Reducing fiscal inequality

Fiscal policies may affect the distribution of income in favour of, or against, the poor. In developing countries with low per capita income, weak administration, and social attitudes not always conducive to tax compliance, the urgent task is to improve tax collection. This proves to be difficult where the tax system is unnecessarily complex and cumbersome or relatively inelastic with respect to changes in income.

Central government taxes on personal income and household expenditure affect the distribution of disposable incomes. A tax system can redistribute personal income in an absolute sense by taking absolutely larger amounts from the better-off than from the poorer members of the population, provided the benefits arising from government spending of tax revenue are not distributed according to the amount paid in taxes.

The equity characteristics of current tax systems can be improved by incorporating moderate progressivity in both income and commodity taxes and by simplifying tax instruments to free administrative resources for collection, auditing and enforcement. The progressivity of the tax system can be enhanced by exempting the income and essential purchases of the poor from the tax net, by eliminating most of the income tax deductions and allowances that primarily benefit the rich, and by subjecting luxury purchases to higher rates of taxation. The revenue loss resulting from high exemptions in the personal income tax can largely be offset by eliminating most allowances. Improving the resource allocation aspects of a tax can also improve its equity aspects. For example, eliminating taxes on production inputs ensures that nominally exempt basic goods are not inadvertently taxed. In most developing countries it is not always certain that the poor derive as much benefit as the rich from public expenditure, but this is a problem to be tackled from the expenditure side of the government budget.

Many developing countries, particularly the least developed countries (LDCs), generate the bulk of domestic revenue through taxes. International trade (import tariffs and export taxes on agricultural commodities) account for an important share of tax revenue (for example, over 75% in The Gambia and in Uganda). This dependence often renders their budgets highly vulnerable to fluctuations in international trade and commodity prices, with consequent instability of revenue generation. Moreover, structural adjustment programmes and stabilization policies usually include the lowering of tariffs and phasing out of export taxes, often resulting in a significant loss of revenue as usually there are no feasible immediate alternatives to taxes an international trade.

To counter this decline in revenues from taxes on international trade, many countries have carried out reforms of the tax structure involving both direct and indirect taxes and have enhanced, in particular, revenues from direct taxes on income and wealth, both personal and corporate. Emphasis has been on moving away from production taxes to consumption taxes which are considered to be less distortional.

Many of the poorer countries have direct taxation concentrating on the formal sector. In general, these taxes are regressive, and accompanied by greater evasion of the more progressive tax by higher income groups. In most developing countries, it is not always certain that the poor derive as much benefit as the rich from public expenditure, but this is a problem to be tackled from the expenditure side of the government budget.

From an equity point of view, progressive direct taxes are preferred over indirect taxes; but from the point of view of increasing savings, it is not clear which type of tax is to be preferred. Tax reform, particularly through reducing tax avoidance and tax evasion by closing loopholes and simplifying procedures, can raise extra resources for the social sectors.

From an equity point of view, progressive direct taxes, are preferred over indirect taxes but from the point of view of increasing savings, it is not clear which type of tax is to be preferred. Many the poorer countries have direct taxation concentrating on the formal sector. In general, these taxes are regressive, and accompanied by greater evasion of the more progressive tax by higher income groups. The incidence of indirect taxes is also regressive at least as between different income groups - for instance between the poorest households in the lower-income brackets and those in the higher-income brackets. Tax reform can raise extra resources for the social sectors, particularly through reducing tax avoidance and tax evasion by closing loopholes and simplifying procedures. According to the UNDP Human Development Report, 1991, Ghana and Jamaica, for instance, have raised their tax revenue considerably through improved tax collection. In some cases, countries have reported introducing special taxes to finance social expenditure.

In some Asian developing countries, for example the Republic of Korea, Sri Lanka, Bangladesh, Nepal and Pakistan, governments have made considerable improvements in tax collection efforts. According to the UNDP Human Development Report, 1991, Ghana and Jamaica, for instance, raised their tax revenue considerably through improved tax collection. In some cases, countries reported introducing special taxes to finance social expenditure.