Financing development; Tax them and they will grow

Poor countries need to get better at raising tax, and multinational firms need to get better at paying it

SOMALIA is not only one of the world’s poorest and least developed countries; it is also one of the most dangerous for tax collectors.

By one reckoning, a fifth of tax collectors in the capital, Mogadishu, were killed in 2012-14. Armed guards now accompany the remainder on their rounds. That may be an extreme case, but most poor countries struggle to raise much revenue to pay for basic infrastructure and services.

Such difficulties was one of the main topics of discussion at a United Nations conference in mid-July in Addis Ababa, the capital of Ethiopia, which debated ways to finance developing countries’ most urgent needs. It was a precursor to two more big powwows this year that hope to set the agenda for development for the next 15 years.

At the first, in New York in September, the UN plans to adopt global targets for development, called the “sustainable development goals”. At the second, in Paris in December, it hopes to agree a global scheme to combat climate change. Christine Lagarde, the head of the IMF, calls the three meetings a “once-in-a-generation opportunity for global development.”

The SDGs are likely to include laudable but expensive pledges to end hunger, halt the spread of AIDS and malaria, and ensure that all children finish secondary school, among other things.

The Overseas Development Institute, a British think-tank, reckons that poor countries will need $148 billion a year to meet them. But with austerity and slow growth across much of the rich world placing aid budgets under threat, poor countries will have to find other sources of finance.

One of these is taxing their own citizens. The idea of spurring development with higher taxes may seem paradoxical, since taxes are usually a drag on growth. Yet in very poor countries, which on average collect just 13 per cent of GDP in tax compared with 34 per cent in the rich world, the opposite is often true: public investment can “crowd in” private investment.

“The amount of tax collected is a powerful measure of an economy’s health,” says Kaushik Basu, the chief economist of the World Bank. “Raising it allows developing countries to invest in education, health and infrastructure, and, hence, in promoting growth.”

Maya Eden and Aart Kraay of the World Bank estimate that an additional dollar of public investment increases the private sort by two dollars. One target floated for the talks in Addis Ababa is to increase the tax take in low-income countries to 20 per cent.

There are many reasons why poor countries don’t collect as much tax as rich ones, the most obvious of which is that lots of their citizens are penniless. Another is that their economies are largely informal and thus beyond the reach of taxmen. The cost of tax collection in sparsely populated regions is often higher than the benefits, and around 60 per cent of sub-Saharan Africans still live in rural areas, for example.

Yet there is plenty of room for improvement. A recent paper from the World Bank argues that some obvious reforms, such as improving tax agencies, could lead to much higher collections. Britain’s Department for International Development has been sending tax administrators abroad for more than 10 years to advise revenue-starved governments.

One such expert, Kieran Holmes, helped to increase annual tax revenue in Rwanda by 6.5 times after automating the collection process, which reduced errors and opportunities for fraud. “Best practice for tax administration is also best practice for businesses,” he says. “They like a stable and predictable environment. You don’t get that when officials collect at random.”

The developing world could also pick its taxes better. Property taxes, including land taxes, naturally fall on those who can afford to pay most, and are economically efficient, since they do not discourage productive activity. Yet sub-Saharan countries raise only 0.5 per cent of GDP in this way.

Tax gains

When four local authorities in Liberia simplified their formula for assessing property values, revenues jumped by three to five times. Improvements in satellite mapping are bringing down the cost of inspecting land.

The Africa Research Institute points out that property taxes are typically implemented by local authorities, which also provide public services. If more power were devolved to local authorities, then better property tax collection should go hand in hand with better services.

Gains would also come from reducing tax exemptions and avoidance, including by foreign investors. Katrin McGauran of SOMO, a Dutch research centre, estimates that tax treaties intended to boost Dutch investment in poor countries cost them US$1 billion in revenues in 2011 alone due to the exemptions they included.

The cost of multinational companies deliberately avoiding tax exceeds US$200 billion a year, according to a recent IMF working paper. Angel Gurría, the secretary-general of the OECD, a club of mostly rich nations, reckons that developing countries lose three times more to tax havens than they receive in international aid each year.

The most common way multinationals avoid taxes is through “transfer pricing” in which their subsidiaries in tax havens buy goods cheaply from arms in more exacting countries, and then sell them on at a higher price, thereby shifting profits to the tax haven.

The OECD is trying to combat such schemes by persuading tax authorities to require firms to disclose where they generate their profits and share the disclosures. A proposal from 137 developing world NGOs goes further, calling for the formation of an international tax agency, although it is unlikely to prosper.

Outright tax dodging is an even bigger problem. Undeclared money transfers, false invoices and the like cost developing countries more than US$990 billion in 2012, according to Global Financial Integrity, a think-tank. That figure equates to almost four per cent of developing countries’ GDP.

In Europe, for instance, non-governmental organisations are lobbying hard for a commitment that rich countries give 0.7 per cent of GDP in official handouts each year, despite the dismal record of official aid in ending poverty. Helping poor countries improve tax collection and limit avoidance may do far more for growth than setting lofty aid targets.

Economist/GB
Much more is possible.