Deepening the tax base

The tax base is the set of economic activities and assets that are taxed. Broadening the tax base by widening the payer net does not necessarily mean more revenues will be collected as the cost of the collection must be considered. Any attempt to broaden the tax net needs to take into account whether the extra revenues outweigh the collection costs. The priority targets should be those benefiting from tax preferences, those misusing transfer pricing to shift profits, and the extractive industry. Many countries have successfully enlarged their tax bases. Tunisia’s has increased its own at a yearly average of 3.5%, South Africa has more than doubled it, as has Egypt in the last five years, while Côte d’Ivoire has rebuilt its tax base after the civil war.

Figure 19 shows where African countries stand in terms of tax base diversification. There is an impressive amount of diversity across African countries with respect to the composition of their tax bases. To extract useful patterns, a typology of six types of countries has been developed. The goal is to distinguish between the quantity of taxes and the political quality of the tax base. In the top row are countries with tax shares above potential, the bottom row features countries with tax shares below potential. Columns classify countries directly according to their tax shares, i.e. collected taxes as a share of GDP, with the first column corresponding to countries with a share smaller or equal to 15% of GDP, the second column, countries with a share of 15%-20% and the third column to those with a tax share above 20%.

Countries with a tax share above what would be expected on the basis of their fundamental characteristics are those that collect few taxes on resource rents. Conversely, countries with a tax share below what would be expected are those that rely heavily on resource rents. Countries rich in natural resources can afford to – and tend to – shy away from more politically demanding forms of taxation. Their fiscal revenues are more exposed to volatile commodity prices, making macroeconomic management and development planning more difficult. Further, the disproportionate importance of resource taxes implies that stakeholders outside the resource extraction sector are insufficiently represented in the tax base, raising concerns about the political representation of a large part of society in these countries.

Another pattern that emerges is that fragile countries – which extreme poverty puts at risk of conflict or disease epidemics – tend to have low tax shares and tax efforts. More stable countries tend to have higher tax effort and tax shares. Some caution is needed in the case of fragile countries. Typically, trade tariffs play an important role in their tax mix while direct taxes play a small role. History shows, however, that public resource mobilization has played an important role in post-conflict countries (Box 4). They need to make a gradual and careful move away from trade taxes, which can only be ended as VAT and other types of tax are phased in (Di John, id.).

Countries also have to be careful about how they increase the share of taxes in national income, especially those with an already high tax effort. Merely increasing tax rates is rarely the solution. It is often better to lower tax rates while eliminating exemptions and expanding the tax base to new payers. There is a limit, though, to the amount of taxes even the most effective administration can collect. For countries with a high tax rate, the main road to enhancing the fiscal share is to widen the tax base by pursuing private sector development. Efficient, effective and fair taxation is a crucial condition for development but fiscal reform is not a substitute for an effective development agenda but it should be a priority.

Box 4: Tax administration/reform in the context of post-war-conflict countries and fragile states

About half of the countries of sub-Saharan Africa can be categorized as fragile states. [3] With some exceptions (mainly oil producers), tax revenues in fragile states are typically less than 20% of GDP, reflecting the low levels of formalization of the economy and weaknesses in tax administration. Key objectives of tax reform in fragile states are to boost budget revenues to fund the rebuilding of public services, to support sustainable economic growth and to contribute to better governance.

Most fragile states have a relatively narrow tax base. Broadening the tax base requires stronger tax administration. Hence alongside tax policy reforms, institutional reforms have also been implemented with financial and technical support from development partners such as the UK Department for International Development (DfID), the World Bank and the IMF. Tax administration reform aims to create a modern system based on voluntary compliance by taxpayers, backed by risk-based selective audits to enforce compliance. Especially in fragile states where technical capacities in both the public and private sectors are weak, this requires the creation of tax systems that are relatively simple, easy for taxpayers to understand and transparent, and where payment procedures for taxpayers are simplified.

