, saving and investment should bepromoted.

Taxes can be used for the mobilization ofresources in the public sector to fuel public sectorinvestment.

In the mobilization of such resources, indirecttaxes can play an important role.

Given that total national income is low indeveloping countries, the scope for achievingadequate tax revenue both for administrationand for bringing about capital accumulation isvery limited (Bhatia,2006).

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Furthermore, in such economies, there is usually an

urgent need for providing basic amenities and

welfare activities such as drinking water, health

services and protection against malnutrition to a

large segment of the population.

Given this enormous need for tax revenue and given

the limited scope for direct taxation, indirect taxeshave to play a crucial role in such economies.

Linked to this same argument, that developing

countries need greater capital accumulation, is theargument that direct taxation, particularly at high

progressive rates of taxation, is detrimental to

increasing private savings and entrepreneurship15


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Merits of Indirect Taxation

There are merits and demerits

However, the success of a good indirect tax systemmainly depends on how far a tax authority minimizesthe demerits while maximizing the merits of indirecttaxation.

Indirect taxation is an effective method of raisingrevenue with less adverse economic effects (Atkinson,1977).

Supply-side economists believe that indirect taxes are

preferable to direct taxes because they create less of adisincentive to work since employees retain more ofwhat they earn, resulting in greater long run outputand a lower general price level.

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Indirect taxes are a powerful tool in enhancing

the production and investment activities of the

economy through guiding resource allocation.

For example, the imposition of a high sales tax

on a particular good would raise the price of

that good and discourage its demand.

Reduced profitability of this item will then lead

to less investment in this product and divert

resources to more profitable ventures.

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Indirect taxes can also be oriented towardsincreasing employment or encouraging theadoption of a particular technology.

For example, if the intention is to encouragecapital-intensive techniques, labour intensiveoutput can be taxed more heavily and vice a

versa. Similarly certain types of indirect taxes are

sometimes referred to as sin taxes, for exampletaxes on alcohol and cigarettes.

These types of taxes are levied by governments todiscourage individuals from partaking in suchactivities.

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Governments favour such taxes as they are

easily accepted by the general public andgenerate high revenues.

Indirect taxes can be made progressive ifnecessities are exempted from taxation and

luxuries are subjected to heavy rates oftaxation so that the tax rates would be higherfor the high priced goods or for goods of

superior quality. Such taxation would be progressive in nature

as these goods are purchased mainly by richpeople.

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Another merit of indirect taxes is that they can

be used as Pigovian taxes.

A Pigovian tax is a tax levied to correct the

negative externalities of a market activity.

For instance, a Pigovian tax may be levied on

producers who pollute the environment to

encourage them to reduce pollution.

In a true market economy, a Pigovian tax is the

most efficient and effective way to correct

negative externalities.

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From an administrative perspective indirect

taxes are generally easier to implement than

direct taxes.

Indirect taxes are included in the price of a

commodity so that they cannot be easily

evaded.

A major argument in favour of indirect taxes

has been that they are relatively easy and

inexpensive to administer (Khan, 2001) and soare appropriate particularly in developing

countries.

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Demerits of Indirect Taxation

Indirect taxes are heavily criticized for unnecessarily

imposing heavy burdens on the lower income classes(Pechman, 1990).

The burden of an indirect tax is more difficult to

assess than a direct tax and in general such taxesconsidered to make a tax structure less progressive

(Henderson, 1948).

Gupta (2002) notes that if a given amount is to be

collected through taxes, the burden of the tax or thesacrifice involved would be greater in the case of

indirect taxes than direct taxes.

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This is because indirect taxes impose an excess

burden through affecting the price and

demand for a commodity. excess burden depending on the change in

price that in turndepends on the demand and

supply elasticity of the product Elasticity determines the feasibility of shifting

the burden from producer to retailer to

consumers. Thus, an indirect tax has a greater adverse

effect on the allocation of resources than a

direct tax.23


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Many people are unaware of how much they arepaying as indirect taxes this goes against one ofthe basic principles of a good tax systemnamely that taxes should be transparent.

If indirect taxes are too high this creates anincentive to avoid taxes through boot-legging

a good example of this would be attempts toevade the high levels of duty on cigarettes bysmuggling them.

At a macro level indirect taxes can cause cost-

push inflation, which in turn can fuel a rise ininflation expectations.

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An important demerit of indirect taxes is that they tend

to be regressive.

