Tax Base Erosion in Developing Countries

Abstract

It is widely believed that the tax base in most developing countries has been severely eroded by legal tax avoidance and illegal tax evasion, brought about largely by poor' tax administration.1 This erosion, it is thought, has had a variety of fiscal effects: tax revenues are lost and the growth of the tax base is dampened, the progressivity implied by the statutory rate structure is not achieved, the costs of tax administration are increased, and horizontal and vertical equity suffer because the effective tax rates faced by individuals depend largely upon their success in playing the tax compliance game. It is not surprising, therefore, that virtually all fiscal reform programs in developing countries start with the promise to improve administration. Better administration is a discretionary government action that at once can lower the tax rate, increase revenues, slow capital flight, and improve the fairness of the system. Yet tax base erosion in developing countries is something about which precious little is known, and, in particular, the empirical evidence about the severity and the nature of the problem is all but nonexistent.2 Why do we know so little about the dimensions of the evasionavoidance problem? One reason is conceptual problems in measuring erosion of the tax base. For example, how does one estimate the substitution of nontaxable for taxable compensation in response to the tax structure, or the extent to which a higher marginal tax rate has induced individuals to report less of their taxable income? Another reason is the problem of comparability across countries. The many legal and