Informality and fiscal legitimacy

Box 8 below explores practical ways to bring small enterprises into the tax net in Africa. The Outlook country surveys show that, for example, Algeria is using a presumptive tax for the mainly informal entrepreneurs. In Zambia a flat-rate ‘base tax’ for rural areas has been introduced along with ‘presumptive taxation’ of 3% on gross income for urban areas. Additionally, a ‘peddler’s licence’ has been issued for street sellers. Senegal has also introduced a system aiming to tackle tax evasion.

Presumptive taxes, the standard prescription for taxing small informal businesses, can distort economic decisions while absorbing large amounts of administrative resources that could be better used chasing large tax evaders. However, taxing small businesses is still politically desirable for turning the informal sector into a stakeholder in government policies. It should be stressed that there is a point where the cost of administrating a tax will outweigh the revenue. This threshold is much lower in developing countries than in developed ones. Therefore, African tax administrations should conduct a careful cost-benefit analysis when deciding how far to go in their efforts to formalise small businesses. 

However, tackling corruption within tax administrations is a priority to establish legitimacy. Corruption undermines tax morale on top of the fact that bribes cut revenues. An appropriately paid tax inspector will be less likely to take bribes. An additional challenge is that talented tax specialists are poached by the private sector, particularly in Africa where tax expertise is scarce. African governments must find solutions, which could include a different pay scale for tax administrators than for regular civil servants. However, excessive use of bonuses and revenue targets can lead to decreased quality and cause frustration amongst tax administrators.

Reducing compliance costs helps with private sector development and lowers the amount of bribe a taxpayer might be willing to pay to avoid declaring and paying tax. Similarly, reducing the number of times a taxpayer needs to interact with tax administrators minimises opportunities for bribery. It also reduces administrative costs and improves compliance. Information technology can also help, as do unambiguous, transparent tax codes. Compliance costs can be reduced by relying more on taxation at source through withholding taxes. The Outlook country surveys reveal that a number of nations, like Uganda and Zambia, have introduced a “Pay as you earn” (PAYE) withholding tax collected by the employer.

Taxpayers who are treated as clients rather than suspected criminals are typically more compliant. Educating taxpayers about fiscal issues brings great benefits for tax collection and contributes to building legitimacy and trust. Well-defined and well-executed educational campaigns using media and new technology can help ensure taxpayers understand compliance requirements. In South Africa and Zambia, for example, tax education campaigns have helped to make the public more aware, increasing voluntary compliance. Customer Relations Managers need to be particularly professional with the biggest clients since the 80/20 rule applies i.e. 20% of taxpayers make up 80% of tax revenue. Setting up a “one-stop-shop” where large clients can deal with all tax liabilities at once can be very rewarding.

— Communicating on tax

Similarly, tax administrations can increase their effectiveness by targeting awareness campaigns to client segments with higher compliance risk (Dohrmann and Pinshaw, 2009). Tax administrations should wave the “carrot” of tax education and high-quality service first but compliance cannot be achieved if they do not wave and also use the “stick” of audits, fines and lawsuits wisely. Low tax compliance in many African countries is worsened by the perception of firms and individuals that paying taxes brings them little public service in return. Similarly, the cost of dodging taxes and risk of getting caught are perceived as low. This undermines legitimacy as tax-paying citizens and firms complain that they are unfairly taxed when they see others who do not fulfil their obligations. In many African countries, small and large taxpayers evade tax, while the middle income segment shoulders the bulk of the burden, generating feelings of inequity and frustration. Aid agencies and multinational firms contribute to undermining compliance as local people observe that they often pay little or no tax. Box 9 explores practical strategies to strengthen fiscal legitimacy in African countries.

Improving tax administration

More effective tax administration gives fewer incentives for taxpayers to bribe their way out of fiscal obligations. It also benefits companies by lowering compliance costs, improving transparency and predictability in tax liabilities. Box 10 documents best practices for effective tax administration in developing countries. The Outlook country surveys show that a number of countries have made a policy priority of facilitating the payment of taxes or set up national capacity building strategies for strengthening tax and customs administrations. These include Senegal, Egypt, Comoros, Central African Republic, Sudan and Uganda.

— How autonomous should tax administrations be?

There is a debate as to whether or not African states should follow the autonomous agency model and set up their tax administrations as institutionally independent bodies or the embedded agency model which keeps them inside the finance ministry or treasury. The first option is supposed to enhance independence and promote change management while the second is said to improve collaboration with policy-makers and other administrations. According to our country surveys, a majority of countries apply the embedded agency model, keeping tax administration inside the finance ministry/ treasury. However, there are also various examples of semi-autonomous tax administrations.

