Characteristics of a Good Taxation System for Developing Countries
In developing countries where market forces are increasingly important in allocating resources, the design of the tax system should be as neutral as possible so as to minimize interference in the allocation process. Different taxes and their necessary characteristics can be discussed as under:
Personal Income Tax
This tax has yielded relatively little revenue in most of the developing countries and the number of individuals subject to this tax (especially at the highest marginal rate) is small. Countries frequently attach great importance to maintaining some degree of nominal progressivity in this tax by applying many rate brackets, and they are reluctant to adopt reforms that will reduce the number of these brackets. Effective rate progressivity could be improved by reducing the degree of nominal rate progressivity and the number of brackets and reducing exemptions and deductions. Indeed, any reasonable equity objective would require no more than a few nominal rate brackets in the personal income tax structure.
Corporate Income Tax
Developing countries are more prone to having multiple rates along sectoral lines (including the complete exemption from tax of certain sectors, especially the parastatal sector) than industrial countries, possibly as a legacy of past economic regimes that emphasized the state’s role in resource allocation. Allowable depreciation of physical assets for tax purposes is an important structural element in determining the cost of capital and the profitability of investment. Rectifying these shortcomings should also receive a high priority in tax policy deliberations in these countries.
Value-Added Tax, Excises, and Import Tariffs
While VAT has been adopted in most developing countries, it frequently suffers from being incomplete in one aspect or another. Many important sectors, most notably services and the wholesale and retail sector, are left out of the VAT net, or the credit mechanism is excessively restrictive (that is, there are denials or delays in providing proper credits for VAT on inputs), especially when it comes to capital goods. As these features allow a substantial degree of cascading (increasing the tax burden for the final user), they reduce the benefits from introducing the VAT in the first place. Rectifying such limitations in the VAT design and administration should be given priority in developing countries.
The most notable shortcoming of the excise systems found in many developing countries is their inappropriately broad coverage of products—often for revenue reasons. A good excise system is invariably one that generates revenue (as a by-product) from a narrow base and with relatively low administrative costs. Reducing import tariffs as part of an overall program of trade liberalization is a major policy challenge currently facing many developing countries.
Tax incentives can be justified if they address some form of market failure, most notably those involving externalities (economic consequences beyond the specific beneficiary of the tax incentive). For example, incentives targeted to promote high-technology industries that promise to confer significant positive externalities on the rest of the economy are usually legitimate. By far, the most compelling case for granting targeted incentives is for meeting regional development needs of these countries. Nevertheless, not all incentives are equally suited for achieving such objectives and some are less cost-effective than others. Unfortunately, the most prevalent forms of incentives found in developing countries tend to be the least meritorious.