A key component of tax reform has been the reorganization of tax administration along functional lines, rather than by the type of tax. This includes setting up large taxpayer departments to handle the companies which often generate up to 70% of domestic tax revenue. Furthermore, 14 sub-Saharan African countries, about half of which are fragile or post-conflict states, have established semi-autonomous revenue agencies to take over tax collection – but not tax policy – from government ministries. The rationale for revenue agencies is that, compared with the civil service, they can pay more competitive salaries and have more managerial autonomy and clearer incentives for collecting revenue.

The achievements of tax reform in fragile states, in terms of raising revenue, have been mixed. In some post-conflict countries where revenue had collapsed, such as the Democratic Republic of Congo, Mozambique, Uganda, Liberia, and Rwanda, tax reforms have facilitated recovery in revenue. Sustaining further increases in the revenue/GDP ratio, on the other hand, has proved more difficult.

Key lessons of tax reform in fragile states include:

(i) political commitment for reform is imperative because raising revenue requires bringing politically influential taxpayers fully into the tax net, for example by removing tax exemptions. Tax incentives have actually become more ubiquitous in SSA since the 1990s and this has weakened the tax effort;

(ii) the authority to make all decisions on tax policy must be centralized in the Ministry of Finance. Agencies which have no responsibility for public finance, such as Investment Agencies, should not have the authority to confer fiscal concessions on taxpayers;

(iii) it is counterproductive to try to enforce complex taxes such as VAT or income tax on small and micro enterprises because the costs of collection outweigh the benefits; these enterprises will pay VAT when they purchase inputs from the formal sector;

(iv) reforms to the tax administration should be part of a broader effort to strengthen governance and public financial management, and

(v) opportunities for corruption are pervasive in tax collection; hence a comprehensive anti-corruption strategy, including an effective internal audit function, is essential.

Source: Martin Brownbridge, Oxford University.

Ending tax preferences

Whether tax incentives are a cost-effective way of overcoming impediments to investment depends on the host country’s investment conditions and characteristics. In general, it is better to focus on the actual impediments to investment and aim to address these directly. Addressing non-tax impediments may be a more effective policy to attract investment than seeking to match the tax incentives provided by other countries, especially if the latter prompts a race to the bottom as countries compete for investment and no country collects much tax as a result.

As case studies show, key investment considerations include market size, political and economic stability, rule of law and protection of property rights. Where tax is identified as a major issue, transparency and stability of the tax law, administrative certainty, and a wide tax treaty network are typically ranked well ahead of targeted tax preferences. Uncertainty over the tax treatment of FDI increases the perception of risk and discourages long-term, capital-intensive investments that governments are typically eager to attract. Administrative discretion in granting tax incentives undermines transparency and creates a perception that the tax authorities are open to influence and persuasion. Where tax systems are seen as unfair or open to negotiation, this risks eroding voluntary compliance with the system.

In providing an attractive tax system for investors, African governments should aim for transparency and certainty of tax treatment, and take steps to limit compliance costs (e.g. through taxpayer education, streamlined payments), before exempting international investors from all or part of their fiscal obligations. Simplifying tax legislation, establishing “Large Business Offices” to improve service to important clients, and initiating electronic payment facilities are all important steps that African nations have used to improve compliance. Businesses are often willing to trade higher tax payments against lower compliance costs and more predictability and transparency in the assessment of their liabilities. Egypt is a good example. The Outlook country surveys confirm the progress made by countries that have established large business offices, including Algeria, Angola, Cameroon, Central African Republic, Côte d’Ivoire, Egypt, the Gambia, Niger, South Africa, Sudan, Uganda and Zambia.

Revenues foregone by tax incentives for investment – such as tax holidays, partial profit exemptions, free trade zones, etc. – tend to exceed by a wide margin the revenue costs expected before the concession is put in place. In particular, countries frequently under-estimate tax planning opportunities for multinationals to extend the coverage of tax relief to shelter non-targeted activities and profits. Increased reliance on other taxes and the need for tax base protection measures place additional strains on the tax system.