— E-government and taxation

Information technology plays an increasing role in African tax administration (Box 11). The relative scarcity of skilled staff in Africa is such that the productivity of available administrators needs to be optimised. Information technology makes the handling of mainstream clients faster, freeing scarce resources for more complex high-potential clients. Investing in self service options like websites and automated phone service has a significant benefit. The advantages are even greater given the fact that administrations which have adopted software late can move directly into the latest generation of tools.

In Africa, political influence on tax collectors must be reduced. Furthermore, to reduce the incentive to accept bribes, governments may pay tax administrators on a different scale from the rest of the administration, which is difficult if tax administration is part of a ministry. However, what appears to matter most for lasting tax reform is not so much the institutional set-up but strong high level political commitment to support the work of the fiscal administration in the eyes of taxpayers and other government branches (Di John, ibid.).

— Decentralisation, the answer to rapid urbanisation?

The second institutional debate is about fiscal federalism – in particular, which taxes, responsibilities and functions are best centralised and which ones are best managed at the regional and municipal level. Usually, local tax administrations in Africa have some tax competences, such as delivering local business patents. However, as confirmed by this Outlook’s country surveys, due to a combination of political reluctance to decentralise power and the severe shortage of capacity, local tax collection is estimated to be of the order of 1% of national income in Africa with a high concentration in large urban centres (Chambas et al., 2007). Various countries, including Algeria, Cameroon, Comoros, Côte d’Ivoire, Namibia, Nigeria and Sierra Leone are decentralising their tax administrations. An important benefit of decentralisation is the opportunity to enhance fiscal legitimacy in the eyes of local taxpayers. This should be balanced, however, against the need to keep a low administrative burden for tax payers, as evidenced in Botswana, where efforts have been made to centralise tax collection. Whatever the political merits of decentralisation, the current situation is unsustainable if local authorities are to provide a minimum level of infrastructure and services. Many African countries are seeking to decentralise responsibilities and expenditure but local revenues have not kept pace. Decentralisation would reduce transfers from the national government to sub-national governments and the vulnerability of local resources to discretionary central decisions.

— Improving tax administration widens policy space

There are many benefits to an efficient tax administration besides the revenue it generates. The ease of paying taxes bears directly on private sector development. Where compliance costs are high, businesses are likely to remain small and in the tax evasion zone. Further, the rate at which a country is able to increase its tax base depends on the quality of its tax policies and tax administration. A low capacity tax administration may not offer policy-makers the opportunity to shift from a sales tax to a VAT system, even though this is generally considered economically more efficient. A country with a weak tax administration may be limited to forms of taxation that runs against other policies aimed at bringing businesses and workers into the formal sector.

Harnessing aid

Partly due to the negative impact of the global economic crisis on government revenues, 2008 and 2009 have seen a resurgence of international co-operation and dialogue on tax policy (Box 12). This positive development has arguably made it easier for African initiatives in public resource mobilisation to attract multilateral and bilateral support. Tax administrations are often amongst the most effective parts of the administrations in African countries and yet they face considerable capacity challenges that donors can help them to address (OECD, 2008b and c). Donors should focus on improving the working environment of local fiscal administrations and help build the capacity for those that are missing the human, technical and financial means to run efficient revenue collection activities. Indeed, increasing the share of aid spent on improving tax administrations is one of the aims of the Task Force on Tax and Development recently launched by the OECD. Key challenges, though, as in other sectors of development co-operation, will be to ensure that the proliferation of initiatives: i) serve African countries’ own priorities for domestic resource mobilisation; ii) facilitate access to information, services and training rather than establish a complex web of overlapping initiatives, and iii) create net capacity in tax administrations, rather than lead to depletion, with tax administrators being eventually hired by firms or donor agencies who pay higher wages, or taken too frenquently on policy dialogue “tours”.

— Why invest aid into public resource mobilisation?

A key argument in favour of using aid to stimulate public resource mobilisation is that the returns of a dollar spent on tax systems can generate several dollars in tax collected. In the words of the President of the African Tax Administration Forum, Oupa Magashula, to the participants in the OECD Global Forum on Development in January 2010, it can have up to “a tenfold multiplier effect on states’ resources”. In this Outlook’s South Africa note, we computed that the cost to revenue ratio of the South African Revenue Service has been low and stable, at around 1%. This implies that on average every South African Rand (ZAR) of resource spent on tax administration generates ZAR 99 in tax revenues, net of collection costs. This may not be true at the margin as the first million ZAR of tax revenues are less costly to collect than the last. But, a tenfold multiplier, which implies a 10% cost to revenue ratio at the margin, is plausible if optimistic. An additional benefit for the government is the accumulation of data collected in the process of bringing in taxes, which expands the knowledge base for general macroeconomic and development planning. Conversely, the multiplier effect does not factor in the cost of collecting tax revenues in terms of lost economic efficiency, as taxes always distort economic decisions on investment, saving, or labour in some way.

