Building stable modern institutions is a huge challenge for developing countries. A fundamental institution for modernization is the tax authority. While tax authorities have remained weak in many parts of the world, global forces are now reshaping them. Through political, technological and sociocultural change, a more hopeful future for effective taxation in emerging markets might lie ahead.
- Taxation presents a huge challenge for developing countries. Countries need to raise tax revenue of at least 15% of their GDP to be able to provide basic services, such as better road infrastructure, healthcare and public safety. Currently, in almost 30 of the 75 poorest countries, tax revenues are below the 15% threshold.
- For developing countries, there are three major tax bases: consumption, income, and natural resources. Consumption tax is a fairly recent phenomenon: the 1990s saw a dramatic adoption of value-added taxes (VATs) among developing economies: from around 20 to over 80. In terms of income taxes (personal and corporate), many developing countries predominantly deal with a series of low volume—high value transactions (i.e. large corporations), which does not support a broad level of compliance with the revenue system. Moreover, in many developing countries, the regulatory environment is designed to extract rather than create value, which increases the likelihood of revenue leakages and negative spillovers from tax incentive schemes, leading to an overall weak system of taxation. As such, for many developing countries, natural resources represent the only way to fund public expenses as these generate strong and relatively stable revenue flows, even with low levels of administrative capacity.
- A McKinsey report highlights global forces that are reshaping tax administrations around the world, such as shifting trade patterns, protectionism, the gig economy, automation, digital transactions, cyberthreats, and digital platforms. As a result, especially developing countries are struggling to adapt, as tax authorities have to digitize interactions with taxpayers, use advanced data analytics and automate tax processes.
- The global integration of supply chains has made it much more difficult for developing countries to collect taxes (e.g. corporations shifting profits to lower tax jurisdictions, tax havens). For example, the Panama and the Paradise papers have exposed the substantial wealth sheltered in low-tax jurisdictions (an estimated 10% of world GDP). Indeed, a United Nations report notes that tax avoidance is much greater in low-income countries and sub-Saharan Africa, Latin America and South Asia than in other regions. Consequently, the OECD set up the BEPS project (2013) and the Common Reporting Standard (2014) of automatic exchange of information to combat tax avoidance.
- Technological solutions for more effective tax administrations are gaining ground. For instance, blockchain could strongly reorganize the processing of taxation by implementing real-time, automated, transparent tax processes. Thailand is going to use blockchain to curb tax avoidance and use machine learning to study tax evasion methods. Countries such as Kazakhstan and Azerbaijan have also announced their intention to improve the tax administration system using blockchain.
Connecting the dots
A well-functioning tax authority is central to a country’s development. In fact, taxation has been a fundamental driver of the evolution of human societies. The world’s first bureaucracies (e.g. China, Egypt) were created to impose, collect and administer taxes. The birth of the first states is linked to the emergence of crops that were visible to tax inspectors. Besides political powers, religious institutions also imposed taxes to fund their expansion, such as the Christian tithe and the Islamic khums. In feudal Europe, vassals paid “scutage” to their lords, and in early modern Europe, modern systems of taxation were established to fund imperial expansion. Moreover, as the costs of war rose, the tax burden increased rapidly (e.g. by 85% in 18th/19th century England), giving rise to the famous cry “No taxation without representation”. All in all, taxation has always been tightly linked to the broader relationship between the state and its citizens.
Taxation is only effective when it is embedded in high trust societies. Francis Fukuyama has argued that low levels of trust among the people of Greece and southern Italy are responsible for high levels of corruption and tax avoidance. This applies even more to developing countries that have never developed inclusive political (i.e. sufficiently centralized, pluralistic administrations) and economic (i.e. protective of private property, rule of law, provision of public services) institutions. In the absence of inclusive institutions, and in the face of extractive institutions (i.e. governments that extract value from their people), levels of trust become so low that taxation
becomes a huge challenge (i.e. people actively seek to avoid taxes).
As global forces are reshaping tax administrations, perhaps a more hopeful future lies ahead for some developing countries. These forces are threefold: political, sociocultural and technological. First, political efforts to build more effective systems of taxation are gaining ground. Declining revenues and high-profile scandals have given rise to efforts such as the OECD projects. More importantly, in regions such as Southeast Asia and Latin America (as we noted before), state reform has gradually improved: as corruption is reduced and the rule of law and public services improve, tax administrations will become more effective as well. Second, as young generations emerge in developing regions, mindsets are shifting and anti-corruption drives are intensifying (e.g. Latin America, Southeast Asia). For example, the “cabeca pretas” in Brazil are a young generation seeking to reform the political system, and anti-corruption sentiment has reached new heights from Mexico to Malaysia. Third, new technologies (e.g. AI, machine learning, virtual assistants, data analytics, blockchain) come with promises to build more effective tax administrations. All in all, effective taxation has to be embedded in a culture of trust. This means that merely building technologically advanced systems will not be sufficient to build robust institutions. However, the amalgamation of these three trends promises a brighter future for emerging markets that have embarked on the right path of state reform, since these changes lead to higher levels of trust.
- While developing countries can potentially leapfrog directly from one level of digital maturity in tax administration to another, this will only benefit countries that have invested in state reform that leads to higher levels of trust (i.e. lower levels of corruption, improved rule of law and provision of public services). The most promising regions in this sense are Southeast Asia, Latin America and parts of East Africa.
- Declining revenues will tempt governments to adopt more intrusive, efficient and uncompromising tax authorities, but without significant state reform, these efforts could backfire and lead people to seek new tax avoidance strategies. When the Roman Empire militarized its tax inspection, Roman tax collectors became villains. Data analytics, AI and sophisticated technological systems for tax administration without high levels of trust could likewise push people into tax avoidance and alternative networks (e.g. cryptocurrencies, tax havens). Indeed, new technologies also increase opportunities for tax evasion: authorities in South Korea recently raided the country’s largest cryptocurrency exchanges for alleged tax evasion. Cash-strapped governments with low capacity (i.e. developing countries and many emerging markets) face greater challenges in managing these risks.