At the same time, competition amongst countries to attract mobile investment creates pressure for continued use of targeted tax incentives. Given this, some degree of cooperation amongst countries may be necessary to prevent a counter-productive race to the bottom in effective tax rates on profit, especially amongst those countries linked by free trade arrangements and thus likely to be in the most direct competition for mobile capital. Arguably, with some form of regional collaboration, the priority of policy makers should be to limit the most damaging tax preferences such as tax holidays and export incentives. A monitoring framework and system to exchange information would be necessary to implement this type of agreement (IMF, 2009).

The African Tax Administration Forum (ATAF, see Box 5), which was officially launched in 2009, could act, if properly mandated, as the political and logistical platform to implement such an agreement and to establish best practices for the reporting of fiscal expenditure. Even without international collaboration, policy options are available at the national level.Morocco and Egypt, for example, have both shown that eliminating exemptions while lowering tax rates can increase overall fiscal revenue. This type of reform is beneficial from a taxation and investment perspective: it boosts tax revenues and the transparency and predictability of the investment environment. Angola, Cameroon, Central African Republic, Côte d’Ivoire, São Tomé and Principe, Senegal and Togo are all pursuing similar reforms. As a prelude to such reforms, tax expenditure analysis and reporting can be useful in stimulating discussion among stakeholders.

Box 5: The African Tax Administration Forum (ATAF), the African Development Bank (AfDB) and related initiatives

The African Tax Administration Forum (ATAF), officially launched in November 2009 in Kampala, Uganda, brings together the heads of African tax administrations* to discuss common challenges and key priorities for effective domestic resource mobilisation. ATAF’s objective is to become a platform for articulating African tax priorities and building the institutional capacity of the continent’s fiscal administrations through peer learning and the sharing of good practices. It is setting up an African Tax Centre to foster experience-sharing, benchmarking, and peer reviewing. ATAF is engaged in regional and international dialogue on taxation.

The African Development Bank (AfDB) is a strategic partner of ATAF since its inception, providing both financial and technical support. Together with ATAF and the Korean African Economic Cooperation Fund, the Bank has established the East Africa Tax Initiative, which focuses on sharing best practices in revenue governance in East Africa (Burundi, Kenya, Rwanda, Tanzania, and Uganda). The AfDB also facilitates deeper dialogue with other pan-African platforms that deal with different aspects of public finances, such as the Collaborative Africa Budget Reform Initiative (CABRI) and the African Organization of Supreme Audit Institutions (AFROSAI).

*ATAF members as of March 1st, 2010: Botswana, Chad, Egypt, Eritrea, Gabon, Gambia, Ghana, Kenya, Lesotho, Liberia, Malawi, Mauritania, Mauritius, Morocco, Namibia, Niger, Nigeria, Rwanda, Senegal, Sierra Leone, South Africa, Sudan, Uganda, Zambia and Zimbabwe.

Source: CABRI & AfDB (2008).

Finally, removing tax exemptions on aid-funded goods, services and personnel could render aid more conducive to effective domestic resource mobilisation not only by generating new fiscal revenues, but also by sending a signal that all economic activity should be subject to taxation (Box 3). The issue of tax exemptions for international assistance projects has been on the agenda of the United Nations Committee of Experts on International Cooperation in Tax Matters for the last few years. In 2006, the Committee discussed draft guidelines prepared by the secretariats of member organisations of the International Tax Dialogue (ITD). However, the UN Committee comprises only tax experts from developed and developing countries. The UN Committee has acknowledged the debate will not advance without the donor agency staff who include the exemptions in memoranda of understanding governing aid contributions. The debate has been given new impetus by the Africa Tax Administration Forum which wishes to engage donors on this topic. African countries should actively engage in these discussions and adopt a common stand.

Dealing with transfer pricing

Even the most sophisticated tax administrations struggle with transfer pricing. There are different approaches to tackling the problem. The most commonly adopted approach is the Arm’s Length Principle. All OECD countries use this principle, as well as non-OECD countries such as Argentina, China, India, Russia, Singapore and South Africa.

