Abstract
Public finance pressures are a central concern in developing countries. With large informal economies, the tax base is narrow and the resulting revenue on average only about half the fraction of GDP seen in developed countries. In response to the resulting tax distortions favoring the informal sector, countries commonly impose a variety of restrictions favoring the formal sector and hindering the entry of new firms that likely join the informal sector. While these policies help protect the country's tax base, they also unfortunately can hinder economic growth, by discouraging entrepreneurial activity.The experiences in China show this trade off dramatically. When restrictions on firm entry were eliminated, economic growth rates jumped but tax revenue fell by two-thirds, since the growth largely took place in sectors that were hard to tax.How should a country then handle these revenue costs of growth-promoting policies? The choices are few: cut expenditures, borrow in the hopes of higher revenue in the future, come up with new sources of revenue such as user fees, or undertake only partial reforms that yield some growth but also help preserve the existing tax base. The paper argues that the latter approach is likely to be the most successful, in spite of the lower resulting growth rate.
Highlights
Is tax revenue low but the tax structure seen in developing countries differs in important ways both from that existing in most developed economies and from that recommended in the optimal taxation literature
How should a country deal with the resulting fall in revenue? One possible response to the drop in government revenue is to borrow in order to replace the lost tax revenue, with the hope that the economic growth induced by market‐ oriented reforms will generate extra tax revenue in the future sufficient to repay this debt
Public‐finance economists appropriately argue for a broad‐based tax that imposes the same tax rate on all economic activity in the economy, thereby avoiding any intersectoral distortions
Summary
According to IMF figures, overall tax revenue in developing countries, as a fraction of GDP, is roughly half of that seen among developed countries. Is tax revenue low but the tax structure seen in developing countries differs in important ways both from that existing in most developed economies and from that recommended in the optimal taxation literature. Given the implausibility of a political economy explanation for such systematic deviations from the policies recommended by the optimal taxation literature, Gordon and Li (forthcoming) searched instead for a source of economic pressures faced in developing countries that had not been taken into account in the optimal taxation models. These pressures lead to forecasted policies similar to those seen Their hypothesis was that firms in poorer countries can much more operate in the cash economy, where evasion of taxes is easy.. For example, tax policies in the United States until World War II broadly resembled those seen in recent years among developing countries, with a heavy reliance on tariffs, excise taxes, and later a corporate income tax. Cash sales leave no paper trail, so no evidence that the government can use to document a taxable transaction
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