To put this in perspective, Table 3 reports cost-revenue ratios for African countries based on the Outlook’s survey. Benin, South Africa and Swaziland display the lowest cost–revenue ratios, around 1%. However, other countries are not far behind, reporting average cost-revenue ratios of no more than 6%.

Another benefit of spending aid on public resource mobilisation is that it can help recipients and donors progress towards the goals set out in the Paris Declaration on aid effectiveness (2005) and the subsequent Accra Agenda for Action (AAA, 2008): increase the use of country systems by donors, untie aid, enhance aid predictability and maximise the ownership of development strategies by aid recipient countries. Indeed, it is governments who decide how to spend the taxes collected. Wider fiscal space makes for wider policy space. Moreover, since stimulating revenue implies that the government is ultimately to convince taxpayers to pay taxes, this type of aid can help to tighten the social contract that binds citizens with their government. Aid contributes to fiscal legitimacy when invested in reporting public expenditure more transparently and in strengthening the capacity of tax administrations. Traditional aid assistance, on the other hand, empowers the government to set priorities independently of taxpayers. We now take stock of recent initiatives in support of public resource mobilisation in Africa.

— Making the most of aid for public resource mobilisation, and managing risks

Donors should not become a substitute for local administrations. Initiatives like taking over operational management of a revenue or customs authority can be very efficient in the short term. However, in the long run, this strategy fails to build legitimate and sustainable public institutions. A significant feature of more successful recent tax reform efforts is that they have not just been externally driven. Britain’s support to the Rwandan Revenue Authority and Germany’s help for the Ghana Revenue Authority are cited as works that secured sustained increases in administrative effectiveness and a high degree of local ownership.

Aid should not undermine the relationship between the fiscal administration and other parts of the government. Assistance should focus on capacity building programmes that also help the general administration and governmental activities. For example, sponsoring a population census and urban land register helps to assess and collect personal income and urban property taxes but also helps civil servants and policy makers formulate and drive social and urban planning.

More generally, discussion about enhancing the capacity of African tax administration must be accompanied by a general discussion about governance, transparency and the eventual use of increased public resources by the government. Increasing the capacity of the fiscal administration, or enhancing the tax base, will not bring long term results if reforms are not visibly linked to productive strategies, including aid policy. Taxes can only be a “facilitator” for the building of capable states, and then only as long as the state is legitimate and its actions are based on a legitimate political consensus. It is therefore important not only to bring politics back into taxation and governance issues but also the specific context of each country.

The participation of developing countries’ tax officials in the global community of tax professionals should be encouraged. The emphasis should be on sharing knowledge and best practices through dialogue. South-South cooperation should be strengthened and supported by the donor community. Transparency in inter-company trade must be increased through country-by-country reporting and the adoption of international accounting standards aimed at tackling transfer pricing. International support should be mobilised to help developing countries while recognizing their differing needs. These needs must be highlighted at international meetings. African tax administrations must be helped to take advantage of such international groups and meetings.

Donors need to deliver on their pledges of policy coherence by putting pressure on their own mining conglomerates to strike decent deals with African nations. They should encourage revenue transparency, including country-by-country reporting, by their companies so that civil groups can question unacceptable deals. Better reporting would also ease the job of African tax administrations in their attempt to report the magnitude and sources of fiscal expenditure to their governments and people. Donors could offer legal assistance to developing countries signing a deal with a multinational enterprise, even if it was based in a different country. Donors should not poach the scarce African tax expertise to meet their needs for local experts.

Revenue conditionality is another way in which aid can be made more conducive to effective domestic resource mobilisation. On the one hand, matching donor contributions and collected taxes could encourage a more active revenue collection policy. Donor budget support would be calculated as a pre-agreed percentage of a government’s collected tax revenues, with an upper limit to the amount of budget support and a provision for the matching percentage to come down as the government’s capacity to raise revenue strengthens. This approach is an incentive to revenue collection by design. State officials know that raising extra revenue will result in additional inflows of donor resources. For this system to work, donors must commit to the medium and long-term through the development of trust funds.

On the other hand, revenue conditionality can focus on how aid affects the way tax is collected, not just how much revenue is collected. This implies a focus on vertical equity, tax payer awareness and education, transparency, strengthening tax-expenditure linkages and bargaining with taxpayers and organised groups when designing revenue conditionality and support for tax reform efforts. The major challenge involves the willingness of donors to make aid flows predictable and reliable, putting into practice agreements on good donor practice embedded in the 2005 Paris Declaration.