Since each individual pays the same rate on their

purchases, the poor pay a larger proportion of their

incomes as indirect taxes.

As a result, indirect taxes can adversely affect efficiency

and inter-sectoral (and inter-personal) distribution ofincome (Khan, 2001).

On distributional grounds, indirect taxes are regarded

as inferior to direct taxes.

Therefore, indirect taxes are generally not suitable from

the point of view of removing inequalities of income

and wealth (Gupta, 2002).

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Minimizing Welfare loss Imposed by Indirect Taxation

Belan and Gauthier (2006) emphasize that the tax

system should meet two fundamental propertiesfor the collection of a given amount of fiscalliabilities to induce the least welfare loss.

First, in accordance with Lipsey and Lancasters

(1956) second best principle, every consumptiongood should be taxed, since a larger fiscal baseallows for reducing tax rates, which alleviates thedistortions caused by state intervention on the

economy.

Second, tax rates should generally not beuniform, and inelastic goods should be taxedmore heavily (Ramsey, 1927).

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This is called the Ramsey taxation principle or

the inverse elasticity rule.

The basic idea behind Ramseys taxationprinciple is to minimize the deadweight loss

which accompanies the use of commodity

taxation. The applicability of the Ramsey rule of taxation

is hampered by the fact that little is known

about the magnitudes of the relevant elasticitiesof goods (Kleven, 2004).

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Ramsey considered the case of one consumer (orequivalently identical consumers who are treatedidentically), and so we have a simple efficiency

problem where distributional considerations areignored.

Notice that the one consumer (identical consumers)

case is somewhat artificial: if so we could and should raise all the required

revenue by a poll tax and have zero commoditytaxes (Stern, 1987).

Furthermore, as quoted in Atkinson and Stiglitz(1972), Prest (1967) and Musgrave (1959) arguethat Ramseys result has been ignored or dismissedas being of little practical significance.

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However, the inverse elasticity rule normally

applies only to a constant cost case in which

average cost (and hence marginal cost) ishorizontal (ibid).

In a competitive market, while the constant cost

case is plausible, it assumes away the producerssurplus.

Though, the constant cost case is plausible in a

competitive market situation, the relevance ofthe constant cost case to an imperfect market

situation is extremely doubtful

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Income Distribution

Christiansen (1984) pointed out that if taxableincome is only an imperfect indicator of ability to

pay (say, because highincome individuals areable to hide some of their income), commoditytaxes on luxuries may help the government toachieve the desired distribution of income.

A commodity should be taxed if it is positivelyrelated to leisure in the sense that more of thegood is consumed if more leisure is obtained at aconstant income level (Little, 1951).

A commodity should be subsidized if it isnegatively related to leisure in the sense that lessof the good is consumed if more leisure isobtained at a constant income level (Little, 1951).

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The poor in developing countries consume verylittle of air conditioners and private cars, forexample.

Direct tax and transfer instruments are generallyweak and far from universal in such countries.

So there are strong distributional grounds for

higher taxes on the goods consumed by the rich. As far as developing countries are concerned one

problem is that the retail and wholesale networkis very informal and much of consumption is not

marketed. therefore a tax based on final consumption will

not be effective in generating much revenue.

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Conclusion A countrys tax system is a major determinant of other

macroeconomic indices such as economic growth,public debt, fiscal deficit and inflation

and therefore taxation policy plays an important role inthe efforts of many developing countries to improvetheir fiscal and economic performance.

Taxation is also an important instrument for attaining aproper pattern of resource allocation, incomedistribution and economic stability, in order that thebenefits of economic development are evenlydistributed.

However, many developing countries still face difficultyin raising tax revenue to the level required forpromoting economic growth.

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In practice, due to poor economic performance,weak economic structure and administrative andpolitical constraints, tax revenue as percentage ofGDP is very low in many developing countries ascompared to developed countries.

As a result, huge fiscal deficits are a chronic

problem in almost all developing countries. In these situations, revenue mobilization through

taxation is an important element in medium-termdevelopment plans that aim to raise domestic

investment and government savings whilereducing reliance on debt creating capital inflows.

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This review of literature regarding the role ofindirect taxes in developing countries highlights

four conclusions. Firstly, indirect taxes seem to be more

appropriate than direct taxes for developingcountries.

Secondly, the tax system should tax more heavily,goods consumed more heavily by the rich.

Thirdly, those goods which are complementary

with leisure should be taxed more heavily. Lastly, those goods which have external

diseconomies should be taxed more heavily.

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