According to the Arm’s Length Principle, the conditions of cross-border transactions between different parts of a multinational enterprise should not differ from those which would be agreed between independent firms, i.e. they should not be distorted by the control relationship that exists between them (Box 6). This principle aims at achieving a dual objective: protecting a country’s tax base against artificial shifting of profits abroad by multinational enterprises, while at the same time limiting the risks of disputes and of economic double taxation that can arise if two countries take differing views as to what the “fair” price of a transaction should be. Under the Arm’s Length Principle, the conditions of commercial or financial transactions between different parts of a multinational enterprise should not differ from those which would be made between independent enterprises in comparable circumstances. In effect, economic double taxation can arise if the same amount of profit is being taxed in two different jurisdictions which take differing views about how to determine “fair” prices.

While the Arm’s Length Principle is simple, its implementation can be complex. Governments need a solid legislative framework and tax administrations to develop the expertise and build the resources to enforce transfer pricing legislation. This can only be done over time, as many OECD countries have experienced and continue to do. This means that risk assessment techniques are needed to focus the enforcement of transfer pricing rules to the riskier areas of cross-border trade.

Box 6: Legal framework to combat transfer pricing abuse: the Arm’s Length Principle

Governments need to ensure that the taxable profits of multinational enterprises (MNEs) are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. For taxpayers, it is essential to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of the arm’s length remuneration for their cross-border transactions with associated enterprises.

The rules to achieve these goals are found in country domestic transfer pricing legislation, in applicable double taxation treaties, and in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD, 2009c). These rules generally embody the Arm’s Length Principle which is endorsed in the OECD and UN Model Tax Conventions. According to this principle, the pricing and other conditions of cross-border transactions between associated enterprises should not differ from those that would be made between independent enterprises in comparable circumstances. It is worth noting that developing countries use a similar principle for customs valuation purposes.

It is inherent to the functioning of multinational enterprises that affiliated enterprises transact with each other. Transfer pricing, i.e. the determination of a price for transactions between associated enterprises, is normal and legitimate business practice. Transfer pricing becomes a problem when non-Arm’s Length terms are used for transactions, i.e. if a company’s transfer pricing deviates from what would be agreed in open market commercial terms, and the distribution of profit between affiliated enterprises becomes distorted. This is a particular problem when multinational enterprises misuse transfer pricing to deliberately shift profit towards low tax countries irrespective of where the economic activity that generates such profits actually takes place.

Examples of possible misuse of transfer pricing that developing countries need to monitor are the possible overvaluation of service or royalty fees charged by a foreign head office or group service companies, and the possible undervaluation of the price of goods sold to foreign affiliates. It must be stressed that tax avoidance by transfer pricing should be distinguished from illegal acts such as not recording commercial transactions or falsifying invoices.

Source: OECD Centre for Tax Policy Administration.

In certain circumstances, unitary taxes, also known as ‘global formula apportionment’, have been suggested as an alternative method to the Arm’s Length Principle for the taxation of multinational enterprises (Mold, 2004). In the 1980s a number of states in the US used such a system to tax multinational activity within their jurisdictions (Vernon, 1998). This approach apportions the global income of a multinational enterprise among its various units on the basis of the relative levels of their business activity, as measured by employment, sales, or assets. Proponents’ arguments are its administrative simplicity, transparency and the fact that it would make transfer pricing activities obsolete. Companies might arguably also benefit from such an approach, as it could simplify internal accounting practices and thereby reduce their own administrative costs.

The approach is not without problems, however. Difficulties arise in determining the amount of a multinational enterprise’s profits to be allocated in this way and the appropriate apportionment formula. These difficulties relate both to reaching any international agreement on the implementation of the apportionment formula and to obtaining and verifying the foreign‑based information any one jurisdiction would need to be able to use the approach effectively. Critics also point to issues of arbitrariness, and the risk that it may encourage non-transparent negotiations between multinational enterprises and tax authorities, thereby engendering corruption.

