Equity and Efficiency in Tax Reform in Developing Countries

Abstract

This paper provides a critical analysis of the current consensus on tax reform in developing countries in terms of both efficiency and equity objectives. Drawing on the recent theoretical advances it shows that the emphasis on value-added tax (VAT) as the main instrument for indirect taxation is likely to result in inefficiency in resource allocation due to production and consumption substitutions in favor of the informal/shadow economy. Such a reform can also have adverse effects on the long-run growth as a small formal sector reduces the scope for technological progress in the economy. Imposition of VAT may also retard the development of markets, especially in the rural areas. The tax reform policies implemented in a large number of developing countries that reduce the tariff and shifts the burden of raising revenue to VAT are also likely to be undesirable in terms of equity. The available evidence shows that the current emphasis on uniform VAT is especially regressive. The prevalence of corruption in tax administration is likely to make the incidence of tax reform more inequitable as compliance with VAT is information-intensive, and thus it places the poor in a disadvantage in the bargaining against a corrupt tax collector given their lack of education and record-keeping.