So which way forward for African countries? The consensus is that fighting transfer pricing abuse requires countries to develop specific legislative measures that are adapted to their legal system and economic context, and to build the administrative expertise needed to enforce them. African governments must carefully consider how much resource to devote to transfer pricing. With the administrative capacity constraints and considerable amounts of tax revenue at stake, a pragmatic approach is needed, adapted to the administrative and institutional means available to governments.

International organisations, including the OECD and the International Monetary Fund, have started offering numerous programmes to support African tax administrators in tackling transfer pricing. Some observers actually worry that there are too many overlapping conferences of that kind to attend, as international organisations compete for attention in this strategic policy area (Reisen, 2010). To be effective, policy advice must be well targeted, and go beyond principles to inform decisions at implementation level. This challenge may be addressed by the recently created Task Force on Tax and Development (see Box 12). A crucial complement to policy advice consists of African tax administrations learning from each other and their peers in other regions of the world. African tax administrations can leverage the experience of other countries that have wrestled with this problem, such as Brazil, China, India and South Africa.

Dealing with extractive industries

African policy makers often have the misconception that any attempt they make to substantially tax extractive industries will jeopardise the activity or discourage further investment (African Development Report, 2007). Experts reckon, however, that most natural resources can be taxed, within the bounds of reason, without scaring away investors. Multinational enterprises do not rank tax considerations very high among the concerns they cite as influencing their investment decisions in Africa (Keen and Mansour, id.)

The extractive industries in Africa can contribute more to sustainable development than they are currently doing. Countries should develop their resources, while meeting international environmental, social, and governance standards, and use the tax revenue from these industries transparently and effectively. Extractive concessions have to be analysed on a case-by-case basis, however, to evaluate if they are paying the right level of tax to their host country.

Some extreme cases were reported by the IMF in 2009. And where multinational firms fail to abide by minimal corporate governance standards in terms of tax contributions, governments should consider renegotiating concessions. Multinational enterprises may threaten to leave but they are unlikely to actually abandon the exploitation of mines because of a reasonable rise in taxes or royalties. Renegotiation of some contracts is warranted under the notion of odious debt.

African states are entitled to receive a fair deal for the exploitation of their natural resources. Botswana’s management of its diamond industry stands as a good example. Negotiations were important to ensure a fair deal for the country. The government renegotiated when circumstances changed and diamond companies became increasingly profitable.

Increased interest in Africa’s minerals from Chinese corporations and other new partners is an opportunity for governments to reap the fiscal rewards of competitive bidding. African states must use this opportunity to generate higher public resources. The rise of commodity prices poses many challenges to African countries and their populations; it is all the more important that the commodity boom be harnessed to boost government revenues. The increased public resources from taxing extractive activities should be used to diversify the economy and improve tax administration rather than for rewarding other taxpayers for political reasons.

The Extractive Industries Transparency Initiative (EITI) is unique in its aim to increase the transparency of transactions between companies and government entities, and of the use of revenues by the governments concerned (Box 7). In 2009, Liberia became the first country to comply with EITI.

Box 7: African Development Bank and extractive industries

Through the Extractive Industries Transparency Initiative (EITI), the AfDB works to improve revenue governance in the management of natural resources, especially extractive industries. By supporting the initiative, the Bank seeks to promote fair, transparent, and efficient use of resource revenues to avoid the “resource curse” and a return to conflict over resources. Its support is directed at two main components: i) the governance of extractive industries; and ii) the implementation of EITI in several countries. In addition, the Bank provides ad hoc policy development support to improve the governance framework for natural resources in individual African countries.

As an observer member of the EITI Board, the Bank attends meetings to keep track of progress and better coordinate with other institutions and stakeholders involved in the provision of technical assistance to African countries. The AfDB and the World Bank are developing a new capacity building initiative which aims to improve governance along the extractive industries value chain. The launch of this “EI Governance Initiative” is expected to take place in the first half of 2010 under the sponsorship of the AfDB and the World Bank.